HSBC Finance Corp 2007 10K-P1

3rd Mar 2008 14:00

HSBC Holdings PLC03 March 2008 -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One)(X) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 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.) 26525 NORTH RIVERWOODS BOULEVARD, METTAWA, 60045 ILLINOIS (ZIP CODE) (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (224) 544-2000 REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE Securities registered pursuant to Section 12(b) of the Act: NAME OF EACH EXCHANGE ON WHICH TITLE OF EACH CLASS REGISTERED ------------------- ------------------------------8.40% Debentures Maturing at Holder's Option Annually on New York Stock Exchange December 15, Commencing in 1986 and Due May 15, 2008 Floating Rate Notes due May 21, 2008 New York Stock Exchange Floating Rate Notes due September 15, 2008 New York Stock Exchange Floating Rate Notes due October 21, 2009 New York Stock Exchange Floating Rate Notes due October 21, 2009 New York Stock Exchange Floating Rate Notes due March 12, 2010 New York Stock Exchange 4.625% Notes due September 15, 2010 New York Stock Exchange 5.25% Notes due January 14, 2011 New York Stock Exchange 6 3/4% Notes due May 15, 2011 New York Stock Exchange 5.7% Notes due June 1, 2011 New York Stock Exchange Floating Rate Notes due April 24, 2012 New York Stock Exchange 5.9% Notes due June 19, 2012 New York Stock Exchange Floating Rate Notes due July 19, 2012 New York Stock Exchange Floating Rate Notes due September 14, 2012 New York Stock Exchange Floating Rate Notes due January 15, 2014 New York Stock Exchange 5.25% Notes due January 15, 2014 New York Stock Exchange 5.0% Notes due June 30, 2015 New York Stock Exchange 5.5% Notes due January 19, 2016 New York Stock Exchange Floating Rate Notes due June 1, 2016 New York Stock Exchange 6.875% Notes due January 30, 2033 New York Stock Exchange 6% Notes due November 30, 2033 New York Stock Exchange Depositary Shares (each representing one-fortieth share New York Stock Exchange of 6.36% Non-Cumulative Preferred Stock, Series B, no par, $1,000 liquidation preference) Guarantee of Preferred Securities of HSBC Capital Trust New York Stock Exchange IX Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer,as defined in Rule 405 of the Securities Act. Yes (X) No ( ) Indicate by check mark if the registrant is not required to file reportspursuant to Section 13 or Section 15(d) of the Act. Yes ( ) No (X) 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 if disclosure of delinquent filers pursuant to Item405 of Regulation S-K is not contained herein, and will not be contained, to thebest of registrant's knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment to thisForm 10-K. (X) Indicate by check mark whether the registrant is a large accelerated filer,an accelerated filer, a non-accelerated filer, or a smaller reporting company.See the definitions of "large accelereated filer," "accelerated filer" and"smaller reporting company" in Rule 12b-2 of the Exchange Act. (Chech one): Large accelerated filer ( ) Accelerated filer ( ) Non-accelerated filer (X) Smaller reporting company ( ) (Do not check if a smaller reporting company) 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 February 28, 2008, there were 58 shares of the registrant's commonstock outstanding, all of which are owned by HSBC Investments (North America)Inc. DOCUMENTS INCORPORATED BY REFERENCE None. -------------------------------------------------------------------------------- TABLE OF CONTENTS PART/ITEM NO PAGE------------ ----PART I -------------------------------------------------------------------------------------Item 1. Business....................................................... 4 Organization History and Acquisition by HSBC................. 4 HSBC North America Operations................................ 4 HSBC Finance Corporation - General........................... 5 Operations................................................... 9 Funding...................................................... 13 Regulation and Competition................................... 15 Corporate Governance and Controls............................ 17 Cautionary Statement on Forward-Looking Statements........... 18Item 1A. Risk Factors................................................... 18Item 1B. Unresolved Staff Comments...................................... 22Item 2. Properties..................................................... 22Item 3. Legal Proceedings.............................................. 22Item 4. Submission of Matters to a Vote of Security Holders............ 25 PART II-------------------------------------------------------------------------------------Item 5. Market for Registrant's Common Equity and Related Stockholder Matters..................................................... 25Item 6. Selected Financial Data........................................ 26Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations....................................... 29 Executive Overview........................................... 29 Basis of Reporting........................................... 40 Critical Accounting Policies................................. 48 Receivables Review........................................... 53 Results of Operations........................................ 56 Segment Results - IFRS Management Basis...................... 65 Credit Quality............................................... 75 Liquidity and Capital Resources.............................. 91 Off Balance Sheet Arrangements and Secured Financings........ 100 Risk Management.............................................. 103 Glossary of Terms............................................ 109 Credit Quality Statistics.................................... 112 Analysis of Credit Loss Reserves Activity.................... 114 Net Interest Margin.......................................... 116 Reconciliations to U.S. GAAP Financial Measures.............. 118Item 7A. Quantitative and Qualitative Disclosures About Market Risk..... 121Item 8. Financial Statements and Supplementary Data.................... 121Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................................ 194Item 9A. Controls and Procedures........................................ 194Item 9B. Other Information.............................................. 194 2 PART/ITEM NO PAGE------------ ---- PART III-------------------------------------------------------------------------------------Item 10. Directors, Executive Officers and Corporate Governance......... 194Item 11. Executive Compensation......................................... 202Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters............................. 232Item 13. Certain Relationships and Related Transactions, and Director Independence................................................ 233Item 14. Principal Accountant Fees and Services......................... 234 PART IV-------------------------------------------------------------------------------------Item 15. Exhibits and Financial Statement Schedules..................... 235 Financial Statements......................................... 235 Exhibits..................................................... 235Signatures.................................................................... 237 3 HSBC Finance Corporation-------------------------------------------------------------------------------- PART I ITEM 1. BUSINESS.-------------------------------------------------------------------------------- ORGANIZATION HISTORY AND ACQUISITION BY HSBC-------------------------------------------------------------------------------- HSBC Finance Corporation traces its origin to 1878 and operated as a consumerfinance company under the name Household Finance Corporation ("HFC") for most ofits history. In 1981, HFC shareholders approved a restructuring that resulted inthe formation of Household International, Inc. ("Household") as a publicly heldholding company and HFC became a wholly-owned subsidiary of Household. For aperiod, Household diversified its operations outside the financial servicesindustry, but returned solely to consumer finance operations through a series ofdivestitures in the 1980's and 1990's. On March 28, 2003, Household was acquired by HSBC Holdings plc ("HSBC") by wayof merger with H2 Acquisition Corporation ("H2"), a wholly owned subsidiary ofHSBC, in a purchase business combination. Following the merger, H2 was renamed"Household International, Inc." Subsequently, HSBC transferred its ownershipinterest in Household to a wholly owned subsidiary, HSBC North America HoldingsInc. ("HSBC North America"), which subsequently contributed Household to itswholly-owned subsidiary, HSBC Investments (North America) Inc. On December 15, 2004, Household merged with its wholly owned subsidiary, HFC. Byoperation of law, following the merger, all obligations of HFC became directobligations of Household. Following the merger, Household changed its name toHSBC Finance Corporation. The name change was a continuation of the rebrandingof the Household businesses to the HSBC brand. These actions were taken tocreate a stronger platform to advance growth across all HSBC business lines. For all reporting periods up to and including the year ended December 31, 2004,HSBC prepared its consolidated financial statements in accordance with U.K.Generally Accepted Accounting Principles ("U.K. GAAP"). From January 1, 2005,HSBC has prepared its consolidated financial statements in accordance withInternational Financial Reporting Standards ("IFRSs") as endorsed by theEuropean Union and effective for HSBC's reporting for the year ended December31, 2005. HSBC Finance Corporation reports to HSBC under IFRSs and, as a result,corporate goals and the individual goals of executives are calculated inaccordance with IFRSs. HSBC NORTH AMERICA OPERATIONS-------------------------------------------------------------------------------- HSBC North America is the holding company for HSBC's operations in the UnitedStates and Canada. The principal subsidiaries of HSBC North America are HSBCFinance Corporation, HSBC Bank Canada, a Federal bank chartered under the lawsof Canada, HSBC USA Inc. ("HUSI"), a U.S. bank holding company, HSBC Markets(USA) Inc., a holding company for investment banking and markets subsidiaries,and HSBC Technology & Services (USA) Inc., a provider of information technologyservices. HUSI's principal U.S. banking subsidiary is HSBC Bank USA, NationalAssociation ("HSBC Bank USA"). Under the oversight of HSBC North America, HSBCFinance Corporation works with its affiliates to maximize opportunities andefficiencies in HSBC's operations in Canada and the United States. Theseaffiliates do so by providing each other with, among other things, alternativesources of liquidity to fund operations and expertise in specialized corporatefunctions and services. This has been demonstrated by purchases and sales ofreceivables between HSBC Bank USA and HSBC Finance Corporation, a pooling ofresources to create a new unit that provides technology services to all HSBCNorth America subsidiaries and shared, but allocated, support among theaffiliates for tax, legal, risk, compliance, accounting, insurance, strategy andinternal audit functions. In addition, clients of HSBC Bank USA and otheraffiliates are investors in our debt and preferred securities, providingsignificant sources of liquidity and capital to HSBC Finance Corporation. HSBCSecurities (USA) Inc., a Delaware corporation, registered broker dealer and asubsidiary of HSBC Markets (USA) Inc., leads or participates as underwriter ofall domestic issuances of our term corporate and asset backed securities. WhileHSBC Finance Corporation does not receive advantaged pricing, the underwritingfees and commissions payable to HSBC Securities (USA) Inc. benefit HSBC as awhole. 4 HSBC Finance Corporation-------------------------------------------------------------------------------- HSBC FINANCE CORPORATION - GENERAL-------------------------------------------------------------------------------- HSBC Finance Corporation's subsidiaries provide middle-market consumers in theUnited States and Canada with several types of loan products. We also currentlyoffer consumer loans in the United Kingdom and the Republic of Ireland. Prior toNovember 2006, when we sold our interests to an affiliate, we also offeredconsumer loans in Slovakia, the Czech Republic and Hungary. HSBC FinanceCorporation is the principal fund raising vehicle for the operations of itssubsidiaries. In this Form 10-K, HSBC Finance Corporation and its subsidiariesare referred to as "we," "us" or "our." Our lending products include real estate secured loans, auto finance loans,MasterCard(1), Visa(1), American Express(1) and Discover(1) credit card loans,private label credit card loans, personal non-credit card loans and prior toOctober 2006, retail sales contracts through our Consumer Lending branches. Wealso initiate tax refund anticipation loans and other related products in theUnited States and offer specialty insurance products in the United States andCanada. The insurance operations in the United Kingdom were sold November 1,2007 to Aviva plc and its subsidiaries ("Aviva"). Subsequent to November 1,2007, we distribute insurance products in the United Kingdom through our branchnetwork which are underwritten by Aviva. We generate cash to fund our businessesprimarily by collecting receivable balances; issuing commercial paper, mediumand long term debt; borrowing from HSBC subsidiaries and investors; sellingconsumer receivables; and borrowing under secured financing facilities. We usethe cash generated by these financing activities to invest in and originate newreceivables, to service our debt obligations and to pay dividends to our parentand preferred stockholders. At December 31, 2007, we had approximately 27,980employees and over 62.5 million customers. Consumers residing in the state ofCalifornia accounted for 12% of our domestic consumer receivables. We also havesignificant concentrations of domestic consumer receivables in Florida 7%, NewYork 6%, Texas 5%, Ohio 5% and Pennsylvania 5%. SIGNIFICANT DEVELOPMENTS RELATED TO OUR MORTGAGE SERVICES AND CONSUMER LENDINGBUSINESSES - HOUSING AND MORTGAGE MARKETS. Real estate markets in a large portion of the United States have been affected by a general slowing in the rate of appreciation in property values, or an actual decline in some markets such as California, Florida and Arizona, while the period of time available properties remain on the market continues to increase. During the second half of 2007, there has been unprecedented turmoil in the mortgage lending industry. The lower secondary market demand for subprime loans resulted in reduced liquidity for subprime mortgages. Mortgage lenders have also tightened lending standards which impacts borrowers' ability to refinance existing mortgage loans. It is now generally believed that the slowdown in the housing market will be deeper in terms of its impact on housing prices and the duration will extend at least through 2008. The combination of these factors has further reduced the refinancing opportunities of some of our customers as the ability to refinance and access any equity in homes is no longer an option to many customers. This impacts both credit performance and run-off rates and has resulted in rising delinquency rates for real estate secured loans in our portfolio and across the industry. - MORTGAGE SERVICES. Mortgage origination volumes were peaking in late 2005 and early 2006, while property values continued to increase rapidly. In the first half of 2006, industry statistics and reports indicated that mortgage loan originations throughout the industry from 2005 and 2006 were performing worse than originations from prior periods. At that time, worsening performance was attributable to the quality of certain loan products, particularly those originated by mortgage brokers, but generally not to declines in real property values. Loans with particularly poor performance were "stated income" loans which were underwritten based upon loan applicants' representations of annual income, not verified by receipt of supporting documentation and "interest-only" loans, for which borrowers paid only interest accrued on their loan for a specified period of time before their monthly payment increased to include an amount to be applied to the principal balance of their loan. Consistent with these trends, during the second ----------(1) MasterCard is a registered trademark of MasterCard International, Incorporated; Visa is a registered trademark of Visa, Inc.; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc. 5 HSBC Finance Corporation-------------------------------------------------------------------------------- quarter of 2006, we began to observe deterioration in the performance of mortgage loans acquired in 2005 by our Mortgage Services business, specifically in the second lien and portions of the first lien portfolios. In the fourth quarter of 2006, the deterioration of these loan types worsened considerably and began to affect the same types of loans acquired in 2006 by Mortgage Services. As additional information on 2005 and 2006 vintages became available, we observed increased and deeper deterioration than originally estimated. Portfolio delinquencies and charge-offs in the Mortgage Services portfolio were significantly higher than forecasted. Analysis of the performance of our second liens that were subordinate to first lien adjustable rate mortgages ("ARMs") in late 2006 indicated a significant level of impairment. Among other things, we observed that as housing prices declined, little, if any, equity remained in the second liens. Losses in the first lien ARM portfolio were also expected to increase based on the size of the scheduled increase in monthly payments as a result of impending interest rate resets. The impact of a softening housing market and portfolio related factors described above, led to a significant increase in estimated losses inherent in the Mortgage Services portfolio, as described herein. A significant number of our second lien mortgages are subordinate to first lien ARMs that face repricing in the near-term which in certain cases may also negatively impact the probability of repayment on our second lien mortgage loan. As the interest rate adjustments will occur in an environment of lower home value appreciation or depreciation and tightening credit, we expect the probability of default for adjustable rate first mortgages subject to repricing as well as any second lien mortgage loans that are subordinate to an adjustable rate first lien held by another lender will be greater than what we have historically experienced prior to late 2006. As more fully discussed in the section "Regulation - Consumer" under "Regulation and Competition", certain legislation and other regulations are being proposed in the United States to address these concerns, but we cannot currently predict the impact of these proposals on our portfolio and financial results in this unprecedented environment. - In December 2006, we established common management over our Consumer Lending and Mortgage Services businesses to enhance our combined organizational effectiveness, drive operational efficiency and improve overall balance sheet management capabilities. - CONSUMER LENDING. Consumer Lending experienced relatively stable performance in its portfolio throughout 2006 and into the first half of 2007. Notwithstanding this relatively stable performance, in late 2006 and early 2007 Consumer Lending noted weakening early stage delinquency in certain real estate secured loans originated since 2005. This was consistent with industry trends for retail portfolio lenders. In addition as noted above, we observed that real estate markets in a large portion of the United States had been affected by a general slowing in the rate of appreciation in property values, or an actual decline in some markets, while the period of time properties available for sale remained on the market had increased. In the third quarter of 2007, Consumer Lending began to experience the impact of an industry-wide tightening of underwriting criteria and the elimination of many loan products previously available to consumers. This significantly reduced the ability of consumers to refinance their loans and to utilize equity in their homes to satisfy outstanding debt. This combined impact of reduced financing options and slowing appreciation or declining property values had a significant effect on delinquency, Consumer Lending's loss forecasts and the estimate of probable credit losses inherent in the loan portfolio. This credit deterioration migrated across all Consumer Lending origination vintages during the second half of 2007, but in particular in loans which were originated in 2006 and the first half of 2007. The deterioration has been most severe in the first lien portions of the portfolio in the geographic regions most impacted by the decline in home value appreciation and rising unemployment rates, particularly in the states of California, Florida, Arizona, Virginia, Washington, Maryland, Minnesota, Massachusetts and New Jersey which account for approximately 55 percent of the increase in dollars of two-months-and-over contractual delinquency during 2007 and approximately 40 percent of Consumer Lending's real estate secured portfolio. This worsening trend and an outlook for increased charge-offs has resulted in a marked increase in the provision for credit losses at our Consumer Lending business during the second half of 2007. In response to this deterioration, Consumer Lending increased collection staffing, expanded the use of its foreclosure avoidance program and took action to reduce risk in its real estate secured and personal non-credit card receivable portfolios going forward. 