HSBC Finance Corp 2007 10K-P2

3rd Mar 2008 14:00

HSBC Holdings PLC03 March 2008 PART 2 CREDIT QUALITY Our two-months-and-over contractual delinquency ratio increased to 7.41 percentat December 31, 2007 from 4.59 percent at December 31, 2006. With the exceptionof our private label portfolio (which primarily consists of our foreign privatelabel portfolio and domestic retail sales contracts that were not sold to HSBCBank USA in December 2004), all products reported higher delinquency levels dueto the impact of the weak housing and mortgage industry and rising unemploymentrates in certain markets, as discussed above, as well as the impact of aweakening U.S. economy. The two-months-and-over contractual delinquency ratiowas also negatively impacted by attrition in our real estate secured receivablesportfolio driven largely by the discontinuation of new correspondent channelacquisitions as well as product changes in our Consumer Lending portfolio whichreduced the outstanding principal balance of the real estate secured portfolio.Our credit card portfolio reported a marked increase in the two-months-and-overcontractual delinquency ratio due to a shift in mix to higher levels of non-prime receivables, seasoning of a growing portfolio and higher levels ofpersonal bankruptcy filings as compared to the exceptionally 38 HSBC Finance Corporation-------------------------------------------------------------------------------- low levels experienced in 2006 following enactment of new bankruptcy legislationin the United States as well as the impact of marketplace conditions describedabove. Dollars of delinquency at December 31, 2007 increased as compared toDecember 31, 2006 across all products, with the exception of our private labelportfolio as a result of recent growth in our foreign private label portfolios. Net charge-offs as a percentage of average consumer receivables for 2007increased 125 basis points from 2006 with increases in all products with theexception of our foreign private label portfolio. The increase in our MortgageServices business reflects the higher delinquency levels discussed above whichare migrating to charge-off and the impact of lower average receivable levelsdriven by the elimination of correspondent purchases. The increase in ourConsumer Lending business reflects portfolio seasoning and higher losses insecond lien loans purchased in 2004 through the third quarter of 2006. Theincrease in net charge-offs as a percent of average consumer receivables for ourcredit card portfolio is due to a higher mix of non-prime receivables in ourcredit card portfolio, portfolio seasoning and higher charge-off levelsresulting from increased levels of personal bankruptcy filings. The increase indelinquency in our Consumer Lending real estate secured portfolio and creditcard portfolio resulting from the marketplace and broader economic conditionswill begin to migrate to charge-off largely in 2008. The increase in net charge-offs as a percent of average consumer receivables for our personal non-creditcard portfolio reflects portfolio seasoning and deterioration of 2006 and 2007vintages in certain geographic regions. The improvement in the net charge-offratio for our private label receivables reflects higher levels of averagereceivables in our foreign operations, partially offset by portfolio seasoning. FUNDING AND CAPITAL On February 12, 2008, HINO made a capital contribution to us of $1.6 billion inexchange for one share of common stock to support ongoing operations and tomaintain capital at levels we believe are prudent in the current marketconditions. The TETMA + Owned Reserves ratio was 13.98 percent at December 31, 2007 and11.02 percent at December 31, 2006. The tangible common equity to tangiblemanaged assets ratio, excluding HSBC acquisition purchase accountingadjustments, was 6.27 percent at December 31, 2007 and 6.72 percent at December31, 2006. On a proforma basis, if the capital contribution on February 12, 2008of $1.6 billion had been received on December 31, 2007, the TETMA + OwnedReserves ratio would have been 99 basis points higher and the tangible commonequity to tangible managed assets ratio, excluding HSBC acquisition purchaseaccounting adjustments would have been 99 basis points higher. Our capitallevels reflect capital contributions of $950 million in 2007 and $163 million in2006 from HINO. Capital levels also reflect common stock dividends of $812million and $809 million paid to our parent in 2007 and 2006, respectively.These ratios represent non-U.S. GAAP financial ratios that are used by HSBCFinance Corporation management and certain rating agencies to evaluate capitaladequacy and may be different from similarly named measures presented by othercompanies. See "Basis of Reporting" and "Reconciliations to U.S. GAAP FinancialMeasures" for additional discussion and quantitative reconciliation to theequivalent U.S. GAAP basis financial measure. FUTURE PROSPECTS Our continued success and prospects for growth are dependent upon access to theglobal capital markets. Numerous factors, both internal and external, may impactour access to, and the costs associated with, these markets. These factors mayinclude our debt ratings, overall economic conditions, overall capital marketsvolatility, the counterparty credit limits of investors to the HSBC Group andthe effectiveness of our management of credit risks inherent in our customerbase. In 2007, the capital markets were severely disrupted and the marketscontinue to be highly risk averse and reactionary. This unprecedented turmoil inthe mortgage lending industry included rating agency downgrades of debt securedby subprime mortgages of some issuers. Although none of our secured financingshave been downgraded and we continued to access the commercial paper market andall other funding sources consistent with our funding plans, this raised ourcost of funding in 2007. Our affiliation with HSBC has improved our access tothe capital markets. This affiliation has given us the ability to use HSBC'sliquidity to partially fund our 39 HSBC Finance Corporation-------------------------------------------------------------------------------- operations and reduce our overall reliance on the debt markets as well asexpanded our access to a worldwide pool of potential investors. Our results are also impacted by general economic conditions, primarilyunemployment, strength of the housing market and property valuations andinterest rates which are largely out of our control. Because we generally lendto customers who have limited credit histories, modest incomes and high debt-to-income ratios or who have experienced prior credit problems, our customers aregenerally more susceptible to economic slowdowns than other consumers. Whenunemployment increases or changes in the rate of home value appreciation ordepreciation occurs, a higher percentage of our customers default on their loansand our charge-offs increase. Changes in interest rates generally affect boththe rates that we charge to our customers and the rates that we must pay on ourborrowings. In 2007, the interest rates that we paid on our debt increased. Wehave experienced higher yields on our receivables in 2007 as a result ofincreased pricing on variable rate products in line with market movements aswell as other repricing initiatives. Our ability to adjust our pricing on someof our products reduces our exposure to an increase in interest rates. In 2007,approximately $4.3 billion of adjustable rate mortgages experienced their firstinterest rate reset. In 2008 and 2009, approximately $3.7 billion and $4.1billion, respectively, of our domestic adjustable rate mortgage loans willexperience their first interest rate reset based on original contractual resetdate and receivable levels outstanding at December 31, 2007. These reset numbersdo not include any loans which were modified through a new modification programinitiated in October 2006 which proactively contacted non-delinquent customersnearing their first interest rate reset. In 2008, we anticipate approximately$1.3 billion of loans modified under this modification program will experiencetheir first reset. In addition, our analysis indicates that a significantportion of the second lien mortgages in our Mortgage Services portfolio atDecember 31, 2007 are subordinated to first lien adjustable rate mortgages thathave already experienced or will experience their first rate reset in the nexttwo years which could in some cases lead to a higher monthly payment. As aresult, delinquency and charge-offs are increasing. The primary risks andopportunities to achieving our business goals in 2008 are largely dependent uponeconomic conditions, which includes a weakened housing market, risingunemployment rates, the likelihood of a recession in the U.S. economy and thedepth of any such recession, a weakening consumer credit cycle and the impact ofARM resets, all of which could result in changes to loan volume, charge-offs,net interest income and ultimately net income. BASIS OF REPORTING-------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States ("U.S. GAAP"). Unless noted,the discussion of our financial condition and results of operations included inMD&A are presented on an owned basis of reporting. Certain reclassificationshave been made to prior year amounts to conform to the current yearpresentation. In addition to the U.S. GAAP financial results reported in our consolidatedfinancial statements, MD&A includes reference to the following information whichis presented on a non-U.S. GAAP basis: EQUITY RATIOS Tangible shareholder's(s') equity plus owned loss reserves totangible managed assets ("TETMA + Owned Reserves") and tangible common equity totangible managed assets excluding HSBC acquisition purchase accountingadjustments are non-U.S. GAAP financial measures that are used by HSBC FinanceCorporation management and certain rating agencies to evaluate capital adequacy.We and certain rating agencies monitor ratios excluding the impact of the HSBCacquisition purchase accounting adjustments as we believe that they representnon-cash transactions which do not affect our business operations, cash flows orability to meet our debt obligations. These ratios also exclude the equityimpact of SFAS No. 115, "Accounting for Certain Investments in Debt and EquitySecurities," the equity impact of SFAS No. 133, "Accounting for DerivativeInstruments and Hedging Activities," and beginning in 2007, the impact of theadoption of SFAS No. 159 including the subsequent changes in fair valuerecognized in earnings associated with debt for which we elected the fair valueoption. Preferred securities issued by certain non-consolidated trusts are alsoconsidered equity in the TETMA + Owned Reserves calculations because of theirlong-term subordinated nature and our ability to defer dividends. Managed assetsinclude owned assets plus loans which we have sold and service with limitedrecourse. These ratios may differ from similarly named measures presented byother companies. The most directly comparable U.S. GAAP financial measure is thecommon and preferred equity to owned assets ratio. For a quantitativereconciliation of these non-U.S. GAAP 40 HSBC Finance Corporation-------------------------------------------------------------------------------- financial measures to our common and preferred equity to owned assets ratio, see"Reconciliations to U.S. GAAP Financial Measures." INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results inaccordance with IFRSs and IFRSs results are used in measuring and rewardingperformance of employees, our management also separately monitors net incomeunder IFRSs (a non-U.S. GAAP financial measure). All purchase accounting fairvalue adjustments relating to our acquisition by HSBC have been "pushed down" toHSBC Finance Corporation for both U.S. GAAP and IFRSs consistent with our IFRSManagement Basis presentation. The following table reconciles our net income ona U.S. GAAP basis to net income on an IFRSs basis: YEAR ENDED 2007 2006----------------------------------------------------------------------------------- (IN MILLIONS)Net income (loss) - U.S. GAAP basis............................ $(4,906) $1,443Adjustments, net of tax: Securitizations.............................................. 20 25 Derivatives and hedge accounting (including fair value adjustments).............................................. 3 (171) Intangible assets............................................ 102 113 Purchase accounting adjustments.............................. 58 42 Loan origination............................................. 6 (27) Loan impairment.............................................. (6) 36 Loans held for resale........................................ (24) 28 Interest recognition......................................... 52 33 Goodwill and other intangible asset impairment charges....... (1,616) - Other........................................................ 162 162 ------- ------Net income (loss) - IFRSs basis................................ $(6,149) $1,684 ======= ====== Significant differences between U.S. GAAP and IFRSs are as follows: SECURITIZATIONS IFRSs - The recognition of securitized assets is governed by a three-step process, which may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows arising from securitized assets have been transferred to a third party and all the risks and rewards of the assets have been transferred, the assets concerned are derecognized. - If the rights to the cash flows are retained by HSBC but there is a contractual obligation to pay them to another party, the securitized assets concerned are derecognized if certain conditions are met such as, for example, when there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If some significant risks and rewards of ownership have been transferred, but some have also been retained, it must be determined whether or not control has been retained. If control has been retained, HSBC continues to recognize the asset to the extent of its continuing involvement; if not, the asset is derecognized. - The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. U.S. GAAP - SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity ("SPE") and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets. 41 HSBC Finance Corporation-------------------------------------------------------------------------------- - Control is surrendered over transferred assets if, and only if, all of the following conditions are met: - The transferred assets are put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. - When HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the SPE, HSBC recognizes this interest at fair value on sale of the assets to the SPE. Impact - On an IFRSs basis, our securitized receivables are treated as owned. Any gains recorded under U.S. GAAP on these transactions are reversed. An owned loss reserve is established. The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. DERIVATIVES AND HEDGE ACCOUNTING IFRSs - Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter ("OTC") derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models. - In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (that is the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (without modification or repackaging) or will be based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading gain or loss on inception of the derivative. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out. - Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. - Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net basis. - The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a 42 HSBC Finance Corporation-------------------------------------------------------------------------------- forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. Hedge Accounting: - It is HSBC's policy to document, at the inception of a hedge, the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking the hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives used in the hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. Fair value hedge: - Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair values of the assets or liabilities or groups thereof that are attributable to the hedged risks. - If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item is amortized to the income statement based on a recalculated effective interest rate over the residual period to maturity, unless the hedged item has been derecognized whereby it is released to the income statement immediately. Cash flow hedge: - The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement. - Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect the income statement. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability. - When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. Net investment hedge: - Hedges of net investments in foreign operations are accounted for in a similar manner to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation. Hedge effectiveness testing: - IAS 39 requires that at inception and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness) to qualify for hedge accounting. Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis. - The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. - For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For retrospective effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective. 