HSBC Finance Corp 10-Q

14th Nov 2007 08:39

HSBC Holdings PLC14 November 2007 -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------ FORM 10-Q ------------ (Mark One)(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007 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, 60070 ILLINOIS (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 (X) 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-accelerated filer (X) Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). Yes ( ) No (X) As of November 8, 2007, there were 57 shares of the registrant's commonstock outstanding, 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 (Loss)....................................... 3 Balance Sheet.................................................... 4 Statement of Changes in Shareholders' Equity..................... 5 Statement of Cash Flows.......................................... 6 Notes to Consolidated Financial Statements....................... 7 Management's Discussion and Analysis of Financial Condition andItem 2. Results of Operations Forward-Looking Statements....................................... 29 Executive Overview............................................... 29 Basis of Reporting............................................... 37 Receivables Review............................................... 44 Results of Operations............................................ 47 Segment Results - IFRS Management Basis.......................... 56 Credit Quality................................................... 64 Liquidity and Capital Resources.................................. 73 Risk Management.................................................. 77 Reconciliations to GAAP Financial Measures....................... 80Item 4. Controls and Procedures.......................................... 81 PART II. OTHER INFORMATION----------------------------------------------------------------------------------- Item 1. Legal Proceedings................................................ 81Item 6. Exhibits......................................................... 83Signature ................................................................. 84 2 PART I. FINANCIAL INFORMATION-------------------------------------------------------------------------------- ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME (LOSS) THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------- ----------------- 2007 2006 2007 2006--------------------------------------------------------------------------------------- (IN MILLIONS)Finance and other interest income................ $ 4,715 $4,535 $14,112 $12,933Interest expense: HSBC affiliates................................ 223 283 674 609 Non-affiliates................................. 1,809 1,650 5,457 4,709 ------- ------ ------- -------NET INTEREST INCOME.............................. 2,683 2,602 7,981 7,615Provision for credit losses...................... 3,202 1,384 6,849 3,498 ------- ------ ------- -------NET INTEREST INCOME (LOSS) AFTER PROVISION FOR CREDIT LOSSES.................................. (519) 1,218 1,132 4,117 ------- ------ ------- -------Other revenues: Securitization related revenue................. 15 24 58 146 Insurance revenue.............................. 244 280 667 750 Investment income.............................. 34 31 92 99 Derivative (expense) income.................... (4) 68 (50) 118 Gain on debt designated at fair value and related derivatives......................... 519 - 533 - Fee income..................................... 660 542 1,862 1,353 Enhancement services revenue................... 167 129 465 382 Taxpayer financial services revenue............ (27) 4 216 258 Gain on receivable sales to HSBC affiliates.... 94 101 298 283 Servicing and other fees from HSBC affiliates.. 133 121 398 355 Other (expense) income......................... (17) 34 (65) 186 ------- ------ ------- -------TOTAL OTHER REVENUES............................. 1,818 1,334 4,474 3,930 ------- ------ ------- -------Costs and expenses: Salaries and employee benefits................. 582 571 1,778 1,716 Sales incentives............................... 54 94 184 272 Occupancy and equipment expenses............... 77 78 240 240 Other marketing expenses....................... 162 197 602 546 Other servicing and administrative expenses.... 319 287 824 762 Support services from HSBC affiliates.......... 300 261 884 783 Amortization of intangibles.................... 63 63 189 206 Policyholders' benefits........................ 142 123 356 348 Goodwill impairment charge..................... 881 - 881 - ------- ------ ------- -------TOTAL COSTS AND EXPENSES......................... 2,580 1,674 5,938 4,873 ------- ------ ------- -------Income (loss) before income tax expense.......... (1,281) 878 (332) 3,174Income tax expense (benefit)..................... (179) 327 166 1,167 ------- ------ ------- -------NET INCOME (LOSS)................................ $(1,102) $ 551 $ (498) $ 2,007 ======= ====== ======= ======= The accompanying notes are an integral part of the consolidated financialstatements. 3 HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET SEPTEMBER 30, DECEMBER 31, 2007 2006---------------------------------------------------------------------------------------- (IN MILLIONS, EXCEPT SHARE DATA)ASSETSCash...................................................... $ 467 $ 871Interest bearing deposits with banks...................... 511 424Securities purchased under agreements to resell........... 1,481 171Securities................................................ 3,190 4,695Receivables, net.......................................... 151,055 157,386Intangible assets, net.................................... 2,029 2,218Goodwill.................................................. 6,036 7,010Properties and equipment, net............................. 455 426Real estate owned......................................... 977 670Derivative financial assets............................... 502 298Other assets.............................................. 6,034 5,049 -------- --------TOTAL ASSETS.............................................. $172,737 $179,218 ======== ========LIABILITIESDebt: Commercial paper, bank and other borrowings............. $ 9,477 $ 11,055 Due to affiliates....................................... 14,602 15,172 Long term debt (with original maturities over one year, including $32.9 billion at September 30, 2007 and $0 at December 31, 2006 carried at fair value).......... 125,430 127,590 -------- --------Total debt................................................ 149,509 153,817 -------- --------Insurance policy and claim reserves....................... 1,004 1,319Derivative related liabilities............................ 39 6Liability for pension benefits............................ 370 355Other liabilities......................................... 3,503 3,631 -------- -------- TOTAL LIABILITIES....................................... 154,425 159,128SHAREHOLDERS' 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, 56 shares issued................................... - - Additional paid-in capital........................... 17,470 17,279 Retained earnings.................................... 115 1,877 Accumulated other comprehensive income............... 152 359 -------- --------TOTAL COMMON SHAREHOLDER'S EQUITY......................... 17,737 19,515 -------- --------TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY................ $172,737 $179,218 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 4 HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 2007 2006--------------------------------------------------------------------------------- (IN MILLIONS)PREFERRED STOCK Balance at beginning and end of period...................... $ 575 $ 575 ======= =======COMMON SHAREHOLDER'S EQUITY ADDITIONAL PAID-IN CAPITAL Balance at beginning of period........................... $17,279 $17,145 Capital contribution from parent company................. 200 - Employee benefit plans, including transfers and other.... (9) (28) ------- ------- Balance at end of period................................. $17,470 $17,117 ------- ------- RETAINED EARNINGS Balance at beginning of period........................... $ 1,877 $ 1,280 Adjustment to initially apply the fair value method of accounting under FASB Statement No. 159, net of tax.... (542) - Net income (loss)........................................ (498) 2,007 Cash dividend equivalents on HSBC's Restricted Share Plan................................................... (5) - Dividends: Preferred stock........................................ (27) (27) Common stock........................................... (690) (616) ------- ------- Balance at end of period................................. $ 115 $ 2,644 ------- ------- ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) Balance at beginning of period........................... $ 359 $ 479 Net change in unrealized gains (losses), net of tax, on: Derivatives classified as cash flow hedges............. (293) (238) Securities available for sale and interest-only strip receivables......................................... (2) 26 Foreign currency translation adjustments................. 88 150 ------- ------- Other comprehensive income (loss), net of tax............ (207) (62) ------- ------- Balance at end of period................................. $ 152 $ 417 ------- -------TOTAL COMMON SHAREHOLDER'S EQUITY............................. $17,737 $20,178 ------- -------COMPREHENSIVE INCOME(LOSS) Net income (loss)........................................... $ (498) $ 2,007 Other comprehensive income (loss)........................... (207) (62) ------- -------COMPREHENSIVE INCOME(LOSS).................................... $ (705) $ 1,945 ======= ======= The accompanying notes are an integral part of the consolidated financialstatements. 5 HSBC Finance Corporation-------------------------------------------------------------------------------- STATEMENT OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2007 2006------------------------------------------------------------------------------------ (IN MILLIONS)CASH FLOWS FROM OPERATING ACTIVITIESNet income (loss).............................................. $ (498) $ 2,007Adjustments to reconcile net income to net cash provided by (used in) operating activities: Gain on receivable sales to HSBC affiliates.................. (298) (283) Loss on real estate secured loan sales to third parties...... 20 - Provision for credit losses.................................. 6,849 3,498 Insurance policy and claim reserves.......................... (58) (168) Depreciation and amortization................................ 256 295 Change in mark-to-market on debt designated at fair value and related derivatives....................................... (776) - Gain on sale of MasterCard Class B shares.................... (115) - Mortage Services goodwill impairment charge.................. 881 - Net change in other assets................................... (396) 26 Net change in other liabilities.............................. (275) 161 Net change in loans held for sale............................ 1,409 751 Net change in debt designated at fair value and derivative related assets and liabilities............................ 2,065 64 Excess tax benefits from share-based compensation arrangements.............................................. (8) (17) Other, net................................................... 803 283 -------- --------Net cash provided by operating activities...................... 9,859 6,617 -------- --------CASH FLOWS FROM INVESTING ACTIVITIESSecurities: Purchased.................................................... (892) (1,587) Matured...................................................... 699 1,039 Sold......................................................... 95 136Net change in short-term securities available for sale......... 1,220 (323)Net change in securities purchased under agreements to resell.. (1,310) 77Net change in interest bearing deposits with banks............. (187) 16Receivables: Originations, net of collections............................. (3,837) (20,537) Purchases and related premiums............................... (210) (702)Cash received in portfolio sales to third parties.............. 2,147 -Cash received in sale of MasterCard Class B shares............. 17 -Cash received in sale of U.K. credit card business............. - 90Properties and equipment: Purchases.................................................... (99) (68) Sales........................................................ 2 19 -------- --------Net cash provided by (used in) investing activities............ (2,355) (21,840) -------- --------CASH FLOWS FROM FINANCING ACTIVITIESDebt: Net change in short-term debt and deposits................... (1,652) (255) Net change in due to affiliates.............................. (713) (1,113) Long term debt issued........................................ 16,265 30,655 Long term debt retired....................................... (21,235) (13,853)Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts.................... - (206)Insurance: Policyholders' benefits paid................................. (221) (206) Cash received from policyholders............................. 165 295Capital contribution from parent............................... 200 -Shareholders' dividends........................................ (717) (643)Excess tax benefits from share-based compensation arrangements................................................. 8 17 -------- --------Net cash provided by (used in) financing activities............ (7,900) 14,691 -------- --------Effect of exchange rate changes on cash........................ (8) 12 -------- --------Net change in cash............................................. (404) (520)Cash at beginning of period.................................... 871 903 -------- --------CASH AT END OF PERIOD.......................................... $ 467 $ 383 ======== ======== 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 and subsidiaries is an indirect wholly owned subsidiaryof HSBC North America Holdings Inc. ("HSBC North America"), which is an indirectwholly owned subsidiary of HSBC Holdings plc ("HSBC"). The accompanyingunaudited interim consolidated financial statements of HSBC Finance Corporationand its subsidiaries have been prepared in accordance with accounting principlesgenerally accepted in the United States of America ("U.S. GAAP") for interimfinancial information and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the information andfootnotes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all normal and recurringadjustments considered necessary for a fair presentation of financial position,results of operations and cash flows for the interim periods have been made.HSBC Finance Corporation may also be referred to in this Form 10-Q as "we," "us"or "our." These unaudited interim consolidated financial statements should beread in conjunction with our Annual Report on Form 10-K for the year endedDecember 31, 2006 (the "2006 Form 10-K"). Certain reclassifications have beenmade to prior period amounts to 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. DISPOSAL ACTIVITIES-------------------------------------------------------------------------------- Beginning in 2006 and continuing in 2007, we have completed several specificstrategic reviews to ensure that our operations and product offerings continueto provide our customers with the most value-added products and maximize riskadjusted returns to HSBC. When coupled with the unprecedented developments inthe mortgage industry in recent months, we have taken specific actions which webelieve are in the best interests of our stakeholders and will best position usfor long-term success. In the first quarter of 2007, we entered into a non-binding agreement to sellthe capital stock of our U.K. insurance operations ("U.K. Insurance Operations")to a third party for cash. The sales price is determined, in part, based on theactual net book value of the assets sold at the time the sale is closed. Theagreement also provides for the purchaser to distribute insurance productsthrough our U.K. branch network for which we will receive commission revenue.The sale was completed November 1, 2007. In the first quarter of 2007, we beganto report the U.K. Insurance Operations as "Held for Sale." At September 30,2007, we continue to classify the U.K. Insurance Operations as "Held for Sale"and have combined assets of $442 million and liabilities of $217 million relatedto the U.K. Insurance Operations separately in our consolidated balance sheetwithin other assets and other liabilities. Our U.K. Insurance Operations arereported in the International Segment. As our carrying value for the U.K.Insurance Operations, including allocated goodwill, was more than the estimatedsales price, we recorded an adjustment of $31 million during the