6 HSBC Finance Corporation-------------------------------------------------------------------------------- - In the fourth quarter of 2007, an impairment charge in the amount of $3,320 million was recorded by our Consumer Lending business, relating to all goodwill, as well as all tradename and customer relationship intangibles associated with the HSBC acquisition. Additional detail regarding this impairment is set forth below in the "Other Significant Developments Since 2004" section. - MORTGAGE SERVICES AND DECISION ONE CLOSURES. Prior to the first quarter 2007, the Mortgage Services operation purchased non-conforming first and second lien position residential mortgage loans, including open-end home equity loans. Purchases were either "flow" acquisitions (i.e., loan by loan) or "bulk" acquisitions (i.e., pools of loans). Through Decision One Mortgage Company, LLC ("Decision One"), Mortgage Services also originated loans sourced by a network of unaffiliated brokers. In March 2007, in response to all the factors described above, we decided to discontinue correspondent channel acquisitions by our Mortgage Services business and in June 2007 indicated that our Decision One wholesale operation, which closed loans sourced by brokers primarily for resale, would continue operations, largely reselling such loans to an HSBC affiliate. However, the turmoil in the mortgage lending industry caused us to re-evaluate our strategy. In September 2007, we announced that we would cease operations of Decision One. The decision to terminate the Decision One operations coupled with our previous announcement of the discontinuation of correspondent channel acquisitions resulted in the impairment of goodwill allocated to the Mortgage Services business. We recorded a non-cash impairment charge of $881 million in the third quarter of 2007 which was disclosed in our Current Report Form 8-K filed on September 21, 2007. - CONSUMER LENDING RISK MITIGATION - BRANCH CLOSURES. In response to the weakening housing market, Consumer Lending took the following actions to reduce risk in its real estate secured and personal non-credit card receivable portfolios going forward including tightening of credit score and debt-to income requirements for first lien loans; reducing loan-to- value ("LTV") ratios in first and second lien loans; eliminating the small volume of ARM loan originations; discontinuing the personal homeowner loan product (a secured high loan-to-value product ("PHL") that we underwrote and serviced like an unsecured loan); tightening underwriting criteria for all products and eliminating guaranteed direct mail loans to new customers. These actions led us to evaluate the appropriate scope and geographic distribution of the Consumer Lending branch network. As a result of this new effort, when coupled with an earlier branch network optimization strategy, we reduced our branch network from 1,382 branches at December 31, 2006 to approximately 1,000 branches at December 31, 2007. - ARM ADJUSTMENT RISK MITIGATION. Numerous risk mitigation efforts have been implemented, commencing in 2006 and continuing throughout 2007 relating to the affected components of the Mortgage Services portfolio. These include enhanced segmentation and analytics to identify the higher risk portions of the portfolio and increased collections capacity. In 2008 and 2009, approximately $3.7 billion and $4.1 billion, respectively, of domestic ARM loans will experience their first interest reset based on original contractual reset date and receivable levels outstanding at December 31, 2007. As part of a new program established in October 2006 specifically designed to meet the needs of select customers with ARMs, we are proactively writing and calling customers who have ARMs nearing the first reset that we expect will be the most impacted by a rate adjustment. As appropriate and in accordance with defined policies, if we believe the customer has the ability to pay for the foreseeable future under the modified terms, we have been modifying the loans in most instances by delaying the first interest rate adjustment. Modifications under this particular program may be permanent, but most in 2006 and 2007 were twelve-months in duration. In 2008, we anticipate approximately $1.3 billion of ARM loans modified under this modification program, which are excluded from the reset numbers above, will experience their first reset. We are currently developing longer term modification programs that will be based on customers needs and their ability to pay and with a view to maximize future cash flow. Going forward, we will be offering our customers longer term modifications, potentially up to 5 years. At the end of the modification term, the ability of customers to pay will be re- evaluated and, if necessary and the customer qualifies for another modification, an additional temporary or permanent modification may then be granted. Additionally we have expanded a program allowing qualified customers to refinance their ARM loan into a fixed rate mortgage loan through our Consumer Lending branch network if all current underwriting criteria are met. For all our receivable portfolios, we have markedly increased our collection capacity. 7 HSBC Finance Corporation-------------------------------------------------------------------------------- OTHER SIGNIFICANT DEVELOPMENTS SINCE 2004 - In 2007, we initiated an ongoing in-depth analysis of the risks and strategies of our remaining businesses and product offerings. Additional detail regarding changes implemented in 2007 as a result of this analysis is set forth in "2007 Events" section of our Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations ("2007 MD&A"). - During the fourth quarter of 2007, we performed interim goodwill and other intangible impairment tests for the businesses where significant changes in the business climate have occurred as required by SFAS No. 142, "Goodwill and Other Intangible Assets," ("SFAS No. 142"). These tests revealed that the business climate changes, including the subprime marketplace conditions described above, when coupled with the changes to our product offerings and business strategies completed through the fourth quarter of 2007 as described in "2007 Events" of Item 7. of the 2007 MD&A, have resulted in an impairment of all goodwill allocated to our Consumer Lending (which includes Solstice Capital Group Inc.) and Auto Finance businesses, as well as all tradename and customer relationship intangibles relating to the HSBC acquisition allocated to our Consumer Lending business. Therefore, we recorded an impairment charge in the fourth quarter of 2007 of $3,320 million relating to our Consumer Lending business (including $858 million related to tradename and customer relationship intangibles) and a $312 million goodwill impairment charge relating to our Auto Finance business. These impairments represent all of the goodwill previously allocated to these businesses and all of the HFC and Beneficial tradenames and customer relationship intangibles associated with the HSBC acquisition. Additionally, the changes to product offerings and business strategies completed through the fourth quarter of 2007 have also resulted in an impairment of the goodwill allocated to our United Kingdom business. As a result, an impairment charge of $378 million was also recorded in the fourth quarter of 2007 representing all of the goodwill previously allocated to this business. - In 2007, we implemented ongoing in-depth cost containment measures. This includes centralizing certain cost functions and increasing the use of HSBC affiliates outside of the United States to provide various support services to our operations, including, among other areas, customer service, systems, collections and accounting functions. - In the third quarter of 2007, we decided to close our loan underwriting, processing and collections center in Carmel, Indiana (the "Carmel Facility") to optimize our facility and staffing capacity given the overall reductions in business volume. The Carmel Facility provided loan underwriting, processing and collection activities for the operations of our Consumer Lending and Mortgage Services business. The collection activities performed in the Carmel Facility have been redeployed to other facilities in our Consumer Lending business. - In May 2007, we decided to integrate our Retail Services and Credit Card Services businesses. It is anticipated that the integration of management reporting will be completed in the first quarter of 2008 and at that time will result in the combination of these businesses into one reporting segment in our financial statements. - Since our acquisition by HSBC, our debt ratings as assigned by Fitch Investor's Service ("Fitch"), Moody's Investors Service ("Moody's") and Standard and Poor's Corporation ("S&P") have improved to AA-, Aa3 and AA- , respectively for our senior debt, while our Commercial Paper ratings have improved to F-1+, P-1, and A-1+, respectively. In the fourth quarter of 2007, Moody's, Standard & Poor's and Fitch changed the total outlook on our issuer default rating from "positive" to "stable." See Exhibit 99.1 to this Form 10-K for a complete listing of debt ratings of HSBC Finance Corporation and our subsidiaries. - Effective January 1, 2007, we elected to early adopt FASB Statement No. 157, "Fair Value Measurements," ("SFAS No. 157"). SFAS No. 157 establishes a single authoritative definition of value, sets out a framework for measuring fair value, and provides a hierarchal disclosure framework for assets and liabilities measured at fair value. The adoption of SFAS No. 157 did not have any impact on our financial position or results of operations. - Effective January 1, 2007, we early adopted SFAS No. 159 which provides for a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain assets and liabilities, with changes in fair value recognized in earnings when they occur. SFAS No. 159 permits the fair value option election ("FVO") on an instrument by instrument basis at the initial 8 HSBC Finance Corporation-------------------------------------------------------------------------------- recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We elected FVO for certain issuances of our fixed rate debt in order to align our accounting treatment with that of HSBC under International Financial Reporting Standards ("IFRSs"). - Our Consumer Lending business purchased Solstice Capital Group Inc. with assets of approximately $49 million in the fourth quarter of 2006. - In November 2006, we acquired the $2.5 billion mortgage loan portfolio of KeyBank, N.A.'s division operated as Champion Mortgage, a retail mortgage lending company. - In November 2006, we sold all of the capital stock of our operations in the Czech Republic, Hungary and Slovakia to a wholly owned subsidiary of HSBC Bank plc. - In 2005, we expanded our presence in the domestic near-prime credit card market and strengthened our capabilities to serve the full spectrum of credit card customers through the acquisition of Metris Companies, Inc. ("Metris"). OPERATIONS-------------------------------------------------------------------------------- Our operations are divided into three reportable segments: Consumer, Credit CardServices and International. Our Consumer segment includes our Consumer Lending,Mortgage Services, Retail Services and Auto Finance businesses. Our Credit CardServices segment includes our domestic MasterCard, Visa, American Express andDiscover credit card business. In May 2007, we decided to integrate our RetailServices and Credit Card Services businesses. We anticipate the integration ofmanagement reporting will be completed in the first quarter of 2008 and at thattime will result in the combination of these businesses into one reportingsegment in our financial statements. Our International segment includes ourforeign operations in the United Kingdom, Canada and the Republic of Ireland andprior to November 9, 2006, operations in Slovakia, the Czech Republic andHungary. The insurance operations in the United Kingdom were sold in November2007 to Aviva. Information about businesses or functions that fall below thesegment reporting quantitative threshold tests such as our Insurance Services,Taxpayer Financial Services and Commercial operations, as well as our Treasuryand Corporate activities, which include fair value adjustments related topurchase accounting and related amortization, are included under the "All Other"caption within our segment disclosure. Corporate goals and individual goals of executives are currently calculated inaccordance with IFRSs under which HSBC prepares its consolidated financialstatements. In 2006 we initiated a project to refine the monthly internalmanagement reporting process to place a greater emphasis on IFRS managementbasis reporting (a non-U.S. GAAP financial measure) ("IFRS Management Basis").As a result, operating results are now being monitored and reviewed, trends arebeing evaluated and decisions about allocating resources, such as employees, arebeing made almost exclusively on an IFRS Management Basis. IFRS Management Basisresults are IFRSs results which assume that the private label and real estatesecured receivables transferred to HSBC Bank USA have not been sold and remainon our balance sheet. IFRS Management Basis also assumes that all purchaseaccounting fair value adjustments relating to our acquisition by HSBC have been"pushed down" to HSBC Finance Corporation. Operations are monitored and trendsare evaluated on an IFRS Management Basis because the customer loan sales toHSBC Bank USA were conducted primarily to appropriately fund prime customerloans within HSBC and such customer loans continue to be managed and serviced byus without regard to ownership. Accordingly, our segment reporting is on an IFRSManagement Basis. However, we continue to monitor capital adequacy, establishdividend policy and report to regulatory agencies on an U.S. GAAP basis. Asummary of the significant differences between U.S. GAAP and IFRSs as theyimpact our results are summarized in Note 21, "Business Segments," in theaccompanying consolidated financial statements. GENERAL We generally serve non-conforming and non-prime consumers. Such customers areindividuals who have limited credit histories, modest incomes, high debt-to-income ratios, high loan-to-value ratios (for auto and real estate securedproducts) or have experienced credit problems caused by occasionaldelinquencies, prior charge-offs, bankruptcy or other credit related actions.These customers generally have higher delinquency and credit loss probabilitiesand are charged a higher interest rate to compensate for the additional risk ofloss and the anticipated 9 HSBC Finance Corporation-------------------------------------------------------------------------------- additional collection initiatives that may have to be undertaken over the lifeof the loan. In our credit card, retail services and international businesses,we also serve prime consumers either through co-branding, merchant relationshipsor direct mailings. 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 are fully compliant with this statement as of December 31, 2007. The impactof this statement will be immaterial on our operations. We use our centralized underwriting, collection and processing functions toadapt our credit standards and collection efforts to national or regional marketconditions. Our underwriting, loan administration and collection functions aresupported by highly automated systems and processing facilities. Our centralizedcollection systems are augmented by personalized early collection efforts.Analytics drive our decisions in marketing, risk pricing, operations andcollections. We service each customer with a view to understanding that customer's personalfinancial needs. We recognize that individuals may not be able to meet all oftheir financial obligations on a timely basis. Our goal is to assist consumersin transitioning through financially difficult times which may lead to theirdoing more business with our lending subsidiaries. As a result, our policies andpractices are designed to be flexible to maximize the collectibility of ourloans while not incurring excessive collection expenses on loans that have ahigh probability of being ultimately uncollectible. However, as discussed above,in the current environment we have been more proactive in modifying loans on atemporary or permanent basis where we believe customers will be unable tocontinue payments. Proactive credit management, "hands-on" customer care andtargeted product marketing are means we use to retain customers and grow ourbusiness. CONSUMER Our Consumer Lending business is one of the largest subprime home equityoriginators in the United States as ranked by Inside B&C Lending. At December31, 2007, this business has approximately 1,000 branches located in 46 states,and approximately 2.8 million active customer accounts, $69.4 billion inreceivables and approximately 11,100 employees. It is marketed under both theHFC and Beneficial brand names, each of which caters to a slightly differenttype of customer in the middle-market population. Both brands offer secured andunsecured loan products, such as first and second lien position closed-endmortgage loans, open-end home equity loans, personal non-credit card loans andauto finance receivables. These products are marketed through our retail branchnetwork, direct mail, telemarketing, and Internet sourced applications andleads. However, due to the worsening market, several actions were taken in 2007to reduce risk in its real estate secured and personal non-credit cardreceivable portfolios including tightening of credit score and debt-to incomerequirements for first lien loans; reducing loan-to-value ("LTV") ratios infirst and second lien loans; eliminating the small volume of ARM loanoriginations; discontinuing the personal homeowner loan product (a secured highloan-to-value product ("PHL") that we underwrote and serviced like an unsecuredloan); tightening underwriting criteria for all products and eliminatingguaranteed direct mail loans to new customers. These actions led us to evaluatethe appropriate scope and geographic distribution of the Consumer Lending branchnetwork. As a result of this new effort, when coupled with an earlier branchnetwork optimization strategy, we have reduced our branch network from 1,382branches at December 31, 2006 to approximately 1,000 branches at December 31,2007. Prior to the first quarter of 2007 when we ceased new purchase activity, ourMortgage Services business purchased non-conforming first and second lien realestate secured loans from a network of unaffiliated third party lenders (i.e.correspondents) based on our underwriting standards. Our Mortgage Servicesbusiness had included the operations of Decision One Mortgage Company ("DecisionOne") which historically originated mortgage loans sourced by independentmortgage brokers and sold such loans to secondary market purchasers, includingMortgage Services. In June 2007, we also limited Decision One's activities tothe origination of loans primarily for resale to the secondary market operationsof our affiliates. Subsequently, the unprecedented developments in the mortgagelending industry resulted in a marked reduction in the secondary market demandfor subprime loans and management concluded that a recovery of a secondarymarket for subprime loans was uncertain and could not 10 HSBC Finance Corporation-------------------------------------------------------------------------------- be expected to stabilize in the near term. As a result of the continuingdeterioration in the subprime mortgage lending industry, in September 2007, weannounced that our Decision One operations would cease. At December 31, 2007,our Mortgage Services business has approximately $33.9 billion in