43 HSBC Finance Corporation-------------------------------------------------------------------------------- Derivatives that do not qualify for hedge accounting: - All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement. U.S. GAAP - The accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39, which HSBC has followed in its IFRSs reporting from January 1, 2005, as described above. However, specific assumptions regarding hedge effectiveness under U.S. GAAP are not permitted by IAS 39. - The requirements of SFAS No. 133 have been effective from January 1, 2001. - The U.S. GAAP 'shortcut method' permits an assumption of zero ineffectiveness in hedges of interest rate risk with an interest rate swap provided specific criteria have been met. IAS 39 does not permit such an assumption, requiring a measurement of actual ineffectiveness at each designated effectiveness testing date. As of December 31, 2007 and 2006, we do not have any hedges accounted for under the shortcut method. - In addition, IFRSs allows greater flexibility in the designation of the hedged item. - Under U.S. GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. FASB Staff Position No. FIN 39-1, "Amendment of FASB Interpretation No. 39," also allows entities that are party to a master netting arrangement to offset the receivable or payable recognized upon payment or receipt of cash collateral against fair value amounts recognized for derivative instruments that have been offset under the same master netting arrangement. These contracts do not meet the requirements for offset under IAS 32 and hence are presented gross on the balance sheet under IFRSs. Impact - Differences between IFRSs and U.S. GAAP as it relates to derivatives and hedge accounting are not significant. - Prior to 2006, the "shortcut method" of hedge effectiveness testing for certain hedging relationships was utilized under U.S. GAAP. DESIGNATION OF FINANCIAL ASSETS AND LIABILITIES AT FAIR VALUE THROUGH PROFIT ANDLOSS IFRSs - Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or a combination of both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. - Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it relates. Financial assets and financial liabilities are recognized using trade date accounting. - Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. 44 HSBC Finance Corporation-------------------------------------------------------------------------------- U.S. GAAP - Prior to the adoption of SFAS No. 159, generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they were required to meet the definition of trading securities in SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities were usually reported at amortized cost under U.S. GAAP. - SFAS No. 159 was issued in February 2007, 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. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at the initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We adopted SFAS No. 159 retroactive to January 1, 2007. Impact - We have accounted for certain fixed rate debt issuances for IFRSs utilizing the fair value option as permitted under IAS 39. Prior to 2007, the fair value option was not permitted under U.S. GAAP. We elected fair value option for certain issuance of our fixed rate debt for U.S. GAAP purposes effective January 1, 2007 to align our accounting treatment with that under IFRSs. GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES IFRSs - Prior to 1998, goodwill under U.K. GAAP was written off against equity. HSBC did not elect to reinstate this goodwill on its balance sheet upon transition to IFRSs. From January 1, 1998 to December 31, 2003 goodwill was capitalized and amortized over its useful life. The carrying amount of goodwill existing at December 31, 2003 under U.K. GAAP was carried forward under the transition rules of IFRS 1 from January 1, 2004, subject to certain adjustments. - IFRS 3 "Business Combinations" requires that goodwill should not be amortized but should be tested for impairment at least annually at the reporting unit level by applying a test based on recoverable amounts. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their market price on the date the transaction is completed. U.S. GAAP - Up to June 30, 2001, goodwill acquired was capitalized and amortized over its useful life which could not exceed 25 years. The amortization of previously acquired goodwill ceased with effect from December 31, 2001. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their average market price over a reasonable period before and after the date on which the terms of the acquisition are agreed and announced. Impact - Goodwill levels are higher under IFRSs than U.S. GAAP as the HSBC purchase accounting adjustments reflect higher levels of intangible assets under U.S. GAAP. Consequently, the amount of goodwill allocated to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses and written off in 2007 is greater under IFRSs, but the amount of intangibles relating to our Consumer Lending business and written off in 2007 is lower under IFRSs. There are also differences in the valuation of assets and liabilities under U.K. GAAP (which were carried forward into IFRSs) and U.S. GAAP which result in a different amortization for the HSBC acquisition. Additionally, there are differences in the valuation of assets and liabilities under IFRSs and U.S. GAAP resulting from the Metris acquisition in December 2005. LOAN ORIGINATION IFRSs - Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. 45 HSBC Finance Corporation-------------------------------------------------------------------------------- U.S. GAAP - Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the income statement account over the life of the loan as an adjustment to interest income (SFAS No. 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) Impact - More costs, such as salary expense are deferred and amortized under U.S. GAAP, than under IFRSs. In 2007, the net costs deferred and amortized against earnings under U.S. GAAP exceeded the net costs deferred and amortized under IFRSs as origination volume slowed. LOAN IMPAIRMENT IFRSs - Where statistical models, using historic loss rates adjusted for economic conditions, provide evidence of impairment in portfolios of loans, their values are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate. The calculations include a reasonable estimate of recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. U.S. GAAP - Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery, the loans are written off in full, or to recoverable value where collateral exists. Delinquency depends on the number of days payment is overdue. The delinquency status is applied consistently across similar loan products in accordance with HSBC's credit guidelines. When local regulators mandate the delinquency status at which write-off must occur for different retail loan products and these regulations reasonably reflect estimated recoveries on individual loans, this basis of measuring loan impairment is reflected in U.S. GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. Impact - Under both IFRSs and U.S. GAAP, HSBC's policy and regulatory instructions mandate that individual loans evidencing adverse credit characteristics which indicate no reasonable likelihood of recovery are written off. When, on a portfolio basis, cash flows can reasonably be estimated in aggregate from these written-off loans, an asset equal to the present value of the future cash flows is recognized under IFRSs. - Subsequent recoveries are credited to earnings under U.S. GAAP, but are adjusted against the recovery asset under IFRSs, resulting in lower earnings under IFRSs. - Net interest income is higher under IFRSs than under U.S. GAAP due to the imputed interest on the recovery asset. LOANS HELD FOR RESALE IFRSs - Under IAS 39, loans held for resale are treated as trading assets. - As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings. - Any gains realized on sales of such loans are recognized in current period earnings on the trade date. U.S. GAAP - Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet. - Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost. - Subsequent gains on sales of such loans are recognized in current period earnings on the settlement date. 46 HSBC Finance Corporation-------------------------------------------------------------------------------- Impact - Because of differences between fair value and LOCOM accounting, adjustments to the recorded value of loan pools held for resale under IFRSs may be higher or lower than the adjustments to the recorded value under U.S. GAAP. INTEREST RECOGNITION IFRSs - The calculation and recognition of effective interest rates under IAS 39 requires an estimate of "all fees and points paid or received between parties to the contract" that are an integral part of the effective interest rate be included. U.S. GAAP - FAS 91 also generally requires all fees and costs associated with originating a loan to be recognized as interest, but when the interest rate increases during the term of the loan it prohibits the recognition of interest income to the extent that the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. Impact - During the second quarter of 2006, we implemented a methodology for calculating the effective interest rate for introductory rate credit card receivables and in the fourth quarter of 2006, we implemented a methodology for calculating the effective interest rate for real estate secured prepayment penalties over the expected life of the products which resulted in an increase to interest income of $154 million ($97 million after-tax) being recognized for introductory rate credit card receivables and a decrease to interest income of $120 million ($76 million after-tax) being recognized for prepayment penalties on real estate secured loans. Of the amounts recognized, approximately $58 million (after-tax) related to introductory rate credit card receivables and approximately $11 million (after-tax) related to prepayment penalties on real estate secured loans would otherwise have been recorded as an IFRSs opening balance sheet adjustment as at January 1, 2005. IFRS MANAGEMENT BASIS REPORTING As previously discussed, corporate goals andindividual goals of executives are currently calculated in accordance with IFRSsunder which HSBC prepares its consolidated financial statements. In 2006 weinitiated a project to refine the monthly internal management reporting processto place a greater emphasis on IFRS management basis reporting (a non-U.S. GAAPfinancial measure). As a result, operating results are now being monitored andreviewed, trends are being evaluated and decisions about allocating resources,such as employees, are being made almost exclusively on an IFRS ManagementBasis. IFRS Management Basis results are IFRSs results which assume that theprivate label and real estate secured receivables transferred to HSBC Bank USAhave not been sold and remain on our balance sheet. IFRS Management Basis alsoassumes that all purchase accounting fair value adjustments relating to ouracquisition by HSBC have been "pushed down" to HSBC Finance Corporation.Operations are monitored and trends are evaluated on an IFRS Management Basisbecause the customer loan sales to HSBC Bank USA were conducted primarily toappropriately fund prime customer loans within HSBC and such customer loanscontinue to be managed and serviced by us without regard to ownership.Accordingly, our segment reporting is on an IFRS Management Basis. However, wecontinue to monitor capital adequacy, establish dividend policy and report toregulatory agencies on an U.S. GAAP basis. A summary of the significantdifferences between U.S. GAAP and IFRSs as they impact our results aresummarized in Note 21, "Business Segments." QUANTITATIVE RECONCILIATIONS OF NON-U.S. GAAP FINANCIAL MEASURES TO U.S. GAAPFINANCIAL MEASURES For quantitative reconciliations of non-U.S. GAAP financialmeasures presented herein to the equivalent GAAP basis financial measures, see"Reconciliations to U.S. GAAP Financial Measures." 47 HSBC Finance Corporation-------------------------------------------------------------------------------- CRITICAL ACCOUNTING POLICIES-------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States. We believe our policies areappropriate and fairly present the financial position of HSBC FinanceCorporation. The significant accounting policies used in the preparation of our financialstatements are more fully described in Note 2, "Summary of SignificantAccounting Policies," to the accompanying consolidated financial statements.Certain critical accounting policies, which affect the reported amounts ofassets, liabilities, revenues and expenses, are complex and involve significantjudgment by our management, including the use of estimates and assumptions. Werecognize the different inherent loss characteristics in each of our loanproducts as well as the impact of operational policies such as customer accountmanagement policies and practices and risk management/collection practices. As aresult, changes in estimates, assumptions or operational policies couldsignificantly affect our financial position or our results of operations. Webase and establish our accounting estimates on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities. Actual results may differ fromthese estimates under different assumptions, customer account managementpolicies and practices, risk management/collection practices, or otherconditions as discussed below. We believe that of the significant accounting policies used in the preparationof our consolidated financial statements, the items discussed below involvecritical accounting estimates and a high degree of judgment and complexity. Ourmanagement has discussed the development and selection of these criticalaccounting policies with our external auditors and the Audit Committee of ourBoard of Directors, including the underlying estimates and assumptions, and theAudit Committee has reviewed our disclosure relating to these accountingpolicies and practices in this MD&A. CREDIT LOSS RESERVES Because we lend money to others, we are exposed to the riskthat borrowers may not repay amounts owed to us when they become contractuallydue. Consequently, we maintain credit loss reserves at a level that we consideradequate, but not excessive, to cover our estimate of probable losses ofprincipal, interest and fees, including late, overlimit and annual fees, in theexisting portfolio. Loss reserves are set at each business unit in consultationwith the Corporate Finance and Credit Risk Management Departments. Loss reserveestimates are reviewed periodically, and adjustments are reflected through theprovision for credit losses in the period when they become known. We believe theaccounting estimate relating to the reserve for credit losses is a "criticalaccounting estimate" for the following reasons: - The provision for credit losses totaled $11.0 billion in 2007, $6.6 billion in 2006 and $4.5 billion in 2005 and changes in the provision can materially affect net income. As a percentage of average receivables, the provision was 6.92 percent in 2007 compared to 4.31 percent in 2006 and 3.76 percent in 2005. - Estimates related to the reserve for credit losses require us to project future delinquency and charge-off trends which are uncertain and require a high degree of judgment. - The reserve for credit losses is influenced by factors outside of our control such as customer payment patterns, economic conditions such as national and local trends in housing markets, interest rates, unemployment rates, loan product features such as adjustable rate mortgage loans, bankruptcy trends and changes in laws and regulations. Because our loss reserve estimate involves judgment and is influenced by factorsoutside of our control, it is reasonably possible such estimates could change.Our estimate of probable net credit losses is inherently uncertain because it ishighly sensitive to changes in economic conditions which influence growth,portfolio seasoning, bankruptcy trends, trends in housing markets, the abilityof customers to refinance their adjustable rate mortgages, delinquency rates andthe flow of loans through the various stages of delinquency, or buckets, therealizable value of any collateral and actual loss exposure. Changes in suchestimates could significantly impact our credit loss reserves and our provisionfor credit losses. For example, a 10% change in our projection of probable netcredit losses on receivables could have resulted in a change of approximately$1.1 billion in our credit loss reserve for receivables at 48 HSBC Finance Corporation-------------------------------------------------------------------------------- December 31, 2007. The reserve for credit losses is a critical accountingestimate for all three of our reportable segments. Credit loss reserves are based on estimates and are intended to be adequate butnot excessive. We estimate probable losses for consumer receivables using a rollrate migration analysis that estimates the likelihood that a loan will progressthrough the various stages of delinquency, or buckets, and ultimately charge offbased upon recent historical performance experience of other loans in ourportfolio. This analysis considers delinquency status, loss experience andseverity and takes into account whether loans are in bankruptcy, have beenrestructured, rewritten, or are subject to forbearance, an external debtmanagement plan, hardship, modification, extension or deferment. Our credit lossreserves also take into consideration the loss severity expected based on theunderlying collateral, if any, for the loan in the event of default. Delinquencystatus may be affected by customer