three monthsended March 31, 2007 as a component of total costs and expenses to record ourinvestment in these operations at the lower of cost or market. No additionaladjustment was determined to be necessary during the three months ended June 30,2007 or September 30, 2007. At September 30, 2007, the assets consistedprimarily of investments of $462 million, unearned credit insurance premiums andclaim reserves on consumer receivables of $(113) million and goodwill of $73million. The liabilities consist primarily of insurance reserves which totaled$210 million at September 30, 2007. The purchaser will assume all theliabilities of the U.K. Insurance Operations as a result of this transaction,subject to certain indemnification rights that will continue to reside with us.Due to our continuing involvement as discussed above, this transaction did notmeet the discontinued operation reporting requirements contained in SFAS No.144, "Accounting for the Impairment and Disposal of Long-Lived Assets." Our Mortgage Services business, which is part of our Consumer Segment, hashistorically purchased non-conforming first and second lien real estate securedloans from a network of unaffiliated third party lenders (i.e. correspondents)based on our underwriting standards. Our Mortgage Services business has includedthe operations of Decision One Mortgage Company ("Decision One") which hashistorically originated mortgage loans sourced by independent mortgage brokersand sold such loans to secondary market purchasers, including Mortgage Services.Earlier in 2007, we 7 HSBC Finance Corporation-------------------------------------------------------------------------------- decided to discontinue the correspondent channel acquisitions of our MortgageServices business and to limit Decision One's activities to the origination ofloans solely for resale to the secondary market operations of our affiliates. Asa result of the decision to discontinue correspondent channel acquisitions,during the nine months ended September 30, 2007, we recorded $5 million (pre-tax) of severance costs, which are included as a component of Salaries andemployee benefits in the consolidated statement of income (loss). Theseseverance costs have been fully paid to the affected employees and no furthercosts resulting from this decision are anticipated. In recent months, the unprecedented developments in the mortgage lendingindustry have resulted in a marked reduction in the secondary market demand forsubprime loans. Management has concluded that a recovery of a secondary marketfor subprime loans is uncertain and at a minimum cannot be expected to stabilizein the near term. As a result of the continuing deterioration in the subprimemortgage lending industry, in September 2007, we announced that our Decision Oneoperations would cease. The impact of the decision to close our Decision Oneoperations, when coupled with the previous decisions related to discontinuingcorrespondent channel acquisitions resulted in the impairment of the goodwillallocated to the Mortgage Services business. As a result, we have recorded agoodwill impairment charge of $881 million in the third quarter of 2007 whichrepresents all of the goodwill previously allocated to the Mortgage Servicesbusiness. We are currently evaluating the ongoing usefulness of the fixed assetsassociated with our Decision One operations. In the event we are unable to usethese assets elsewhere in our operations, there could be as much as a $16million non-cash charge relating to these fixed assets in the fourth quarter of2007. Additionally, as a result of the decision to terminate the Decision Oneoperations, we currently anticipate we will incur closure costs of up to $86million (pre-tax) related to one-time termination and other employee benefits,lease termination and associated costs and other miscellaneous expenses. Of thisamount, $10 million (pre-tax) of one-time termination and employee benefitcosts, which are included as a component of Salaries and employee benefits inthe consolidated statement of income (loss), was recorded in the third quarterof 2007 and will be paid to employees in future periods. While our entireMortgage Services business is currently operating in a run-off mode, we have notreported this business as a discontinued operation consistent with the reportingguidance contained in EITF Topic D-104. Additionally in the third quarter of 2007, we decided to close our loanunderwriting, processing and collections center in Carmel, Indiana (the "CarmelFacility") to optimize our facility and staffing capacity given the overallreductions in business volumes. The Carmel Facility provided loan underwriting,processing and collection activities for the operations of our Consumer Lendingand Mortgage Services business, both of which are included in our ConsumerSegment. As a result of the decision to close the Carmel Facility, we recorded$5 million (pre-tax) of severance costs in the three months ended September 30,2007, which are included as a component of Salaries and employee benefits in theconsolidated statement of income (loss), and will be paid to employees in futureperiods. 8 HSBC Finance Corporation-------------------------------------------------------------------------------- 3. SECURITIES-------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRSEPTEMBER 30, 2007 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------- (IN MILLIONS)Corporate debt securities...................... $2,220 $7 $(43) $2,184Money market funds............................. 200 - - 200U.S. government sponsored enterprises(1)....... 257 1 (2) 256U.S. government and Federal agency debt securities................................... 37 - - 37Non-government mortgage backed securities...... 217 - (1) 216Other.......................................... 267 1 (3) 265 ------ -- ---- ------Subtotal....................................... 3,198 9 (49) 3,158Accrued investment income...................... 32 - - 32 ------ -- ---- ------Securities..................................... $3,230 $9 $(49) $3,190 ====== == ==== ====== GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRDECEMBER 31, 2006 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------- (IN MILLIONS)Corporate debt securities...................... $2,530 $11 $(40) $2,501Money market funds............................. 1,051 - - 1,051U.S. government sponsored enterprises(1)....... 369 1 (3) 367U.S. government and Federal agency debt securities................................... 43 - (1) 42Non-government mortgage backed securities...... 271 - - 271Other.......................................... 428 - (3) 425 ------ --- ---- ------Subtotal....................................... 4,692 12 (47) 4,657Accrued investment income...................... 38 - - 38 ------ --- ---- ------Securities..................................... $4,730 $12 $(47) $4,695 ====== === ==== ====== -------- (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Money market funds included $854 million at December 31, 2006 which arerestricted for the sole purpose of paying down certain secured financings at theestablished payment date. There were no restricted money market funds atSeptember 30, 2007. The decrease in securities available for sale at September 30, 2007 is due tothe reclassification to other assets of approximately $462 million of securitiesrelated to the U.K. Insurance Operations which at September 30, 2007 areclassified as "Held for Sale," and included within other assets, as well as theuse of $854 million in money market funds to pay down secured financings duringthe nine months ended September 30, 2007. A summary of gross 9 HSBC Finance Corporation-------------------------------------------------------------------------------- unrealized losses and related fair values as of September 30, 2007 and December31, 2006, classified as to the length of time the losses have existed follows: LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OFSEPTEMBER 30, 2007 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS---------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Corporate debt securities.... 185 $(15) $552 413 $(28) $945U.S. government sponsored enterprises................ 28 - 68 32 (2) 67U.S. government and Federal agency debt securities..... 5 -(1) 21 8 -(1) 11Non-government mortgage backed securities.......... 17 (1) 96 6 - 5Other........................ 35 (2) 94 35 (1) 102 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, 2006 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS---------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Corporate debt securities.... 133 $(6) $465 511 $(34) $1,178U.S. government sponsored enterprises................ 30 -(1) 101 43 (3) 149U.S. government and Federal agency debt securities..... 8 -(1) 21 20 (1) 16Non-government mortgage backed securities.......... 10 -(1) 60 9 - 7Other........................ 16 -(1) 57 52 (3) 173 -------- (1) Less than $500 thousand. The gross unrealized losses on our securities available for sale have remainedstable during the first nine months of 2007 as decreases in interest ratesduring the year were offset by the impact of wider credit spreads. Thecontractual terms of these securities do not permit the issuer to settle thesecurities at a price less than the par value of the investment. Sincesubstantially all of these securities are rated A- or better, and because wehave the ability and intent to hold these investments until maturity or a marketprice recovery, these securities are not considered other-than-temporarilyimpaired. 10 HSBC Finance Corporation-------------------------------------------------------------------------------- 4. RECEIVABLES-------------------------------------------------------------------------------- Receivables consisted of the following: SEPTEMBER 30, DECEMBER 31, 2007 2006---------------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured....................................... $ 91,162 $ 97,884Auto finance.............................................. 13,128 12,504Credit card............................................... 29,103 27,714Private label............................................. 2,768 2,509Personal non-credit card.................................. 21,289 21,367Commercial and other...................................... 148 181 -------- --------Total receivables......................................... 157,598 162,159HSBC acquisition purchase accounting fair value adjustments............................................. (64) (60)Accrued finance charges................................... 2,421 2,228Credit loss reserve for receivables....................... (8,634) (6,587)Unearned credit insurance premiums and claims reserves.... (296) (412)Interest-only strip receivables........................... 7 6Amounts due and deferred from receivable sales............ 23 51 -------- --------Total receivables, net.................................... $151,055 $157,386 ======== ======== 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. Loans held for sale to external parties by Decision One totaled $289 million atSeptember 30, 2007 and $1.7 billion at December 31, 2006. Our Consumer Lendingbusiness had loans held for sale totaling $8 million at September 30, 2007 and$32 million at December 31, 2006 relating to its subsidiary, Solstice CapitalGroup Inc. ("Solstice"). Additionally, our Canada business had loans held forsale at September 30, 2007 totaling $35 million. Loans held for sale areincluded in receivables and carried at the lower of cost or market. In November 2006, we acquired $2.5 billion of real estate secured receivablesfrom Champion Mortgage ("Champion") a division of KeyBank, N.A. and on December1, 2005 we acquired $5.3 billion of credit card receivables as part of ouracquisition of Metris Companies Inc. ("Metris"). The receivables acquired weresubject to the requirements of Statement of Position 03-3, "Accounting forCertain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3") to theextent there was evidence of deterioration of credit quality since originationand for which it was probable, at acquisition, that all contractually requiredpayments would not be collected and in the case of Metris, that the associatedline of credit had been closed. The carrying amount of Champion real estate secured receivables subject to therequirements of SOP 03-3 was $79 million at September 30, 2007 and $116 millionat December 31, 2006 and is included in the real estate secured receivables inthe table above. The outstanding contractual balance of these receivables was$101 million at September 30, 2007 and $143 million at December 31, 2006. AtSeptember 30, 2007 and December 31, 2006, no credit loss reserve for theportions of the acquired receivables subject to SOP 03-3 had been established asthere had been no decrease to the expected future cash flows since theacquisition. During the nine months ended September 30, 2007, there was areclassification to accretable yield from non-accretable difference representingan increase to the estimated cash flows to be collected on the underlyingChampion portfolio. The carrying amount of the Metris receivables which were subject to SOP 03-3 was$126 million as of September 30, 2007 and $223 million at December 31, 2006 andis included in the credit card receivables in the table above. The outstandingcontractual balance of these receivables was $189 million at September 30, 2007and $334 million at December 31, 2006. At September 30, 2007 and December 31,2006, no credit loss reserve for 11 HSBC Finance Corporation-------------------------------------------------------------------------------- the acquired receivables subject to SOP 03-3 had been established as there hadbeen no decrease to the expected future cash flows since the acquisition. Duringthe nine months ended September 30, 2007 and September 30, 2006 there werereclassifications to accretable yield from non-accretable differencerepresenting an increase to the estimated cash flows to be collected on theunderlying Metris portfolio. The following summarizes the accretable yield on Metris and Champion receivablesat September 30, 2007 and September 30, 2006: NINE MONTHS ENDED SEPTEMBER 30, 2007 2006-------------------------------------------------------------------------------- (IN MILLIONS)Accretable yield beginning of period.............................. $(76) $(122)Accretable yield amortized to interest income during the period... 