receivablesand approximately 300,000 active customer accounts. Approximately 56% of theMortgage Services portfolio were fixed rate loans and 81% were in a first lienposition. On December 29, 2004, our domestic private label receivable portfolio (excludingretail sales contracts at our Consumer Lending business) of approximately $12.2billion of receivables was sold to HSBC Bank USA, and agreements were enteredinto to sell substantially all future receivables to HSBC Bank USA on a dailybasis and to service the portfolio for HSBC Bank USA for a fee. As a result, wenow sell substantially all domestic private label receivables (excluding retailsales contracts) upon origination, but service the entire portfolio on behalf ofHSBC Bank USA. According to The Nilson Report, the private label servicingportfolio is the third largest portfolio in the U.S. Our Retail Servicesbusiness has over 60 active merchant relationships and we service approximately15.9 million active customer accounts and have over 2,200 employees. At December31, 2007, the serviced private label portfolio consisted of approximately 10% ofreceivables in the furniture industry, 34% in the consumer electronics industry,31% in the power sport vehicle (snowmobiles, personal watercraft, all terrainvehicles and motorcycles) industry and approximately 15% in the department storeindustry. Private label financing products are generated through merchant retaillocations, merchant catalog and telephone sales, and direct mail and Internetapplications. Our Auto Finance business purchases, from approximately 9,200 active dealerrelationships, retail installment contracts of consumers who may not have accessto traditional, prime-based lending sources. We also originate and refinanceauto loans through direct mail solicitations, alliance partners, consumerlending customers and the Internet. The alliance agreements were terminatedduring 2007 and the final funding occurred in December 2007. The termination ofthe alliance will not have a material impact on our results. At December 31,2007, this business had approximately $12.1 billion in receivables,approximately 820,000 active customer accounts and 2,500 employees.Approximately 34% of auto finance receivables are secured by new vehicles.Throughout 2007, we continued to shift the mix of new originations to a highercredit quality by eliminating higher risk loan populations. These actions havereduced volume in 2007 by 20-25% in our dealer channel and are expected tocontinue to reduce volume into 2008, resulting in reduced net income andnarrower spreads over time. We have also begun to shift the mix of new loanvolume in the direct-to-consumer channel to higher credit quality. Inanticipation of a continuation of the slowing of the economy, we areimplementing additional actions to reduce risk in 2008 originations which willresult in further reductions in volume going forward. CREDIT CARD SERVICES Our Credit Card Services business includes our MasterCard, Visa, AmericanExpress and Discover receivables in the United States originated under variousbrands, including The GM Card(R), the AFL-CIO Union Plus(R) ("UP") credit card,Household Bank, Orchard Bank, HSBC and the Direct Merchants Bank branded creditcards. This business has approximately $30.5 billion in receivables, over 21million active customer accounts and 5,700 employees. According to The NilsonReport, this business is the fifth largest issuer of MasterCard or Visa creditcards in the United States (based on receivables). The GM Card(R), a co-brandedcredit card issued as part of our alliance with General Motors Corporation("GM"), enables customers to earn discounts on the purchase or lease of a new GMvehicle. The UP card program with the AFL-CIO provides benefits and services tomembers of various national and international labor unions. The Household Bankand Orchard Bank credit cards offer specialized credit card products toconsumers underserved by traditional providers or are marketed in conjunctionwith certain merchant relationships established through our Retail Servicesbusiness. The Direct Merchants Bank branded credit card is a general purposecard marketed to non-prime customers through direct mail and strategicpartnerships. HSBC branded cards are targeted through direct mail and Internetto the prime market. In addition, Credit Card Services services $1.1 billion ofreceivables held by an affiliate, HSBC Bank USA. New receivables and accountsrelated to the HSBC Bank USA portfolio are originated by HSBC Bank Nevada, N.A.,and receivables are sold daily to HSBC Bank USA. Our Credit Card Services business is generated primarily through direct mail,telemarketing, Internet applications, application displays, promotional activityassociated with our affinity and co-branding relationships, mass-media 11 HSBC Finance Corporation-------------------------------------------------------------------------------- advertisement (The GM Card(R)) and merchant relationships sourced through ourRetail Services business. We also cross-sell our credit cards to our existingConsumer Lending customers as well as our Taxpayer Financial Services and AutoFinance customers. We are considering the sale of our GM MasterCard and Visaportfolio to HSBC Bank USA. See "Segment Results -- IFRS Management Basis"included in the 2007 MD&A for further discussion. Although our relationships with GM and the AFL-CIO enable us to access aproprietary customer base, in accordance with our agreements with theseinstitutions, we own all receivables originated under the programs and areresponsible for all credit and collection decisions as well as the funding forthe programs. These programs are not dependent upon any payments, guarantees orcredit support from these institutions. As a result, we are not directlydependent upon GM or the AFL-CIO for any specific earnings stream associatedwith these programs. In 2004 and 2005, we jointly agreed with GM and the AFL-CIO, respectively, to extend the term of these respective co-branded andAffinity Card Programs. These agreements do not expire in the near term. INTERNATIONAL Our United Kingdom subsidiary is a mid-market consumer lender focusing oncustomer service through its branch locations, and consumer electronics throughits retail finance operations and telemarketing. This business offers securedand unsecured lines of credit, secured and unsecured closed-end loans, retailfinance products and insurance products. We operate in England, Scotland, Wales,Northern Ireland and the Republic of Ireland. In December 2005 we sold our U.K.credit card business to HSBC Bank plc. Under agreement with HSBC Bank plc, wecontinue to provide collection services and other support services, includingcomponents of the compliance, financial reporting and human resource functions,for this credit card portfolio. Loans held in the United Kingdom and the Republic of Ireland are originatedthrough a branch network consisting of 135 Beneficial Finance branches,merchants, direct mail, broker referrals, the Internet and outboundtelemarketing. At December 31, 2007 we had approximately $5.3 billion inreceivables, 1.5 million customer accounts and 2,150 employees in our operationsin the United Kingdom and the Republic of Ireland. In November 2006, we sold our consumer finance operations in the Czech Republic,Hungary and Slovakia to a wholly owned subsidiary of HSBC Bank plc. On November1, 2007, we sold all of the capital stock of our United Kingdom insuranceoperations to Aviva for a purchase price of approximately $206 million in cash.At that same time, we entered into an exclusive distribution agreement withAviva for the future sale of insurance products through all of our loanorigination channels. Our Canadian business offers real estate secured and unsecured lines of credit,real estate secured and unsecured closed-end loans, insurance products, privatelabel credit cards, MasterCard credit card loans, retail finance products andauto loans to Canadian consumers. These products are marketed through 110 branchoffices in 10 provinces, through direct mail, 18 merchant relationships, 2,400auto dealer relationships and the Internet. At December 31, 2007, this businesshad approximately $5.1 billion in receivables, 1.6 million customer accounts and1,500 employees. ALL OTHER Our Insurance business distributes and manages the distribution of credit life,disability and unemployment, accidental death and disability, term life, wholelife, annuities, disability, long term care and a variety of other specialtyinsurance products to our customers and the customers of affiliated financialinstitutions, such as HSBC Bank USA. Such products currently are offeredthroughout the United States and Canada and are offered to customers based upontheir particular needs. Insurance distributed to our customers is directlywritten by or reinsured with one or more of our subsidiaries. Insurance sold tocustomers of HSBC Bank USA and certain other affiliates is written primarily byunaffiliated insurance companies. The Taxpayer Financial Services business is a U.S. provider of tax-relatedfinancial products to consumers through about 36,000 unaffiliated professionaltax preparer locations and tax preparation software providers. Serving around 11million customers, this business leverages the annual U.S. income tax filingprocess to provide products that offer consumers quick and convenient access tofunds in the amount of their anticipated tax refund. Our 12 HSBC Finance Corporation-------------------------------------------------------------------------------- Taxpayer Financial Services business processes refund anticipation products thatare originated by HSBC Bank USA and HSBC Trust Company (Delaware), N.A. In 2007,this business generated a loan volume of approximately $17.4 billion andemployed 126 full-time employees. To help ensure high standards of responsible lending, we provide industry-leading compliance programs for our tax preparer business partners. Key elementsof our compliance efforts include mandatory online compliance and sales-practicetraining, expanded tax preparer due diligence processes, and on-going salespractice monitoring to help ensure that our customers are treated fairly andthat they understand their financial choices. Additionally, access to freeconsumer financial education resources and a 48-hour satisfaction guarantee areoffered to customers, which further enhances our compliance and customer serviceefforts. In early 2007, we began a strategic review of our Taxpayer FinancialServices ("TFS") business to ensure we offer only the most value-added financialservices tax products. As a result, in March 2007 we decided that beginning withthe 2008 tax season we will discontinue pre-season and pre-file loan products.We have also elected not to renew contracts with certain third-party preparersas they came up for renewal and have negotiated early termination agreementswith others. In the fourth quarter, we also decided to stop participating incross collection activities with other refund anticipation loan providers. Weestimate these actions could reduce Taxpayer Financial Services revenue byapproximately $110 million in 2008. We have less than $140 million in commercial receivables. The commercialportfolio is being managed to eliminate the portfolio as circumstances permit.There are no active operations. FUNDING-------------------------------------------------------------------------------- We fund our operations globally and domestically, using a combination of capitalmarket and affiliate debt, preferred equity, sales of consumer receivables andborrowings under secured financing facilities. We will continue to fund a largepart of our operations in the global capital markets, primarily through the useof secured financings, commercial paper, medium-term notes and long-term debt.We will also continue to sell certain receivables, including our domesticprivate label originations to HSBC Bank USA. Our sale of the entire domesticprivate label portfolio (excluding retail sales contracts at our ConsumerLending business) to HSBC Bank USA occurred in December 2004. We now originateand sell substantially all newly originated private label receivables to HSBCBank USA on a daily basis. In 2007, these sales were a significant source offunding as we sold $22.7 billion in receivables to HSBC Bank USA. Additionally,during 2007 we sold $2.7 billion of loans from our Mortgage Services loanportfolio to unaffiliated purchasers. Our affiliation with HSBC has improved our access to the capital markets. Inaddition to providing several important sources of direct funding, ouraffiliation with HSBC has also expanded our access to a worldwide pool ofpotential investors. While these new funding synergies have somewhat reduced ourreliance on traditional sources to fund our growth, we balance our use ofaffiliate and third-party funding sources to minimize funding expense whilemaximizing liquidity. Our long-term debt, preferred stock and commercial paper, as well as the long-term debt and commercial paper of our Canadian subsidiary, have been assignedinvestment grade ratings by all nationally recognized statistical ratingorganizations. For a detailed listing of the ratings that have been assigned toHSBC Finance Corporation and our significant subsidiaries as of December 31,2007, see Exhibit 99.1 to this Form 10-K. Our affiliates provided funding sources for our operations through draws on abank line in the U.K., investing in our debt, acquiring credit card, privatelabel and real estate secured receivables, providing additional common equityand underwriting sales of our debt securities to HSBC clients and customers. In2007, total HSBC related funding aggregated $44.5 billion. In the first quarterof 2007, HINO made a capital contribution of $200 million and in the lastquarter of 2007 a capital contribution of $750 million, each in exchange for oneshare of common stock. On February 12, 2008, HINO made a capital contribution of$1.6 billion in exchange for one share of common stock. A detailed listing ofthe sources of such funding can be found in "Liquidity and Capital Resources" inour 2007 MD&A. We expect to continue to obtain significant funding from HSBCrelated sources in the future. 13 HSBC Finance Corporation-------------------------------------------------------------------------------- Historically, securitization of consumer receivables has been a source offunding and liquidity for HSBC Finance Corporation. In order to align ouraccounting treatment with that of HSBC, in the third quarter of 2004 we began tostructure all new collateralized funding transactions as secured financings. Thetermination of sale treatment for new collateralized funding activity reducedreported net income under U.S. GAAP, but did not impact cash received fromoperations. Existing credit card and personal non-credit card transactions thatwere structured as sales to revolving trusts required the addition of newreceivables to support required cash distributions on outstanding securitiesuntil the contractual obligation terminated, which occurred in September of2007. Generally, for each securitization and secured financing we utilize creditenhancement to obtain investment grade ratings on the securities issued by thetrust. To ensure that adequate funds are available to pay investors theircontractual return, we may retain various forms of interests in assets securinga funding transaction, whether structured as a securitization or a securedfinancing, such as over-collateralization, subordinated series, residualinterests (in the case of securitizations) in the receivables or we may fundcash accounts. Over-collateralization is created by transferring receivables tothe trust issuing the securities that exceed the balance of the securities to beissued. Subordinated interests provide additional assurance of payment toinvestors holding senior securities. Residual interests are also referred to asinterest-only strip receivables and represent rights to future cash flows fromreceivables in a securitization trust after investors receive their contractualreturn. Cash accounts can be funded by an initial deposit at the time thetransaction is established and/or from interest payments on the receivables thatexceed the investor's contractual return. Our continued success and prospects for growth are largely dependent upon accessto the global capital markets. Numerous factors, internal and external, mayimpact our access to, and the costs associated with, these markets. Thesefactors may include our debt ratings, economic conditions, overall capitalmarkets volatility and the effectiveness of our management of credit risksinherent in our customer base. In 2007, the capital markets were severelydisrupted and the markets continue to be highly risk averse and reactionary.While these events increased our 2007 interest expense, they had no impact onour ability to fund our operations. Our funding objectives were accomplishedthrough the utilization of a variety of financing alternatives and a reductionin total receivables. Over the course of the second half of 2007, we experienced a significantwidening of credit spreads corresponding to the primary and secondary markets inboth our secured and unsecured debt. This spread widening was consistent withwidening experienced by other financial institutions that were active in theorigination, purchase and/or sale of subprime consumer receivables.Additionally, the overall volume of debt issued by finance sector participantsdeclined during this period as the traditional buyers of these securitiessignificantly reduced their purchases in favor of cash equivalent securities andgovernment issued debt. The deterioration in the subprime credit described above has also resulted in areduction in the number of financial institutions willing to provide directfinancing for subprime related assets. Several institutions that previouslyprovided both secured and unsecured credit to us either have not, or indicatedthey will not, renew maturing credit facilities. For those institutions thatcontinue to provide credit, the corresponding credit facilities incorporate morecomprehensive credit performance requirements and increased pricing to reflectthe perceived quality of the underlying assets. While we expect overall creditavailability will decline, 2008 financing requirements will be satisfied throughlower loan originations in combination with funding from the sale of commercialpaper, new secured and unsecured debt issuance and HSBC sourced liquidity. Additional information on our sources and availability of funding are set forthin the "Liquidity and Capital Resources" and "Off Balance Sheet Arrangements"sections of our 2007 MD&A. We will continue to use derivative financial instruments to hedge our currencyand interest rate risk exposure. A description of our use of derivativefinancial instruments, including interest rate swaps and foreign exchangecontracts and other quantitative and qualitative information about our marketrisk is set forth in Item 7. of the 2007 MD&A under the caption "RiskManagement" and Note 14, "Derivative Financial Instruments," of our consolidatedfinancial statements ("2007 Financial Statements"). 