account management policies and practices,such as the restructure of accounts, forbearance agreements, extended paymentplans, modification arrangements, loan rewrites and deferments. When customeraccount management policies or changes thereto, shift loans from a "higher"delinquency bucket to a "lower" delinquency bucket, this will be reflected inour roll rates statistics. To the extent that restructured accounts have agreater propensity to roll to higher delinquency buckets, this will be capturedin the roll rates. Since the loss reserve is computed based on the composite ofall these calculations, this increase in roll rate will be applied toreceivables in all respective buckets, which will increase the overall reservelevel. In addition, loss reserves on consumer receivables are maintained toreflect our judgment of portfolio risk factors which may not be fully reflectedin the statistical roll rate calculation or when historical trends are notreflective of current inherent losses in the loan portfolio. Risk factorsconsidered in establishing loss reserves on consumer receivables include recentgrowth, product mix, unemployment rates, bankruptcy trends, geographicconcentrations, loan product features such as adjustable rate loans, economicconditions such as national and local trends in housing markets and interestrates, portfolio seasoning, account management policies and practices, currentlevels of charge-offs and delinquencies, changes in laws and regulations andother items which can affect consumer payment patterns on outstandingreceivables, such as natural disasters and global pandemics. For commercialloans, probable losses are calculated using estimates of amounts and timing offuture cash flows expected to be received on loans. While our credit loss reserves are available to absorb losses in the entireportfolio, we specifically consider the credit quality and other risk factorsfor each of our products. We recognize the different inherent losscharacteristics in each of our products as well as customer account managementpolicies and practices and risk management/ collection practices. Charge-offpolicies are also considered when establishing loss reserve requirements toensure the appropriate reserves exist for products with longer charge-offperiods. We also consider key ratios such as reserves as a percentage ofnonperforming loans, reserves as a percentage of net charge-offs and number ofmonths charge-off coverage in developing our loss reserve estimate. In additionto the above procedures for the establishment of our credit loss reserves, ourCredit Risk Management and Corporate Finance Departments independently assessand approve the adequacy of our loss reserve levels. We periodically re-evaluate our estimate of probable losses for consumerreceivables. Changes in our estimate are recognized in our statement of income(loss) as provision for credit losses in the period that the estimate ischanged. Our credit loss reserves for receivables increased $4.3 billion fromDecember 31, 2006 to $10.9 billion at December 31, 2007 as a result of thehigher delinquency and loss estimates for real estate secured receivables at ourMortgage Services and Consumer Lending businesses due to higher levels ofcharge-off and delinquency, the market conditions discussed above which resultin loans staying on balance sheet longer and generating higher losses as well ashigher loss estimates in second lien loans purchased from 2004 through the thirdquarter of 2006 by our Consumer Lending business. In addition, the higher creditloss reserve levels are the result of higher dollars of delinquency in our otherportfolios driven by growth, portfolio seasoning, current marketplace conditionsand a weakening U.S. economy as well as increased levels of personal bankruptcyfilings as compared to the exceptionally low levels experienced in 2006following enactment of new bankruptcy legislation in the United States whichwent into effect in October 2005. Higher credit loss reserves at December 31,2007 also reflect a higher mix of non-prime receivables in our Credit CardServices business. Credit loss reserves at our U.K. operations increased as aresult of a refinement in the methodology used to calculate roll ratepercentages which we believe reflects a better estimate of probable lossescurrently inherent in the loan portfolio as well as higher loss estimates for 49 HSBC Finance Corporation-------------------------------------------------------------------------------- restructured loans. Our reserves as a percentage of receivables were 6.98percent at December 31, 2007, 4.06 percent at December 31, 2006 and 3.23 percentat December 31, 2005. Reserves as a percentage of receivables increased comparedto December 31, 2006 primarily due to higher real estate loss estimates asdiscussed above. For more information about our charge-off and customer account managementpolicies and practices, see "Credit Quality - Delinquency and Charge-offs" and"Credit Quality - Customer Account Management Policies and Practices." GOODWILL AND INTANGIBLE ASSETS Goodwill and intangible assets with indefinitelives are not subject to amortization. Intangible assets with finite lives areamortized over their estimated useful lives. Goodwill and intangible assets arereviewed annually on July 1 for impairment using discounted cash flows, butimpairment is reviewed earlier if circumstances indicate that the carryingamount may not be recoverable. We consider significant and long-term changes inindustry and economic conditions to be our primary indicator of potentialimpairment. We believe the impairment testing of our goodwill and intangibles is a criticalaccounting estimate due to the level of goodwill ($2.8 billion) and intangibleassets ($1.1 billion) recorded at December 31, 2007 and the significant judgmentrequired in the use of discounted cash flow models to determine fair value.Discounted cash flow models include such variables as revenue growth rates,expense trends, interest rates and terminal values. Based on an evaluation ofkey data and market factors, management's judgment is required to select thespecific variables to be incorporated into the models. Additionally, theestimated fair value can be significantly impacted by the risk adjusted cost ofcapital used to discount future cash flows. The risk adjusted cost of capitalpercentage is generally derived from an appropriate capital asset pricing model,which itself depends on a number of financial and economic variables which areestablished on the basis of management's judgment. Because our fair valueestimate involves judgment and is influenced by factors outside our control, itis reasonably possible such estimates could change. When management's judgmentis that the anticipated cash flows have decreased and/or the risk adjusted costof capital has increased, the effect will be a lower estimate of fair value. Ifthe fair value is determined to be lower than the carrying value, an impairmentcharge may be recorded and net income will be negatively impacted. Impairment testing of goodwill requires that the fair value of each reportingunit be compared to its carrying amount. A reporting unit is defined as anydistinct, separately identifiable component of an operating segment for whichcomplete, discrete financial information is available that management regularlyreviews. For purposes of the annual goodwill impairment test, we assigned ourgoodwill to our reporting units. As previously discussed, in the third quarterof 2007, we recorded a goodwill impairment charge of $881 million whichrepresents all of the goodwill allocated to our Mortgage Services business. Withthe exception of our Mortgage Services business, at July 1, 2007, the estimatedfair value of each reporting unit exceeded its carrying value, resulting in noneof our remaining goodwill being impaired. As a result of the strategic changes discussed above, during the fourth quarterof 2007 we performed interim goodwill and other intangible impairment tests forthe businesses where significant changes in the business climate have occurredas required by SFAS No. 142, "Goodwill and Other Intangible Assets," ("SFAS No.142"). These tests revealed that the business climate changes, including thesubprime marketplace conditions discussed above, when coupled with the changesto our product offerings and business strategies completed through the fourthquarter of 2007, have resulted in an impairment of all goodwill allocated to ourConsumer Lending and Auto Finance businesses. Therefore, we recorded a goodwillimpairment charge in the fourth quarter of 2007 of $2,462 million relating toour Consumer Lending business and $312 million relating to our Auto Financebusiness. In addition, the changes to our product offerings and businessstrategies completed through the fourth quarter of 2007 have also resulted in animpairment of the goodwill allocated to our United Kingdom business. As aresult, an impairment charge of $378 million was also recorded in the fourthquarter representing all of the goodwill previously allocated to this business.For all other businesses, the fair value of each of these reporting unitscontinues to exceed its carrying value including goodwill. To the extent additional changes in the strategy of our remaining businesses orproduct offerings occur from the ongoing strategic analysis previouslydiscussed, we will be required by SFAS No. 142 to perform interim goodwill 50 HSBC Finance Corporation-------------------------------------------------------------------------------- impairment tests for the impacted businesses which could result in additionalgoodwill impairment in future periods. Impairment testing of intangible assets requires that the fair value of theasset be compared to its carrying amount. For all intangible assets, at July 1,2007, the estimated fair value of each intangible asset exceeded its carryingvalue and, as such, none of our intangible assets were impaired. As a result ofthe strategic changes discussed above, during the fourth quarter of 2007 we alsoperformed an interim impairment test for the HFC and Beneficial tradenames andcustomer relationship intangibles relating to the HSBC acquisition allocated toour Consumer Lending business. This testing resulted in an impairment of thesetradename and customer relationship intangibles and we recorded an impairmentcharge in the fourth quarter of 2007 of $858 million representing all of theremaining value assigned to these tradenames and customer relationshipintangibles allocated to our Consumer Lending business. VALUATION OF DERIVATIVE INSTRUMENTS, DEBT AND DERIVATIVE INCOME We regularly usederivative instruments as part of our risk management strategy to protect thevalue of certain assets and liabilities and future cash flows against adverseinterest rate and foreign exchange rate movements. All derivatives arerecognized on the balance sheet at fair value. As of December 31, 2007, therecorded fair values of derivative assets and liabilities were $3,842 millionand $71 million, respectively, exclusive of the related collateral that has beenreceived or paid which is netted against these values for financial reportingpurposes in accordance with FIN 39-1. We believe the valuation of derivativeinstruments is a critical accounting estimate because certain instruments arevalued using discounted cash flow modeling techniques in lieu of market valuequotes. These modeling techniques require the use of estimates regarding theamount and timing of future cash flows, which are also susceptible tosignificant change in future periods based on changes in market rates. Theassumptions used in the cash flow projection models are based on forward yieldcurves which are also susceptible to changes as market conditions change. We utilize HSBC Bank USA to determine the fair value of substantially all of ourderivatives using these modeling techniques. We regularly review the results ofthese valuations for reasonableness by comparing to an internal determination offair value or third party quotes. Significant changes in the fair value canresult in equity and earnings volatility as follows: - Changes in the fair value of a derivative that has been designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability (including losses or gains on firm commitments), are recorded in current period earnings. - Changes in the fair value of a derivative that has been designated and qualifies as a cash flow hedge are recorded in other comprehensive income to the extent of its effectiveness, until earnings are impacted by the variability of cash flows from the hedged item. - Changes in the fair value of a derivative that has not been designated as an effective hedge is reported in current period earnings. A derivative designated as an effective hedge will be tested for effectivenessin all circumstances under the long-haul method. For these transactions, weformally assess, both at the inception of the hedge and on a quarterly basis,whether the derivative used in a hedging transaction has been and is expected tocontinue to be highly effective in offsetting changes in fair values or cashflows of the hedged item. This assessment is conducted using statisticalregression analysis. If it is determined as a result of this assessment that a derivative is notexpected to be a highly effective hedge or that it has ceased to be a highlyeffective hedge, we discontinue hedge accounting as of the beginning of thequarter in which such determination was made. We also believe the assessment ofthe effectiveness of the derivatives used in hedging transactions is a criticalaccounting estimate due to the use of statistical regression analysis in makingthis determination. Similar to discounted cash flow modeling techniques,statistical regression analysis also requires the use of estimates regarding theamount and timing of future cash flows, which are susceptible to significantchange in future periods based on changes in market rates. Statisticalregression analysis also involves the use of additional assumptions includingthe determination of the period over which the analysis should occur as well asselecting a convention for the treatment of credit spreads in the analysis. Thestatistical regression analysis for our derivative instruments is performed byeither HSBC Bank USA or another third party. 51 HSBC Finance Corporation-------------------------------------------------------------------------------- The outcome of the statistical regression analysis serves as the foundation fordetermining whether or not the derivative is highly effective as a hedginginstrument. This can result in earnings volatility as the mark-to-market onderivatives which do not qualify as effective hedges and the ineffectivenessassociated with qualifying hedges are recorded in current period earnings. Themark-to market on derivatives which do not qualify as effective hedges was $(7)million in 2007, $28 million in 2006 and $156 million in 2005. Theineffectiveness associated with qualifying hedges was $(48) million in 2007,$169 million in 2006 and $41 million in 2005. See "Results of Operations" inManagement's Discussion and Analysis of Financial Condition and Results ofOperations for a discussion of the yearly trends. Effective January 1, 2007, we elected the fair value option for certain issuanceof our fixed rate debt in order to align our accounting treatment with that ofHSBC under IFRS. As of December 31, 2007, the recorded fair value of such debtwas $32.9 billion. We believe the valuation of this debt is a criticalaccounting estimate because valuation estimates obtained from third partiesinvolve inputs other than quoted prices to value both the interest ratecomponent and the credit component of the debt. Changes in such estimates, andin particular the credit component of the valuation, can be volatile from periodto period and may markedly impact the total mark-to-market on debt designated atfair value recorded in our consolidated statement of income (loss). For example,a 10 percent change in the movement in the value of our debt designated at fairvalue could have resulted in a change to our reported mark-to-market ofapproximately $128 million. For more information about our policies regarding the use of derivativeinstruments, see Note 2, "Summary of Significant Accounting Policies," and Note14, "Derivative Financial Instruments," to the accompanying consolidatedfinancial statements. CONTINGENT LIABILITIES Both we and certain of our subsidiaries are parties tovarious legal proceedings resulting from ordinary business activities relatingto our current and/or former operations which affect all three of our reportablesegments. Certain of these activities are or purport to be class actions seekingdamages in significant amounts. These actions include assertions concerningviolations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certainthat we will ultimately prevail in each instance. Also, as the ultimateresolution of these proceedings is influenced by factors that are outside of ourcontrol, it is reasonably possible our estimated liability under theseproceedings may change. However, based upon our current knowledge, our defensesto these actions have merit and any adverse decision should not materiallyaffect our consolidated financial condition, results of operations or cashflows. 