39 86Reclassification from non-accretable difference................... (7) (35) ---- -----Accretable yield at end of period................................. $(44) $ (71) ==== ===== Real estate secured receivables are comprised of the following: SEPTEMBER 30, DECEMBER 31, 2007 2006---------------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured: Closed-end: First lien........................................... $73,158 $78,023 Second lien.......................................... 14,213 15,091 Revolving: First lien........................................... 473 556 Second lien.......................................... 3,318 4,214 ------- -------Total real estate secured receivables..................... $91,162 $97,884 ======= ======= We generally serve non-conforming and non-prime consumers. Such customers areindividuals who have limited credit histories, modest incomes, high debt-to-income ratios or have experienced credit problems caused by occasionaldelinquencies, prior charge-offs, bankruptcy or other credit related actions. Asa result, the majority of our secured receivables have a high loan-to-valueratio. Prior to our decision to cease operations, our Decision One mortgageoperation offered, among other products, interest-only loans largely for resale,which beginning in 2007 were sold solely to HSBC Bank USA to support thesecondary market activities of our affiliates. Interest-only loans historicallyoriginated by our Consumer Lending business or acquired by our correspondentchannel are no longer offered. Our Solstice subsidiary also offers interest-onlyloans for resale to third parties. Interest-only loans allow customers to paythe interest only portion of the monthly payment for a period of time whichresults in lower payments during the initial loan period. However, subsequentevents affecting a customer's financial position could affect the ability ofcustomers to repay the loan in the future when the principal payments arerequired. At September 2007, the outstanding balance of our interest-only loanswas $4.7 billion, or 3 percent of receivables. At December 31, 2006, theoutstanding balance of our interest-only loans was $6.7 billion, or 4 percent ofreceivables. Through the third quarter of 2007, we also offered adjustable rate mortgage("ARM") loans under which pricing adjusts on the receivable in line with marketmovements, in some cases, following an introductory fixed rate period. AtSeptember 30, 2007, we had approximately $20.3 billion in adjustable ratemortgage loans at our Consumer Lending and Mortgage Services businesses. AtDecember 31, 2006, we had approximately $29.8 billion in adjustable ratemortgage loans at our Consumer Lending and Mortgage Services businesses. Themajority of our adjustable rate mortgages were acquired from correspondentlenders of our Mortgage Services business. In the first quarter of 2007, wediscontinued correspondent channel acquisitions subject to fulfilling earliercommitments. Consequently, the percentage of adjustable rate real estate securedreceivables will decrease significantly over time. In the fourth quarter of 2007and throughout 2008, approximately $3.0 billion and $3.9 billion, respectively,of our 12 HSBC Finance Corporation-------------------------------------------------------------------------------- adjustable rate mortgage loans will experience their first interest rate resetbased on receivable levels outstanding at September 30, 2007. In addition, ouranalysis indicates that a significant portion of the second lien mortgages inour Mortgage Services portfolio at September 30, 2007 are subordinated to firstlien adjustable rate mortgages that will face a rate reset between now and 2009.As interest rates have risen over the last three years, many adjustable rateloans are expected to require a significantly higher monthly payment followingtheir first adjustment. A customer's financial situation at the time of theinterest rate reset could affect our customer's ability to repay the loan afterthe adjustment. As part of our risk mitigation efforts relating to the affected components ofthe Mortgage Services portfolio, in October 2006 we established a new programspecifically designed to meet the needs of select customers with ARMs. We areproactively writing and calling customers who have adjustable rate mortgageloans nearing the first reset that we expect will be the most impacted by a rateadjustment. Through a variety of means, we are assessing their ability to makethe adjusted payment and, as appropriate and in accordance with definedpolicies, are modifying the loans in most instances by delaying the firstinterest rate adjustment for twelve months, allowing time for the customer toseek alternative financing or improve their individual situation. Since theinception of this program we have made more than 31,000 outbound contacts andmodified more than 8,000 loans with an aggregate balance of $1.2 billion. Theseloans are not reflected in the interest rate reset volumes discussed in thepreceding paragraph. Unless these customers who have benefited from a loanmodification are able to obtain other financing, these loans will also besubject to an interest rate reset at the end of the modification period. During 2006 and 2005 we increased our portfolio of stated income loans. Statedincome loans are underwritten based on the loan applicant's representation ofannual income which is not verified by receipt of supporting documentation and,accordingly, carry a higher risk of default if the customer has not accuratelyreported their income. Prior to our decision to cease operations of DecisionOne, it offered stated income loans which, beginning in 2007, were sold solelyto HSBC Bank USA to support the secondary market activities of our affiliates.The outstanding balance of stated income loans in our real estate securedportfolio was $8.7 billion at September 30, 2007 and $11.8 billion at December31, 2006. On June 29, 2007, the Federal Financial Regulatory Agencies (the "Agencies")issued a final statement on subprime mortgage lending which reiterates many ofthe principles addressed in the existing guidance relating to risk managementpractices and consumer protection laws involving adjustable rate mortgageproducts and the underwriting process on stated income and interest-only loans.We will be fully compliant with this statement by December 31, 2007. The impactof this statement will be immaterial on our operations. Receivables serviced with limited recourse consisted of the following: SEPTEMBER 30, DECEMBER 31, 2007 2006---------------------------------------------------------------------------------------- (IN MILLIONS)Auto finance.............................................. $ 79 $271Credit card............................................... 500 500Personal non-credit card.................................. - 178 ---- ----Total..................................................... $579 $949 ==== ==== 13 HSBC Finance Corporation-------------------------------------------------------------------------------- 5. CREDIT LOSS RESERVES-------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: THREE MONTHS NINE MONTHS ENDED SEPTEMBER ENDED SEPTEMBER 30, 30, ----------------- ----------------- 2007 2006 2007 2006---------------------------------------------------------------------------------------- (IN MILLIONS)Credit loss reserves at beginning of period...... $ 7,157 $ 4,649 $ 6,587 $ 4,521Provision for credit losses...................... 3,202 1,384 6,849 3,498Charge-offs...................................... (1,948) (1,333) (5,468) (3,620)Recoveries....................................... 208 195 653 474Other, net....................................... 15 (10) 13 12 ------- ------- ------- -------Credit loss reserves at end of period............ $ 8,634 $ 4,885 $ 8,634 $ 4,885 ======= ======= ======= ======= Our provision for credit losses increased markedly during both periods. Furtheranalysis of credit quality and credit loss reserves and our credit loss reservemethodology are presented in Item 2, "Management's Discussion and Analysis ofFinancial Condition and Results of Operations" of this Form 10-Q under thecaptions "Executive Overview," "Results of Operations,"and "Credit Quality." 6. INTANGIBLE ASSETS-------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYING GROSS AMORTIZATION VALUE---------------------------------------------------------------------------------------- (IN MILLIONS)SEPTEMBER 30, 2007Purchased credit card relationships and related programs............................................ $1,736 $ 682 $1,054Retail services merchant relationships................ 270 243 27Other loan related relationships...................... 333 161 172Trade names........................................... 717 13 704Technology, customer lists and other contracts........ 282 210 72 ------ ------ ------Total................................................. $3,338 $1,309 $2,029 ====== ====== ======DECEMBER 31, 2006Purchased credit card relationships and related programs............................................ $1,736 $ 580 $1,156Retail services merchant relationships................ 270 203 67Other loan related relationships...................... 333 135 198Trade names........................................... 717 13 704Technology, customer lists and other contracts........ 282 189 93 ------ ------ ------Total................................................. $3,338 $1,120 $2,218 ====== ====== ====== 14 HSBC Finance Corporation-------------------------------------------------------------------------------- Estimated amortization expense associated with our intangible assets for each ofthe following years is as follows: YEAR ENDING DECEMBER 31,----------------------------------------------------------------------------------- (IN MILLIONS)2007................................................................ $2532008................................................................ 2112009................................................................ 1982010................................................................ 1692011................................................................ 169Thereafter.......................................................... 352 During the third quarter of 2007, we completed our annual impairment test ofintangible assets. As a result of our testing, we determined that the fair valueof each intangible asset exceeded its carrying value. Therefore, we haveconcluded that none of our intangible assets are impaired. 7. 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 at the dateof our acquisition by HSBC or our acquisition of Metris are adjusted againstgoodwill pursuant to Statement of Financial Accounting Standards No. 109,"Accounting for Income Taxes." Changes in the carrying amount of goodwill are as follows: 2007 2006--------------------------------------------------------------------------------- (IN MILLIONS)Balance at January 1,........................................... $7,010 $7,003Adjustment to Metris purchase price............................. - 25Goodwill allocated to U.K. Insurance Operations reclassified to "Held for Sale"............................................... (73) -Goodwill impairment related to the Mortgage Services business... (881) -Goodwill allocated to our European Operations sold to HBEU...... - (13)Change in estimate of the tax basis of assets and liabilities recorded in the HSBC acquisition.............................. (60) (8)Change in estimate of the tax basis of assets and liabilities recorded in the Metris acquisition............................ - (8)Impact of foreign exchange rates................................ 40 39 ------ ------Balance at September 30,........................................ $6,036 $7,038 ====== ====== During the third quarter of 2007, we completed our annual impairment test ofgoodwill. For purposes of this test, we assign the goodwill to our reportingunits (as defined in SFAS No. 142, "Goodwill and Other Intangible Assets"). Asdiscussed in Note 2, "Disposal Activities", in the third quarter of 2007 werecorded a goodwill impairment charge of $881 million which represents all ofthe goodwill allocated to our Mortgage Services business. With the exception ofour Mortgage Services business, the fair value of each of the reporting units towhich goodwill was assigned exceeded its carrying value including goodwill.Therefore, we have concluded that none of the remaining goodwill is impaired.Goodwill is reviewed for impairment in interim periods if the circumstancesindicate that the carrying amount assigned to a reporting unit may not berecoverable. 8. INCOME TAXES-------------------------------------------------------------------------------- Effective January 1, 2007, we adopted FASB Interpretation No. 48, "Accountingfor Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109"("FIN No. 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 15 HSBC Finance Corporation-------------------------------------------------------------------------------- return. FIN No. 48 also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure andtransition. The adoption of FIN 48 did not have a significant impact on ourfinancial results and did not result in a cumulative effect adjustment to theJanuary 1, 2007 balance of retained earnings. The adoption resulted in thereclassification of $65 million of deferred tax liability to current taxliability to account for uncertainty in the timing of tax benefits as well asthe reclassification of $141 million of deferred tax asset to current tax assetto account for highly certain pending adjustments in the timing of tax benefits.The total amount of unrecognized tax benefits was $273 million at January 1,2007 and $217 million at September 30, 2007. The state tax portion of theseamounts is reflected gross and not reduced by the federal tax effect. The totalamount of unrecognized tax benefits that, if recognized, would affect theeffective tax rate was $70 million at January 1, 2007 and $87 million atSeptember 30, 2007. We remain subject to Federal income tax examination for years 1998 and forwardand State income tax examinations for years 1996 and forward. The Company doesnot anticipate that any significant tax positions have a reasonable possibilityof being effectively settled within the next twelve months. It is our policy to recognize interest accrued related to unrecognized taxbenefits in costs and expenses as a component of Other servicing andadministrative expenses in the consolidated statement of income (loss). As ofJanuary 1, 2007, we had accrued $67 million for the payment of interestassociated with uncertain tax positions. During the nine months ended September30, 2007, we reduced our accrual for the payment of interest associated withuncertain tax positions by $2 million. Effective tax rates are analyzed as follows: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, --------------- --------------- 2007 2006 2007 2006 ----- ---- ----- -----------------------------------------------------------------------------------------------Statutory Federal income tax rate................. (35.0)% 35.0% (35.0)% 35.0%Increase (decrease) in rate resulting from: State and local taxes, net of Federal benefit... (.7) 1.7 2.2 1.7 Non-deductible goodwill......................... 21.9 - 84.7 - Tax on sales of leveraged leases................ - - 6.5 - Low income housing and other tax credits........ (1.2) (2.3) (14.4) (1.9) Effects of foreign operations................... .7 2.0 7.9 .8 Tax exempt income............................... (.3) (.2) (3.0) (.2) Other........................................... .7 1.0 1.3 1.4 ----- ---- ----- ----Effective tax rate................................ (13.9)% 37.2% 50.2% 36.8% ===== ==== ===== ==== The effective tax rate for the three and nine month periods ended September 30,2007 was significantly impacted by the non-tax deductible reduction forsubstantially all of the goodwill related to the Mortgage Services business.Additionally, the effective tax rate for the nine month period ended September30, 2007 was also impacted by the acceleration of tax from sales of leveragedleases. The percentage impact of the reconciling items is larger in the ninemonth period ended September 30, 2007 as a result of the significantly lowerpre-tax loss in the year-to-date period. In addition to the above items, theeffective tax rate differs from the statutory federal income tax rate primarilybecause of the effects of state and local income taxes and tax credits,including low income housing. 9. RELATED PARTY TRANSACTIONS-------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and itssubsidiaries. These transactions occur at prevailing market rates and terms andinclude funding arrangements, derivative execution, purchases and sales ofreceivables, servicing arrangements, information technology services, item andstatement processing services, 16 HSBC Finance Corporation-------------------------------------------------------------------------------- banking and other miscellaneous services. The following tables present relatedparty balances and the income and (expense) generated by related partytransactions: SEPTEMBER 30, DECEMBER 31, 2007 2006---------------------------------------------------------------------------------------- (IN MILLIONS)ASSETS, (LIABILITIES) AND EQUITY:Derivative financial assets (liability), net.............. $ 478 $ 234Affiliate preferred stock received in sale of U.K. credit card business(1)........................................ 305 294Other assets.............................................. 655 528Due to affiliates......................................... (14,602) (15,172)Other liabilities......................................... (318) (506)Premium on sale of European Operations in 2006 to an affiliate recorded as an increase to additional paid in capital................................................. - 13 -------- (1) Balance may fluctuate between periods due to foreign currency exchange rate impact. THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, ------------- ------------- 2007 2006 2007 2006------------------------------------------------------------------------------------- (IN MILLIONS)INCOME/(EXPENSE):Interest expense on borrowings from HSBC and subsidiaries........................................ $(223) $(283) $(674) $(609)Interest income on advances to HSBC affiliates........ 9 7 24 18HSBC Bank USA, National Association ("HSBC Bank USA"): Real estate secured servicing, sourcing, underwriting and pricing revenues................ 3 3 7 9 Gain on daily sale of domestic private label receivable originations.......................... 94 92 272 257 Gain on daily sale of credit card receivables....... 16 9 42 26 Loss on sale of real estate secured receivables..... (16) - (16) - Taxpayer financial services loan origination and other fees....................................... - - (19) (17) Domestic private label receivable servicing and related fees..................................... 101 99 300 292 Other servicing, processing, origination and support revenues......................................... 21 13 70 34Support services from HSBC affiliates................. (300) (261) (884) (783)HSBC Technology and Services (USA) Inc. ("HTSU"): Rental revenue...................................... 12 11 36 34 Administrative services revenue..................... 4 2 10 8 Servicing and other fees from other HSBC affiliates....................................... 4 4 11 12Stock based compensation expense with HSBC............ (25) (20) (85) (59) The notional value of derivative contracts outstanding with HSBC subsidiariestotaled $92.4 billion at September 30, 2007 and $82.8 billion at December 31,2006. When the fair value of our agreements with affiliate counterpartiesrequires the posting of collateral by the affiliate, it is provided in the formof cash and recorded on our balance sheet, consistent with third partyarrangements. The level of the fair value of our agreements with affiliatecounterparties above which collateral is required to be posted is $75 million.At September 30, 2007, the fair value of our agreements with affiliatecounterparties required the affiliate to provide cash collateral of $2.8 billionwhich is offset against the fair value amount recognized for derivativeinstruments that have been offset under the same master netting arrangement andrecorded in our balance sheet as a component of derivative related assets. AtDecember 31, 2006, the fair value of our agreements with affiliatecounterparties required the affiliate to provide cash collateral of $1.0 billionwhich is offset against the fair value amount recognized for derivativeinstruments that 17 HSBC Finance Corporation-------------------------------------------------------------------------------- have been offset under the same master netting arrangement and recorded in ourbalance sheet as a component of derivative related assets. We had extended a line of credit of $2 billion to HSBC USA Inc. which expired inJuly of 2006 and was not renewed. Annual commitment fees associated with thisline of credit were recorded in interest income and reflected as Interest incomeon advances to HSBC affiliates in the table above. We have extended a revolving line of credit to HTSU, which was increased to $.6billion on January 5, 2007. The balance outstanding under this line of creditwas $.6 billion at September 30, 2007 and $.5 billion at December 31, 2006 andis included in other assets. Interest income associated with this line of creditis recorded in interest income and reflected as Interest income on advances toHSBC affiliates in the table above. We have extended revolving lines of credit to subsidiaries of HSBC Bank USA foran aggregate total of $2.3 billion. There are no balances outstanding under anyof these lines of credit at either September 30, 2007 or December 31, 2006. Due to affiliates includes amounts owed to subsidiaries of HSBC (other thanpreferred stock). At September 30, 2007 and December 31, 2006, we had a commercial paper back stopcredit facility of $2.5 billion from HSBC supporting domestic issuances and arevolving credit facility of $5.7 billion from HSBC Bank plc ("HBEU") to fundour operations in the U.K. As of September 30, 2007, $3.9 billion wasoutstanding under the U.K. lines and no balances were outstanding on thedomestic lines. As of December 31, 2006, $4.3 billion was outstanding under theU.K. lines and no balances were outstanding on the domestic lines. Annualcommitment fee requirements to support availability of these lines are includedas a component of Interest expense on borrowings from HSBC and subsidiaries. In the nine months ended September 30, 2007, we sold approximately $646 millionof real estate secured receivables originated by our subsidiary, Decision One,to HSBC Bank USA. We recorded a pre-tax loss on these sales of $16 million inthe year-to-date period. In the fourth quarter of 2006 we sold approximately$669 million of real estate secured receivables originated by our subsidiary,Decision One, to HSBC Bank USA and recorded a pre-tax gain of $17 million on thesale. Each of these sales was effected as part of our then current strategy tooriginate loans through Decision One for sale and securitization through thesecondary mortgage market operations of our affiliates. Decision One has sinceceased origination operations. In the second quarter of 2007, we sold $2.2 billion of loans from the MortgageServices portfolio to third parties. HSBC Markets (USA) Inc., a related HSBCentity, assisted in the transaction by soliciting interest and placing the loanswith interested third parties. Fees paid for these services totaled $4 millionand were included as a component of the approximately $20 million loss realizedon the sale of this loan portfolio. In the third quarter of 2007, we sold a portion of our MasterCard Class B shareportfolio to third parties. HSBC Bank USA assisted with one of the transactionsby placing shares with interested third parties. Fees paid to HSBC Bank USArelated to this sale were $2 million and were included as a component of theapproximately $115 million net gain realized on the sale of these shares. On November 9, 2006, as part of our continuing evaluation of strategicalternatives with respect to our U.K. and European operations, we sold all ofthe capital stock of our operations in the Czech Republic, Hungary, and Slovakia(the "European Operations") to a wholly owned subsidiary of HBEU for anaggregate purchase price of approximately $46 million. Because the sale of thisbusiness was between affiliates under common control, the premium received inexcess of the book value of the stock transferred was recorded as an increase toadditional paid-in capital and was not reflected in earnings. The assetsconsisted primarily of $199 million of receivables and goodwill which totaledapproximately $13 million. The liabilities consisted primarily of debt whichtotaled $179 million. HBEU assumed all the liabilities of the EuropeanOperations as a result of this transaction. In December 2005, we sold our U.K. credit card business, including $2.5 billionof receivables, the associated cardholder relationships and the related retainedinterests in securitized credit card receivables to HBEU for an aggregatepurchase price of $3.0 billion. The purchase price, which was determined basedon a comparative 18 HSBC Finance Corporation-------------------------------------------------------------------------------- analysis of sales of other credit card portfolios, was paid in a combination ofcash and $261 million of preferred stock issued by a subsidiary of HBEU with arate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assetsreferred to above, the sale also included the account origination platform,including the marketing and credit employees associated with this function, aswell as the lease associated with the credit card call center and relatedleaseholds and call center employees to provide customer continuity after thetransfer as well as to allow HBEU direct ownership and control of originationand customer service. We have retained the collection operations related to thecredit card operations and have entered into a service level agreement for aperiod of not less than two years to provide collection services and othersupport services, including components of the compliance, financial reportingand human resource functions, for the sold credit card operations to HBEU for afee. We received $8 million during the three months ended September 30, 2007 and$24 million during the nine months ended September 30, 2007 under this servicelevel agreement. We received $6 million during the three months ended September30, 2006 and $17 million during the nine months ended September 30, 2006 underthis service level agreement. Additionally, the management teams of HBEU and ourremaining U.K. operations are jointly involved in decision making involving cardmarketing to ensure that growth objectives are met for both businesses. Becausethe sale of this business was between affiliates under common control, thepremium received in excess of the book value of the assets transferred of $182million, including the goodwill assigned to this business, was recorded as anincrease to additional paid-in capital and was not 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 HSBC Bank USA for $12.4 billion. We continue to service the soldprivate label receivables and receive servicing and related fee income from HSBCBank USA for these services. As of September 30, 2007, we were servicing $18.0billion of domestic private label receivables for HSBC Bank USA and as ofDecember 31, 2006, we were servicing $18.1 billion of domestic private labelreceivables for HSBC Bank USA. We received servicing and related fee income fromHSBC Bank USA of $101 million during the three months ended September 30, 2007and $300 million during the nine months ended September 30, 2007. We receivedservicing and related fee income from HSBC Bank USA of $99 million during thethree months ended September 30, 2006 and $292 million during the nine monthsended September 30, 2006. Servicing and related fee income is reflected asDomestic private label receivable servicing and related fees in the table above.We continue to maintain the related customer account relationships and,therefore, sell new domestic private label receivable originations (excludingretail sales contracts) to HSBC Bank USA on a daily basis. We sold $15.9 billionof private label receivables to HSBC Bank USA during the nine months endedSeptember 30, 2007 and $15.2 billion during the nine months ended September 30,2006. The gains associated with the sale of these receivables are reflected inthe table above and are recorded in Gain on daily sale of domestic private labelreceivable originations. In 2003 and 2004, we sold a total of approximately $3.7 billion of real estatesecured receivables from our Mortgage Services business to HSBC Bank USA. Undera separate servicing agreement, we service all real estate secured receivablessold to HSBC Bank USA including loans purchased from correspondent lenders priorto September 1, 2005. As of September 30, 2007, we were servicing $2.6 billionof real estate secured receivables for HSBC Bank USA. The fee revenue associatedwith these receivables is recorded in servicing fees from HSBC affiliates and isreflected as Real estate secured servicing, sourcing, underwriting and pricingrevenues in the above table. Under various service level agreements, we also provide other services to HSBCBank USA. These services include credit card servicing and processing activitiesthrough our Credit Card Services business, loan servicing through our AutoFinance business and other operational and administrative support. Fees receivedfor these services are reported as servicing fees from HSBC affiliates and arereflected as Other servicing, processing, origination and support revenues inthe table above. Additionally, HSBC Bank USA services certain real estatesecured loans on our behalf. Fees paid for these services are reported assupport services from HSBC affiliates and are reflected as Support services fromHSBC affiliates, in the table above. We currently use an HSBC affiliate located outside of the United States toprovide various support services to our operations including among other areas,customer service, systems, collection and accounting functions. We incurredcosts related to these services of $38 million during the three months endedSeptember 30, 2007 and 19 HSBC Finance Corporation-------------------------------------------------------------------------------- $115 million in the year-to-date period. We incurred costs related to theseservices of $26 million during the three months ended September 30, 2006 and $70million in the nine months ended September 30, 2006. The expenses related tothese services are included as a component of Support services from HSBCaffiliates in the table above. 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 2004, our Canadian business began to originate and service auto loans foran HSBC affiliate in Canada. Fees received for these services are included inother income and are reflected in Servicing and other fees from other HSBCaffiliates in the table above. Since October 1, 2004, HSBC Bank USA has served as an originating lender forloans initiated by our Taxpayer Financial Services business for clients ofvarious third party tax preparers. Starting on January 1, 2007, HSBC TrustCompany (Delaware), N.A. ("HTCD") also began to serve as an originating lenderfor these loans. We purchase the loans originated by HSBC Bank USA and HTCDdaily for a fee. Origination fees paid for these loans totaled $19 millionduring the nine months ended September 30, 2007 and $17 million during the ninemonths ended September 30, 2006. These origination fees are included as anoffset to taxpayer financial services revenue and are reflected as Taxpayerfinancial services loan origination and other fees in the above table. 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 credit card receivables from HSBC Bank USA forapproximately $99 million, which are included in intangible assets. Thereceivables continue to be owned by HSBC Bank USA. We service these receivablesfor HSBC Bank USA and receive servicing and related fee income from HSBC BankUSA. As of September 30, 2007 we were servicing $1.0 billion of credit cardreceivables for HSBC Bank USA. Originations of new accounts and receivables aremade by HBNV and new receivables are sold daily to HSBC Bank USA. We sold $2.0billion of credit card receivables to HSBC Bank USA during the nine months endedSeptember 30, 2007 and $1.7 billion during the nine months ended September 30,2006. The gains associated with the sale of these receivables are reflected inthe table above and are recorded in Gain on daily sale of credit cardreceivables. 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 HSBC Bank USA and other subsidiaries of HSBC. We also receiverevenue from HTSU for rent on certain office space, which has been recorded as areduction of occupancy and equipment expenses, and for certain administrativecosts, which has been recorded as other income. In a separate transaction in December 2005, we transferred our informationtechnology services employees in the U.K. to a subsidiary of HBEU. Subsequent tothe transfer, operating expenses relating to information technology, which havepreviously been reported as salaries and fringe benefits or other servicing andadministrative expenses, are now billed to us by HBEU and reported as Supportservices from HSBC affiliates. During the first quarter of 2006, the informationtechnology equipment in the U.K. was sold to HBEU for a purchase price equal tothe 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 $1 million during the three months endedSeptember 30, 2007 and $12 million during the nine months ended September 30,2007. Fees paid for such services totaled approximately $12 million during thethree months ended September 30, 2006 and $34 million during the nine monthsended September 30, 2006. For debt not accounted for under the fair valueoption, these fees are amortized over the life of the related debt. 20 HSBC Finance Corporation-------------------------------------------------------------------------------- Domestic employees of HSBC Finance Corporation participate in a defined benefitpension plan sponsored by HSBC North America. See Note 10, "Pension and OtherPostretirement Benefits," 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 $25 million during the three months ended September 30, 2007 and $85 millionduring the nine months ended September 30, 2007. Our share of the expense ofthese plans was $20 million during the three months ended September 30, 2006 and$59 million for the nine months ended September 30, 2006. These expenses arerecorded in salary and employee benefits and are reflected in the above table asStock based compensation expense with HSBC. 10. PENSION AND OTHER POSTRETIREMENT BENEFITS-------------------------------------------------------------------------------- Effective January 1, 2005, the two previously separate domestic defined benefitpension plans of HSBC Finance Corporation and HSBC Bank USA were combined into asingle HSBC North America defined benefit pension plan which facilitated thedevelopment of a unified employee benefit policy and unified employee benefitplan 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 (loss) are shown in the tablebelow and reflect the portion of the pension expense of the combined HSBC NorthAmerica pension plan which has been allocated to HSBC Finance Corporation: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER SEPTEMBER 30, 30, ----------- ----------- 2007 2006 2007 2006------------------------------------------------------------------------------------ (IN MILLIONS)Service cost - benefits earned during the period......... $ 12 $ 13 $ 38 $ 39Interest cost............................................ 17 15 49 45Expected return on assets................................ (21) (18) (63) (58)Recognized losses........................................ 2 3 4 9 ---- ---- ---- ----Net periodic benefit cost................................ $ 10 $ 13 $ 28 $ 35 ==== ==== ==== ==== We sponsor various additional defined benefit pension plans for our foreignbased employees. Pension expense for our foreign defined benefit pension planswas $.9 million for the three months ended September 30, 2007 and $2.5 millionfor the nine months ended September 30, 2007. Pension expense for our foreigndefined benefit pension plans was $.7 million for the three months endedSeptember 30, 2006 and $2.0 million for the nine months ended September 30,2006. Components of the net periodic benefit cost for our postretirement benefitsother than pensions are as follows: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, ------------- ------------- 2007 2006 2007 2006----------------------------------------------------------------------------------------- (IN MILLIONS)Service cost - benefits earned during the period........ $ 2 $1 $ 4 $ 3Interest cost........................................... 3 4 10 12Expected return on assets............................... - - - -Recognized (gains) losses............................... (1) - (1) - --- -- --- ---Net periodic benefit cost............................... $ 4 $5 $13 $15 === == === === 21 HSBC Finance Corporation-------------------------------------------------------------------------------- 11. 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(1) and Visa(1) and other credit cardbusiness. Our International segment consists of our foreign operations in theUnited Kingdom, Canada and the Republic of Ireland and, prior to November 9,2006, our operations in Slovakia, the Czech Republic and Hungary. The All Othercaption includes our Insurance and Taxpayer Financial Services and Commercialbusinesses, each of which falls below the quantitative threshold test under SFASNo. 131 for determining reportable segments, as well as our corporate andtreasury activities. In May 2007, we decided to integrate our Retail Services and Credit CardServices businesses. Combining Retail Services with Credit Card Servicesenhances our ability to provide a single credit card and private label solutionfor the market place. We are currently evaluating the impact this integrationwill have on our financial reporting in the future, including segment reporting.There have been no changes in the basis of our segmentation or any changes inthe measurement of segment profit as compared with the presentation in our 2006Form 10-K. Our segment results are presented on an International Financial ReportingStandards ("IFRSs") management basis (a non-U.S. GAAP financial measure) ("IFRSManagement Basis") as operating results are monitored and reviewed, trends areevaluated and decisions about allocating resources, such as employees, are madealmost exclusively on an IFRS Management Basis since we report results to ourparent, HSBC, who prepares its consolidated financial statements in accordancewith IFRSs. IFRS Management Basis results are IFRSs results adjusted to assumethat the private label and real estate secured receivables transferred to HSBCBank USA have not been sold and remain on our balance sheet. Operations aremonitored and trends are evaluated on an IFRS Management Basis because thecustomer loan sales to HSBC Bank USA were conducted primarily to appropriatelyfund prime customer loans within HSBC and such customer loans continue to bemanaged and serviced by us without regard to ownership. However, we continue tomonitor capital adequacy, establish dividend policy and report to regulatoryagencies on a U.S. GAAP basis. 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. ----------(1) MasterCard is a registered trademark of MasterCard International,Incorporated and Visa is a registered trademark of Visa USA, Inc. 22 HSBC Finance Corporation-------------------------------------------------------------------------------- Reconciliation of our IFRS Management Basis segment results to the U.S. GAAPconsolidated totals are as follows: IFRS MANAGEMENT CREDIT ADJUSTMENTS/ BASIS MANAGEMENT CARD INTER- ALL RECONCILING CONSOLIDATED BASIS IFRS CONSUMER SERVICES NATIONAL OTHER ITEMS TOTALS ADJUSTMENTS(4) ADJUSTMENTS(5)------------------------------------------------------------------------------------------------------------------------ (IN MILLIONS)THREE MONTHS ENDED SEPTEMBER 30, 2007Net interest income... $ 2,145 $ 900 $ 219 $ (188) $ - $ 3,076 $ (409) $ 42Other operating income (Total other revenues)........... 60 916 56 648 (84)(1) 1,596 11 (70)Loan impairment charges (Provision for credit losses).. 2,585 764 128 - 1(2) 3,478 (320) 41Operating expenses (Total costs and expenses)........... 720 446 135 1,473(7) - 2,774 5 (451)Net income (loss)..... (686) 377 6 (1,088) (54) (1,445) (60) 403Customer loans (Receivables)....... 138,265 29,585 10,370 149 - 178,369 (20,633) (138)Assets................ 136,157 29,162 11,033 31,126 (8,204)(3) 199,274 (20,059) (5,604)Intersegment revenues............ 76 3 6 (1) (84)(1) - - - -------- ------- ------- ------- ------- -------- -------- -------THREE MONTHS ENDED SEPTEMBER 30, 2006Net interest income... $ 2,187 $ 737 $ 207 $ (259) $ - $ 2,872 $ (305) $ 67Other operating income (Total other revenues)........... 283 651 59 (32) (75)(1) 886 85 125Loan impairment charges (Provision for credit losses).. 1,034 393 135 1 1(2) 1,564 (149) (14)Operating expenses (Total costs and expenses)........... 766 452 118 152 - 1,488 (8) (29)Net income (loss)..... 442 356 (5) (303) (48) 442 (45) 154Customer loans (Receivables)....... 141,620 26,357 9,398 184 - 177,559 (20,391) (128)Assets................ 143,507 26,879 10,864 28,011 (8,197)(3) 201,064 (20,762) (4,690)Intersegment revenues............ 61 6 9 (1) (75)(1) - - - -------- ------- ------- ------- ------- -------- -------- -------NINE MONTHS ENDED SEPTEMBER 30, 2007Net interest income... $ 6,446 $ 2,548 $ 640 $ (615) $ - $ 9,019 $ (1,047) $ 68Other operating income (Total other revenues)........... 425 2,369 151 1,160 (225)(1) 3,880 86 (127)Loan impairment charges (Provision for credit losses).. 5,187 1,824 537 (1) 4(2) 7,551 (712) 13Operating expenses (Total costs and expenses)........... 2,227 1,423 405 1,759(7) - 5,814 - (455)Net income (loss)..... (328) 1,050 (115) (1,105) (145) (643) (173) 318Intersegment revenues............ 199 13 17 (4) (225)(1) - - - -------- ------- ------- ------- ------- -------- -------- -------NINE MONTHS ENDED SEPTEMBER 30, 2006Net interest income... $ 6,558 $ 2,341 $ 618 $ (721) $ - $ 8,796 $ (951) $ (135)Other operating income (Total other revenues)........... 870 1,692 174 415 (219)(1) 2,932 227 128Loan impairment charges (Provision for credit losses).. 2,478 970 363 (1) 4(2) 3,814 (443) 160Operating expenses (Total costs and expenses)........... 2,296 1,321 349 441 - 4,407 (16) (99)Net income (loss)..... 1,700 1,111 36 (476) (141) 2,230 (182) (41)Intersegment revenues............ 181 16 25 (3) (219)(1) - - - -------- ------- ------- ------- ------- -------- -------- ------- IFRS U.S. GAAP RECLASS- CONSOLIDATED IFICATIONS(6) TOTALS--------------------------------------------------- (IN MILLIONS)THREE MONTHS ENDED SEPTEMBER 30, 2007Net interest income... $ (26) $ 2,683Other operating income (Total other revenues)........... 281 1,818Loan impairment charges (Provision for credit losses).. 3 3,202Operating expenses (Total costs and expenses)........... 252 2,580Net income (loss)..... - (1,102)Customer loans (Receivables)....... - 157,598Assets................ (874) 172,737Intersegment revenues............ - - ------- --------THREE MONTHS ENDED SEPTEMBER 30, 2006Net interest income... $ (32) $ 2,602Other operating income (Total other revenues)........... 238 1,334Loan impairment charges (Provision for credit losses).. (17) 1,384Operating expenses (Total costs and expenses)........... 223 1,674Net income (loss)..... - 551Customer loans (Receivables)....... - 157,040Assets................ (1,708) 173,904Intersegment revenues............ - - ------- --------NINE MONTHS ENDED SEPTEMBER 30, 2007Net interest income... $ (59) $ 7,981Other operating income (Total other revenues)........... 635 4,474Loan impairment charges (Provision for credit losses).. (3) 6,849Operating expenses (Total costs and expenses)........... 579 5,938Net income (loss)..... - (498)Intersegment revenues............ - - ------- --------NINE MONTHS ENDED SEPTEMBER 30, 2006Net interest income... $ (95) $ 7,615Other operating income (Total other revenues)........... 643 3,930Loan impairment charges (Provision for credit losses).. (33) 3,498Operating expenses (Total costs and expenses)........... 581 4,873Net income (loss)..... - 2,007Intersegment revenues............ - - ------- -------- -------- (1) Eliminates intersegment revenues. 23 HSBC Finance Corporation-------------------------------------------------------------------------------- (2) Eliminates bad debt recovery sales between operating segments. (3) Eliminates investments in subsidiaries and intercompany borrowings. (4) Management Basis Adjustments represent the private label and real estate secured receivables transferred to HBUS. (5) IFRS Adjustments consist of the accounting differences between U.S. GAAP and IFRSs which have been described more fully below. (6) Represents differences in balance sheet and income statement presentation between IFRSs and U.S. GAAP. (7) As discussed in Note 2, "Disposal Activities", in the third quarter of 2007 we recorded a goodwill impairment charge of $1.3 billion on an IFRSs basis which represents the goodwill allocated to our Mortgage Services business. A summary of the significant differences between U.S. GAAP and IFRSs as theyimpact our results are summarized below: SECURITIZATIONS - On an IFRSs basis, securitized receivables are treated asowned. Any gains recorded under U.S. GAAP on these transactions are reversed. Anowned loss reserve is established. The impact from securitizations resulting inhigher net income under IFRSs is due to the recognition of income on securitizedreceivables under U.S. GAAP in prior periods. DERIVATIVES AND HEDGE ACCOUNTING (INCLUDING FAIR VALUE ADJUSTMENTS) - The IFRSsderivative accounting model is similar to U.S. GAAP requirements, but IFRSs doesnot permit use of the short-cut method of hedge effectiveness testing. Prior toJanuary 1, 2007, the differences between U.S. GAAP and IFRSs related primarilyto the fact that a different population of derivatives qualified for hedgeaccounting under IFRSs than U.S. GAAP and that HSBC Finance Corporation hadelected the fair value option under IFRSs on a significant portion of its fixedrate debt which was being hedged by receive fixed swaps. Prior to the issuanceof FASB Statement No. 159, "The Fair Value Option for Financial Assets andFinancial Liabilities," ("SFAS No. 159") in February 2007, U.S. GAAP did notpermit the use of the fair value option. As a result of our early adoption ofSFAS No. 159 which is more fully discussed in Note 12, "Fair Value Option,"effective January 1, 2007, we utilize fair value option reporting for the samefixed rate debt issuances under both U.S. GAAP and IFRSs. INTANGIBLE ASSETS AND GOODWILL - Intangible assets under IFRSs are significantlylower than those under U.S. GAAP as the newly created intangibles associatedwith our acquisition by HSBC are reflected in goodwill for IFRSs which resultsin a higher goodwill balance under IFRSs. As a result, amortization ofintangible assets is lower under IFRSs and the amount of goodwill allocated toour Mortgage Services business and written off during the third quarter of 2007is greater under IFRSs. PURCHASE ACCOUNTING ADJUSTMENTS - There are differences in the valuation ofassets and liabilities under U.K. GAAP (which were carried forward into IFRSs)and U.S. GAAP which result in a different amortization for the HSBC acquisition.Additionally there are differences in the valuation of assets and liabilitiesunder IFRSs and U.S. GAAP resulting from the Metris acquisition in December2005. DEFERRED LOAN ORIGINATION COSTS AND PREMIUMS - Under IFRSs, loan originationcost deferrals are more stringent and result in lower costs being deferred thanpermitted under U.S. GAAP. In addition, all deferred loan origination fees,costs and loan premiums must be recognized based on the expected life of thereceivables under IFRSs as part of the effective interest calculation whileunder U.S. GAAP they may be amortized on either a contractual or expected lifebasis. CREDIT LOSS IMPAIRMENT PROVISIONING - IFRSs requires a discounted cash flowmethodology for estimating impairment on pools of homogeneous customer loanswhich requires the incorporation of the time value of money relating to recoveryestimates. Also under IFRSs, future recoveries on charged-off loans are accruedfor on a discounted basis and interest is recorded based on collectibility. LOANS HELD FOR RESALE - IFRSs requires loans held for resale to be treated astrading assets and recorded at their fair market value. Under U.S. GAAP, loansheld for resale are designated as loans on the balance sheet and recorded at thelower of amortized cost or market. Under U.S. GAAP, the income and expensesrelated to loans held for sale are reported similarly to loans held forinvestment. Under IFRSs, the income and expenses related to loans held for saleare reported in other operating income. 24 HSBC Finance Corporation-------------------------------------------------------------------------------- INTEREST RECOGNITION - The calculation of effective interest rates under IFRS 39requires an estimate of "all fees and points paid or recovered between partiesto the contract" that are an integral part of the effective interest rate beincluded. In June 2006, we implemented a methodology for calculating theeffective interest rate for introductory rate credit card receivables underIFRSs over the expected life of the product. In December 2006, we implemented amethodology to include prepayment penalities as part of the effective interestrate and recognized such penalties over the expected life of the receivables.U.S. GAAP generally prohibits recognition of interest income to the extent thenet interest in the loan would increase to an amount greater than the amount atwhich the borrower could settle the obligation. Also under U.S. GAAP, prepaymentpenalties are generally recognized as received. OTHER - There are other less significant differences between IFRSs and U.S. GAAPrelating to pension expense, severance and closure costs, changes in taxestimates and other miscellaneous items. See "Basis of Reporting" in Item 7. Management's Discussion and Analysis ofFinancial Condition and results of Operations in our Annual Report on Form 10-Kfor the year ended December 31, 2006 for a more complete discussion ofdifferences between U.S. GAAP and IFRSs. 12. FAIR VALUE OPTION-------------------------------------------------------------------------------- Effective January 1, 2007, we early adopted SFAS No. 159 which provides for afair value option election that allows companies to irrevocably elect fair valueas the initial and subsequent measurement attribute for certain financial assetsand liabilities, with changes in fair value recognized in earnings as theyoccur. SFAS No. 159 permits the fair value option election ("FVO") on aninstrument by instrument basis at the initial recognition of an asset orliability or upon an event that gives rise to a new basis of accounting for thatinstrument. We elected FVO for certain issuances of our fixed rate debt in orderto align our accounting treatment with that of HSBC under IFRSs. Under IFRSs, anentity can only elect FVO accounting for financial assets and liabilities thatmeet certain eligibility criteria which are not present under SFAS No. 159. Whenwe elected FVO reporting for IFRSs, in addition to certain fixed rate debtissuances which did not meet the eligibility criteria, there were also certainfixed rate debt issuances for which only a portion of the issuance met theeligibility criteria to qualify for FVO reporting. To align our U.S. GAAP andIFRSs accounting treatment, we have adopted SFAS No. 159 only for the fixed ratedebt issuances which also qualify for FVO reporting under IFRSs. The following table presents information about the eligible instruments forwhich we elected FVO and for which a transition adjustment was recorded. BALANCE SHEET BALANCE SHEET JANUARY 1, 2007 JANUARY 1, 2007 PRIOR TO ADOPTION NET GAIN (LOSS) AFTER ADOPTION OF FVO UPON ADOPTION OF FVO--------------------------------------------------------------------------------------------------- (IN MILLIONS)Fixed rate debt designated at fair value.... $(30,088) $(855) $(30,943) ======== ----- ========Pre-tax cumulative-effect of adoption of FVO....................................... (855)Increase in deferred tax asset.............. 