14 HSBC Finance Corporation-------------------------------------------------------------------------------- REGULATION AND COMPETITION-------------------------------------------------------------------------------- REGULATION CONSUMER Our consumer finance businesses operate in a highly regulated environment. Thesebusinesses are subject to laws relating to consumer protection, including,without limitation, fair lending, use of credit reports, privacy matters, anddisclosure of credit terms and correction of billing errors. They also aresubject to certain regulations and legislation that limit operations in certainjurisdictions. For example, limitations may be placed on the amount of interestor fees that a loan may bear, the amount that may be borrowed, the types ofactions that may be taken to collect or foreclose upon delinquent loans or theinformation about a customer that may be shared. Our consumer branch lendingoffices are generally licensed in those jurisdictions in which they operate.Such licenses have limited terms but are renewable, and are revocable for cause.Failure to comply with these laws and regulations may limit the ability of ourlicensed lenders to collect or enforce loan agreements made with consumers andmay cause our lending subsidiaries to be liable for damages and penalties. Due to the recent turmoil in the mortgage lending markets, there has been asignificant amount of legislative and regulatory focus on this industry. OnDecember 20, 2007, President Bush signed into law the "Mortgage Forgiveness DebtRelief Act" which exempts taxpayers from income tax on up to $2 million in debtrelief through modifications to mortgages on a "qualified principal residence."This legislation has been considered essential to modification initiatives, suchas the HOPE NOW Alliance. Additional information concerning the HOPE NOWAlliance and HSBC Finance Corporation's membership is provided below. There also continues to be a significant amount of legislative activity,nationally, locally and at the state level, aimed at curbing lending practicesdeemed to be "predatory", particularly when such practices are believed todiscriminate against certain groups. In December 2007, the Federal Reserve Boardreleased for comment its proposed rule regarding substantial changes toRegulation Z of the Truth in Lending Act to protect consumers from unfair ordeceptive home mortgage lending and advertising practices. In addition, stateshave sought to alter lending practices through consumer protection actionsbrought by state attorneys general and other state regulators. States are alsostarting to request that mortgage lenders accept certain "principles" to beapplied by their companies in servicing mortgage loans. Legislative activity inthis area has targeted certain abusive practices such as loan "flipping" (makinga loan to refinance another loan where there is no tangible benefit to theborrower), "steering" (making loans that are more costly than the borrowersqualifications require), fee "packing" (addition of unnecessary, unwanted andunknown fees to a borrower), "equity stripping" (lending without regard to theborrower's ability to repay or making it impossible for the borrower torefinance with another lender), and outright fraud. The most recent legislationaddresses a vast array of mortgage lending practices. Additionally, it is likelythat state and Federal legislators and regulatory authorities may consideractions requiring additional loan disclosures, limiting permissible interchangefees charged to merchants and suppliers, requiring lenders to consider themaximum payment potentially due when reviewing loan applications and limitingrates and fees charged on tax refund anticipation loans. Although we have theability to react quickly to new laws and regulations which relate to ourbusinesses, it is not possible to estimate the effect, if any, these initiativeswill have on us in a particular locality or nationally as well as whether therewill be additional costs imposed on our businesses as a result of any newlegislation or regulation. HSBC Finance Corporation does not condone or endorse any abusive lendingpractices. We continue to work with regulators and consumer groups to createappropriate safeguards to avoid abusive practices while allowing our borrowersto continue to have access to credit for personal purposes, such as the purchaseof homes, automobiles and consumer goods. As part of this effort we have adopteda set of lending best practice initiatives. Also, as part of our risk mitigationefforts relating to the affected components of the Mortgage Services portfolio,in October 2006 we established a program specifically designed to meet the needsof select customers with ARMs. We are proactively writing and calling customerswho have adjustable rate mortgage loans nearing the first reset that we expectwill be the most impacted by a rate adjustment. Through a variety of means, weare assessing their ability to make the adjusted payment and, as appropriate andin accordance with defined policies, are modifying the loans in most instancesby delaying the first interest rate adjustment for twelve months, allowing timefor the customer to 15 HSBC Finance Corporation-------------------------------------------------------------------------------- seek alternative financing or improve their individual situation. Customers whocontinue to have affordability issues at the end of the modification period canqualify for additional longer term assistance. A further description of the riskmitigation efforts of HSBC Finance Corporation may be found under the section"Significant Developments related to our Mortgage Services and Consumer LendingBusinesses." Additionally, at the end of 2007, we agreed to participate in theHOPE NOW Alliance, an alliance among counselors, servicers, investors and othermortgage market participants to create a unified, coordinated plan to maximizeoutreach efforts to homeowners at risk of losing their homes. As part of theHOPE NOW Alliance, HSBC Finance Corporation along with other national loanservicers, has indicated its support for the ARM loan foreclosure and lossavoidance principles coordinated by the American Securitization Forum ("ASF").The plan was announced by President Bush on December 6, 2007. 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.As of December 31, 2007, we are fully compliant with this statement. The impactof this statement will be immaterial on our operations. BANKING INSTITUTIONS Our credit card banking subsidiary, HSBC Bank Nevada, N.A. ("HSBC Bank Nevada"),is a Federally chartered 'credit card bank' which is also a member of theFederal Reserve System. HSBC Bank Nevada is subject to regulation, supervisionand examination by the Office of the Comptroller of the Currency ("OCC"). Thedeposits of HSBC Bank Nevada are insured by the Federal Deposit InsuranceCorporation ("FDIC"), which renders it subject to relevant FDIC regulation. As a result of our acquisition by HSBC, HSBC Finance Corporation and itssubsidiaries became subject to supervision, regulation and examination by theBoard of Governors of the Federal Reserve System (the "Federal Reserve Board").HSBC is a bank holding company under the U.S. Bank Holding Company Act of 1956,as amended (the "BHCA") as a result of its ownership of HSBC Bank USA. OnJanuary 1, 2004, HSBC formed a new company to hold all of its North Americaoperations, including HSBC Finance Corporation and its subsidiaries. Thiscompany, HSBC North America is also a bank holding company under the BHCA, byvirtue of its ownership of HSBC Bank USA. HSBC and HSBC North America areregistered as financial holding companies under the Gramm-Leach-Bliley Actamendments to the BHCA, enabling them to offer a broad range of financialproducts and services. In December 2007, US regulators published a final rule regarding Risk-BasedCapital Standards: Advanced Capital Adequacy Framework - Basel II. This finalrule represents the U.S. adoption of the Basel II International Capital Accord("Basel II"). The final rule becomes effective April 1, 2008, and requires largebank holding companies, including HSBC North America, to adopt its provisions nolater than April 1, 2011. HSBC North America has established comprehensive BaselII implementation project teams comprised of risk management specialistsrepresenting all risk disciplines. We anticipate that the implementation ofBasel II could impact the funding mix of HSBC Finance Corporation but notnecessarily require an increase to its equity capital levels. In addition, U.S. bank regulatory agencies have maintained the 'leverage'regulatory capital requirements that generally require United States banks andbank holding companies to maintain a minimum amount of capital in relation totheir balance sheet assets (measured on a non-risk-weighted basis). HSBC BankNevada is subject to these capital requirements. In addition, HSBC North America and HSBC Finance Corporation continue to supportthe HSBC implementation of the Basel II framework, as adopted by the U.K.Financial Services Authority ("FSA"). We supply data regarding credit risk,operational risk and market risk to support HSBC's regulatory capital and riskweighted asset calculations. Revised FSA capital adequacy rules for HSBC becameeffective January 1, 2008. HSBC Bank Nevada, like other FDIC-insured banks, may be required to payassessments to the FDIC for deposit insurance under the FDIC's Bank InsuranceFund. Under the FDIC's risk-based system for setting deposit insuranceassessments, an institution's assessments vary according to its deposit levelsand other factors. 16 HSBC Finance Corporation-------------------------------------------------------------------------------- The Federal Deposit Insurance Corporation Improvement Act of 1991 provides forextensive regulation of insured depository institutions such as HSBC BankNevada, including requiring Federal banking regulators to take 'promptcorrective action' with respect to FDIC-insured banks that do not meet minimumcapital requirements. At December 31, 2007, HSBC Bank Nevada was well-capitalized under applicable OCC and FDIC regulations. Our principal United Kingdom subsidiary (HFC Bank Limited, formerly known as HFCBank plc) is subject to oversight and regulation by the FSA and the IrishFinancial Services Regulatory Authority of the Republic of Ireland. We haveindicated our intent to the FSA to maintain the regulatory capital of thisinstitution at specified levels. We also maintain a trust company in Canada, which is subject to regulatorysupervision by the Office of the Superintendent of Financial Institutions. INSURANCE Our insurance business is subject to regulatory supervision under the laws ofthe states and provinces in which it operates. Regulations vary from state tostate, and province to province, but generally cover licensing of insurancecompanies, premium and loss rates, dividend restrictions, types of insurancethat may be sold, permissible investments, policy reserve requirements, andinsurance marketing practices. Certain of our activities related to the marketing and distribution of insurancein the United Kingdom are subject to regulatory supervision by the FSA. COMPETITION The consumer financial services industry in which we operate is highlyfragmented and intensely competitive. We generally compete with banks, thrifts,insurance companies, credit unions, mortgage lenders and brokers, financecompanies, investment banks, and other domestic and foreign financialinstitutions in the United States, Canada and the United Kingdom. We compete byexpanding our customer base through portfolio acquisitions or alliance and co-branding opportunities, offering a variety of consumer loan products andmaintaining a strong service orientation. Customers are generally attracted toconsumer finance products based upon price, available credit limits, monthlypayment requirements and other product features. As a result, customer loyaltyis often limited. We believe our focus on the specific needs of our customers,proprietary credit scoring models and strong analytics in all aspects of ourbusiness allow us to compete effectively for middle market customers. CORPORATE GOVERNANCE AND CONTROLS-------------------------------------------------------------------------------- HSBC Finance Corporation maintains a website at www.hsbcusa.com/hsbc_finance onwhich we make available, as soon as reasonably practicable after filing with orfurnishing to the SEC, our annual report on Form 10-K, quarterly reports on Form10-Q, current reports on Form 8-K, and any amendments to these reports. Ourwebsite also contains our Corporate Governance Standards and committee chartersfor the Audit, Compensation, Executive and Nominating and Governance Committeesof our Board of Directors. We have a Statement of Business Principles and Codeof Ethics that expresses the principles upon which we operate our businesses.Integrity is the foundation of all our business endeavors and is the result ofcontinued dedication and commitment to the highest ethical standards in ourrelationships with each other, with other organizations and individuals who areour customers. You can find our Statement of Business Principles and Code ofEthics on our corporate website. We also have a Code of Ethics for SeniorFinancial Officers that applies to our finance and accounting professionals thatsupplements the Statement of Business Principles. That Code of Ethics isincorporated by reference in Exhibit 14 to this Annual Report on Form 10-K. Youcan request printed copies of this information at no charge. Requests should bemade to HSBC Finance Corporation, 26525 North Riverwoods Boulevard, Mettawa,Illinois 60045, Attention: Corporate Secretary. HSBC Finance Corporation has a Disclosure Committee that is responsible formaintenance and evaluation of our disclosure controls and procedures and forassessing the materiality of information required to be disclosed in 17 HSBC Finance Corporation-------------------------------------------------------------------------------- periodic reports filed with the SEC. Among its responsibilities is the review ofquarterly certifications of business and financial officers throughout HSBCFinance Corporation as to the integrity of our financial reporting process, theadequacy of our internal and disclosure control practices and the accuracy ofour financial statements. CERTIFICATIONS In addition to certifications from our Chief Executive Officer and ChiefFinancial Officer pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of2002 (attached to this report on Form 10-K as Exhibits 31 and 32), we have alsofiled a certification with the New York Stock Exchange (the "NYSE") from ourChief Executive Officer certifying that he is not aware of any violation by HSBCFinance Corporation of the applicable NYSE corporate governance listingstandards in effect as of March 3, 2008. CAUTIONARY STATEMENT ON FORWARD-LOOKING STATEMENTS-------------------------------------------------------------------------------- Certain matters discussed throughout this Form 10-K constitute forward-lookingstatements within the meaning of the Private Securities Litigation Reform Act of1995. In addition, we may make or approve certain statements in future filingswith 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", "appears", "believe", "intends","expects", "estimates", "targeted", "plans", "anticipates", "goal" and similarexpressions are intended to identify forward-looking statements but should notbe considered as the only means through which these statements may be made.These matters or statements will relate to our future financial condition,economic forecast, results of operations, plans, objectives, performance orbusiness developments and will involve known and unknown risks, uncertaintiesand other factors that may cause our actual results, performance or achievementsto be materially different from that which was expressed or implied by suchforward-looking statements. Forward-looking statements are based on our currentviews and assumptions and speak only as of the date they are made. HSBC FinanceCorporation undertakes no obligation to update any forward-looking statement toreflect subsequent circumstances or events. ITEM 1A. RISK FACTORS-------------------------------------------------------------------------------- The following discussion provides a description of some of the important riskfactors that could affect our actual results and could cause our results to varymaterially from those expressed in public statements or documents. However,other factors besides those discussed below or elsewhere in other of our reportsfiled or furnished with the SEC, could affect our business or results. Thereader should not consider any description of such factors to be a complete setof all potential risks that may face HSBC Finance Corporation. GENERAL BUSINESS, ECONOMIC, POLITICAL AND MARKET CONDITIONS. Our business andearnings are affected by general business, economic, market and politicalconditions in the United States and abroad. Given the concentration of ourbusiness activities in the United States, we are particularly exposed todownturns in the United States economy. For example in a poor economicenvironment there is greater likelihood that more of our customers orcounterparties could become delinquent on their loans or other obligations tous, which, in turn, could result in higher levels of provision for credit lossesand charge-offs which would adversely affect our earnings. General business,economic and market conditions that could affect us include short-term and long-term interest rates, inflation, recession, monetary supply, fluctuations in bothdebt and equity capital markets in which we fund our operations, market value ofconsumer owned real estate throughout the United States, consumer perception asto the availability of credit and the ease of filing of bankruptcy. In 2007, asignificant slow down in the appreciation of property values was experiencedthrough much of the United States. Certain markets experienced depreciation inproperty values, and this appears to be a growing trend. We believe that theslowdown in the housing market will be deeper in terms of its impact on housingprices and the duration will extend at least through 2008. Continued or expandedslowing of appreciation or increased depreciation can be expected to result inhigher delinquency and losses in our real estate portfolio. In addition, certainchanges to the conditions described above could diminish demand for our productsand services, or increase the cost to provide such products or services. 18 HSBC Finance Corporation-------------------------------------------------------------------------------- Mortgage lenders have tightened lending standards and eliminated many"affordability" products that generally carry higher risk, such as interest-onlyand introductory "teaser-rate" ARM loans. These actions have impacted borrowers'abilities to refinance existing mortgage loans. The ability to refinance andextract equity from their homes is no longer an option to many of our customers.This impacts both credit performance and run-off rates and has resulted inrising delinquency rates for real estate secured loans in our portfolio. This isalso expected to continue. In the fourth quarter of 2007, we have also seenunemployment rates rise in the same markets which are experiencing the greatesthome value depreciation as well as continuing marked increases in gasoline andheating costs. Additionally, an increasing inventory of homes for sale combinedwith declining property values in many markets is resulting in increased lossseverity on homes that are foreclosed and remarketed and is impacting the desireof some of our customers to continue to pay on the loan. Economy.com hasrecently indicated a number of U.S. market sectors may already be in arecession. If a widespread recessionary economy develops, additional losses arelikely. If a severe recession ensues, additional losses are likely to besignificant. It may be anticipated that market conditions may cause a contagioneffect in other types of consumer loans, such as credit card and auto loans. Acts or threats of war or terrorism, and actions taken by the United States orother governments in response to such acts or threats, as well as changes inpolitical conditions could affect business and economic conditions in the UnitedStates and consequently, our earnings. ADJUSTABLE RATE MORTGAGES. Our Mortgage Services business acquired a significantnumber of ARM loans that were originated in a period of unusually low interestrates. A substantial majority of these loans bore a fixed rate for the first twoor three years of the loan, followed by annual interest and payment rate resets.As interest rates have fluctuated since June 2004, many of our customers holdingARMs in the Mortgage Services portfolio may face monthly payment increasesfollowing their first interest rate adjustment date. The decreased availabilityof refinancing alternatives has impacted the run-off that typically occurs as anARM nears its first rate reset. Interest rate adjustments on first mortgages mayalso have a direct impact on a borrower's ability to repay any underlying secondlien mortgage loan on a property. Similarly, as interest-only mortgage loansleave the interest-only payment period, the ability of borrowers to make theincreased payments may be impacted. The Mortgage Services portfolio alsocontains a significant number of second lien loans that are subordinated to anARM held by a third party as well as interest-only loans. In 2008, approximately$3.7 billion of domestic ARM loans will have their initial payment rate resetbased on the original contracted reset date. Additionally, in 2008, weanticipate approximately $1.3 billion of ARM loans modified under a newmodification program introduced in October 2006, which are excluded from thereset numbers above, will experience their first reset. Continued inability torefinance could lead to an increase in delinquency, charge-off and losses. FEDERAL AND STATE REGULATION. We operate in a highly regulated environment.Changes in federal, state and local laws and regulations affecting banking,consumer credit, bankruptcy, privacy, consumer protection or other matters couldmaterially impact our performance. Specifically, attempts by local, state andnational regulatory agencies to control alleged "predatory" or discriminatorylending practices and to address perceived problems with the mortgage lendingindustry through broad or targeted legislative or regulatory initiatives aimedat lenders' operations in consumer lending