52 HSBC Finance Corporation-------------------------------------------------------------------------------- RECEIVABLES REVIEW-------------------------------------------------------------------------------- The following table summarizes receivables at December 31, 2007 and increases(decreases) over prior periods: INCREASES (DECREASES) FROM --------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, --------------- --------------- 2007 $ % $ %--------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Real estate secured(1)..................... $ 88,661 $(9,224) (9.4)% $ 5,835 7.0%Auto finance............................... 13,257 753 6.0 2,553 23.9Credit card................................ 30,390 2,676 9.7 6,280 26.0Private label.............................. 3,093 584 23.3 573 22.7Personal non-credit card................... 20,649 (718) (3.4) 1,104 5.6Commercial and other....................... 144 (37) (20.4) (64) (30.8) -------- ------- ----- ------- -----Total receivables.......................... $156,194 $(5,966) (3.7)% $16,281 11.6% ======== ======= ===== ======= ===== -------- (1) Real estate secured receivables are comprised of the following: INCREASES (DECREASES) FROM ---------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, ---------------- --------------- 2007 $ % $ %------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Mortgage Services............................. $33,906 $(14,187) (29.5)% $(7,649) (18.4)%Consumer Lending.............................. 50,542 4,316 9.3 12,320 32.2Foreign and all other......................... 4,213 647 18.1 1,164 38.2 ------- -------- ----- ------- -----Total real estate secured..................... $88,661 $ (9,224) (9.4)% $ 5,835 7.0% ======= ======== ===== ======= ===== REAL ESTATE SECURED RECEIVABLES Real estate secured receivables can be furtheranalyzed as follows: INCREASES (DECREASES) FROM -------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, --------------- -------------- 2007 $ % $ %--------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Real estate secured: Closed-end: First lien............................. $71,459 $(6,565) (8.4)% $4,640 6.9% Second lien............................ 13,672 (1,419) (9.4) 1,857 15.7 Revolving: First lien............................. 436 (120) (21.6) (190) (30.4) Second lien............................ 3,094 (1,120) (26.6) (472) (13.2) ------- ------- ----- ------ -----Total real estate secured................... $88,661 $(9,224) (9.4)% $5,835 7.0% ======= ======= ===== ====== ===== 53 HSBC Finance Corporation-------------------------------------------------------------------------------- The following table summarizes various real estate secured receivablesinformation for our Mortgage Services and Consumer Lending businesses: YEAR ENDED DECEMBER 31, -------------------------------------------------------------------- 2007 2006 2005 -------------------- -------------------- -------------------- MORTGAGE CONSUMER MORTGAGE CONSUMER MORTGAGE CONSUMER SERVICES LENDING SERVICES LENDING SERVICES LENDING-------------------------------------------------------------------------------------------------------- (IN MILLIONS)Fixed rate....................... $18,379((1)) $47,563(2) $21,857(1) $42,675(2) $18,876(1) $36,415(2)Adjustable rate.................. 15,527 2,979 26,235 3,551 22,679 1,807 -------- ------- ------- ------- ------- -------Total............................ $ 33,906 $50,542 $48,092 $46,226 $41,555 $38,222 ======== ======= ======= ======= ======= =======First lien....................... $ 27,239 $43,645 $38,153 $39,684 $33,897 $33,017Second lien...................... 6,667 6,897 9,939 6,542 7,658 5,205 -------- ------- ------- ------- ------- -------Total............................ $ 33,906 $50,542 $48,092 $46,226 $41,555 $38,222 ======== ======= ======= ======= ======= =======Adjustable rate.................. $ 11,904 $ 2,979 $20,108 $ 3,551 $17,826 $ 1,807Interest only.................... 3,623 - 6,127 - 4,853 - -------- ------- ------- ------- ------- -------Total adjustable rate............ $ 15,527 $ 2,979 $26,235 $ 3,551 $22,679 $ 1,807 ======== ======= ======= ======= ======= =======Total stated income (low documentation)................. $ 7,943 $ - $11,772 $ - $ 7,344 $ - ======== ======= ======= ======= ======= ======= -------- (1) Includes fixed rate interest-only loans of $411 million at December 31, 2007, $514 million at December 31, 2006 and $249 million at December 31, 2005. (2) Includes fixed rate interest-only loans of $48 million at December 31, 2007, $46 million at December 31, 2006 and $0 million at December 31, 2005. Real estate secured receivables decreased from the year-ago period driven bylower receivable balances in our Mortgage Services business resulting from ourdecision in March 2007 to discontinue new correspondent channel acquisitions.Also contributing to the decrease were Mortgage Services loan portfolio sales in2007 which totaled $2.7 billion. These actions have resulted in a significantreduction in the Mortgage Services portfolio since December 31, 2006. Thisattrition was partially offset by a decline in loan prepayments due to fewerrefinancing opportunities for our customers due to the previously discussedtrends impacting the mortgage lending industry as well as the higher interestrate environment which resulted in fewer prepayments as fewer alternatives torefinance loans existed for some of our customers. The balance of this portfoliowill continue to decrease going forward as the loan balances liquidate. Thereduction in our Mortgage Services portfolio was partially offset by growth inour Consumer Lending branch business. Growth in our branch-based ConsumerLending business improved due to higher sales volumes and the decline in loanprepayments discussed above. However, this growth was partially offset by theactions taken in the second half of 2007 to reduce risk going forward in ourConsumer Lending business, including eliminating the small volume of ARM loans,capping second lien LTV ratio requirements to either 80 or 90 percent based ongeography and the overall tightening of credit score, debt-to-income and LTVrequirements for first lien loans. These actions, when coupled with asignificant reduction in demand for subprime loans across the industry, haveresulted in loan attrition in the fourth quarter of 2007 and will markedly limitgrowth of our Consumer Lending real estate secured receivables in theforeseeable future. Additionally, the 2006 real estate secured receivablebalances in our Consumer Lending business were impacted by the acquisition ofthe $2.5 billion Champion portfolio in November 2006. 54 HSBC Finance Corporation-------------------------------------------------------------------------------- The following table summarizes by lien position the Mortgage Services realestate secured loans originated and acquired subsequent to December 31, 2004 asa percentage of the total portfolio which were outstanding as of the followingdates: MORTGAGE SERVICES' RECEIVABLES ORIGINATED OR ACQUIRED AFTER DECEMBER 31, 2004 AS A PERCENTAGE OF TOTAL PORTFOLIO-----------------------------------------------------------------------------------------AS OF FIRST LIEN SECOND LIEN-----------------------------------------------------------------------------------------December 31, 2007........................................... 74% 90%December 31, 2006........................................... 74 90December 31, 2005........................................... 65 89 The following table summarizes by lien position the Consumer Lending real estatesecured loans originated and acquired subsequent to December 31, 2005 as apercentage of the total portfolio which were outstanding as of the followingdates: CONSUMER LENDING'S RECEIVABLES ORIGINATED OR ACQUIRED AFTER DECEMBER 31, 2005 AS A PERCENTAGE OF TOTAL PORTFOLIO-----------------------------------------------------------------------------------------AS OF FIRST LIEN SECOND LIEN-----------------------------------------------------------------------------------------December 31, 2007........................................... 51% 65%December 31, 2006........................................... 34 46 AUTO FINANCE RECEIVABLES Auto finance receivables increased over the year-agoperiod due to organic growth principally in the near-prime portfolio as a resultof growth in the consumer direct loan program and lower securitization levels.These increases were partially offset by lower originations in the dealernetwork portfolio as a result of actions taken to reduce risk in the portfolio. CREDIT CARD RECEIVABLES Credit card receivables reflect strong domestic organicgrowth in our General Motors, Union Privilege, Metris and non-prime portfolios,partially offset by the actions taken in the fourth quarter to slow receivablegrowth. PRIVATE LABEL RECEIVABLES Private label receivables increased in 2007 as aresult of growth in our UK and Canadian businesses and changes in the foreignexchange rate since December 31, 2006, partially offset by the termination ofnew domestic retail sales contract originations in October 2006 by our ConsumerLending business. PERSONAL NON-CREDIT CARD RECEIVABLES Personal non-credit card receivables arecomprised of the following: INCREASES (DECREASES) FROM ------------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, --------------- ----------------- 2007 $ % $ %-------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Domestic personal non-credit card.......... $13,980 $ 217 1.6% $ 2,586 22.7%Union Plus personal non-credit card........ 175 (60) (25.5) (158) (47.4)Personal homeowner loans................... 3,891 (356) (8.4) (282) (6.8)Foreign personal non-credit card........... 2,603 (519) (16.6) (1,042) (28.6) ------- ----- ----- ------- -----Total personal non-credit card receivables.............................. $20,649 $(718) (3.4)% $ 1,104 5.6% ======= ===== ===== ======= ===== Personal non-credit card receivables decreased during 2007 as a result of theactions taken in the second half of the year by our Consumer Lending business toreduce risk going forward, including elimination of guaranteed direct mail loansto new customers, the discontinuance of personal homeowner loans and tighteningunderwriting criteria. Domestic and foreign personal non-credit card loans (cash loans with nosecurity) historically have been made to customers who may not qualify foreither a real estate secured or personal homeowner loan ("PHL"). The averagepersonal non-credit card loan is approximately $5,900 and 40 percent of thepersonal non-credit card portfolio is 55 HSBC Finance Corporation-------------------------------------------------------------------------------- closed-end with terms ranging from 12 to 60 months. The Union Plus personal non-credit card loans are part of our affinity relationship with the AFL-CIO and areunderwritten similar to other personal non-credit card loans. In the fourth quarter of 2007 we discontinued originating PHL's. PHL's typicallyhave terms of 120 to 240 months and are subordinate lien, home equity loans withhigh (100 percent or more) combined loan-to-value ratios which we underwrote,priced and service like unsecured loans. The average PHL in portfolio atDecember 31, 2007 is approximately $14,000. Because recovery upon foreclosure isunlikely after satisfying senior liens and paying the expenses of foreclosure,we did not consider the collateral as a source for repayment in ourunderwriting. As we have discontinued originating PHL's, this portfolio willdecrease going forward. DISTRIBUTION AND SALES We reach our customers through many differentdistribution channels and our growth strategies vary across product lines. TheConsumer Lending business originates real estate and personal non-credit cardproducts through its retail branch network, direct mail, telemarketing andInternet applications. As a result of the decision to discontinue correspondentchannel acquisitions and to cease Decision One's operations, the MortgageServices portfolio is currently running-off. Private label receivables aregenerated through point of sale, merchant promotions, application displays,Internet applications, direct mail and telemarketing. Auto finance receivablesare generated primarily through dealer relationships from which installmentcontracts are purchased. Additional auto finance receivables are generatedthrough direct lending which, includes Internet applications, direct mail, inour Consumer Lending branches and, prior to the fourth quarter of 2007, includedalliance partner referrals. Credit card receivables are generated primarilythrough direct mail, telemarketing, Internet applications, application displaysincluding in our Consumer Lending retail branch network, promotional activityassociated with our co-branding and affinity relationships, mass mediaadvertisements and merchant relationships sourced through our Retail Servicesbusiness. Based on certain criteria, we offer personal non-credit card customers who meetour current underwriting standards the opportunity to convert their loans intoreal estate secured loans. This enables our customers to have access toadditional credit at lower interest rates. This also reduces our potential lossexposure and improves our portfolio performance as previously unsecured loansbecome secured. We converted approximately $606 million of personal non-creditcard loans into real estate secured loans in 2007 and $665 million in 2006. Itis not our practice to rewrite or reclassify delinquent secured loans (realestate or auto) into personal non-credit card loans. RESULTS OF OPERATIONS-------------------------------------------------------------------------------- NET INTEREST INCOME The following table summarizes net interest income: YEAR ENDED DECEMBER 31, 2007 (1) 2006 (1) 2005 (1)-------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Finance and other interest income...... $18,683 11.44% $17,562 11.33% $13,216 10.61%Interest expense....................... 8,132 4.98 7,374 4.76 4,832 3.88 ------- ----- ------- ----- ------- -----Net interest income.................... $10,551 6.46% $10,188 6.57% $ 8,384 6.73% ======= ===== ======= ===== ======= ===== -------- (1) % Columns: comparison to average owned interest-earning assets. The increases in net interest income during 2007 were due to higher averagereceivables and higher overall yields, partially offset by higher interestexpense. Overall yields increased due to increases in our rates on fixed andvariable rate products which reflected market movements and various otherrepricing initiatives. Yields were also favorably impacted by receivable mixwith increased levels of higher yielding products such as credit cards andhigher levels of average personal non-credit card receivables. Overall yieldimprovements were also impacted by a shift in mix to higher yielding ConsumerLending real estate secured receivables resulting from attrition in the loweryielding Mortgage Services real estate secured receivable portfolio.Additionally, these higher yielding Consumer Lending real estate securedreceivables are remaining on the balance sheet longer due to lower run-offrates. Overall yield improvements were partially offset by the impact of growthin non-performing assets. The higher interest expense in 2007 was due to ahigher cost of funds resulting from the refinancing of maturing debt at highercurrent 56 HSBC Finance Corporation-------------------------------------------------------------------------------- rates as well as higher average rates for our short-term borrowings. This waspartially offset by the adoption of SFAS No. 159, which resulted in $318 millionof realized losses on swaps which previously were accounted for as effectivehedges under SFAS No. 133 and reported as interest expense now being reported inother revenues. Our purchase accounting fair value adjustments include bothamortization of fair value adjustments to our external debt obligations andreceivables. Amortization of purchase accounting fair value adjustmentsincreased net interest income by $124 million in 2007 and $418 million in 2006. The increase in net interest income during 2006 was due to higher averagereceivables and higher overall yields, partially offset by higher interestexpense. Overall yields increased due to increases in our rates on fixed andvariable rate products which reflected market movements and various otherrepricing initiatives which in 2006 included reduced levels of promotional ratebalances. Yields in 2006 were also favorably impacted by receivable mix withincreased levels of higher yielding products such as credit cards, due in partto the full year benefit from the Metris acquisition and reduced securitizationlevels; higher levels of personal non-credit card receivables due to growth andhigher levels of second lien real estate secured loans. The higher interestexpense, which contributed to lower net interest margin, was due to a largerbalance sheet and a significantly higher cost of funds due to a rising interestrate environment. In addition, as part of our overall liquidity managementstrategy, we continue to extend the maturity of our liability profile whichresults in higher interest expense. Amortization of purchase accounting fairvalue adjustments increased net interest income by $418 million in 2006, whichincluded $62 million relating to Metris and $520 million in 2005, which included$4 million relating to Metris. Net interest margin was 6.46 percent in 2007, 6.57 percent in 2006 and 6.73percent in 2005. Net interest margin decreased in both 2007 and 2006 as theimprovement in the overall yield on our receivable portfolio, as discussedabove, was more than offset by the higher funding costs. The following tableshows the impact of these items on net interest margin: 2007 2006----------------------------------------------------------------------------------Net interest margin - December 31, 2006 and 2005, respectively.... 