313 -----After-tax cumulative-effect of adoption of FVO adjustment to retained earnings....... $(542) ===== Long term debt (with original maturities over one year) of $125.5 billion atSeptember 30, 2007, includes $32.9 billion of fixed rate debt accounted forunder FVO. We did not elect FVO for $37.2 billion of fixed rate debt currentlycarried on our balance sheet within long term debt for the reasons discussedabove. Fixed rate debt accounted for under FVO at September 30, 2007 has anaggregate unpaid principal balance of $33.1 billion. The fair value of the fixed rate debt accounted for under FVO is determined by athird party and includes the full market price (credit and interest rate impact)based on observable market data. The adoption of FVO has not impacted howinterest expense is calculated and reported for the fixed rate debt instruments.The adoption of FVO has however impacted the way we report realized gains andlosses on the swaps associated with this debt which previously qualified aseffective hedges under SFAS No. 133. Upon the adoption of SFAS No. 159 forcertain fixed 25 HSBC Finance Corporation-------------------------------------------------------------------------------- rate debt, we eliminated hedge accounting on these swaps and, as a result,realized gains and losses are no longer reported in interest expense but insteadare reported as "Gain on debt designated at fair value and related derivatives"within other revenues. During the three months ended September 30, 2007, we recorded a net loss fromfair value changes on our fixed rate debt accounted for under FVO of $(115)million and a net gain from fair value changes on our fixed rate debt accountedfor under FVO of $496 million during the nine months ended September 30, 2007which is included in "Gain on debt designated at fair value and relatedderivatives" as a component of other revenues in the consolidated statement ofincome (loss). "Gain on debt designated at fair value and related derivatives"in the consolidated statement of income (loss) also includes the mark-to-marketadjustment on derivatives related to the debt designated at fair value as wellas net realized gains or losses on these derivatives. The components of "Gain ondebt designated at fair value and related derivatives" are as follows: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, 2007 2007 ------------- ------------- (IN MILLIONS)Interest rate component.................................. $(723) $(350)Credit risk component.................................... 608 846 ----- -----Total mark-to-market on debt designated at fair value.... (115) 496Mark-to-market on the related derivatives................ 719 280Net realized losses on the related derivatives........... (85) (243) ----- -----Gain on debt designated at fair value and related derivatives............................................ $ 519 $ 533 ===== ===== The movement in the fair value reflected in "Gain on debt designated at fairvalue and related derivatives" includes the effect of credit spread changes andinterest rate changes, including any ineffectiveness in the relationship betweenthe related swaps and our debt. As credit spreads narrow, accounting losses arebooked and the reverse is true if credit spreads widen. Differences arisebetween the movement in the fair value of our debt and the fair value of therelated swap due to the different credit characteristics. The size and directionof the accounting consequences of such changes can be volatile from period toperiod but do not alter the cash flows intended as part of the documentedinterest rate management strategy. The changes in the interest rate component for both periods reflect a decreasein the LIBOR curve since December 31, 2006. Changes in the credit risk componentof the debt were significant during the three month period ended September 30,2007. For both the three month and the nine month periods, the changes in creditrisk were due to a general widening of credit spreads across all domestic bondmarket sectors as well as the general lack of liquidity in the secondary bondmarket in the quarter. 13. FAIR VALUE MEASUREMENTS-------------------------------------------------------------------------------- Effective January 1, 2007, we elected to early adopt FASB Statement No. 157,"Fair Value Measurements," ("SFAS No. 157"). SFAS No. 157 establishes a singleauthoritative definition of value, sets out a framework for measuring fairvalue, and provides a hierarchal disclosure framework for assets and liabilitiesmeasured at fair value. The adoption of SFAS No. 157 did not have any impact onour financial position or results of operations. The following table presents information about our assets and liabilitiesmeasured at fair value on a recurring basis as of September 30, 2007, andindicates the fair value hierarchy of the valuation techniques utilized todetermine such fair value. In general, fair values determined by Level 1 inputsuse quoted prices (unadjusted) in active markets for identical assets orliabilities that we have the ability to access. Fair values determined by Level2 inputs use inputs other than quoted prices included in Level 1 that areobservable for the asset or liability, either directly or indirectly. Level 2inputs include quoted prices for similar assets and liabilities in activemarkets, quoted prices for identical or similar assets or liabilities in marketswhere there are few transactions and inputs other than quoted prices that areobservable for the asset or liability, such as interest rates and yield curvesthat are observable at 26 HSBC Finance Corporation-------------------------------------------------------------------------------- commonly quoted intervals. Level 3 inputs are unobservable inputs for the assetor liability and include situations where there is little, if any, marketactivity for the asset or liability. ASSETS (LIABILITIES) QUOTED PRICES IN MEASURED AT ACTIVE MARKETS FOR SIGNIFICANT OTHER SIGNIFICANT FAIR VALUE AT IDENTICAL ASSETS OBSERVABLE INPUTS UNOBSERVABLE INPUTS SEPTEMBER 30, 2007 (LEVEL 1) (LEVEL 2) (LEVEL 3)--------------------------------------------------------------------------------------------------------------- (IN MILLIONS)Derivatives: Risk management related, net(1)................. $ 3,254 $ - $ 3,254 $- Loan and forward sales commitments............ -(3) - - -(3)Available for sale securities................ 3,190 3,190 - -Real estate owned(2)........ 1,086 - 1,086 -Repossessed vehicles(2)..... 49 - 49 -Long term debt carried at fair value................ 32,938 - 32,938 - -------- (1) The fair value disclosed excludes swap collateral that we either receive or deposit with our interest rate swap counterparties. Such swap collateral is recorded on our balance sheet at an amount which "approximates fair value" as discussed in FASB Staff Position No. FIN 39-1, "Amendment of FASB Interpretation No. 39" and is netted on the balance sheet with the fair value amount recognized for derivative instruments. (2) The fair value disclosed is unadjusted for transaction costs as required by SFAS No. 157. The amounts recorded in the consolidated balance sheet are recorded net of transaction costs as required by FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." (3) Less than $500 thousand. The balances of our commitments which utilize significant unobservable inputs(Level 3) did not change significantly during the quarter. The following table presents information about our assets measured at fair valueon a non-recurring basis as of September 30, 2007 and indicates the fair valuehierarchy of the valuation techniques utilized to determine such fair value, asdefined by SFAS No. 157. ASSETS (LIABILITIES) QUOTED PRICES IN MEASURED AT ACTIVE MARKETS FOR SIGNIFICANT OTHER SIGNIFICANT FAIR VALUE AT IDENTICAL ASSETS OBSERVABLE INPUTS UNOBSERVABLE INPUTS SEPTEMBER 30, 2007 (LEVEL 1) (LEVEL 2) (LEVEL 3)--------------------------------------------------------------------------------------------------------------- (IN MILLIONS)Loans held for sale......... $272(1) $- $272 $-Net investment in U.K. Insurance Operations held for sale.................. 225 - 225 - -------- (1) The fair value disclosed above excludes $17 million of loans held for sale for which the fair value exceeds our carrying value. Loans held for sale are recorded at the lower of aggregate cost or fair value.At September 30, 2007, loans held for sale with a carrying value of $445 millionwere written down to their current fair value resulting in an impairment chargeof $173 million. Fair value is generally determined by estimating a grosspremium or discount. The estimated gross premium or discount is derived fromrecent loan sales and pricing currently observable in the market, the weightedaverage coupon of the loans relative to market interest rates as well as marketliquidity and loan related credit characteristics. In accordance with the provisions of FASB Statement No. 144, "Accounting for theImpairment or Disposal of Long-Lived Assets," our U.K. Insurance Operations witha net carrying amount of $256 million, including the goodwill allocated to theseoperations, were written down to their fair value of $225 million, resulting ina loss of 27 HSBC Finance Corporation-------------------------------------------------------------------------------- $31 million, which was included as a component of total costs and expensesduring the three months ended March 31, 2007. No additional adjustment wasdetermined to be necessary during the three months ended September 30, 2007. In accordance with the provisions of FASB Statement No. 142, "Goodwill and OtherIntangible Assets," goodwill with a carrying amount of $881 million allocated toour Mortgage Services business was written down to its implied fair value of $0during the three months ended September 30, 2007. Assets and liabilities which could also be measured at fair value on a non-recurring basis include intangible assets. 14. NEW ACCOUNTING PRONOUNCEMENTS-------------------------------------------------------------------------------- In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, "Amendment ofFASB Interpretation No. 39" ("FSP 39-1"). FSP 39-1 allows entities that areparty to a master netting arrangement to offset the receivable or payablerecognized upon payment or receipt of cash collateral against fair value amountsrecognized for derivative instruments that have been offset under the samemaster netting arrangement in accordance with FASB Interpretation No. 39. Theguidance in FSP 39-1 is effective for fiscal years beginning after November 15,2007, with early adoption permitted. Entities are required to recognize theeffects of applying FSP 39-1 as a change in accounting principle throughretroactive application for all financial statements presented unless it isimpracticable to do so. We adopted FSP 39-1 during the second quarter of 2007and retroactively applied its requirements to all prior periods as required byFSP 39-1. At September 30, 2007 and December 31, 2006, the fair value ofderivatives included in derivative financial assets have been reduced by $2,791million and $1,164 million, respectively, representing the payable recognizedupon receipt of cash collateral for derivative instruments that have been offsetunder the same master netting arrangement in accordance with FSP 39-1. AtSeptember 30, 2007 and December 31, 2006, the fair value of derivatives includedin derivative financial liabilities have been reduced by $46 million and $53million, respectively, representing the receivable recognized upon payment ofcash collateral for derivative instruments that have been offset under the samemaster netting arrangement in accordance with FSP 39-1. The adoption of FSP 39-1had no impact on our results of operations or our cash flows. 28 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 andwith our Annual Report on Form 10-K for the year ended December 31, 2006 (the"2006 Form 10-K"). MD&A may contain certain statements that may be forward-looking in nature within the meaning of the Private Securities Litigation ReformAct of 1995. In addition, we may make or approve certain statements in futurefilings with the SEC, in press releases, or oral or written presentations byrepresentatives of HSBC Finance Corporation that are not statements ofhistorical fact and may also constitute forward-looking statements. Words suchas "may", "will", "should", "would", "could", "intend", "believe", "expect","estimate", "target", "plan", "anticipates", "goal" and similar expressions areintended to identify forward-looking statements but should not be considered asthe only means through which these statements may be made. These matters orstatements will relate to our future financial condition, results of operations,plans, objectives, performance or business developments and will involve knownand unknown 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. EXECUTIVE OVERVIEW-------------------------------------------------------------------------------- HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC Holdingsplc ("HSBC"). HSBC Finance Corporation may also be referred to in the MD&A as"we", "us", or "our". Net loss was $(1,102) million for the three months ended September 30, 2007compared with net income of $551 million in the prior year quarter. Net loss was$(498) million for the nine months ended September 30, 2007 compared with netincome of $2,007 million in the prior year period. We experienced a marked decline in net income in the current quarter as comparedto the previous quarter. Net loss was $(1,102) million for the three monthsended September 30, 2007 compared to net income of $63 million for the threemonths ended June 30, 2007. The primary drivers of this decrease are summarizedbelow: (AFTER-TAX, IN MILLIONS)-----------------------------------------------------------------------------------------Net income - June 30, 2007..................................... $ 63Goodwill impairment related to the Mortgage Services business.. (852)Higher provision for credit losses............................. (790)Higher gain on debt designated at fair value and related derivatives.................................................. 408Higher Decision One losses on loans held for sale.............. (13)Gain on sale of MasterCard Class B shares in third quarter..... 72Other, net..................................................... 10 -------Net loss - September 30, 2007.................................. $(1,102) ======= The increase in our provision for credit losses in the third quarter of 2007 ascompared to the second quarter of 2007 was largely driven by higher lossestimates in our Consumer Lending and Mortgage Services portfolios due tomarkedly higher levels of real estate secured delinquency. As discussed morefully below, certain mortgage lending industry trends, including housing pricedeterioration worsened and are now having a material impact on portions of ourConsumer Lending real estate portfolio. Normal portfolio seasoning across allproducts and higher loss estimates at our Credit Card Services business due toreceivable growth and a higher mix of non-prime receivables contributed to theincrease. These increases were partially offset by a lower provision for creditloss in our United Kingdom operations as the second quarter of 2007 reflectedhigher loss estimates for restructured loans. In the third 29 HSBC Finance Corporation-------------------------------------------------------------------------------- quarter of 2007, we recorded a goodwill impairment charge of $852 million(after-tax) relating to our Mortgage Services business as a result of ourdecision in September 2007 to cease our Decision One operations. The higher gainon debt designated at fair value and related derivatives in the third quarterlargely reflects a significantly higher mark-to-market adjustment related tocredit risk on fair value option debt as the third quarter was impacted by awidening of credit spreads, including an adverse impact from the performance ofsubprime mortgage markets which affected credit spreads through the entirefinancial services industry. In the third quarter of 2007, we sold a portion ofour portfolio of MasterCard Class B shares for an after-tax gain of $72 million.Losses on loans held for sale by our Decision One mortgage operations were alsohigher in the third quarter reflecting the current market conditions. Net loss was $(1,102) million for the three months ended September 30, 2007, ascompared to net income of $551 million in the prior year quarter. Net loss was$(498) million for the nine months ended September 30, 2007, as compared to netincome of $2,007 million in the prior year period. The decrease in both periodsis largely due to a markedly higher provision for credit losses and the impactof lower receivable growth driven largely by the discontinuance of correspondentchannel acquisitions in the first quarter of 2007. In addition to the provisionfor credit losses, our results in the current year quarter and year-to-dateperiods were impacted by a goodwill impairment charge of $852 million (after-tax) relating to our Mortgage Services business. This was partially offset bygains from the change in the credit risk component of our fair value optioneddebt due to significantly wider credit spreads which increased net income by$383 million (after-tax) in the three months ended September 30, 2007 and $532million (after-tax) in the year-to-date period. Collectively, these itemsincreased our net loss by $469 million in the quarter and $320 million year-to-date. When compared to the