markets, including non-traditionalmortgage products or tax refund anticipation loans, could affect us insubstantial and unpredictable ways, including limiting the types of consumerloan products we can offer. With a changing political climate in Washington,D.C, the highly publicized difficulties in the mortgage markets and an upcomingelection year, we anticipate increased consumer protection activity at theFederal level. In addition, new risk-based capital guidelines and reportinginstructions, including changes in response to the Basel II Capital Accordscould require a significant increase in our capital requirements or changes inour funding mix, resulting in lower net income. We cannot determine whether suchlegislative or regulatory initiatives will be instituted or predict the impactsuch initiatives would have on our results. LIQUIDITY. Our liquidity is critical to our ability to operate our businesses,grow and be profitable. A compromise to our liquidity could therefore have anegative effect on our financial results. In 2007, the capital markets wereseverely disrupted and the markets continue to be highly risk averse andreactionary. Traditional providers of credit to the subprime market are eitherreducing their exposure to this asset class or markedly tightening the creditstandards necessary to receive financing for subprime assets. This has raisedour cost of funds. Potential conditions 19 HSBC Finance Corporation-------------------------------------------------------------------------------- that could negatively affect our liquidity include diminished access to capitalmarkets, unforeseen cash or capital requirements, an inability to sell assets orexecute secured financing transactions due to reduced investor appetite for non-prime assets and an inability to obtain expected funding from HSBC subsidiariesand clients. Our credit ratings are an important part of maintaining our liquidity, as areduction in our credit ratings would also negatively affect our liquidity. Acredit ratings downgrade could potentially increase borrowing costs, anddepending on its severity, limit access to capital markets, require cashpayments or collateral posting, and permit termination of certain contractsmaterial to us. MANAGEMENT PROJECTIONS. Our management is required to use certain estimates inpreparing our financial statements, including accounting estimates to determineloan loss reserves, reserves related to future litigation, and the fair marketvalue of certain assets and liabilities, among other items. In particular, loanloss reserve estimates are influenced by factors outside our control. HSBCFinance Corporation's statistical model for estimating inherent probable creditlosses in its loan portfolio is based upon historical data. As the recentdownturn in the performance of the mortgage portfolio was sudden, dramatic andunprecedented, the statistical, historical models utilized by HSBC FinanceCorporation have not fully captured inherent probable risk. As a result,judgment has become a more significant component of the estimation of inherentprobable losses in the portfolio. To the extent historical averages of theprogression of loans into stages of delinquency and the amount of loss realizedupon charge-off are not predictive of future losses and management is unable toaccurately evaluate the portfolio risk factors not fully reflected in thehistorical model, unexpected additional losses could result. LAWSUITS AND REGULATORY INVESTIGATIONS AND PROCEEDINGS. HSBC Finance Corporationor one of our subsidiaries is named as a defendant in various legal actions,including class actions and other litigation or disputes with third parties, aswell as investigations or proceedings brought by regulatory agencies. These orother future actions brought against us may result in judgments, settlements,fines, penalties or other results, including additional compliance requirements,adverse to us which could materially adversely affect our business, financialcondition or results of operation, or cause us serious reputational harm. Weanticipate that there will be increased litigation resulting from the mortgagemarket downturn as borrowers allege they obtained unaffordable loans or loanswith terms that were unsuitable for that borrower. OPERATIONAL RISKS. Our businesses are dependent on our ability to process alarge number of increasingly complex transactions. If any of our financial,accounting, or other data processing systems fail or have other significantshortcomings, we could be materially adversely affected. We are similarlydependent on our employees. We could be materially adversely affected if anemployee causes a significant operational break-down or failure, either as aresult of human error or where an individual purposefully sabotages orfraudulently manipulates our operations or systems. Third parties with which wedo business could also be sources of operational risk to us, including relatingto break-downs or failures of such parties' own systems or employees. Any ofthese occurrences could result in diminished ability by us to operate one ormore of our businesses, potential liability to clients, reputational damage andregulatory intervention, all of which could materially adversely affect us. We may also be subject to disruptions of our operating systems arising fromevents that are wholly or partially beyond our control, which may include, forexample, computer viruses or electrical or telecommunications outages or naturaldisasters, such as Hurricane Katrina, or events arising from local or regionalpolitics, including terrorist acts. Such disruptions may give rise to losses inservice to customers, inability to collect our receivables in affected areas andother loss or liability to us. In a company as large and complex as ours, lapses or deficiencies in internalcontrol over financial reporting are likely to occur from time to time, andthere is no assurance that significant deficiencies or material weaknesses ininternal controls may not occur in the future. In addition there is the risk that our controls and procedures as well asbusiness continuity and data security systems prove to be inadequate. Any suchfailure could affect our operations and could materially adversely affect ourresults of operations by requiring us to expend significant resources to correctthe defect, as well as by exposing us to litigation or losses not covered byinsurance. 20 HSBC Finance Corporation-------------------------------------------------------------------------------- Changes to operational practices from time to time, such as determinations tosell receivables from our domestic private label portfolio, structuring all newcollateralized funding transactions as secured financings, or changes to ourcustomer account management and risk management/collection policies andpractices could materially positively or negatively impact our performance andresults. RISK MANAGEMENT. We seek to monitor and control our risk exposure through avariety of separate but complementary financial, credit, operational, complianceand legal reporting systems, including models and programs that predict loandelinquency and loss. While we employ a broad and diversified set of riskmonitoring and risk mitigation techniques, those techniques and the judgmentsthat accompany their application are complex and cannot anticipate everyeconomic and financial outcome or the specifics and timing of such outcomes.Accordingly, our ability to successfully identify and manage risks facing us isan important factor that can significantly impact our results. CHANGES IN ACCOUNTING STANDARDS. Our accounting policies and methods arefundamental to how we record and report our financial condition and results ofoperations. From time to time the Financial Accounting Standards Board ("FASB"),the International Accounting Standards Board ("IASB"), the SEC and our bankregulators, including the Office of Comptroller of the Currency and the Board ofGovernors of the Federal Reserve System, change the financial accounting andreporting standards that govern the preparation and disclosure of externalfinancial statements. These changes are beyond our control, can be hard topredict and could materially impact how we report and disclose our financialresults and condition, including our segment results. We could be required toapply a new or revised standard retroactively, resulting in our restating priorperiod financial statements in material amounts. We may, in certain instances,change a business practice in order to comply with new or revised standards. COMPETITION. We operate in a highly competitive environment and while there hasbeen significant consolidation in the financial services industry in 2007 andcontinuing into 2008, as the market stabilizes we expect competitive conditionsto again intensify as the remaining players in the financial services industrywill be larger, better-capitalized and more geographically-diverse companies.This will include lenders with access to government sponsored organizations thatare capable of offering a wider array of consumer financial products andservices at competitive prices. In addition, the traditional segregation of thefinancial services industry into prime and non-prime segments has eroded and inthe future is expected to continue to do so, further increasing competition forour core customer base. Such competition may impact the terms, rates, costsand/or profits historically included in the loan products we offer or purchase.There can be no assurance that the significant and increasing competition in thefinancial services industry will not materially adversely affect our futureresults of operations. ACQUISITION INTEGRATION. We have in the past and may in the future seek to growour business by acquiring other businesses or loan portfolios, such as ouracquisitions of Metris Companies, Inc. ("Metris") in 2005 and Solstice CapitalGroup Inc. and the mortgage portfolio of Champion Mortgage in 2006. There can beno assurance that our acquisitions will have the anticipated positive results,including results relating to: the total cost of integration; anticipated cross-sell opportunities; the time required to complete the integration; the amount oflonger-term cost savings; or the overall performance of the combined entity.Integration of an acquired business can be complex and costly, sometimesincluding combining relevant accounting and data processing systems andmanagement controls, as well as managing relevant relationships with clients,suppliers and other business partners, as well as with employees. There is no assurance that any business or portfolio in the future will besuccessfully integrated and will result in all of the positive benefitsanticipated. If we are not able to integrate successfully any futureacquisitions, there is the risk our results of operations could be materiallyand adversely affected. EMPLOYEE RETENTION. Our employees are our most important resource and, in manyareas of the financial services industry, competition for qualified personnel isintense. If we were unable to continue to retain and attract qualified employeesto support the various functions of our business, including the credit riskanalysis, underwriting, servicing, collection and sales, our performance,including our competitive position, could be materially adversely affected. 21 HSBC Finance Corporation-------------------------------------------------------------------------------- REPUTATIONAL RISK. Our ability to attract and retain customers and conductbusiness transactions with our counterparties could be adversely affected to theextent our reputation, or the reputation of affiliates operating under the HSBCbrand is damaged. Our failure to address, or to appear to fail to address,various issues that could give rise to reputational risk could cause harm to usand our business prospects. Reputational issues include, but are not limited to,appropriately addressing potential conflicts of interest, legal and regulatoryrequirements, ethical issues, adequacy of anti-money laundering processes,privacy issues, record-keeping, sales and trading practices, the properidentification of the legal, reputational, credit, liquidity and market risksinherent in products offered and general company performance. The failure toaddress these issues appropriately could make our customers unwilling to dobusiness with us, which could adversely affect our results of operations. ITEM 1B. UNRESOLVED STAFF COMMENTS.-------------------------------------------------------------------------------- We have no unresolved written comments from the Securities and ExchangeCommission Staff that have been outstanding for more than 180 days at December31, 2007. ITEM 2. PROPERTIES.-------------------------------------------------------------------------------- Our operations are located throughout the United States, in 10 provinces inCanada and in the United Kingdom, with principal facilities located inLewisville, Texas; New Castle, Delaware; Brandon, Florida; Jacksonville,Florida; Tampa, Florida; Maitland, Florida; Chesapeake, Virginia; VirginiaBeach, Virginia; Whitemarsh, Maryland; Hanover, Maryland; Baltimore, Maryland;Minnetonka, Minnesota; Bridgewater, New Jersey; Rockaway, New Jersey; Las Vegas,Nevada; Tulsa, Oklahoma; Tigard, Oregon; Chicago, Illinois; Deerfield, Illinois;Elmhurst, Illinois; Franklin Park, Illinois; Mount Prospect, Illinois; ProspectHeights, Illinois; Schaumburg, Illinois; Vernon Hills, Illinois; Wood Dale,Illinois; Pomona, California; Salinas, California; San Diego, California;London, Kentucky; Sioux Falls, South Dakota; Fort Mill, South Carolina; Toronto,Ontario and Montreal, Quebec, Canada; and Windsor, Bracknell and Birmingham,United Kingdom. In January 2006 we entered into a lease for a building in theVillage of Mettawa, Illinois. The new facility will consolidate our ProspectHeights, Mount Prospect, Chicago and Deerfield offices. Construction of thebuilding began in the spring of 2006 with the move planned for first and secondquarters of 2008. The new address of HSBC Finance Corporation is 26525 NorthRiverwoods Boulevard, Mettawa, Illinois 60045. Substantially all branch offices, divisional offices, corporate offices,regional processing and regional servicing center spaces are operated underlease with the exception of the office buildings in Windsor and Birmingham,United Kingdom operations, a credit card processing facility in Las Vegas,Nevada; a processing center in Vernon Hills, Illinois; and servicing facilitiesin Kentucky, Mt. Prospect, Illinois and Chesapeake, Virginia. We believe thatsuch properties are in good condition and meet our current and reasonablyanticipated needs. ITEM 3. LEGAL PROCEEDINGS.-------------------------------------------------------------------------------- GENERAL We are parties to various legal proceedings resulting from ordinary businessactivities relating to our current and/or former operations. Certain of theseactions are or purport to be class actions seeking damages in very largeamounts. These actions assert violations of laws and/or unfair treatment ofconsumers. Due to the uncertainties in litigation and other factors, we cannotbe certain that we will ultimately prevail in each instance. We believe that ourdefenses to these actions have merit and any adverse decision should notmaterially affect our consolidated financial condition. However, losses may bematerial to our results of operations for any particular future period dependingon our income level for that period. CONSUMER LITIGATION During the past several years, the press has widely reported certain industryrelated concerns, including rising delinquencies, the tightening of credit andmore recently, increasing litigation. Some of the litigation instituted 22 HSBC Finance Corporation-------------------------------------------------------------------------------- against lenders is being brought in the form of purported class actions byindividuals or by state or federal regulators or state attorneys general. Likeother companies in this industry, we are involved in litigation regarding ourpractices. The cases generally allege inadequate disclosure or misrepresentationduring the loan origination process. In some suits, other parties are also namedas defendants. Unspecified compensatory and punitive damages are sought. Thejudicial climate in many states is such that the outcome of these cases isunpredictable. Although we believe we have substantive legal defenses to theseclaims and are prepared to defend each case vigorously, a number of such caseshave been settled or otherwise resolved for amounts that in the aggregate arenot material to our operations. Insurance carriers have been notified asappropriate. LOAN DISCRIMINATION LITIGATION Since July of 2007, HSBC Finance Corporation and/or one or more of itssubsidiaries has been named as a defendant in four class actions filed in thefederal courts in the Northern District of Illinois, the Central District ofCalifornia and the District of Massachusetts: Zamudio v. HSBC North AmericaHoldings and HSBC Finance Corporation d/b/a Beneficial, (N.D. Ill. 07CV5413),National Association for the Advancement of Colored People ("NAACP") v.Ameriquest Mortgage Company, et al. including HSBC Finance Corporation (C.D.Ca., No. SACV07-0794AG(ANx)), Toruno v. HSBC Finance Corporation and DecisionOne Mortgage Company, LLC (C.D. Ca., No. CV07-05998JSL(RCx) and Suyapa Allen v.Decision One Mortgage Company, LLC, HSBC Finance Corporation, et al. (D. Mass.,C.A. 07-11669). Each suit alleges that the named entities racially discriminatedagainst their customers by using loan pricing policies and procedures that haveresulted in a disparate impact against minority customers. Violations of variousfederal statutes, including the Fair Housing Act and the Equal CreditOpportunity Act, are claimed. At this time, we are unable to quantify thepotential impact from these actions, if any. CITY OF CLEVELAND LITIGATION On January 10, 2008, a suit captioned, City of Cleveland v. Deutsche Bank TrustCompany , et al. (No. 1:08-CV-00139), was filed in the Cuyahoga County CommonPleas Court against twenty-one financial services entities. HSBC FinanceCorporation is a defendant. The City of Cleveland ("City") seeks damages itallegedly incurred relating to property foreclosures. The alleged damages areclaimed to be the result of defendants' creation of a public nuisance in theCity through their respective involvement as lenders and/or securitizers of sub-prime mortgages on properties located in Cleveland. On January 16, 2008, thecase was removed to the United States District Court for the Northern Districtof Ohio. On January 17, 2008, the City filed a motion seeking a Court orderremanding the case back to state Common Pleas Court. CREDIT CARD SERVICES LITIGATION Since June 2005, HSBC Finance Corporation, HSBC North America, and HSBC, as wellas other banks and the Visa and Master Card associations, were named asdefendants in four class actions filed in Connecticut and the Eastern Districtof New York; Photos Etc. Corp. et al. v. Visa U.S.A., Inc., et al. (D. Conn. No.3:05-CV-01007 (WWE)): National Association of Convenience Stores, et al. v. VisaU.S.A., Inc., et al. (E.D.N.Y. No. 05-CV 4520 (JG)); Jethro Holdings, Inc., etal. v. Visa U.S.A., Inc. et al. (E.D.N.Y. No. 05-CV-4521 (JG)); and AmericanBooksellers Ass'n v. Visa U.S.A., Inc. et al. (E.D.N.Y. No. 05-CV-5391 (JG)).Numerous other complaints containing similar allegations (in which no HSBCentity is named) were filed across the country against Visa, MasterCard andother banks. These actions principally allege that the imposition of a no-surcharge rule by the associations and/or the establishment of the interchangefee charged for credit card transactions causes the merchant discount fee paidby retailers to be set at supracompetitive levels in violation of the Federalantitrust laws. In response to motions of the plaintiffs on October 19, 2005,the Judicial Panel on Multidistrict Litigation (the "MDL Panel") issued an orderconsolidating these suits and transferred all of the cases to the EasternDistrict of New York. The consolidated case is: In re Payment Card InterchangeFee and Merchant Discount Antitrust Litigation, MDL 1720, E.D.N.Y. Aconsolidated, amended complaint was filed by the plaintiffs on April 24, 2006.Discovery has begun. At this time, we are unable to quantify the potentialimpact from this action, if any. 23 HSBC Finance Corporation-------------------------------------------------------------------------------- SECURITIES LITIGATION In August 2002, we restated previously reported consolidated financialstatements. The restatement related to certain MasterCard and Visa co-brandingand affinity credit card relationships and a third party marketing agreement,which were entered into between 1992 and 1999. All were part of our Credit CardServices segment. In consultation with our prior