6.57% 6.73%Impact to net interest margin resulting from: Receivable pricing.............................................. .18 .52 Receivable mix.................................................. .21 .20 Impact of non-performing assets................................. (.22) .02 Cost of funds................................................... (.22) (.88) Other........................................................... (.06) (.02) ---- ----Net interest margin - December 31, 2007 and 2006, respectively.... 6.46% 6.57% ==== ==== The varying maturities and repricing frequencies of both our assets andliabilities expose us to interest rate risk. When the various risks inherent inboth the asset and the debt do not meet our desired risk profile, we usederivative financial instruments to manage these risks to acceptable interestrate risk levels. See "Risk Management" for additional information regardinginterest rate risk and derivative financial instruments. PROVISION FOR CREDIT LOSSES The provision for credit losses includes currentperiod net credit losses and an amount which we believe is sufficient tomaintain reserves for losses of principal, interest and fees, including late,overlimit and annual fees, at a level that reflects known and inherent losses inthe portfolio. Growth in receivables and portfolio seasoning ultimately resultin higher provision for credit losses. The provision for credit losses may alsovary from year to year depending on a variety of additional factors includingproduct mix and the credit quality of the loans in our portfolio including,historical delinquency roll rates, customer account management policies andpractices, risk management/collection policies and practices related to our loanproducts, economic conditions such as national and local trends in housingmarkets and interest rates, changes in laws and regulations and our analysis ofperformance of products originated or acquired at various times. 57 HSBC Finance Corporation-------------------------------------------------------------------------------- The following table summarizes provision for owned credit losses: YEAR ENDED DECEMBER 31, 2007 2006 2005--------------------------------------------------------------------------------------- (IN MILLIONS)Provision for credit losses.............................. $11,026 $6,564 $4,543 Our provision for credit losses increased $4.5 billion in 2007 primarilyreflecting higher loss estimates in our Consumer Lending, Credit Card Servicesand Mortgage Services businesses due to the following: - Consumer Lending experienced higher loss estimates primarily in its real estate secured receivable portfolio due to higher levels of charge-off and delinquency driven by 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 and a weak housing market as 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 a 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 portions of the portfolio 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, our provision for credit losses in 2007 for our United Kingdombusiness reflects a $93 million increase in credit loss reserves, resulting froma refinement in the methodology used to calculate roll rate percentages to beconsistent with our other businesses and which we believe reflects a betterestimate of probable losses currently inherent in the loan portfolio as well ashigher loss estimates for restructured loans of $68 million. These increases tocredit loss reserves were more than offset by improvements in delinquency andcharge-offs which resulted in an overall lower credit loss provision in ourUnited Kingdom business. Net charge-off dollars for 2007 increased $2,197 million compared to 2006. Thisincrease was driven by the impact of the marketplace and broader economicconditions described above in our Mortgage Services and Consumer Lendingbusinesses as well as higher average receivable levels, seasoning in our creditcard and Consumer Lending portfolios and increased levels of personal bankruptcyfilings as compared to the exceptionally low filing levels experienced in 2006,particularly in our credit card portfolios, as a result of a new bankruptcy lawin the United States which went into effect in October 2005. Our provision for credit losses increased $2,021 million during 2006. Theprovision for credit losses in 2005 included increased provision expense of $185million relating to Hurricane Katrina and $113 million in the fourth quarter dueto bankruptcy reform legislation. Excluding these adjustments and a subsequentrelease of $90 million of Hurricane Katrina reserves in 2006, the provision forcredit losses increased $2,409 million or 57 percent in 2006. The increase inthe provision for credit losses was largely driven by deterioration in theperformance of mortgage 58 HSBC Finance Corporation-------------------------------------------------------------------------------- loans acquired in 2005 and 2006 by our Mortgage Services business as discussedabove. Also contributing to this increase in provision in 2006 was the impact ofhigher receivable levels and normal portfolio seasoning including the Metrisportfolio acquired in December 2005. These increases were partially offset byreduced bankruptcy filings, the benefit of stable unemployment levels in theUnited States in 2006 and the sale of the U.K. card business in December 2005.Net charge-off dollars for 2006 increased $866 million compared to 2005 drivenby our Mortgage Services business, as discussed above. Also contributing to theincrease in net charge-off dollars was higher credit card charge-off due to thefull year impact of the Metris portfolio, the one-time accelerations of charge-offs at our Auto Finance business due to a change in policy, the discontinuationof a forbearance program at our U.K. business (see "Credit Quality" for furtherdiscussion) and the impact of higher receivable levels and portfolio seasoningin our auto finance and personal non-credit card portfolios. These increaseswere partially offset by the impact of reduced bankruptcy levels following thespike in filings and subsequent charge-off we experienced in the fourth quarterof 2005 as a result of the legislation which went into effect in October 2005,the benefit of stable unemployment levels in the United States, and the sale ofthe U.K. card business in December 2005. We increased our credit loss reserves in both 2007 and 2006 as the provision forcredit losses was $4,310 million greater than net charge-offs in 2007 and $2,045million greater than net charge-offs in 2006. The provision as a percent ofaverage owned receivables was 6.92 percent in 2007, 4.31 percent in 2006 and3.76 percent in 2005. The increase in 2007 reflects higher loss estimates at ourConsumer Lending, Credit Card Services and Mortgage Services business asdiscussed above including higher dollars of delinquency. The increase in 2006reflects higher loss estimates and charge-offs at our Mortgage Services businessas discussed above, as well as higher dollars of delinquency in our otherbusinesses driven by growth and portfolio seasoning. Reserve levels in 2006 alsoincreased due to higher early stage delinquency consistent with the industrytrend in certain Consumer Lending real estate secured loans originated sincelate 2005. See "Critical Accounting Policies," "Credit Quality" and "Analysis of CreditLoss Reserves Activity" for additional information regarding our loss reserves.See Note 7, "Credit Loss Reserves" in the accompanying consolidated financialstatements for additional analysis of loss reserves. OTHER REVENUES The following table summarizes other revenues: YEAR ENDED DECEMBER 31, 2007 2006 2005--------------------------------------------------------------------------------------- (IN MILLIONS)Securitization related revenue............................ $ 70 $ 167 $ 211Insurance revenue......................................... 806 1,001 997Investment income......................................... 145 274 134Derivative (expense) income............................... (79) 190 249Gain on debt designated at fair value and related derivatives............................................. 1,275 - -Fee income................................................ 2,415 1,911 1,568Enhancement services revenue.............................. 635 515 338Taxpayer financial services revenue....................... 247 258 277Gain on receivable sales to HSBC affiliates............... 419 422 413Servicing fees from HSBC affiliates....................... 536 506 440Other (expense) income.................................... (70) 179 336 ------ ------ ------Total other revenues...................................... $6,399 $5,423 $4,963 ====== ====== ====== 59 HSBC Finance Corporation-------------------------------------------------------------------------------- Securitization related revenue is the result of the securitization of ourreceivables and includes the following: YEAR ENDED DECEMBER 31, 2007 2006 2005------------------------------------------------------------------------------------ (IN MILLIONS)Net initial gains............................................ $ - $ - $ -Net replenishment gains(1)................................... 24 30 154Servicing revenue and excess spread.......................... 46 137 57 --- ---- ----Total........................................................ $70 $167 $211 === ==== ==== -------- (1) Net replenishment gains reflect inherent recourse provisions of $18 million in 2007, $41 million in 2006 and $252 million in 2005. The decline in securitization related revenue in 2007 was due to decreases inthe level of securitized receivables as a result of our decision in the thirdquarter of 2004 to structure all new collateralized funding transactions assecured financings. Because existing public credit card transactions werestructured as sales to revolving trusts that required replenishments ofreceivables to support previously issued securities, receivables continued to besold to these trusts until the revolving periods ended, the last of which was inthe fourth quarter of 2007. While the termination of sale treatment on newcollateralized funding activity and the reduction of sales under replenishmentagreements reduced our reported net income, there is no impact on cash receivedfrom operations. See Note 2, "Summary of Significant Accounting Policies," and Note 8, "AssetSecuritizations," to the accompanying consolidated financial statements and "OffBalance Sheet Arrangements and Secured Financings" for further information onasset securitizations. Insurance revenue decreased in 2007 primarily due to lower insurance salesvolumes in our U.K. operations, largely due to a planned phase out of the use ofour largest external broker between January and April 2007, as well as theimpact of the sale of our U.K. insurance operations to Aviva in November 2007.As the sales agreement provides for the purchaser to distribute insuranceproducts through our U.K. branch network in return for a commission, goingforward we will receive insurance commission revenue which should partiallyoffset the loss of insurance premium revenues. The decrease in insurance revenuefrom our U.K. operations was partially offset by higher insurance revenue in ourdomestic operations due to the introduction of lender placed products in ourAuto Finance business and the negotiation of lower commission payments incertain products offered by our Retail Services business net of the impact ofthe cancellation of a significant policy effective January 1, 2007. The increasein insurance revenue in 2006 was primarily due to higher sales volumes and newreinsurance activity beginning in the third quarter of 2006 in our domesticoperations, partially offset by lower insurance sales volumes in our U.K.operations. Investment income, which includes income on securities available for sale in ourinsurance business and realized gains and losses from the sale of securities,decreased as 2006 investment income reflects a gain of $123 million on the saleof our investment in Kanbay International, Inc. ("Kanbay"). Excluding the impactof this gain in the prior year, investment income in 2007 decreased primarilydue to higher amortization of fair value adjustments. The increase in 2006 wasprimarily due to the gain on the sale of our investment in Kanbay discussedabove. Derivative (expense) income includes realized and unrealized gains and losses onderivatives which do not qualify as effective hedges under SFAS No. 133 as wellas the ineffectiveness on derivatives which are qualifying hedges. Prior to theelection of FVO reporting for certain fixed rate debt, we accounted for therealized gains and losses on swaps associated with this debt which qualified aseffective hedges under SFAS No. 133 in interest expense and any ineffectivenesswhich resulted from changes in the fair value of the swaps as compared tochanges in the interest rate component value of the debt was recorded as acomponent of derivative income. With the adoption of SFAS No. 159 beginning inJanuary 2007, we eliminated hedge accounting on these swaps and as a result,realized and unrealized gains and losses on these derivatives and changes in theinterest rate component value of the aforementioned debt are now included inGain on debt designated at fair value and related derivatives in theconsolidated statement of income (loss) which impacts the comparability ofderivative income between periods. 60 HSBC Finance Corporation-------------------------------------------------------------------------------- Derivative (expense) income is summarized in the table below: 2007 2006 2005------------------------------------------------------------------------------------ (IN MILLIONS)Net realized gains (losses).................................. $(24) $ (7) $ 52Mark-to-market on derivatives which do not qualify as effective hedges........................................... (7) 28 156Ineffectiveness.............................................. (48) 169 41 ---- ---- ----Total........................................................ $(79) $190 $249 ==== ==== ==== Derivative income decreased in 2007 due to changes in the interest rate curveand to the adoption of SFAS No. 159. Changes in interest rates resulted in alower value of our cash flow interest rate swaps as compared to the priorperiods. The decrease in income from ineffectiveness is due to a significantlylower number of interest rate swaps which are accounted for under the long-haulmethod of accounting as a result of the adoption of SFAS No. 159. As discussedabove, the mark-to-market on the swaps associated with debt we have nowdesignated at fair value, as well as the mark-to-market on the interest ratecomponent of the debt, which accounted for the majority of the ineffectivenessrecorded in 2006, is now reported in the consolidated income statement as Gainon debt designated at fair value and related derivatives. Additionally, in thesecond quarter of 2006, we completed the redesignation of all remaining shortcut hedge relationships as hedges under the long-haul method of accounting.Redesignation of swaps as effective hedges reduces the overall volatility ofreported mark-to-market income, although re-establishing such swaps as long-haulhedges creates volatility as a result of hedge ineffectiveness. All derivativesare economic hedges of the underlying debt instruments regardless of theaccounting treatment. In 2006, derivative income decreased primarily due to a significant reductionduring 2005 in the population of interest rate swaps which do not qualify forhedge accounting under SFAS No. 133. In addition, during 2006 we experienced arising interest rate environment compared to a yield curve that generallyflattened in the comparable period of 2005. The income from ineffectiveness inboth periods resulted from the designation during 2005 of a significant numberof our derivatives as effective hedges under the long-haul method of accounting.These derivatives had not previously qualified for hedge accounting under SFASNo. 133. In addition, as discussed above all of the hedge relationships whichqualified under the shortcut method provisions of SFAS No. 133 wereredesignated, substantially all of which are hedges under the long-haul methodof accounting. Redesignation of swaps as effective hedges reduces the overallvolatility of reported mark-to-market income, although establishing such swapsas long-haul hedges creates volatility as a result of hedge ineffectiveness. Net income volatility, whether based on changes in interest rates for swapswhich do not qualify for hedge accounting or ineffectiveness recorded on ourqualifying hedges under the long haul method of accounting, impacts thecomparability of our reported results between periods. Accordingly, derivativeincome for the year ended December 31, 2007 should not be considered indicativeof the results for any future periods. Gain on debt designated at fair value and related derivatives reflects fairvalue changes on our fixed rate debt accounted for under FVO as a result ofadopting SFAS No. 159 effective January 1, 2007 as well as the fair valuechanges and realized gains (losses) on the related derivatives associated withdebt designated at fair value. Prior to the election of FVO reporting forcertain fixed rate debt, we accounted for the realized gains and losses on swapsassociated with this debt which qualified as effective hedges under SFAS No. 133in interest expense and any ineffectiveness which resulted from changes in thevalue of the swaps as compared to changes in the interest rate component valueof the debt was recorded in derivative income. These components are summarizedin the table below: 61 HSBC Finance Corporation-------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 2007 2006--------------------------------------------------------------------------------------- (IN MILLIONS)Mark-to-market on debt designated at fair value: Interest rate component...................................... $ (994) $- Credit risk component........................................ 