year-ago periods, the increase in provision for creditlosses in 2007 reflects higher loss estimates in our Consumer Lending, MortgageServices and Credit Card Services businesses due to the following: Consumer Lending experienced higher loss estimates primarily in its real estate secured receivable portfolio due to higher levels of charge-off and delinquency driven by a faster deterioration of portions of the real estate secured receivable portfolio in the third quarter of 2007. Weakening early stage delinquency previously reported continued to worsen and migrate into later stage delinquency due to the marketplace changes as discussed more fully below. Lower receivable run-off, growth in average receivables and portfolio seasoning also resulted in a higher real estate secured credit loss provision. Also contributing to the increase in both periods was higher loss estimates in Consumer Lending's personal non- credit card portfolio due to seasoning, a deterioration of 2006 vintages originated through the direct mail channel in certain geographic regions and increased levels of personal bankruptcy filings as compared to the exceptionally low filing levels experienced in 2006 as a result of the new bankruptcy law in the United States which went into effect in October 2005. Mortgage Services experienced higher levels of charge-offs and delinquency as portions of this portfolio purchased in 2005 and 2006 continue to season and progress as expected into various stages of delinquency and charge-off. Additionally during the third quarter of 2007, our Mortgage Services portfolio has also experienced higher loss estimates in these portfolios, particularly in the second lien portfolio, as the mortgage lending industry trends we have experienced worsened, and receivable run- off has slowed. Credit Card Services experienced higher loss estimates as a result of higher average receivable balances due in part in the nine month period to lower securitization levels, portfolio seasoning, a shift in mix to higher levels of non-prime receivables, as well as the increased levels of personal bankruptcy filings discussed above. The comparability of the provision for credit losses between 2006 and 2007 isaffected by several factors in 2006, including exceptionally low levels ofpersonal bankruptcy filings in the United States as a result of the newbankruptcy law which took effect in October 2005, the impact of significantreceivable growth in 2004 and 2005 which had not yet fully seasoned and anoverall favorable credit environment in the United States. Higher costs andexpenses as compared to the prior periods also contributed to the net loss,partially offset by higher net interest income and higher other revenues. Costs and expenses were higher in both periods compared to the prior periods tosupport higher levels of average receivables including increased collectionactivities. However, the rate of increase in costs and expenses in the currentquarter was lower as compared to the first half of 2007, despite restructurecharges recorded in the three months ended September 30, 2007 related to ourdecision to cease operations of Decision One and to close a loan 30 HSBC Finance Corporation-------------------------------------------------------------------------------- underwriting, processing and collection facility in Carmel, Indiana. This was aresult of lower marketing expenses, lower sales incentives resulting from thetermination of correspondent channel acquisitions, and the impact of entity-wideinitiatives to reduce costs. The net impact of these decisions, and the proposedConsumer Lending branch network restructuring (see page 34), will be to reduceour head count by approximately 6,000, or 20 percent, during the period January1, 2007 to March 31, 2008 when we will have fully implemented the announcedrestructuring. The increase in net interest income during both periods was dueto growth in average receivables and an improvement in the overall yield on theportfolio, partly offset by a higher cost of funds. Changes in receivable mixalso contributed to the increase in yield due to the impact of increased levelsof higher yielding products such as credit cards and personal non-credit cardsdue in part, to higher average levels of these receivables and for the nine-month period, lower securitization levels as compared to the year-ago periods.Overall yield improvements were partially offset by the impact of growth in non-performing loans. Other revenues increased in both periods due to higher feeincome as a result of higher volumes in our credit card portfolios and theimpact of adopting FASB Statement No. 159, "The Fair Value Option for FinancialAssets and Financial Liabilities," ("SFAS No. 159") as credit spreads widened inthe first and third quarter of 2007, partially offset by lower derivative incomeand lower other income due to realized losses incurred on sales of real estatesecured receivables by our Decision One mortgage operations and, in the year-to-date period, from the sale of a $2.2 billion Mortgage Services loan portfolio.The lower derivative income was due to changes in the interest rate curve and tothe adoption of SFAS No. 159. Declines in interest rates resulted in a lowervalue of our interest rate swaps as compared to the prior periods. As a resultof the adoption of SFAS No. 159, we eliminated hedge accounting for materiallyall fixed rate debt designated at fair value. The fair value change in theassociated swaps, which accounted for the majority of the derivative income in2006, is now reported as "Gain on debt designated at fair value and relatedderivatives" in the consolidated statement of income (loss) along with the mark-to-market on the fixed rate debt. Our return on average owned assets ("ROA") was (2.54) percent for the quarterended September 30, 2007 and (.38) percent for the nine months ended September30, 2007 compared to 1.28 percent for the three months ended September 30, 2006and 1.60 percent for the nine months ended September 30, 2006. ROA wassignificantly impacted in both the three and nine month periods ended September30, 2007 by the goodwill impairment charge relating to our Mortgage Servicesbusiness which was partially offset by the change in the credit risk componentof our fair value optioned debt. Excluding these items, ROA decreased 274 basispoints as compared to the prior year quarter and 173 basis points as compared tothe year-ago period. The decrease during these periods was a result of the lowernet income during the period, as discussed above and for the year-to-date perioddue to higher average assets. We continue to monitor the impact of several trends affecting the mortgagelending industry. Industry statistics and reports indicate that mortgage loanoriginations throughout the industry from 2005 and 2006 are performing worsethan originations from prior periods. Real estate markets in a large portion ofthe United States have been affected by a general slowing in the rate ofappreciation in property values, or an actual decline in some markets such asCalifornia, Florida and Arizona, while the period of time available propertiesremain on the market continues to increase. During the third quarter of 2007,there has been unprecedented turmoil in the mortgage lending industry, includingrating agency downgrades of debt secured by subprime mortgages of some issuerswhich resulted in a marked reduction in secondary market demand for subprimeloans. However, none of our secured financings were downgraded and we havecontinued to access the commercial paper market and all other funding sourcesconsistent with our funding plans. The lower demand for subprime loans resultedin reduced liquidity in the marketplace for subprime mortgages. Mortgage lendersalso tightened lending standards which impacted borrower's ability to refinanceexisting mortgage loans. It is now generally believed that the slowdown in thehousing market will be deeper in terms of its impact on housing prices and theduration will be much longer than originally anticipated. The combination ofthese factors has further reduced the refinancing opportunities of some of ourcustomers as the ability to refinance and access any equity in their homes is nolonger an option to many customers. This impacts both credit performance andrun-off rates and has resulted in rising delinquency rates for real estatesecured loans in our portfolio and across the industry. These factors have alsoimpacted the ability of some borrowers to pay the increase in their adjustablerate mortgage ("ARM") loan payment as the interest rates on their loans adjustupward under their contracts. Interest rate adjustments on first mortgages mayalso have a direct impact on a borrower's 31 HSBC Finance Corporation-------------------------------------------------------------------------------- ability to repay any underlying second lien mortgage loan on a property.Similarly, as interest-only mortgage loans leave the interest-only paymentperiod, the ability of borrowers to make the increased payments may be impacted. In 2006, we began to experience a deterioration in the performance of mortgageloans acquired in 2005 and 2006 by our Mortgage Services business, particularlyin the second lien and portions of the first lien portfolio. We have continuedto experience higher than normal delinquency levels in the first nine months of2007 in these portions of our Mortgage Services portfolio. The rate of increasein delinquency in the third quarter has increased in part due to the marketplaceconditions discussed above. Dollars of two-months-and-over contractualdelinquency in our Mortgage Services business increased $595 million or 22percent since June 2007 and $967 million or 42 percent since the beginning ofthe year. A significant number of our second lien customers have underlyingadjustable rate first mortgages that face repricing in the near-term which alsonegatively impacts the probability of repayment on the related second lienmortgage loan. As the interest rate adjustments will occur in an environment ofsignificantly higher interest rates, lower home value appreciation andtightening credit, we expect the probability of default for adjustable ratefirst mortgages subject to repricing as well as any second lien mortgage loansthat are subordinate to an adjustable rate first lien held by another lenderwill be greater than what we have historically experienced. We previously reported in the second quarter of 2007 that we were beginning toexperience weakening early stage performance in certain Consumer Lending realestate secured loans originated since late 2005, consistent with the industrytrend. This trend worsened materially in the third quarter of 2007 as theweakening early stage delinquency continued to worsen and migrate into laterstage delinquency, largely a result of the marketplace conditions discussedabove. Credit performance of our Consumer Lending mortgage portfoliodeteriorated across all vintages during the quarter, including 2007originations, but in particular in loans which were originated in 2006. Dollarsof two-months-and-over contractual delinquency in our Consumer Lending realestate portfolio increased $462 million, or 40 percent since June 2007 and $585million or 57 percent since the beginning of the year. The deterioration hasbeen most severe in the first lien portions of the portfolio in the geographicregions most impacted by the decline in home value appreciation, in particularthe states of California, Florida, Arizona, Virginia, Washington, Maryland,Minnesota, Massachusetts and New Jersey which account for approximately 70percent of the increase in dollars of two-months-and-over contractualdelinquency during 2007. As previously discussed, this worsening trend and anoutlook for increased charge-offs has resulted in a marked increase in theprovision for credit losses at our Consumer Lending business during the thirdquarter. In response to this deterioration, Consumer Lending is increasingcollection staffing and expanding the use of loss mitigation programs, similarto those initiated by Mortgage Services, as discussed in the followingparagraph. We expect portions of our Mortgage Services and Consumer Lendingportfolios to remain under pressure in 2007 and 2008 as the affectedoriginations season further. Accordingly, as a result of these marketplaceconditions we expect the increasing trend in overall real estate secureddelinquency and charge-off in dollars and percentages to continue. Numerous risk mitigation efforts have been implemented relating to the affectedcomponents of the Mortgage Services portfolio. These include enhancedsegmentation and analytics to identify the higher risk portions of the portfolioand increased collections capacity. As appropriate and in accordance withdefined policies, we will restructure and/or modify loans if we believe thecustomer has the ability to pay for the foreseeable future under therestructured/modified terms. Modifications may be permanent, but most have beensix-months or twelve-months in duration. At the end of the modification term,the ability of customers to pay will be re-evaluated and, if necessary and thecustomer qualifies for another modification, an additional temporary orpermanent modification may then be granted. Loans which have been granted apermanent modification, a twelve-month modification, or two consecutive six-month modifications, are reserved for as a troubled debt restructure inaccordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan"which requires reserves to be based on the present value of all future cashflows. We are also contacting customers who have adjustable rate mortgage loansnearing the first reset that we expect will be the most impacted by a rateadjustment in order to assess their ability to make the adjusted payment and, asappropriate, modify the loans for one year. As a result of this specific riskmitigation effort, we have modified more than 8,000 loans with an aggregatebalance of $1.2 billion. Additionally we have expanded a program allowingqualified customers to refinance their adjustable rate mortgage loan into afixed rate mortgage loan through our Consumer Lending branch network if allcurrent underwriting criteria are met. For the nine months ended September 30,2007, we have refinanced 2,275 customers through this program. In the 32 HSBC Finance Corporation-------------------------------------------------------------------------------- second half of 2006, we slowed growth in this portion of the portfolio byimplementing repricing initiatives in selected origination segments andtightening underwriting criteria, especially for second lien, stated income andlower credit scoring segments. Early in 2007, we announced our decision todiscontinue correspondent channel acquisitions. Reserve levels for real estate secured receivables at our Mortgage Services andConsumer Lending businesses can be further analyzed as follows: CONSUMER MORTGAGE LENDING SERVICES --------------- ---------------- THREE MONTHS THREE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, --------------- ---------------- 2007 2006 2007 2006------------------------------------------------------------------------------------------ (IN MILLIONS)Credit loss reserves at beginning of period...... $ 492 $250 $2,147 $ 557Provision for credit losses...................... 659 105 692 252Charge-offs...................................... (142) (96) (426) (138)Recoveries....................................... 2 2 11 7Other, net....................................... - - - (3) ------ ---- ------ -----Credit loss reserves at end of period............ $1,011 $261 $2,424 $ 675 ====== ==== ====== ===== CONSUMER LENDING ---------------- MORTGAGE SERVICES NINE MONTHS ----------------- ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------- ----------------- 2007 2006 2007 2006------------------------------------------------------------------------------------------- (IN MILLIONS)Credit loss reserves at beginning of period..... $ 278 $ 295 $ 2,085 $ 421Provision for credit losses..................... 1,136 237 1,433 589Charge-offs..................................... (409) (277) (1,122) (347)Recoveries...................................... 