auditors, Arthur Andersen LLP,we treated payments made in connection with these agreements as prepaid assetsand amortized them in accordance with the underlying economics of theagreements. Our current auditor, KPMG LLP, advised us that, in its view, thesepayments should have either been charged against earnings at the time they weremade or amortized over a shorter period of time. The restatement resulted in a$155.8 million, after-tax, retroactive reduction to retained earnings atDecember 31, 1998. As a result of the restatement, and other corporate events,including, e.g., the 2002 settlement with 50 states and the District of Columbiarelating to real estate lending practices, HSBC Finance Corporation, and itsdirectors, certain officers and former auditors, have been involved in variouslegal proceedings, some of which purport to be class actions. A number of theseactions allege violations of Federal securities laws, were filed between Augustand October 2002, and seek to recover damages in respect of allegedly false andmisleading statements about our common stock. These legal actions have beenconsolidated into a single purported class action, Jaffe v. HouseholdInternational, Inc., et al., No. 02 C 5893 (N.D. Ill., filed August 19, 2002),and a consolidated and amended complaint was filed on March 7, 2003. On December3, 2004, the court signed the parties' stipulation to certify a class withrespect to the claims brought under sec. 10 and sec. 20 of the SecuritiesExchange Act of 1934. The parties stipulated that plaintiffs will not seek tocertify a class with respect to the claims brought under sec. 11 and sec. 15 ofthe Securities Act of 1933 in this action or otherwise. The amended complaint purports to assert claims under the Federal securitieslaws, on behalf of all persons who purchased or otherwise acquired oursecurities between October 23, 1997 and October 11, 2002, arising out of allegedfalse and misleading statements in connection with our collection, sales andlending practices, the 2002 state settlement agreement referred to above, therestatement and the HSBC merger. The amended complaint, which also names asdefendants Arthur Andersen LLP, Goldman, Sachs & Co., and Merrill Lynch, Pierce,Fenner & Smith, Inc., fails to specify the amount of damages sought. In May2003, we, and other defendants, filed a motion to dismiss the complaint. OnMarch 19, 2004, the Court granted in part, and denied in part the defendants'motion to dismiss the complaint. The Court dismissed all claims against MerrillLynch, Pierce, Fenner & Smith, Inc. and Goldman Sachs & Co. The Court alsodismissed certain claims alleging strict liability for alleged misrepresentationof material facts based on statute of limitations grounds. The claims thatremain against some or all of the defendants essentially allege the defendantsknowingly made a false statement of a material fact in conjunction with thepurchase or sale of securities, that the plaintiffs justifiably relied on suchstatement, the false statement(s) caused the plaintiffs' damages, and that someor all of the defendants should be liable for those alleged statements. OnFebruary 28, 2006, the Court also dismissed all alleged sec. 10 claims thatarose prior to July 30, 1999, shortening the class period by 22 months. Factdiscovery is concluded. Expert discovery is presently expected to conclude onMarch 16, 2008. Separately, one of the defendants, Arthur Andersen LLP, enteredinto a settlement of the claims against Arthur Andersen. This settlementreceived Court approval in April, 2006. At this time we are unable to quantifythe potential impact from this action, if any. With respect to this securities litigation, we believe that we have not, and ourofficers and directors have not, committed any wrongdoing and there will be nofinding of improper activities that may result in a material liability to us orany of our officers or directors. 24 HSBC Finance Corporation-------------------------------------------------------------------------------- ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.-------------------------------------------------------------------------------- Not applicable PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.-------------------------------------------------------------------------------- Not applicable 25 HSBC Finance Corporation-------------------------------------------------------------------------------- ITEM 6. SELECTED FINANCIAL DATA.-------------------------------------------------------------------------------- On March 28, 2003, HSBC Holdings plc ("HSBC") acquired HSBC Finance Corporation(formerly Household International, Inc.). This resulted in a new basis ofaccounting reflecting the fair market value of our assets and liabilities forthe "successor" periods beginning March 29, 2003. Information for the"predecessor" period prior to the merger is presented using our historical basisof accounting, which impacts comparability to our "successor" periods. To assistin the comparability of our financial results, the "predecessor period" (January1 to March 28, 2003) has been combined with the "successor period" (March 29 toDecember 31, 2003) to present "combined" results for the year ended December 31,2003. MAR. 29 JAN. 1 YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED THROUGH THROUGH DEC. 31, DEC. 31, DEC. 31, DEC. 31, DEC. 31, DEC. 31 MAR. 28, 2007 2006 2005 2004 2003 2003 2003---------------------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (SUCCESSOR) (PREDECESSOR) (IN MILLIONS)STATEMENT OF INCOME DATANet interest income and other revenues excluding the credit risk component of fair value optioned debt-operating basis(1)...................... $15,334 $15,611 $13,347 $12,454 $11,672 $8,888 $2,784Credit risk component of fair value optioned debt........... 1,616 - - - - - -Gain on bulk sale of private label receivables(2).......... - - - 663 - - -Provision for credit losses- operating basis(1)............ 11,026 6,564 4543 4,296 3,967 2,991 976Goodwill and other intangible asset impairment charges...... 4,891 - - - - - -Total costs and expenses, excluding goodwill and other intangible asset impairment charges and nonrecurring expense items(1).............. 6,884 6,760 6,141 5,691 5,032 3,850 1,182HSBC acquisition related costs incurred by HSBC Finance Corporation................... - - - - 198 - 198Adoption of FFIEC charge-off policies for domestic private label and credit card portfolios(1),(7)............. - - - 190 - - -Income tax expense (benefit).... (945) 844 891 1,000 872 690 182 ------- ------- ------- ------- ------- ------ ------Net income (loss)(1)............ $(4,906) $ 1,443 $ 1,772 $ 1,940 $ 1,603 $1,357 $ 246 ======= ======= ======= ======= ======= ====== ====== YEAR ENDED DECEMBER 31, 2007 2006 2005 2004 2003-------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (IN MILLIONS)BALANCE SHEET DATATotal assets........................... $165,504 $179,218 $156,522 $130,190 $119,052Receivables:(2) Domestic: Real estate secured............... $ 84,461 $ 94,332 $ 79,792 $ 61,946 $ 49,026 Auto finance...................... 12,899 12,193 10,434 7,490 4,138 Credit card....................... 30,091 27,499 23,963 12,371 9,577 Private label..................... 147 289 356 341 9,732 Personal non-credit card.......... 18,045 18,245 15,900 12,049 9,624 Commercial and other.............. 144 181 208 315 399 -------- -------- -------- -------- -------- Total domestic....................... $145,787 $152,739 $130,653 $ 94,512 $ 82,496 -------- -------- -------- -------- -------- 26 HSBC Finance Corporation-------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 2007 2006 2005 2004 2003-------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (IN MILLIONS) Foreign: Real estate secured............... $ 4,200 $ 3,552 $ 3,034 $ 2,874 $ 2,195 Auto finance...................... 358 311 270 54 - Credit card....................... 299 215 147 2,264 1,605 Private label..................... 2,946 2,220 2,164 3,070 2,872 Personal non-credit card.......... 2,604 3,122 3,645 4,079 3,208 Commercial and other.............. - - - 2 2 -------- -------- -------- -------- -------- Total foreign........................ $ 10,407 $ 9,420 $ 9,260 $ 12,343 $ 9,882 -------- -------- -------- -------- -------- Total receivables: Real estate secured............... $ 88,661 $ 97,885 $ 82,826 $ 64,820 $ 51,221 Auto finance...................... 13,257 12,504 10,704 7,544 4,138 Credit card....................... 30,390 27,714 24,110 14,635 11,182 Private label..................... 3,093 2,509 2,520 3,411 12,604 Personal non-credit card.......... 20,649 21,367 19,545 16,128 12,832 Commercial and other.............. 144 181 208 317 401 -------- -------- -------- -------- -------- Total owned receivables.............. $156,194 $162,160 $139,913 $106,855 $ 92,378 ======== ======== ======== ======== ========Commercial paper, bank and other borrowings........................... $ 8,424 $ 11,055 $ 11,454 $ 9,060 $ 9,354Due to affiliates(3)................... 14,902 15,172 15,534 13,789 7,589Long term debt......................... 123,262 127,590 105,163 85,378 79,632Preferred stock(4)..................... 575 575 575 1,100 1,100Common shareholder's equity(4),(5)..... 13,584 19,515 18,904 15,841 16,391 -------- -------- -------- -------- -------- YEAR ENDED DECEMBER 31, 2007 2006 2005 2004 2003-------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED)SELECTED FINANCIAL RATIOSReturn on average assets(1)............ (2.80)% .85% 1.27% 1.57% 1.46%Return on average common shareholder's equity(1)............................ (26.59) 7.07 9.97 10.99 10.89Net interest margin.................... 6.46 6.57 6.73 7.33 7.75Efficiency ratio(1).................... 68.69 41.55 44.10 42.05 42.97Consumer net charge-off ratio(1)....... 4.22 2.97 3.03 4.00 4.06Consumer two-month-and-over contractual delinquency.......................... 7.41 4.59 3.89 4.13 5.40Reserves as a percent of net charge- offs(8).............................. 162.4 145.8 123.8 89.9 105.7Reserves as a percent of receivables(9)....................... 6.98 4.06 3.23 3.39 4.11Reserves as a percent of nonperforming loans................................ 123.4 114.8 106.9 100.9 92.8Common and preferred equity to owned assets............................... 8.56% 11.21% 12.43% 13.01% 14.69%Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves")(6)(9)..................... 13.98 11.02 10.55 9.04 9.50Tangible common equity to tangible managed assets....................... 6.09 6.08 6.07 4.67 5.04Excluding HSBC acquisition purchase accounting adjustments: TETMA + Owned Reserves............... 14.18 11.67 11.51 10.75 11.42 Tangible common equity to tangible managed assets(6)................. 6.27 6.72 7.02 6.38 6.98 27 HSBC Finance Corporation-------------------------------------------------------------------------------- -------- (1) The following table, which contains non-U.S. GAAP financial information is provided for comparison of our operating trends only and should be read in conjunction with our U.S. GAAP financial information. For 2004, the operating trends, percentages and ratios presented below exclude the $121 million decrease in net income relating to the adoption of Federal Financial Institutions Examination Council ("FFIEC") charge-off policies for our domestic private label (excluding retail sales contracts at our Consumer Lending business) and credit card receivables and the $423 million (after- tax) gain on the bulk sale of domestic private label receivables (excluding retail sales contracts at our Consumer Lending business) to an affiliate, HSBC Bank USA, National Association ("HSBC Bank USA"). For 2003, the operating results, percentages and ratios exclude $167 million (after-tax) of HSBC acquisition related costs and other merger related items. See "Basis of Reporting" and "Reconciliations to U.S. GAAP Financial Measures" in Management's Discussion and Analysis for additional discussion and quantitative reconciliations to the equivalent U.S. GAAP basis financial measure. YEAR ENDED DECEMBER 31, 2007 2006 2005 2004 2003-------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (DOLLARS ARE IN MILLIONS)Operating net income (loss).......... $(4,906) $1,443 $1,772 $1,638 $1,770Return on average assets............. (2.80)% .85% 1.27% 1.32% 1.61%Return on average common shareholder's equity............... (26.59) 7.07 9.97 9.21 12.08Consumer net charge-off ratio........ 4.22 2.97 3.03 3.84 4.06Efficiency ratio..................... 68.69 41.55 44.10 43.84 41.21 (2) During 2007, we sold $2.7 billion of real estate secured loans from the Mortgage Services loan portfolio. In November 2006, we purchased $2.5 billion of real estate secured receivables from Champion Mortgage ("Champion") and we sold the capital stock of our operations in the Czech Republic, Hungary and Slovakia (the "European Operations") to a wholly owned subsidiary of HSBC Bank plc ("HBEU"), which included $199 million of private label and personal non-credit card receivables. In the fourth quarter of 2006 we purchased Solstice Capital Group Inc. ("Solstice") which included $32 million of real estate secured receivables. In 2005, we sold our U.K. credit card business, which included receivables of $2.5 billion, to HBEU and acquired $5.3 billion in credit card receivables in conjunction with our acquisition of Metris Companies, Inc. ("Metris"). In 2004, we sold $.9 billion of higher quality non-conforming real estate secured receivables and sold our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business) of $12.2 billion to HSBC Bank USA. In 2003, we sold $2.8 billion of higher quality non-conforming real estate secured receivables to HSBC Bank USA and acquired owned basis private label portfolios totaling $1.2 billion and credit card portfolios totaling $.9 billion. (3) We received $44.5 billion, $44.6 billion, $44.1 billion, $35.7 billion and $14.7 billion in HSBC related funding as of December 31, 2007, 2006, 2005, 2004 and 2003, respectively. See Liquidity and Capital Resources for the components of this funding. (4) In conjunction with the acquisition by HSBC, our 7.625%, 7.60%, 7.50% and 8.25% preferred stock was converted into the right to receive cash which totaled approximately $1.1 billion. In consideration of HSBC transferring sufficient funds to make these payments, we issued $1.1 billion Series A preferred stock to HSBC on March 28, 2003. Also on March 28, 2003, we called for redemption of our $4.30, $4.50 and 5.00% preferred stock. In September 2004, HSBC North America Holdings Inc. ("HSBC North America") issued a new series of preferred stock to HSBC in exchange for our Series A preferred stock. In October 2004, HSBC Investments (North America) Inc. ("HINO") issued a new series of preferred stock to HSBC North America in exchange for our Series A preferred stock. Our Series A preferred stock was exchanged by HINO for $1.1 billion of additional common equity in December 2005. In June 2005, we issued 575,000 shares of 6.36 percent Non-Cumulative Preferred Stock, Series B to third parties. (5) In 2007, we received capital contributions of $950 million from HINO to support ongoing operations and to maintain capital at levels we believe are prudent in the current market conditions. In 2006, we received a capital contribution of $163 million from HINO to fund a portion of the purchase of our acquisition of the Champion portfolio. In 2005, we received a capital contribution of $1.2 billion from HINO to fund a portion of the purchase of our acquisition of Metris. Common shareholder's equity at December 31, 2007, 2006, 2005, 2004 and 2003 reflects push-down accounting adjustments resulting from the HSBC merger. (6) TETMA + Owned Reserves and tangible common equity to tangible managed assets excluding HSBC purchase accounting adjustments are non-U.S. GAAP financial ratios that are used by HSBC Finance Corporation management or certain rating agencies as a measure to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See "Basis of Reporting" for additional discussion on the use of non-U.S. GAAP financial measures and "Reconciliations to U.S. GAAP Financial Measures" for quantitative reconciliations to the equivalent U.S. GAAP basis financial measure. (7) In December 2004, we adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios. The adoption of the FFIEC charge-off policies resulted in a reduction to net income of $121 million in the fourth quarter of 2004. The domestic private label portfolio was subsequently sold to HSBC Bank USA on December 29, 2004. (8) This ratio was positively impacted in 2007 and 2006 by markedly higher loss estimates at our Mortgage Services business and, in 2007, at our Consumer Lending business, as the related charge-offs will occur in future periods. In addition, the acquisition of Metris in December 2005 has positively impacted this ratio in 2005. Reserves as a percentage of net charge-offs excluding Metris at December 31, 2005 was 118.2 percent. Additionally, the adoption of FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios and subsequent sale of the domestic private label portfolio (excluding retail sales contracts at our consumer lending business) in December 2004 have negatively impacted these ratios. Reserves as a percentage of net charge-offs excluding net charge-offs associated with the domestic private label portfolio sold in 2004 and the impact of adopting FFIEC charge-off policies for these portfolios was 109.2 percent. (9) This ratio was positively impacted in 2007 and 2006 by markedly higher credit loss reserves at our Mortgage Services business and, in 2007, at our Consumer Lending business. 28 HSBC Finance Corporation-------------------------------------------------------------------------------- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS.-------------------------------------------------------------------------------- EXECUTIVE OVERVIEW ORGANIZATION AND BASIS OF REPORTING HSBC Finance Corporation (formerly Household International, Inc.) andsubsidiaries is an indirect wholly owned subsidiary of HSBC North AmericaHoldings Inc. ("HSBC North America") which is a wholly owned subsidiary of HSBCHoldings plc ("HSBC"). HSBC Finance Corporation may also be referred to inManagement's Discussion and Analysis of Financial Condition and Results ofOperations ("MD&A") as "we", "us", or "our". HSBC Finance Corporation provides middle-market consumers with several types ofloan products in the United States, Canada, and prior to November 9, 2006,Slovakia, the Czech Republic and Hungary ("European Operations"). We alsocurrently offer consumer loans in the United Kingdom and the Republic ofIreland. Our lending products include real estate secured loans, auto financeloans, MasterCard(1), Visa(1), American Express(1) and Discover(1)credit cardloans ("Credit Card"), private label credit card loans, including retail salescontracts and personal non-credit card loans. We also initiate tax refundanticipation loans and other related products in the United States and offerspecialty insurance products in the United States, Canada and prior to November1, 2007, the United Kingdom. Subsequent to the sale of our United Kingdominsurance operations in November 2007 to Aviva plc and its subsidiaries("Aviva"), insurance products distributed in the United Kingdom through ourbranch network are underwritten by Aviva. We generate cash to fund ourbusinesses primarily by collecting receivable balances, issuing commercialpaper, medium and long term debt; borrowing from HSBC subsidiaries and customersand borrowing under secured financing facilities. We use the cash generated toinvest in and originate new receivables, to service our debt obligations and topay dividends to our parent. 