1,616 - ------ --Total mark-to-market on debt designated at fair value.......... 622 -Mark-to-market on the related derivatives...................... 971 -Net realized gains (losses) on the related derivatives......... (318) - ------ --Total.......................................................... $1,275 $- ====== == The change in the fair value of the debt and the change in value of the relatedderivatives reflects the following: - Interest rate curve - Falling interest rates in 2007 caused the value of our fixed rate FVO debt to increase thereby resulting in a loss in the interest rate component. The value of the receive fixed/pay variable swaps rose in response to these falling interest rates and resulted in a gain in mark-to-market on the related derivatives. - Credit - Our credit spreads widened significantly during 2007, resulting from the general widening of credit spreads related to the financial and fixed income sectors as well as the general lack of liquidity in the secondary bond market in the second half of 2007. The fair value benefit from the change of our own credit spreads is the result of having historically raised debt at credit spreads which are not available under today's market conditions. FVO results are also affected by the differences in cash flows and valuationmethodologies for the debt and related derivative. Cash flows on debt arediscounted using a single discount rate from the bond yield curve whilederivative cash flows are discounted using rates at multiple points along theLIBOR yield curve. The impacts of these differences vary as the shape of theseinterest rate curves change. Fee income, which includes revenues from fee-based products such as creditcards, increased in 2007 and 2006 due to higher credit card fees, particularlyrelating to our non-prime credit card portfolios due to higher levels of creditcard receivables and, in 2006, due to improved interchange rates. Theseincreases were partially offset by the changes in fee billings implementedduring the fourth quarter of 2007 discussed above which decreased fee income in2007 by approximately $55 million. Increases in 2006 were partially offset bythe impact of FFIEC guidance which limits certain fee billings for non-primecredit card accounts and higher rewards program expenses. Enhancement services revenue, which consists of ancillary credit card revenuefrom products such as Account Secure Plus (debt protection) and IdentityProtection Plan, was higher in both periods primarily as a result of higherlevels of credit card receivables and higher customer acceptance levels.Additionally, the acquisition of Metris in December 2005 contributed to higherenhancement services revenue in 2006. Taxpayer financial services ("TFS") revenue decreased in 2007 due to higherlosses attributable to increased levels of fraud detected by the IRS in taxreturns filed in the 2007 tax season, restructured pricing, partially offset byhigher loan volume in the 2007 tax season and a change in revenue recognitionfor fees on TFS' unsecured product. TFS revenue decreased in 2006 as 2005 TFSrevenues reflects gains of $24 million on the sales of certain bad debt recoveryrights to a third party. Excluding the impact of these gains in the prior year,TFS revenue increased in 2006 due to increased loan volume during the 2006 taxseason. Gains on receivable sales to HSBC affiliates consists primarily of daily salesof domestic private label receivable originations (excluding retail salescontracts) and certain credit card account originations to HSBC Bank USA. Alsoincluded are sales of real estate secured receivables, primarily consisting ofDecision One loan sales to HSBC Bank USA since June 2007 and prior to ourdecision to cease its operations. In 2007, we sold approximately $645 million ofreal estate secured receivables from our Decision One operations to HSBC BankUSA to support the secondary market activities of our affiliates and realized aloss of $16 million. In 2006, we sold approximately $669 million of 62 HSBC Finance Corporation-------------------------------------------------------------------------------- real estate secured receivables from our Decision One operations to HSBC BankUSA and realized a pre-tax gain of $17 million. Excluding the gains and losseson Decision One real estate secured receivable portfolio from both periods, in2007 gain on receivable sales to HSBC affiliates increased reflecting highersales volumes of domestic private label receivable and credit card accountoriginations and higher premiums on our credit card sales volumes, partiallyoffset by lower premiums on our domestic private label sales volumes. In 2006,the increase is due to gains on bulk sales of real estate secured receivables toHSBC Bank USA from our Decision One operations. Servicing fees from HSBC affiliates represents revenue received under servicelevel agreements under which we service credit card and domestic private labelreceivables as well as real estate secured and auto finance receivables for HSBCaffiliates. The increases primarily relate to higher levels of receivables beingserviced on behalf of HSBC Bank USA and in 2006 the servicing fees we receivefor servicing the credit card receivables sold to HBEU in December 2005. Other income decreased in 2007 primarily due to losses on real estate securedreceivables held for sale by our Decision One mortgage operations of $229million in 2007 compared to gains on real state secured receivables held forsale of $21 million in 2006. Loan sale volumes in our Decision One mortgageoperations decreased from $11.8 billion in 2006 to $3.9 billion in 2007 and asof November 2007, ceased. Additionally, other income includes a loss of $25million on the sale of $2.7 billion of real estate secured receivables by ourMortgage Services business in 2007. These decreases were partially offset by anet gain of $115 million on the sale of a portion of our portfolio of MasterCardClass B shares in 2007. Lower gains on miscellaneous asset sales in 2007,including real estate investments also contributed to the decrease in otherincome. The decrease in other income in 2006 was due to lower gains on sales ofreal estate secured receivables by our Decision One mortgage operations and anincrease in the liability for estimated losses from indemnification provisionson Decision One loans previously sold. COSTS AND EXPENSES The following table summarizes total costs and expenses: YEAR ENDED DECEMBER 31, 2007 2006 2005--------------------------------------------------------------------------------------- (IN MILLIONS)Salaries and employee benefits........................... $ 2,342 $2,333 $2,072Sales incentives......................................... 212 358 397Occupancy and equipment expenses......................... 379 317 334Other marketing expenses................................. 748 814 731Other servicing and administrative expenses.............. 1,337 1,115 917Support services from HSBC affiliates.................... 1,192 1,087 889Amortization of intangibles.............................. 253 269 345Policyholders' benefits.................................. 421 467 456Goodwill and other intangible asset impairment charges... 4,891 - - ------- ------ ------Total costs and expenses................................. $11,775 $6,760 $6,141 ======= ====== ====== Salaries and employee benefits in 2007 included $37 million in severance costsrelated to the decisions to discontinue correspondent channel acquisitions,cease Decision One operations, reduce our Consumer Lending and Canadian branchnetworks and close the Carmel Facility. Excluding these severance costs, the netimpact of these decisions, when coupled with normal attrition, has been toreduce headcount in the second half of 2007 by approximately 4,100 or 13 percentand as a result, salary expense was much lower in the second half of 2007 ascompared to the first half of the year. For the full year of 2007, we reducedheadcount by approximately 5,000 or 16 percent. Salary expense in 2007 was alsoreduced as a result of lower employment costs derived through the use of an HSBCaffiliate located outside the United States. Costs incurred and charged to us bythis affiliate are reflected in Support services from HSBC affiliates.Additionally, in 2007 we experienced lower salary expense in our Credit CardServices business due to efficiencies from the integration of the Metrisacquisition which occurred in December 2005. These decreases were largely offsetby increased collection activities and higher employee benefit costs. Theincreases in 2006 were a result of additional staffing, primarily in ourConsumer Lending, Mortgage 63 HSBC Finance Corporation-------------------------------------------------------------------------------- Services, Retail Services and Canadian operations as well as in our corporatefunctions to support growth. Salaries in 2006 were also higher due to additionalstaffing in our Credit Card Services operations as a result of the acquisitionof Metris in December 2005 which was partially offset by lower staffing levelsin our U.K. business as a result of the sale of the cards business in 2005. Effective December 20, 2005, our U.K. based technology services employees weretransferred to HBEU. As a result, operating expenses relating to informationtechnology, which were previously reported as salaries and employee benefits,are now billed to us by HBEU and reported as support services from HSBCaffiliates. Sales incentives decreased in 2007 and 2006 due to lower origination volumes inour correspondent operations resulting from the decisions to reduce acquisitionsincluding second lien and selected higher risk products in the second half of2006 and the decision in March 2007 to discontinue all correspondent channelacquisitions. The decrease in 2007 also reflects the impact of ceasingoperations of our Decision One business as well as lower origination volumes inour Consumer Lending business. The decreases in 2006 also reflect lower volumesin our U.K. business partially offset by increases in our Canadian operations. Occupancy and equipment expenses increased in 2007 primarily due to leasetermination and associated costs of $52 million as well as fixed asset writeoffs of $17 million in 2007 related to the decisions to discontinuecorrespondent channel acquisitions, cease Decision One operations, reduce ourConsumer Lending and Canadian branch networks and close the Carmel Facility. Thedecrease in 2006 was a result of the sale of our U.K. credit card business inDecember 2005 which included the lease associated with the credit card callcenter as well as lower repairs and maintenance costs. These decreases in 2006were partially offset by higher occupancy and equipment expenses resulting fromour acquisition of Metris in December 2005. Other marketing expenses includes payments for advertising, direct mail programsand other marketing expenditures. The decrease in marketing expense in 2007reflects the decision in the second half of 2007 to reduce credit card, co-branded credit card and personal non-credit card marketing expenses in an effortto slow receivable growth in these portfolios. The increase in 2006 wasprimarily due to increased domestic credit card marketing expense including theMetris portfolio acquired in December 2005, and expenses related to the launchof a co-brand credit card in the third quarter of 2006. Other servicing and administrative expenses increased in 2007 primarily due tohigher REO expenses, a valuation adjustment of $31 million to record ourinvestment in the U.K. Insurance Operations at the lower of cost or market as aresult of designating this operations as "Held for Sale" in the first quarter of2007, and the impact of lower deferred origination costs due to lower volumes.These increases were partially offset by lower insurance operating expenses inour domestic operations and an increase in interest income of approximately $69million relating to various contingent tax items with the taxing authority. Theincrease in 2006 was as a result of higher REO expenses due to higher volumesand higher losses and higher systems costs as well as the impact of lowerdeferred origination costs at our Mortgage Services business due to lowervolumes. Support services from HSBC affiliates, which includes technology and otherservices charged to us by HTSU as well as services charged to us by an HSBCaffiliate located outside of the United States providing operational support toour businesses, including among other areas, customer service, systems,collection and accounting functions. Support services from HSBC affiliatesincreased in 2007 and 2006 to support higher levels of average receivables aswell as an increase in the number of employees located outside of the UnitedStates. Amortization of intangibles decreased in 2007 as an individual contractualrelationship became fully amortized in the first quarter of 2006. The decreasein 2006 also reflects lower intangible amortization related to our purchasedcredit card relationships due to a contract renegotiation with one of our co-branded credit card partners in 2005, partially offset by amortization expenseassociated with the Metris cardholder relationships. Policyholders' benefits decreased in 2007 primarily due to lower policyholders'benefits in our U.K. operations resulting from the sale of the U.K. insuranceoperations in November 2007 as previously discussed. Prior to the sale,policyholders' benefits in the U.K. had increased due to a new reinsuranceagreement, partially offset by lower sales volumes. We also experienced lowerpolicyholder benefits during 2007 in our domestic operations due to lower 64 HSBC Finance Corporation-------------------------------------------------------------------------------- disability claims in 2007 as well as a reduction in the number of reinsurancetransactions in 2007. The increases in 2006 were due to higher sales volumes andnew reinsurance activity in our domestic operations beginning in the thirdquarter of 2006, partially offset by lower amortization of fair valueadjustments relating to our insurance business. Goodwill and other intangible asset impairment charges reflects the impairmentcharges for our Mortgage Services, Consumer Lending, Auto Finance and UnitedKingdom business as previously discussed. The following table summarizes theimpairment charges for these businesses during 2007: MORTGAGE CONSUMER AUTO UNITED SERVICES LENDING FINANCE KINGDOM TOTAL-------------------------------------------------------------------------------------------- (IN MILLIONS)Goodwill.................................. $881 $2,462 $312 $378 $4,033Tradenames................................ - 700 - - 700Customer relationships.................... - 158 - - 158 ---- ------ ---- ---- ------ $881 $3,320 $312 $378 $4,891 ==== ====== ==== ==== ====== The following table summarizes our efficiency ratio: YEAR ENDED DECEMBER 31, 2007 2006 2005---------------------------------------------------------------------------------------U.S. GAAP basis efficiency ratio....................... 68.69% 41.55% 44.10% Our efficiency ratio in 2007 was markedly impacted by the goodwill and otherintangible asset impairment charges relating to our Mortgage Services, ConsumerLending, Auto Finance and United Kingdom businesses which was partially offsetby the change in the credit risk component of our fair value optioned debt.Excluding these items, in 2007 the efficiency ratio deteriorated 179 basispoints. This deterioration was primarily due to realized losses on real estatesecured receivable sales, lower derivative income and higher costs and expenses,partially offset by higher fee income and higher net interest income due tohigher levels of average receivables. Our efficiency ratio in 2006 improved dueto 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. INCOME TAXES Our effective tax rates were as follows: YEAR ENDED DECEMBER 31, EFFECTIVE TAX RATE--------------------------------------------------------------------------------------2007............................................................. (16.2)%2006............................................................. 36.92005............................................................. 