6 6 49 15Release of credit loss reserves related to loan sales......................................... - - (21) -Other, net...................................... - - - (3) ------ ----- ------- -----Credit loss reserves at end of period........... $1,011 $ 261 $ 2,424 $ 675 ====== ===== ======= ===== The provision for credit losses reflects our estimate of losses which have beenincurred as of the periods presented above. See "Results of Operations" includedin this MD&A for further discussion of our provision for credit losses and"Credit Quality" also included in this MD&A for further discussion on charge-offtrends experienced by our Mortgage Services and Consumer Lending businesses in2007. In March 2007, we decided to discontinue correspondent channel acquisitions byour Mortgage Services business and in June 2007 indicated that our Decision Onewholesale operation, which closed loans sourced by brokers primarily for resale,would continue operations, largely reselling such loans to an HSBC affiliate.However, the aforementioned recent turmoil in the mortgage lending industry hascaused us to re-evaluate our strategy. In September 2007, we concluded thatrecovery of a secondary market for subprime loan products is uncertain and at aminimum, could not be expected to stabilize in the near term which led to anannouncement that we would cease the operations of Decision One. The decision toterminate the operations of our Decision One business when coupled with ourprevious announcement of the discontinuation of correspondent channelacquisitions resulted in the impairment of the goodwill allocated to theMortgage Services business and, as such, we recorded a non-cash impairmentcharge of $881 million in the third quarter to write-off all of the goodwillallocated to this business. The actions described above, combined with normalportfolio attrition, including refinance and charge-off, will continue to resultin significant reductions in the principal balance of our Mortgage Services loanportfolio during 2007 and beyond. 33 HSBC Finance Corporation-------------------------------------------------------------------------------- As the developments in the mortgage industry have continued to unfold, inaddition to the decisions related to our Mortgage Services business, weinitiated an ongoing in-depth analysis of the risks and strategies of ourremaining businesses and product offerings. The following summarizes the changeswe have implemented or intend to implement in the future: Consumer Lending: Several actions have been taken to reduce risk including the discontinuation of the Personal Homeowner Loan ("PHL") product, the discontinuation of certain direct marketing activities to prospective customers, eliminating the small volume of ARM loan originations and capping loan-to-value ("LTV") ratios on second lien loans at 80 or 90 percent depending upon geography which will materially reduce volume associated with second liens going forward and the tightening of credit score and debt-to- income requirements for first lien loans. We have also continued to tighten underwriting criteria for our personal non-credit card loans. To put into perspective, the scale of the reduction in business in 2008 contemplated by these changes, measured on the basis of gross revenues, the risk reduction measures outlined above would represent around 5 percent of Consumer Lending revenues which in the year-to-date in 2007 were some $6.3 billion. These actions have also led us to evaluate the appropriate scope and geographic distribution of the Consumer Lending branch network. As a result of an earlier branch network optimization strategy, we are already closing or consolidating 100 branches during 2007. In November 2007, we have now decided to close or consolidate up to 260 additional branches prior to December 31, 2007. This will result in a network of approximately 1,000 branches. We expect to incur closure costs of up to $55 million, a substantial portion of which will be recorded in the fourth quarter of 2007. The major components of the estimated associated costs are as follows: (IN MILLIONS)--------------------------------------------------------------------------------One-time termination and other employee benefits................. $21Lease termination and associated costs of closing branches....... 33Other miscellaneous expenses..................................... 1 --- Total.......................................................... $55 === We currently estimate that expenses could be reduced by approximately $150 million in 2008 as a result of these actions. Credit Card Services: We will be implementing certain changes related to fee and finance charge billings beginning in the fourth quarter of 2007 as a result of continuing reviews to ensure our practices reflect our brand principles. While estimates of the potential impact of these changes are based on numerous assumptions and take into account factors which are difficult to predict, such as changes in customer behavior, we estimate that these changes will reduce fee and finance charge income by $50 million to $60 million in the fourth quarter of 2007 and $225 million to $250 million in 2008. In the fourth quarter of 2007 we will begin slowing growth in receivables and accounts in light of an anticipated slowing in the economy. Additionally, we have elected to slow the level of credit line increases and balance transfer offers to our existing customers. If we observe a strengthening in the economy, we intend to resume growth. In addition, we are also considering the sale of our General Motors ("GM") MasterCard and Visa portfolio to HSBC Bank USA. See "Segment Results -- IFRS Management Basis" included in this MD&A for further discussion of this potential portfolio sale. Auto Finance: Throughout 2007, we have continued to shift the mix of new loan volume originations to a higher credit quality which is producing narrower spreads. This has resulted in a higher mix of direct-to-consumer originations in our auto finance portfolio. Additionally, in August, 2007, a decision was made to terminate unprofitable alliance agreements with third parties which is not expected to have a significant impact to origination volume going forward. Retail Services: We are selectively tightening underwriting criteria and credit line management criteria to mitigate risk while we monitor the current economic environment. United Kingdom: In March 2007, we entered into an agreement to sell our United Kingdom insurance operations to a third party. The agreement also provides for the purchaser to distribute insurance products through our United Kingdom branch network for which we will receive commission revenue. The sale was completed on November 1, 2007. Additionally, as part of our strategic review, we have tightened underwriting criteria for all 34 HSBC Finance Corporation-------------------------------------------------------------------------------- product offerings and discontinued offering second lien loans with a LTV ratio greater than 100 percent. We are also currently evaluating placing similar LTV caps on our first lien loans. Canada: We have tightened underwriting criteria for various real estate and unsecured products in Canada which is leading to lower volumes and resulted in our announcement in October 2007 of our decision to close 30 branches by November 1, 2007. Additionally, in October 2007 we decided to exit the subprime mortgage broker based business in Canada and that we will reorganize the business into two regions to optimize management efficiencies and to reduce expenses. Taxpayer Financial Services: In early 2007, we began a strategic review of our Taxpayer Financial Services ("TFS") business to ensure that we offer only the most value-added financial services tax products. As a result, in March 2007 we decided that beginning with the 2008 tax season we will discontinue pre-season and pre-file products. We have also elected not to renew contracts with third- party preparers as they came up for renewal and have negotiated early termination agreements with others. We anticipate these actions could reduce Taxpayer financial services revenue by up to 45 percent in 2008. To the extent additional changes in the strategy of our remaining business orproduct offerings occur from the ongoing analysis discussed above, we will berequired by SFAS No. 142, "Goodwill and Other Intangible Assets," to performinterim goodwill impairment tests for the impacted businesses which could resultin goodwill impairment charges in future periods. Effective January 1, 2007, we early adopted SFAS No. 159 which provides for afair value option election that allows companies to irrevocably elect fair valueas the initial and subsequent measurement attribute for certain assets andliabilities, with changes in fair value recognized in earnings when they occur.SFAS No. 159 permits the fair value option election ("FVO") on an instrument byinstrument basis at the initial recognition of an asset or liability or upon anevent that gives rise to a new basis of accounting for that instrument. Weelected FVO for certain issuances of our fixed rate debt in order to align ouraccounting treatment with that of HSBC under International Financial ReportingStandards ("IFRSs"). The adoption of SFAS No. 159 resulted in a $542 millioncumulative-effect after-tax reduction to the January 1, 2007 opening balancesheet. In addition, the impact of the adoption of SFAS No. 159 on 2007 revenuebased on the change in the credit risk component of fair value optioned debt was$608 million in the three months ended September 30, 2007 and $846 million inthe year-to-date period. On June 29, 2007, the Federal Financial Regulatory Agencies (the "Agencies")issued a final statement on subprime mortgage lending which reiterates many ofthe principles addressed in the existing guidance relating to risk managementpractices and consumer protection laws involving adjustable rate mortgageproducts and the underwriting process on stated income and interest-only loans.We will be fully compliant with this statement by December 31, 2007. The impactof this statement will be immaterial on our operations. The financial information set forth below summarizes selected financialhighlights of HSBC Finance Corporation as of September 30, 2007 and 2006 and forthe three and nine month periods ended September 30, 2007 and 2006. THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------- --------------- 2007 2006 2007 2006--------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Net income (loss).................................. $(1,102) $ 551 $ (498) $2,007Return on average owned assets..................... (2.54)% 1.28% (.38)% 1.60%Return on average common shareholder's equity ("ROE").......................................... (23.40) 10.77 (3.67) 13.31Net interest margin................................ 6.66 6.56 6.53 6.64Consumer net charge-off ratio, annualized.......... 4.40 2.92 4.01 2.80Efficiency ratio(1)................................ 55.93 40.68 46.14 40.41 35 HSBC Finance Corporation-------------------------------------------------------------------------------- AS OF SEPTEMBER 30, 2007 2006---------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Receivables.................................................. $157,598 $157,040Two-month-and-over contractual delinquency ratios............ 6.13% 4.19% -------- (1) Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits. Receivables were $157.6 billion at September 30, 2007, $157.9 billion at June30, 2007 and $157.0 billion at September 30, 2006. While real estate securedreceivables have been a primary driver of growth in recent years, in the thirdquarter of 2007 real estate secured growth in our Consumer Lending business wasmore than offset by lower receivable balances in our Mortgage Services businessresulting from decisions in the second half of 2006 to reduce purchases ofhigher risk products and in March 2007 to discontinue all loan acquisitions byour Mortgage Services business. As discussed above, in the third quarter of2007, we announced our decision to cease operations of our Decision One businessand also implemented risk mitigation efforts and changes to product offerings inall remaining business that will result in reductions of aggregate receivablebalances in future periods. Compared to June 30, 2007, receivable levelsprimarily reflect attrition in our Mortgage Services portfolio as discussedabove, partially offset by growth in our Consumer Lending and Credit Cardbusinesses. Compared to September 30, 2006, with the exception of real estatesecured receivables due to the lower receivable balances at our MortgageServices business, we experienced growth in all of our receivable productsparticularly in our credit card portfolio due to strong domestic organic growthin our General Motors, Union Privilege, Metris and non-prime portfolios. Thelower receivable balances at our Mortgage Services business as compared to theyear-ago period also reflect the sale of $.5 billion in the first quarter and$2.2 billion in the second quarter of real estate secured loans from ourMortgage Services portfolio. Our two-months-and-over contractual delinquency ratio increased compared to boththe prior year quarter and prior quarter. Compared to both periods, with theexception of our private label portfolio, all products reported higherdelinquency levels due to higher receivable levels and higher real estatesecured delinquency at our Consumer Lending and Mortgage Services businesses dueto the weak housing and mortgage industry as discussed above. The two-months-and-over contractual delinquency ratio was also negatively impacted by lowerreal estate secured receivables growth driven largely by the discontinuation ofnew correspondent channel acquisitions which significantly reduced theoutstanding principal balance of the Mortgage Services loan portfolio. Ourcredit card portfolio reported a marked increase in the two-months-and-overcontractual delinquency ratio due to a shift in mix to higher levels of non-prime receivables, seasoning of a growing portfolio and higher levels ofpersonal bankruptcy filings as compared to the exceptionally low levelsexperienced in 2006 following enactment of new bankruptcy legislation in theUnited States. Net charge-offs as a percentage of average consumer receivables for the quarterincreased compared to both the prior year quarter and prior quarter in allproducts with the exception of our foreign private label portfolio. The increasein our Mortgages Services business reflects the higher delinquency levelsdiscussed above which are migrating to charge-off and the impact of lowerreceivable levels driven by the elimination of correspondent purchases. Theincrease in our Consumer Lending business reflects portfolio seasoning andhigher loss estimates in second lien loans purchased in 2004 through the thirdquarter of 2006 as part of a second lien bulk acquisition program which has beendiscontinued. At September 30, 2007, the outstanding principal balance of thesesecond lien loans acquired by the Consumer Lending business was approximately$1.1 billion. The marked increase in delinquency in our Consumer Lending realestate secured portfolio experienced in the current quarter largely as a resultof marketplace conditions will not begin to migrate to charge-off largely until2008. The increase in net charge-offs as a percent, annualized, of averageconsumer receivables for our credit card portfolio is due to higher charge-offlevels resulting from higher receivable balances as compared to the year-agoperiod, increased levels of personal bankruptcy filings as compared to theexceptionally low levels experienced in 2006 following enactment of the newbankruptcy law in the United States. The increase in net charge-offs as apercent, annualized, of average consumer receivables for our personal non-creditcard portfolio reflects portfolio seasoning and deterioration of 2006 vintagesoriginated through the direct mail channel in certain geographic regions. 36 HSBC Finance Corporation-------------------------------------------------------------------------------- Our efficiency ratio deteriorated as compared to the prior year quarter and theyear-ago period. Our efficiency ratio was significantly impacted in both thethree and nine month periods ended September 30, 2007 by the goodwill impairmentcharge relating to our Mortgage Services business which was partially offset bythe change in the credit risk component of our fair value optioned debt.Excluding these items, the efficiency ratio deteriorated 83 basis points ascompared to the prior year quarter and 137 basis points as compared to the year-ago period. The deterioration in the three months ended September 30, 2007 wasprimarily due to realized losses on real estate secured receivable sales andlower derivative income, partially offset by higher fee income and higher netinterest income due to higher levels of average receivables. Excluding thegoodwill impairment charge, costs and expenses during the quarter wereessentially flat as increased collection activities and severance costs recordedduring the quarter were largely offset by lower salary and employee benefits andsales incentives resulting from the discontinuance of correspondent channelacquisitions, lower marketing expenses and the impact of cost containmentmeasures. In the nine month period, realized losses on real estate securedreceivable sales, lower derivative income and higher costs and expenses weremore than offset by higher fee income and higher net interest income due to thehigher levels of average receivables discussed above. This information is provided by RNS The company news service from the London Stock ExchangeMORE TO FOLLOW

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