2007 EVENTS - We continue to monitor the impact of several trends affecting the mortgage lending industry. Industry statistics and reports indicate that mortgage loan originations throughout the industry from 2005, 2006 and 2007 are performing worse than originations from prior periods. Real estate markets in a large portion of the United States have been affected by a general slowing in the rate of appreciation in property values, or an actual decline in some markets such as California, Florida and Arizona, while the period of time properties remain on the market continues to increase. During the second half of 2007, there has been unprecedented turmoil in the mortgage lending industry, including rating agency downgrades of debt secured by subprime mortgages of some issuers which resulted in a marked reduction in secondary market demand for subprime loans. The lower demand for subprime loans resulted in reduced liquidity in the marketplace for subprime mortgages. Mortgage lenders have tightened lending standards which impacts a borrower's ability to refinance existing mortgage loans. It is now generally believed that the slowdown in the housing market will be deeper in terms of its impact on housing prices and the duration will extend at least through 2008. The combination of these factors has further reduced the refinancing opportunities of some of our customers as the ability to refinance and access any equity in their homes is no longer an option to many customers. This impacts both credit performance and run-off rates and has resulted in rising delinquency rates for real estate secured loans in our portfolio and across the industry. In the fourth quarter of 2007, we have also seen unemployment rates rise in the same markets which are experiencing the greatest home value depreciation, continued marked increases in gasoline and home heating costs as well as a general slowing of the U.S economy. Economy.com has recently indicated a number of U.S. market sectors may already be in a recession. These economic conditions have also impacted the ability of some borrowers to make payments on their loans, including any increase in their adjustable rate mortgage ("ARM") loan payment as the interest rates on their loans adjust under their contracts. Interest rate adjustments on first mortgages may also have a direct impact on a borrower's ability ----------(1) MasterCard is a registered trademark of MasterCard International, Incorporated; Visa is a registered trademark of Visa, Inc.; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc. 29 HSBC Finance Corporation-------------------------------------------------------------------------------- to repay any underlying second lien mortgage loan on a property. Similarly, as interest-only mortgage loans leave the interest-only payment period, the ability of borrowers to make the increased payments may be impacted. The increasing inventory of homes for sale and declining property values in many markets is resulting in increased loss severity on homes that are foreclosed and remarketed and is impacting the desire of some of our customers to continue to pay on their loans. Consumer Lending experienced relatively stable performance in its portfolio throughout 2006 and into the first half of 2007. Notwithstanding this relatively stable performance, in late 2006 and early 2007 we reported that we were beginning to experience weakening early stage performance in certain Consumer Lending real estate secured loans originated since late 2005, consistent with the industry trend. This trend worsened materially in second half of 2007 as the weakening early stage delinquency continued to deteriorate and migrate into later stage delinquency, largely a result of the marketplace conditions discussed above. Credit performance of our Consumer Lending mortgage portfolio deteriorated across all vintages during the second half of 2007, but in particular in loans which were originated in 2006 and the first half of 2007. Dollars of two-months-and-over contractual delinquency in our Consumer Lending real estate portfolio increased $1.1 billion, or 106 percent in 2007. The deterioration has been most severe in the first lien portions of the portfolio in the geographic regions most impacted by the housing market downturn and rising unemployment rates, particularly in the states of California, Florida, Arizona, Virginia, Washington, Maryland, Minnesota, Massachusetts and New Jersey which account for approximately 55 percent of the increase in dollars of two-months-and-over contractual delinquency during 2007. At December 31, 2007 40 percent of Consumer Lending's real estate portfolio was located in these nine states. This worsening trend and an outlook for increased charge-offs has resulted in a marked increase in the provision for credit losses at our Consumer Lending business in 2007. In response to this deterioration, Consumer Lending has taken steps to address the growing delinquency in its portfolios by expanding the use of its foreclosure avoidance program as well as increasing collection staffing. In addition, Consumer Lending took the following actions in the second half of the year to reduce risk in its real estate secured and personal non-credit card receivable portfolios going forward: - Tightening of credit score and debt-to income requirements for first lien loans - Reduction in loan-to-value ("LTV") ratios in first and second lien loans - Elimination of the small volume of ARM loan originations - Elimination of the personal homeowner loan ("PHL") product - Tightening underwriting criteria for all products - Elimination of guaranteed direct mail loans to new customers These actions resulted in lower new loan originations in the fourth quarter of 2007 and are expected to materially reduce origination volume in our Consumer Lending business going forward. The scale of the reduction in business in 2008 due to the risk reduction measures outlined above would reduce Consumer Lending's finance and other interest income by approximately 5 percent (approximately $400 million based upon 2007 finance and other interest income.) In 2006, we began a branch optimization initiative with the objective of increasing the number of branches in better performing markets and decreasing the number of branches in underperforming markets. As a result of the marketplace turmoil in the second half of 2007 discussed above, rising delinquencies and charge-offs, the markedly lower origination volumes projected for 2008, and a desire to achieve cost-savings, a new effort was initiated in the fourth quarter to consider a more aggressive approach to sizing the branch network and recorded a restructuring charge of $25 million related to this effort. As a result we have reduced our Consuming Lending branch network from 1,382 branches at December 31, 2006 to approximately 1,000 branches at December 31, 2007. No further costs resulting from this decision are anticipated. We currently estimate that expenses could be reduced by approximately $150 million in 2008 as a result of these actions. 30 HSBC Finance Corporation-------------------------------------------------------------------------------- We believe that this resized branch network will allow us to achieve desired cost-savings as well as position us for future growth when the market returns to normalized levels. In 2006, we reported that we began to experience a deterioration in the credit performance of mortgage loans acquired in 2005 and 2006 by our Mortgage Services business, particularly in the second lien and portions of the first lien portfolio. We have continued to experience higher than normal delinquency levels in 2007 in these portions of our Mortgage Services portfolio. In the second half of 2007, we experienced further credit deterioration in these portions of the Mortgage Services loan portfolio due to the marketplace conditions discussed above and a slowing U.S. economy. As a result, delinquency in our Mortgage Services business increased markedly compared to the first half of 2007. Overall, dollars of two-months-and-over contractual delinquency in our Mortgage Services business increased $1.7 billion or 75 percent in 2007. A significant number of our second lien customers have underlying adjustable rate first mortgages that face repricing in the near-term which in certain cases also negatively impact the probability of repayment on the related second lien mortgage loan. As the interest rate adjustments will occur in an environment of lower home value appreciation or depreciation and tightening credit, we expect the probability of default for adjustable rate first mortgages subject to repricing as well as any second lien mortgage loans that are subordinate to an adjustable rate first lien held by another lender will be greater than what we have historically experienced prior to late 2006. Numerous risk mitigation efforts have been implemented relating to the affected components of the Mortgage Services portfolio. These include enhanced segmentation and analytics to identify the higher risk portions of the portfolio and increased collections capacity. As appropriate and in accordance with defined policies, we restructure and/or modify loans if we believe the customer has the ability to pay for the foreseeable future under the restructured/modified terms. Modifications may be permanent, but most in 2006 and 2007 were six-months or twelve-months in duration. We are currently developing longer term modification programs that will be based on customers needs and ensure we maximize future cash flow. Going forward, we will be offering our customers longer term modifications, potentially up to 5 years. At the end of a temporary modification term, the ability of customers to pay will be re-evaluated and, if necessary and the customer qualifies for another modification, an additional temporary or permanent modification may then be granted. Loans granted a modification that equals or exceeds twelve months, including those receiving two consecutive six-month modifications, are reserved for as a troubled debt restructure in accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" which requires a cash flow analysis to assess impairment. We are also contacting customers who have adjustable rate mortgage loans nearing the first reset that we expect will be the most impacted by a rate adjustment in order to assess their ability to make the adjusted payment and, as appropriate, modify the loans. As a result of this specific risk mitigation effort, we modified more than 8,500 loans with an aggregate balance of $1.4 billion in 2007 and modified more than 10,300 loans with an aggregate balance of $1.6 billion since the inception of the program. Additionally in 2007, we refinanced more than 4,000 customers of our Mortgage Services business with adjustable rate mortgages to fixed rate loans with an outstanding receivable balance at December 31, 2007 of $679 million. For all our receivable portfolios, we have markedly increased our collection capacity. In the fourth quarter of 2007, the market conditions discussed above have also resulted in higher than expected delinquency levels in our domestic credit card and auto finance receivables although the increased delinquency in our domestic auto finance portfolio is not as severe as has been experienced elsewhere in the industry. Dollars of two-months- and-over contractual delinquency in our domestic credit card receivables increased $474 million, or 37 percent in 2007 and for our domestic auto finance receivables increased $65 million, or 16 percent. The increase in delinquency in our credit card receivable portfolio is across all vintages, primarily in the same markets experiencing the greatest home value depreciation. Rising unemployment rates in these markets and a weakened U.S. economy is also contributing to these increases. As a result of these marketplace and broader economic conditions we expect the increasing trend in delinquency and charge-off in dollars and percentages to continue in all products in our domestic receivable portfolios. 31 HSBC Finance Corporation-------------------------------------------------------------------------------- We expect our Mortgage Services and Consumer Lending portfolios to remain under significant pressure in 2008 as the affected originations season further. We expect these marketplace and broader economic conditions will have a marked impact on our overall delinquency and charge-off dollars and percentages in 2008 as compared to 2007, the extent of which will be based on future economic conditions, their impact on customer payment patterns and other factors which are beyond our control. - In March 2007, we decided to discontinue correspondent channel acquisitions by our Mortgage Services business and in June 2007 indicated that our Decision One wholesale 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 caused us to re-evaluate our strategy and in September 2007, when we concluded that recovery of a secondary market for subprime loan products was uncertain and, at a minimum, that market could not be expected to stabilize in the near term, we announced that we closed Decision One's origination operations. The decision to terminate the operations of our Decision One business when coupled with our previous announcement of the discontinuation of correspondent channel acquisitions resulted in the impairment of the goodwill allocated to the Mortgage Services business and, as such, we recorded a non-cash impairment charge of $881 million in the third quarter of 2007 to write-off all of the goodwill allocated to this business. The actions described above, combined with normal portfolio attrition including refinance and charge-off, will continue to result in significant reductions in the principal balance of our Mortgage Services loan portfolio in 2008. - As the developments in the mortgage industry have continued to unfold, in addition to the decisions related to our Mortgage Services and Consumer Lending businesses discussed above, in 2007 we initiated an ongoing in- depth analysis of the risks and strategies of our remaining businesses and product offerings. The following summarizes the changes we have implemented in 2007 or intend to implement in the future: - Credit Card Services: During the fourth quarter of 2007 we implemented certain changes related to fee and finance charge billings as a result of continuing reviews to ensure our practices fully 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 reduced fee and finance charge income by approximately $55 million in 2007 and will reduce fee and finance charge income in 2008 by up to approximately $250 million. Also in the fourth quarter of 2007, we began slowing receivable and account growth by tightening initial credit line sales authorization criteria, closing inactive accounts, decreasing credit lines and tightening underwriting criteria for credit line increases. Additionally we have reduced balance transfer volume and tightened cash access. 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. - Auto Finance: Throughout 2007, we continued to shift the mix of new originations to a higher credit quality by eliminating higher risk loan populations. These actions have reduced volume in 2007 by 20-25 percent in our dealer channel and are expected to continue to reduce volume into 2008 resulting in reduced net income and narrower spreads over time. We have also begun to shift the mix of new loan volume in the direct-to-consumer channel to higher credit quality. 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. In anticipation of a continuation of the slowing of the economy, we are implementing additional actions to reduce risk in 2008 originations which will result in further volume reductions going forward. - Retail Services: We implemented numerous credit-tightening efforts across our retail merchant base, including the power sports industry, and reduced contingent lines with inactive accounts. - United Kingdom: As part of our review, we tightened underwriting criteria for all product offerings. We discontinued offering second lien loans with a LTV ratio greater than 100 percent through our branch network and second lien loans with a LTV ratio greater than 90% through our broker channel. This caused 32 HSBC Finance Corporation-------------------------------------------------------------------------------- a material reduction in origination volumes of real estate secured loans in this business in the fourth quarter. In December 2007, we signed a two year extension through 2009 with our largest retail partner, the Dixon Stores Group. In November 2007, in a continued effort to simplify the business, we sold our United Kingdom insurance operations to Aviva. See "Segment Results - IFRS Management Basis" included in this MD&A for further discussion of this disposal. We continue to evaluate the scope of our other United Kingdom operations. - Canada: In order to align our lending strategies in the U.S. and Canada, we tightened underwriting criteria for various real estate and unsecured products and eliminated PHL product offerings in Canada which resulted in lower volumes. As a result, we closed 29 branches in the fourth quarter of 2007. We also decided to reduce the mortgage operations in Canada which closed loans sourced by brokers. We are currently reorganizing the Canadian 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 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 loan products. We have also elected not to renew contracts with certain third-party preparers as they came up for renewal and have negotiated early termination agreements with others. In the fourth quarter, we have also decided to stop participating in cross collection activities with other refund anticipation loan providers. We estimate these actions could reduce Taxpayer Financial Services revenue by approximately $110 million in 2008. Beginning in 2007, we implemented ongoing in-depth cost containment measures which will continue into 2008. This includes centralizing certain cost functions and increasing the use of HSBC affiliates outside of the United States to provide various support services to our operations including, among other areas, customer service, systems, collection and accounting functions. When coupled with the resizing of the Consumer Lending branch network discussed above, we believe we will be appropriately positioned for future growth when market conditions improve. - As a result of the strategic changes discussed above, during the fourth quarter of 2007 we performed interim goodwill and other intangible impairment tests for the businesses where significant changes in the business climate have occurred as required by SFAS No. 142, "Goodwill and Other Intangible Assets," ("SFAS No. 142"). These tests revealed that the business climate changes, including the subprime marketplace conditions discussed above, when coupled with the changes to our product offerings and business strategies completed through the fourth quarter of 2007, have resulted in an impairment of all goodwill allocated to our Consumer Lending (which includes Solstice) and Auto Finance businesses as well as all tradename and customer relationship intangibles relating to the HSBC acquisition allocated to our Consumer Lending business. Therefore, we recorded an impairment charge in the fourth quarter of 2007 of $3,320 million relating to our Consumer Lending business ($858 million associated with the tradename and customer relationship intangibles) and a $312 million goodwill impairment charge relating to our Auto Finance business. These impairments represent all of the goodwill previously allocated to these businesses and all of HFC and Beneficial tradenames and customer relationship intangibles associated with the HSBC acquisition allocated to the Consumer Lending business. In addition, the changes to product offerings and business strategies completed through the fourth quarter of 2007 have also resulted in an impairment of the goodwill allocated to our United Kingdom business. As a result, an impairment charge of $378 million was recorded in the fourth quarter of 2007 representing all of the goodwill previously allocated to this business. For all other businesses, the fair value of each of these reporting units continues to exceed its carrying value including goodwill. - In May 2007, we decided to integrate our Retail Services and Credit Card Services business. Combining Retail Services with Credit Card Services enhances our ability to provide a single credit card and private label solution for the market place. We anticipate the integration of management reporting will be completed 33 HSBC Finance Corporation-------------------------------------------------------------------------------- in the first quarter of 2008 and at that time will result in the combination of these businesses into one reporting segment in our financial statements. - In the third quarter of 2007, we decided to close our loan underwriting, processing and collections center in Carmel, Indiana (the "Carmel Facility") to optimize our facility and staffing capacity given the overall reductions in business volumes. The Carmel Facility provided loan underwriting, processing and collection activities for the operations of our Consumer Lending and Mortgage Services business. The collection activities performed in the Carmel Facility have been redeployed to other facilities in our Consumer Lending business. - In the fourth quarter of 2007, Moody's, Standard & Poor's and Fitch changed the total outlook on our issuer default rating from "positive" to "stable." - We have facilities with commercial and investment banks under which our domestic operations may issue securities backed with auto finance, credit card and personal non-credit card receivables which are renewable at the bank's option. As a result of the unprecedented turmoil in the marketplace, there has been a marked reduction in secondary market demand for subprime loans. As a result we anticipate that in 2008, certain of these facilities will not be renewed and that others will be renewed at higher prices. In addition, our single seller mortgage facility was not renewed in 2007. In spite of these actions, we believe we will continue to have adequate sources of funds. - In the first quarter of 2007, HSBC Investments (North America) Inc.