33.5 The effective tax rate for 2007 was significantly impacted by the non-taxdeductability of a substantial portion of the goodwill impairment chargesassociated with our Mortgage Services, Consumer Lending, Auto Finance and UnitedKingdom businesses as well as the acceleration of tax from sales of leveragedleases. The increase in the effective tax rate for 2006 as compared to 2005 wasdue to higher state income taxes and lower tax credits as a percentage of incomebefore taxes. The increase in state income taxes was primarily due to anincrease in the blended statutory tax rate of our operating companies. Theeffective tax rate differs from the statutory federal income tax rate primarilybecause of the effects of state and local income taxes and tax credits. See Note15, "Income Taxes," for a reconciliation of our effective tax rate. SEGMENT RESULTS - IFRS MANAGEMENT BASIS-------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services andInternational. Our Consumer segment consists of our Consumer Lending, MortgageServices, Retail Services and Auto Finance businesses. Our Credit 65 HSBC Finance Corporation-------------------------------------------------------------------------------- Card Services segment consists of our domestic MasterCard and Visa and othercredit card business. Our International segment consists of our foreignoperations in the United Kingdom, Canada, the Republic of Ireland, and prior toNovember 2006 our operations in Slovakia, the Czech Republic and Hungary. Theaccounting policies of the reportable segments are described in Note 2, "Summaryof Significant Accounting Policies," to the accompanying financial statements. There have been no changes in the basis of our segmentation or any changes inthe measurement of segment profit as compared with the presentation in our 2006Form 10-K. In May 2007, we decided to integrate our Retail Services and CreditCard Services business. Combining Retail Services with Credit Card Servicesenhances our ability to provide a single credit card and private label solutionfor the market place. We anticipate the integration of management reporting willbe completed in the first quarter of 2008 and at that time will result in thecombination of these businesses into one reporting segment in our financialstatements. Our segment results are presented on an IFRS Management Basis (a non-U.S. GAAPfinancial measure) as operating results are monitored and reviewed, trends areevaluated and decisions about allocating resources such as employees are madealmost exclusively on an IFRS Management Basis since we report results to ourparent, HSBC, who prepares its consolidated financial statements in accordancewith IFRSs. IFRS Management Basis results are IFRSs results adjusted to assumethat the private label and real estate secured receivables transferred to HSBCBank USA have not been sold and remain on our balance sheet. IFRS ManagementBasis also assumes that the purchase accounting fair value adjustments relatingto our acquisition by HSBC have been "pushed down" to HSBC Finance Corporation.These fair value adjustments including goodwill have been allocated to Corporatewhich is included in the "All Other" caption within our segment disclosure andthus not reflected in the reportable segment discussions that follow. Operationsare monitored and trends are evaluated on an IFRS Management Basis because thecustomer loan sales to HSBC Bank USA were conducted primarily to appropriatelyfund prime customer loans within HSBC and such customer loans continue to bemanaged and serviced by us without regard to ownership. However, we continue tomonitor capital adequacy, establish dividend policy and report to regulatoryagencies on a U.S. GAAP basis. A summary of the significant differences betweenU.S. GAAP and IFRSs as they impact our results are summarized in Note 21,"Business Segments." CONSUMER SEGMENT The following table summarizes the IFRS Management Basisresults for our Consumer segment for the years ended December 31, 2007, 2006 and2005. YEAR ENDED DECEMBER 31, 2007 2006 2005---------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Net income (loss)(1)................................. $ (1,795) $ 988 $ 1,981Net interest income.................................. 8,447 8,588 8,401Other operating income............................... 523 909 814Intersegment revenues................................ 265 242 108Loan impairment charges.............................. 8,816 4,983 3,362Operating expenses................................... 3,027 2,998 2,757Customer loans....................................... 136,739 144,697 128,095Assets............................................... 132,602 146,395 130,375Net interest margin.................................. 6.01% 6.23% 7.15%Return on average assets............................. (1.29) .71 1.68 -------- (1) The Consumer Segment net income (loss) reported above includes a net loss of $(1,828) million in 2007 for our Mortgage Services business which is no longer generating new loan origination volume as a result of the decisions to discontinue correspondent channel acquisitions and cease Decision One operations. Our Mortgage Services business reported a net loss of $(737) million in 2006 and reported net income of $509 million in 2005. 2007 net income (loss) compared to 2006 Our Consumer segment reported a net lossin 2007 due to higher loan impairment charges, lower net interest income andlower other operating income, partially offset by lower operating expenses. 66 HSBC Finance Corporation-------------------------------------------------------------------------------- Loan impairment charges for the Consumer segment increased markedly in 2007reflecting higher loss estimates in our Consumer Lending and Mortgage Servicesbusinesses 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 a new bankruptcy law in the United States which went into effect in October 2005. - Mortgage Services experienced higher levels of charge-offs and delinquency as portions of the 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. Also contributing to the increase in loan impairment charges was a higher mix ofunsecured loans such as private label and personal non-credit card receivables,deterioration in credit performance of portions of our Retail Services privatelabel portfolio, increased levels of personal bankruptcy filings as compared tothe exceptionally low filing levels experienced in 2006 as a result of the newbankruptcy law in the United States which went into effect in October 2005 andthe effect of a weak U.S. economy. The increase in loan impairment charges inour Retail Services business reflects higher delinquency levels due todeterioration in credit performance, seasoning of the co-branded credit cardintroduced in the third quarter of 2006, higher bankruptcy levels and the affectfrom a weakening U.S. economy. Loan impairment charges in our Retail Servicesbusiness also reflect a refinement in the methodology used to estimate inherentlosses on private label loans less than 30 days delinquent which increasedcredit loss reserves by $107 million in the fourth quarter. In 2007, credit lossreserves for the Consumer segment increased as loan impairment charges were $3.8billion greater than net charge-offs. Net interest income decreased as higher finance and other interest income,primarily due to higher average customer loans and higher overall yields, wasmore than offset by higher interest expense. This decrease was partially offsetby a reduction in net interest income in 2006 of $120 million due to anadjustment to recognize prepayment penalties on real estate secured loans overthe expected life of the product. Overall yields reflect growth in unsecuredcustomer loans at current market rates. The higher interest expense was due tosignificantly higher cost of funds. The decrease in net interest margin was aresult of the cost of funds increasing more rapidly than our ability to increasereceivable yields. However in the second half of 2007, net interest margin hasshown improvement due to a shift in mix to higher yielding Consumer Lending realestate secured receivables resulting from attrition in the lower yieldingMortgage Services real estate secured receivable portfolio. Additionally, thesehigher yielding Consumer Lending real estate secured receivables are remainingon the balance sheet longer due to lower run-off rates. Overall yieldimprovements were partially offset by the impact of growth in non-performingassets. Other operating income decreased primarily due to losses on loans heldfor sale by our Decision One mortgage operations, losses on our real estateowned portfolio and the loss on the bulk sales during 2007 from the MortgageServices portfolio, partially offset by higher late and overlimit feesassociated with our co-branded credit card portfolio. Operating expenses werehigher due to restructuring charges of $103 million, including the write off offixed assets, related to the decisions to discontinue correspondent channelacquisitions, to cease Decision One operations, to close a loan underwriting,processing and collection facility in Carmel, Indiana and to reduce the ConsumerLending branch network as well as the write off of $46 million of goodwillrelated to the acquisition of Solstice Capital Group, Inc. 67 HSBC Finance Corporation-------------------------------------------------------------------------------- which was included in the Consumer segment results. These increases werepartially offset by lower professional fees and lower operating expensesresulting from lower mortgage origination volumes and the termination ofemployees as part of the decision to discontinue new correspondent channelacquisitions and to cease Decision One operations. ROA was (1.29) percent for 2007 compared to.71 percent in 2006. The decrease inthe ROA ratio was primarily due to the increase in loan impairment charges asdiscussed above, as well as higher average assets. 2006 net income compared to 2005 Our Consumer segment reported lower net incomein 2006 due to higher loan impairment charges and operating expenses, partiallyoffset by higher net interest income and higher other operating income. Loan impairment charges for the Consumer segment increased markedly during 2006.The increase in loan impairment charges was largely driven by deterioration inthe performance of mortgage loans acquired in 2005 and 2006 by our MortgageServices business, particularly in the second lien and portions of the firstlien portfolios which resulted in higher delinquency, charge-off and lossestimates in these portfolios. These increases were partially offset by areduction in the estimated loss exposure resulting from Hurricane Katrina ofapproximately $68 million in 2006 as well as the benefit of low unemploymentlevels in the United States. In 2006, we increased loss reserve levels as theprovision for credit losses was greater than net charge-offs by $1,597 million,which included $1,627 million related to our Mortgage Services business. Operating expenses were higher in 2006 due to lower deferred loan originationcosts in our Mortgage Services business as mortgage origination volumesdeclined, higher marketing expenses due to the launch of a new co-brand creditcard in our Retail Services business, higher salary expense and higher supportservices from affiliates to support growth. Net interest income increased during 2006 primarily due to higher averagecustomer loans and higher overall yields, partially offset by higher interestexpense. Overall yields reflect strong growth in real estate secured customerloans at current market rates and a higher mix of higher yielding second lienreal estate secured loans and personal non-credit card customer loans due togrowth. These increases were partially offset by a reduction in net interestincome of $120 million due to an adjustment to recognize prepayment penalties onreal estate secured loans over the expected life of the product. Net interestmargin decreased from the prior year as the higher yields discussed above wereoffset by higher interest expense due to a larger balance sheet and asignificantly higher cost of funds resulting from a rising interest rateenvironment. The increase in other operating income in 2006 was primarily due to higherinsurance commissions, higher late fees and a higher fair value adjustment forour loans held for sale, partially offset by higher REO expense due to highervolumes and losses. In the fourth quarter of 2006, our Consumer Lending business completed theacquisition of Solstice Capital Group Inc. ("Solstice") with assets ofapproximately $49 million, in an all cash transaction for approximately $50million. Solstice's 2007 pre-tax income did not meet the required thresholdrequiring payment of additional consideration. Solstice markets a range ofmortgage and home equity products to customers through direct mail. All of thegoodwill associated with the Solstice acquisition was written off in the fourthquarter of 2007 as part of the Consumer Lending goodwill impairment chargepreviously discussed. ROA was .71 percent in 2006 and 1.68 percent in 2005. The decrease in the ROAratio in 2006 is due to the decrease in net income discussed above as well asthe growth in average assets. 68 HSBC Finance Corporation-------------------------------------------------------------------------------- Customer loans for our Consumer segment can be analyzed as follows: INCREASES (DECREASES) FROM --------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, --------------- -------------- 2007 $ % $ %------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Real estate secured.......................... $ 86,434 $(9,061) (9.5)% $4,153 5.0%Auto finance................................. 12,912 445 3.6 1,289 11.1Private label, including co-branded cards.... 19,414 957 5.2 1,935 11.1Personal non-credit card..................... 17,979 (299) (1.6) 1,267 7.6 -------- ------- ---- ------ ----Total customer loans......................... $136,739 $(7,958) (5.5)% $8,644 6.7% ======== ======= ==== ====== ==== -------- (1) Real estate secured receivables are comprised of the following: INCREASES (DECREASES) FROM ------------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, ----------------- ---------------- 2007 $ % $ %------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS)Mortgage Services............................. $36,216 $(13,380) (27.0)% $(8,082) (18.2)%Consumer Lending.............................. 50,218 4,319 9.4 12,235 32.2 ------- -------- ----- ------- -----Total real estate secured..................... $86,434 $ (9,061) (9.5)% $ 4,153 5.0% ======= ======== ===== ======= ===== Customer loans decreased 6 percent at December 31, 2007 as compared to $144.7billion at December 31, 2006. Real estate secured loans decreased markedly in2007. The decrease in real estate secured loans was primarily in our MortgageServices portfolio as a result of revisions to its business plan beginning inthe second half of 2006 and continuing into 2007. These decisions have resultedin a significant decrease in the Mortgage Services portfolio since December 31,2006. This attrition was partially offset by a decline in loan prepayments dueto fewer refinancing opportunities for our customers as a result of thepreviously discussed trends impacting the mortgage lending industry. Attritionin this portfolio will continue going forward. The decrease in our MortgageServices portfolio was partially offset by growth in our Consumer Lending branchbusiness. Growth in our branch-based Consumer Lending business improved due tohigher sales volumes and the decline in loan prepayments discussed above.However, this growth was partially offset by the actions taken in the secondhalf of 2007 to reduce risk going forward in our Consumer Lending business,including eliminating the small volume of ARM loans, capping second lien LTVratio requirements to either 80 or 90 percent based on geography and the overalltightening of credit score, debt-to-income and LTV requirements for first lienloans. These actions, when coupled with a significant reduction in demand forsubprime loans across the industry, have resulted in loan attrition in thefourth quarter of 2007 and will markedly limit growth of our Consumer Lendingreal estate secured receivables in the foreseeable future. Growth in our autofinance portfolio reflects organic growth principally in the near-primeportfolio as a result of growth in our direct to consumer business, partiallyoffset by lower originations in the dealer network portfolio as a result ofactions taken to reduce risk in the portfolio. The increase in our private labelportfolio is due to organic growth and growth in the co-branded card portfoliolaunched by our Retail Services operations during the third quarter of 2006.Personal non-credit card receivables decreased during 2007 as a result of theactions taken in the second half of the year by our Consumer Lending business toreduce risk going forward, including a reduction in direct mail campaignofferings, the discontinuance of personal homeowner loans and tighteningunderwriting criteria. Customer loans increased 13 percent to $144.7 billion at December 31, 2006 ascompared to $128.1 billion at December 31, 2005. Real estate growth in 2006 wasstrong as a result of growth in our branch-based Consumer Lending business. Inaddition, our correspondent business experienced growth during the first sixmonths of 2006. 69 HSBC Finance Corporation-------------------------------------------------------------------------------- However, as discussed above, in the second half of 2006, management revised itsbusiness plan and began tightening underwriting standards on loans purchasedfrom correspondents including reducing purchases of second lien and selectedhigher risk segments resulting in lower volumes in the second half of 2006.Growth in our branch- based Consumer Lending business reflects higher salesvolumes than in 2005 as we continued to emphasize real estate secured loans,including a near-prime mortgage product we first introduced in 2003. Real estatesecured customer loans also increased as a result of portfolio acquisitions,including the $2.5 billion of customer loans related to the Champion portfoliopurchased in November 2006 as well as purchases from a portfolio acquisitionprogram of $.4 billion in 2006. In addition, a decline in loan prepayments in2006 resulted in lower run-off rates for our real estate secured portfolio whichalso contributed to overall growth. Our Auto Finance business also reportedorganic growth, principally in the near-prime portfolio, from increased volumein both the dealer network and the consumer direct loan program. The privatelabel portfolio increased in 2006 due to strong growth within consumerelectronics and powersports as well as new merchant signings. Growth in ourpersonal non-credit card portfolio was the result of increased marketing,including several large direct mail campaigns. CREDIT CARD SERVICES SEGMENT The following table summarizes the IFRS ManagementBasis results for our Credit Card Services segment for the years ended December31, 2007, 2006 and 2005. YEAR ENDED DECEMBER 31, 2007 2006 2005--------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Net income............................................. $ 1,184 $ 1,386 $ 813Net interest income.................................... 