("HINO") made a capital contribution to us of $200 million and in the fourth quarter of 2007 made an additional capital contribution to us of $750 million, each in exchange for one share of common stock. These capital contributions were to support ongoing operations and to maintain capital at levels that we believe are prudent in the current market conditions. During 2007, we paid $812 million of dividends to HINO. On February 12, 2008, HINO made a capital contribution to us of $1.6 billion in exchange for one share of common stock. - Effective January 1, 2007, we early adopted SFAS No. 159 which provides for a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. The adoption of SFAS No. 159 resulted in an after-tax cumulative-effect reduction to the January 1, 2007 opening balance of retained earnings of $538 million. See Note 2, "Summary of Significant Accounting Policies," and Note 13, "Long Term Debt (With Original Maturities Over One Year)," to the accompanying consolidated financial statements for further discussion of the adoption of SFAS No. 159. - Effective January 1, 2007, we elected to early adopt FASB Statement No. 157, "Fair Value Measurements," ("SFAS No. 157"). SFAS No. 157 establishes a single authoritative definition of value, sets out a framework for measuring fair value, and provides a hierarchal disclosure framework for assets and liabilities measured at fair value. The adoption of SFAS No. 157 did not have any impact on our financial position or results of operations. - Effective January 1, 2007, we adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN No. 48"). The adoption resulted in the reclassification of $65 million of deferred tax liability to current tax liability to account for uncertainty in the timing of tax benefits as well as the reclassification of $141 million of deferred tax asset to current tax asset to account for highly certain pending adjustments in the timing of tax benefits. See Note 15, "Income Taxes", to the accompanying consolidated financial statements. PERFORMANCE, DEVELOPMENTS AND TRENDS The net loss was $4.9 billion in 2007 compared to net income of $1.4 billion in2006 and $1.8 billion in 2005. Our 2007 results were markedly impacted bygoodwill impairment charges of $3,763 million (after-tax) relating to ourMortgage Services, Consumer Lending, Auto Finance and United Kingdom businessesas well as by impairment charges of $541 million (after-tax) relating to the HFCand Beneficial tradenames and customer relationship 34 HSBC Finance Corporation-------------------------------------------------------------------------------- intangibles relating to our Consumer Lending business. This was partially offsetby gains from the change in the credit risk component of our fair value optioneddebt which resulted from our adoption of SFAS No. 159, which increased netincome by $1,017 million (after-tax) in 2007. The combined impact of these itemswas to increase our net loss by $3,287 million in 2007. Excluding the impact ofthese items, the net loss in 2007 was largely due to a markedly higher provisionfor credit losses and the impact of lower receivable growth. Lower receivablegrowth was driven by the discontinuance of correspondent channel acquisitions inthe first quarter of 2007 and the changes in product offerings beginning in thesecond half of 2007. In addition, higher other revenues and higher net interestincome were partially offset by higher costs and expenses excluding the goodwilland other intangible asset impairment charges. The increase in provision for credit losses in 2007 primarily reflects higherloss estimates in our Consumer Lending, Credit Card Services and MortgageServices 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 an accelerated deterioration of portions of the real estate secured receivable portfolio in the second half of 2007. Weakening early stage delinquency previously reported continued to worsen in 2007 and migrate into later stage delinquency due to the marketplace changes previously discussed. 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 were higher loss estimates in second lien loans purchased in 2004 through the third quarter of 2006. At December 31, 2007, the outstanding principal balance of these acquired second lien loans was approximately $1.0 billion. Additionally, higher loss estimates in Consumer Lending's personal non-credit card portfolio contributed to the increase due to seasoning, a deterioration of 2006 and 2007 vintages 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. - Credit Card Services experienced higher loss estimates as a result of higher average receivable balances, portfolio seasoning, higher levels of non-prime receivables originated in 2006 and in the first half of 2007, as well as the increased levels of personal bankruptcy filings discussed above. Additionally, in the fourth quarter of 2007, Credit Card Services began to experience increases in delinquency in all vintages, particularly in the markets experiencing the greatest home value depreciation. Rising unemployment rates in these markets and a weakening U.S. economy also contributed to the increase. - Mortgage Services experienced higher levels of charge-offs and delinquency as the second lien and portions of the first lien portfolios purchased in 2005 and 2006 continued to season and progress as expected into later stages of delinquency and charge-off. Additionally during the second half of 2007, our Mortgage Services portfolio also experienced higher loss estimates as receivable run-off continued to slow and the mortgage lending industry trends we had been experiencing worsened. In addition to the factors discussed above, our provision for credit losses in2007 for our United Kingdom business reflects a $93 million increase in creditloss reserves, resulting from a refinement in the methodology used to calculateroll rate percentages to be consistent with our other businesses and which webelieve reflects a better estimate of probable losses currently inherent in theloan portfolio as well as higher loss estimates for restructured loans of $68million. These increases to credit loss reserves were more than offset byimprovements in delinquency and charge-offs which resulted in an overall lowercredit loss provision in our United Kingdom business. On a consolidated basis, we recorded loss provision in excess of net charge-offsof $4,310 million in 2007 compared to $2,045 million in 2006. Consequently, ourcredit loss reserve levels increased markedly in 2007. Reserve levels 35 HSBC Finance Corporation-------------------------------------------------------------------------------- for real estate secured receivables at our Mortgage Services and ConsumerLending businesses can be further analyzed as follows: CONSUMER MORTGAGE LENDING SERVICES -------------- ----------------YEAR ENDED DECEMBER 31, 2007 2006 2007 2006-------------------------------------------------------------------------------------- (IN MILLIONS)Credit loss reserves at beginning of period........ $ 278 $ 295 $ 2,085 $ 421Provision for credit losses........................ 1,696 351 3,051 2,202Charge-offs........................................ (597) (378) (1,605) (557)Recoveries......................................... 9 9 63 22Release of credit loss reserves related to loan sales............................................ - - (21) -Other, net......................................... - 1 - (3) ------ ----- ------- ------Credit loss reserves at end of period.............. $1,386 $ 278 $ 3,573 $2,085 ====== ===== ======= ====== 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. Costs and expenses were negatively impacted by the goodwill and other intangibleasset impairment charges of $4.9 billion related to our Mortgage Services,Consumer Lending, Auto Finance and United Kingdom businesses as discussed aboveas well as by restructuring charges totaling $106 million, primarily related tothe decisions to discontinue correspondent channel acquisitions, cease DecisionOne operations, reduce our Consumer Lending and Canadian branch networks andclose the Carmel Facility. The net impact of these decisions has been to reduceheadcount by approximately 4,100 or 13 percent in the second half of 2007.Excluding the goodwill and other intangible asset impairment charges andrestructuring charges, costs and expenses decreased in 2007, despite higherlevels of average receivables and added collection capacity, due to lowermarketing expenses, lower sales incentives and the impact of entity-wideinitiatives to reduce costs, partially offset by higher collection costs and REOexpenses. The increase in net interest income in 2007 was due to higher averagereceivables and an improvement in the overall yield on the portfolio, partlyoffset by higher interest expense due to a higher cost of funds. As discussedmore fully below, the overall yield improvements reflect repricing initiativesand changes in receivable mix, partially offset by growth in non-performingassets. Other revenues increased in 2007 due to higher fee income as a result ofhigher volumes in our credit card portfolios and the impact of adopting SFAS No.159 as credit spreads widened in 2007, partially offset by lower derivativeincome, lower insurance revenue and lower other income due to realized lossesincurred on sales of real estate secured receivables by our Decision Onemortgage operations and from the sale of $2.7 billion real estate securedreceivables from the Mortgage Services portfolio. The lower derivative incomewas due to changes in the interest rate curve as declining interest ratesresulted in a lower value of our interest rate swaps as compared to the priorperiods. Also, as a result of the adoption of SFAS No. 159, we eliminated hedgeaccounting for essentially all fixed rate debt designated at fair value,lowering derivative income. The fair value change in the associated swaps, whichaccounted for the majority of the derivative income in 2006, is now reported as"Gain on debt designated at fair value and related derivatives" in theconsolidated statement of income (loss) along with the mark-to-market on thefixed rate debt. Lower insurance revenues primarily reflect lower insurancesales volumes in the U.K. prior to the sale of our U.K. Insurance operations inNovember 2007. Amortization of purchase accounting fair value adjustmentsdecreased net income by $119 million in 2007 and increased net income by $96million in 2006. Net income decreased markedly in 2006 primarily due to a substantial increase inour provision for credit losses and higher costs and expenses, which waspartially offset by higher net interest income and higher other revenues. Asdiscussed above, the higher provision for credit losses was largely driven byhigher delinquency and losses at our Mortgage Services business as loansacquired in 2005 and 2006 in the second lien and portions of the first lien realestate secured portfolio are experiencing markedly higher delinquency and, forloans acquired in 2005 and early 36 HSBC Finance Corporation-------------------------------------------------------------------------------- 2006, higher charge-offs. Also contributing to the increase in loss provisionwas the impact of higher receivable levels and portfolio seasoning including theMetris portfolio acquired in December 2005. These increases were partiallyoffset by lower bankruptcy losses as a result of reduced filings following thebankruptcy law changes in October 2005, the benefit of stable unemploymentlevels in the United States and a reduction in the estimated loss exposureresulting from Hurricane Katrina. Costs and expenses increased to supportreceivables growth including the full year impact in 2006 of our acquisition ofMetris in December 2005, as well as increases in REO expenses as a result ofhigher volumes and higher losses on sale. These increases were partially offsetby lower expenses at our U.K. business following the sale of the cards businessin December 2005 and lower intangible amortization. The increase in net interestincome was due to growth in average receivables and an improvement in theoverall yield on the portfolio, partly offset by a higher cost of funds. Changesin receivable mix also contributed to the increase in yield due to the impact ofincreased levels of higher yielding credit card receivables due to lowersecuritization levels and our acquisition of Metris which contributed $161million of net income in 2006. Other revenues on an operating basis increasedprimarily due to higher fee income and enhancement services revenue, as well ashigher affiliate servicing fees, partially offset by lower other income, lowerderivative income and lower securitization related income. Fee income andenhancement services revenue were higher in 2006 as a result of higher volumesin our credit card portfolios, primarily resulting from our acquisition ofMetris. The increase in fee income was partially offset by the impact of FFIECguidance which limits certain fee billings for non-prime credit card accounts.Affiliate servicing fees increased due to higher levels of receivables beingserviced. The decrease in other income was primarily due to lower gains on salesof real estate secured receivables by our Decision One mortgage operations andan increase in the liability for estimated losses from indemnificationprovisions on Decision One loans previously sold. The decrease in derivativeincome was primarily due to a rising interest rate environment and a significantreduction during 2005 in the population of interest rate swaps which did notqualify for hedge accounting under SFAS No. 133. Securitization related revenuedecreased due to reduced securitization activity. Amortization of purchaseaccounting fair value adjustments increased net income by $96 million in 2006,which included $14 million relating to Metris, compared to $102 million in 2005,which included $1 million relating to Metris. Our net interest margin was 6.46 percent in 2007 compared to 6.57 percent in2006 and 6.73 percent in 2005. As discussed above, the decrease in 2007 was dueto a higher cost of funds, partially offset by the impact of higher averagereceivables and higher overall yields. The higher interest expense in 2007 wasdue to a higher cost of funds resulting from the refinancing of maturing debt athigher current rates as well as higher average rates for our short-termborrowings. This was partially offset by the adoption of SFAS No. 159, whichresulted in $318 million of realized losses on swaps which previously wereaccounted for as effective hedges under SFAS No. 133 and reported as interestexpense now being reported in other revenues. Overall yields increased due toincreases in our rates on fixed and variable rate products which reflectedmarket movements and various other repricing initiatives. Yields were alsofavorably impacted by receivable mix with increased levels of higher yieldingproducts such as credit cards, due in part to reduced securitization levels andhigher levels of average personal non-credit card receivables. Overall yieldimprovements were also impacted during the second half of 2007 by a shift in mixto higher yielding Consumer Lending real estate secured receivables resultingfrom attrition in the lower yielding Mortgage Services real estate securedreceivable portfolio. Additionally, these higher yielding Consumer Lending realestate secured receivables are remaining on balance sheet longer due to lowerrun-off rates. Overall yield improvements were negatively impacted by growth innon-performing assets. The decrease in net interest margin in 2006 was due to higher funding costs,partially offset by improvements in the overall yield on the portfolio. Overallyield increases in 2006 were due to increases in our rates on fixed and variablerate products which reflected market movements and various other repricinginitiatives which included reduced levels of promotional rate balances. Yieldsin 2006 were also favorably impacted by receivable mix with increased levels ofhigher yielding products such as credit cards due in part to the full yearbenefit from the Metris acquisition and reduced securitization levels, increasedlevels of personal non-credit card receivables due to growth and higher levelsof second lien real estate secured loans. Our effective income tax rate was (16.2) percent in 2007, 36.9 percent in 2006and 33.5 percent in 2005. The effective tax rate for 2007 was significantlyimpacted by the non-tax deductability of a substantial portion of the 37 HSBC Finance Corporation-------------------------------------------------------------------------------- goodwill impairment charges associated with our Mortgage Services, ConsumerLending, Auto Finance and United Kingdom businesses as well as the accelerationof tax from sales of leveraged leases. The increase in the effective tax ratefor 2006 as compared to 2005 was due to higher state income taxes and lower taxcredits as a percentage of income before taxes. The increase in state incometaxes was primarily due to an increase in the blended statutory tax rate of ouroperating companies. The effective tax rate differs from the statutory federalincome tax rate primarily because of the effects of state and local income taxesand tax credits. See Note 15, "Income Taxes," for a reconciliation of oureffective tax rate. Receivables decreased to $156.2 billion at December 31, 2007, a 4 percentdecrease from December 31, 2006. While real estate secured receivables have beena primary driver of growth in recent years, in 2007 real estate secured growthin our Consumer Lending business was more than offset by lower receivablebalances in our Mortgage Services business resulting from the decision in March2007 to discontinue all loan acquisitions by our Mortgage Services business aswell as the sale of $2.7 billion of loans from the Mortgage Services loanportfolio in 2007. As discussed above, in the second half of 2007 we implementedrisk mitigation efforts and changes to product offerings in all remainingbusinesses which when coupled with our decision to discontinue Mortgage Servicesloan originations, will result in reductions of aggregate receivable balances infuture periods. Compared to December 31, 2006, we experienced growth in ourcredit card, auto finance and private label receivable portfolios, particularlyin our credit card portfolio due to strong domestic organic growth in ourGeneral Motors, Union Privilege, Metris and non-prime portfolios. Our return on average common shareholder's equity ("ROE") was (26.59) percent in2007 compared to 7.07 percent in 2006 and 9.97 percent in 2005. Our return onaverage owned assets ("ROA") was (2.80) percent in 2007 compared to .85 percentin 2006 and 1.27 percent in 2005. ROE and ROA were significantly impacted in2007 by the goodwill and other intangible asset impairment charges discussedabove which was partially offset by the change in the credit risk component ofour fair value optioned debt. Excluding these items, ROE decreased 1,598 basispoints and ROA decreased 177 basis points as compared to 2006. The decrease wasa result of the lower net income in 2007 and for ROA also due to higher averageassets. Our efficiency ratio was 68.69 percent in 2007 compared to 41.55 percent in 2006and 44.10 percent in 2005. Our efficiency ratio in 2007 was markedly impacted bythe goodwill and other intangible asset impairment charges discussed above whichwas partially offset by the change in the credit risk component of our fairvalue optioned debt. Excluding these items, in 2007 the efficiency ratiodeteriorated 179 basis points. This deterioration was primarily due to realizedlosses on real estate secured receivable sales by our Decision One operations,lower derivative income and higher costs and expenses, partially offset byhigher fee income and higher net interest income due to higher levels of averagereceivables. Our efficiency ratio in 2006 improved due to higher net interestincome and higher fee income and enhancement services revenues due to higherlevels of receivables, partially offset by an increase in total costs andexpenses to support receivable growth as well as higher losses on REOproperties. The improvement in efficiency ratio in 2006 was primarily a resultof higher net interest income and higher fee income and enhancement servicesrevenues due to higher levels of receivables, partially offset by an increase intotal costs and expenses to support receivable growth as well as higher losseson REO properties. MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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