3,430 3,151 2,150Other operating income................................. 3,078 2,360 1,892Intersegment revenues.................................. 18 20 21Loan impairment charges................................ 2,752 1,500 1,453Operating expenses..................................... 1,872 1,841 1,315Customer loans......................................... 30,458 28,221 25,979Assets................................................. 30,005 28,780 28,453Net interest margin.................................... 11.77% 11.85% 10.42%Return on average assets............................... 4.13 5.18 4.13 2007 net income compared to 2006 Our Credit Card Services segment reported lowernet income in 2007 primarily due to higher loan impairment charges and higheroperating expenses, partially offset by higher net interest income and higherother operating income. Loan impairment charges were higher due to higherdelinquency levels as a result of receivable growth, the impact of marketplacechanges and the weakening U.S. economy as discussed above, a continued shift inmix to higher levels of non-prime receivables and portfolio seasoning as well asan increase in bankruptcy filings as compared to the period year which benefitedfrom reduced levels of personal bankruptcy filings following the enactment of anew bankruptcy law in the United States in October 2005. In 2007, we increasedloss reserves by recording loss provision greater than net charge-off of $784million. Net interest income increased due to higher overall yields due in part to higherlevels of near-prime and non-prime customer loans, partially offset by higherinterest expense. Net interest margin decreased in 2007 as net interest incomeduring 2006 benefited from the implementation of a methodology for calculatingthe effective interest rate for introductory rate credit card customer loansunder IFRSs over the expected life of the product. Of the amount recognized,$131 million increased net interest income in 2006 which otherwise would havebeen recorded in prior periods. Excluding the impact of the above from netinterest margin, net interest margin increased primarily due to higher overallyields due to increases in non-prime customer loans, higher pricing on variablerate products and other pricing initiatives, partially offset by a higher costof funds. Increases in other operating income resulted from loan growth which resulted inhigher late fees and overlimit fees and higher enhancement services revenue fromproducts such as Account Secure Plus (debt protection) and Identity ProtectionPlan. These increases were partially offset by changes in fee billingsimplemented during the fourth quarter of 2007, as discussed below whichdecreased fee income in 2007 by approximately $55 million. 70 HSBC Finance Corporation-------------------------------------------------------------------------------- Additionally, we recorded a gain of $113 million on the sale of our portfolio ofMasterCard Class B shares. Higher operating expenses were also incurred tosupport receivable growth including increases in marketing expenses in the firsthalf of 2007. Higher operating expenses were partially offset by lower salaryexpense due to efficiences from the integration of the Metris acquisition whichoccurred in December 2005. Beginning in the third quarter of 2007, we decreasedmarketing expenses in an effort to slow receivable growth in our credit cardportfolio. Also in the fourth quarter of 2007 to further slow receivable growth,we slowed new account growth, tightened initial credit line sales authorizationcriteria, closed inactive accounts, decreased credit lines and tightenedunderwriting criteria for credit line increases, reduced balance transfer volumeand tightened cash access. The decrease in ROA in 2007 is due to higher average assets and the lower netincome as discussed above. In the fourth quarter of 2007, the Credit Card Services business initiatedcertain changes related to fee and finance charge billings as a result ofcontinuing reviews to ensure our practices reflect our brand principles. Whileestimates of the potential impact of these changes are based on numerousassumptions and take into account factors which are difficult to predict such aschanges in customer behavior, we estimate that these changes will reduce fee andfinance charge income in 2008 by up to approximately $250 million. We are also considering the sale of our General Motors MasterCard and Visaportfolio to HSBC Bank USA in the future in order to maximize the efficient useof capital and liquidity at each entity. Any such sale will be subject toobtaining the necessary regulatory and other approvals, including the approvalof General Motors. We would, however, maintain the customer accountrelationships and, subsequent to the initial receivable sale, additional volumewould be sold to HSBC Bank USA on a daily basis. At December 31, 2007, the GMPortfolio had an outstanding receivable balance of approximately $7.0 billion.If this bulk sale occurs, it is expected to result in a significant gain uponcompletion. In future periods, our net interest income, fee income and provisionfor credit losses for GM credit card receivables would be reduced, while otherincome would increase due to gains from continuing sales of GM credit cardreceivables and receipt of servicing revenue on the portfolio from HSBC BankUSA. We anticipate that the net effect of these potential sales would not have amaterial impact on our future results of operations. 2006 net income compared to 2005 Our Credit Card Services segment reportedhigher net income in 2006. The increase in net income was primarily due tohigher net interest income and higher other operating income, partially offsetby higher operating expenses and higher loan impairment charges. The acquisitionof Metris, which was completed in December 2005, contributed $147 million of netincome during 2006 as compared to $4 million in 2005. Net interest income increased in 2006 largely as a result of the Metrisacquisition, which contributed to higher overall yields due in part to higherlevels of non-prime customer loans, partially offset by higher interest expense.As discussed above, net interest income in 2006 also benefited from theimplementation of a methodology for calculating the effective interest rate forintroductory rate credit card customer loans under IFRSs over the expected lifeof the product. Of the amount recognized, $131 million increased net interestincome in 2006 which otherwise would have been recorded in prior periods. Netinterest margin increased primarily due to higher overall yields due toincreases in non-prime customer loans, including the customer loans acquired aspart of Metris, higher pricing on variable rate products and other repricinginitiatives. These increases were partially offset by a higher cost of funds.Net interest margin in 2006 was also positively impacted by the adjustmentsrecorded for the effective interest rate for introductory rate MasterCard/Visacustomer loans discussed above. Although our non-prime customer loans tend tohave smaller balances, they generate higher returns both in terms of netinterest margin and fee income. Increases in other operating income resulted from portfolio growth, includingthe Metris portfolio acquired in December 2005 which has resulted in higher latefees, higher interchange revenue and higher enhancement services revenue fromproducts such as Account Secure Plus (debt protection) and Identity ProtectionPlan. This increase in fee income was partially offset by adverse impacts oflimiting certain fee billings and changes to the required minimum monthlypayment amount on non-prime credit card accounts in accordance with FFIECguidance. 71 HSBC Finance Corporation-------------------------------------------------------------------------------- Higher operating expenses were incurred to support receivable growth, includingthe Metris portfolio acquisition, and increases in marketing expenses. Theincrease in marketing expenses in 2006 was primarily due to the Metris portfolioacquired in December 2005 and increased investment in our non-prime portfolio. Loan impairment charges were higher in 2006. Loan impairment charges in 2005were impacted by incremental credit loss provisions relating to the spike inbankruptcy filings leading up to October 17, 2005, which was the effective dateof new bankruptcy laws in the United States and higher provisions relating toHurricane Katrina. Excluding these items, provisions in 2006 nonethelessincreased, reflecting receivable growth and portfolio seasoning, including thefull year impact of the Metris portfolio, partially offset by the impact oflower levels of bankruptcy filings following the enactment of new bankruptcylaws in October 2005, higher recoveries as a result of better rates available inthe non-performing asset sales market and a reduction of our estimate ofincremental credit loss exposure related to Hurricane Katrina of approximately$26 million. In 2006, we increased loss reserves by recording loss provisiongreater than net charge-off of $328 million. The increase in ROA in 2006 is primarily due to the higher net income asdiscussed above, partially offset by higher average assets. Customer loans Customer loans increased 8 percent to $30.5 billion at December31, 2007 compared to $28.2 billion at December 31, 2006. The increase reflectsstrong domestic organic growth in our General Motors, Union Privilege, Metrisand non-prime portfolios. However, as discussed above, we have implementednumerous actions in the fourth quarter of 2007 which will limit growth in 2008. Customer loans increased 9 percent to $28.2 billion at December 31, 2006compared to $26.0 billion at December 31, 2005. The increase reflects strongdomestic organic growth in our Union Privilege as well as other non-primeportfolios including Metris. INTERNATIONAL SEGMENT The following table summarizes the IFRS Management Basisresults for our International segment for the years ended December 31, 2007,2006 and 2005. YEAR ENDED DECEMBER 31, 2007 2006 2005--------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Net income (loss)...................................... $ (60) $ 42 $ 481Net interest income.................................... 844 826 971Gain on sales to affiliates............................ - 29 464Other operating income, excluding gain on sales to affiliates........................................... 231 254 306Intersegment revenues.................................. 17 33 17Loan impairment charges................................ 610 535 620Operating expenses..................................... 548 495 635Customer loans......................................... 10,425 9,520 9,328Assets................................................. 10,607 10,764 10,905Net interest margin.................................... 8.34% 8.22% 7.35%Return on average assets............................... (.56) .37 3.52 2007 net income (loss) compared to 2006 Our International segment reported a netloss in 2007 reflecting higher loan impairment charges, higher operatingexpenses and lower other operating income, partially offset by higher netinterest income. As discussed more fully below, net income in 2006 also includeda $29 million gain on the sale of the European Operations to HBEU. Applyingconstant currency rates, which uses the average rate of exchange for 2006 totranslate current period net income, the net loss for 2007 would not have beenmaterially different. Loan impairment charges in our Canadian operations increased due to an increasein delinquency and charge-off due to receivable growth. Loan impairment chargesin our U.K. operations reflect a $93 million increase in credit loss reserves,resulting from a refinement in the methodology used to calculate roll ratepercentages to be consistent with our other business and which we believereflects a better estimate of probable losses currently inherent in the 72 HSBC Finance Corporation-------------------------------------------------------------------------------- loan portfolio and higher loss estimates for restructured loans which were morethan offset by overall improvements in delinquency and charge-off which resultedin an overall lower credit loss provision in our U.K. operations. In 2007, weincreased segment loss reserves by recording loss provision greater than netcharge-off of $127 million. Net interest income increased primarily as a result of higher receivable levelsin our Canadian operations, partially offset by higher interest expense in ourCanadian operations and lower receivable levels in our U.K. operations. Thelower receivable levels in our U.K. subsidiary were due to decreased salesvolumes resulting from an overall challenging credit environment in the U.K. aswell as the sale of our European Operations in November 2006. Net interestmargin increased due to higher yields on customer loans in our U.K. operationsas we have increased pricing on many of our products reflecting the risinginterest rates in the U.K., partially offset by the impact of the sale of theEuropean Operations in November 2006 as well as a higher cost of funds in bothour U.K. and Canadian operations. Other operating income decreased due to lower insurance sales volumes in ourU.K. operations, largely due to a planned phase out of the use of our largestexternal broker between January and April 2007, as well as the impact of thesale of our U.K. Insurance Operations to Aviva in November 2007. As the salesagreement provides for the purchaser to distribute insurance products throughour U.K. branch network, going forward we will receive insurance commissionrevenue which we anticipate will significantly offset the loss of insurancepremium revenues and the related policyholder benefits. Operating expensesincreased to support receivable growth in our Canadian operations. In our U.K.operations, operating expenses were also higher due to higher legal fees andhigher marketing expenses. ROA was (.56) percent for 2007 compared to .37 percent in 2006. The decrease inROA is primarily due to the increase in loan impairment charges as discussedabove, partially offset by lower average assets. In November 2007, we sold the capital stock of our U.K. Insurance Operations toAviva for an aggregate purchase price of approximately $206 million. TheInternational segment recorded a gain on sale of $38 million (pre-tax) as aresult of this transaction. As the fair value adjustments related to purchaseaccounting resulting from our acquisition by HSBC and the related amortizationare allocated to Corporate, which is included in the "All Other" caption withinour segment disclosures, the gain recorded in the International segment does notinclude the goodwill write-off resulting from this transaction of $79 million onan IFRS Management Basis. We continue to evaluate the scope of our other U.K.operations. 2006 net income compared to 2005 Our International segment reported lower netincome in 2006. However, net income in 2006 includes the $29 million gain on thesale of the European Operations to HBEU and in 2005 includes the $464 milliongain on the sale of the U.K. credit card business to HBEU. As discussed morefully below, the gains reported by the International segment exclude the write-off of goodwill and intangible assets associated with these transactions.Excluding the gain on sale from both periods, the International segment reportedhigher net income in 2006 primarily due to lower loan impairment charges andlower operating expenses, partially offset by lower net interest income andlower other operating income. Applying constant currency rates, which uses theaverage rate of exchange for 2005 to translate current period net income, thenet income in 2006 would have been lower by $2 million. Loan impairment charges decreased in 2006 primarily due to the sale of our U.K.credit card business partially offset by increases due to the deterioration ofthe financial circumstances of our customers across the U.K. and increases atour Canadian business due to receivable growth. We increased loss reserves byrecording loss provision greater than net charge-offs of $3 million in 2006. Operating expenses decreased as a result of the sale of our U.K. credit cardbusiness in December 2005. The decrease in operating expenses was partiallyoffset by increased costs associated with growth in the Canadian business. Net interest income decreased during 2006 primarily as a result of lowerreceivable levels in our U.K. subsidiary. The lower receivable levels were dueto the sale of our U.K. credit card business in December 2005, including $2.5billion in customer loans, to HBEU as discussed more fully below, as well asdecreased sales volumes in the U.K. resulting from a continuing challengingcredit environment in the U.K. This was partially offset by higher net 73 HSBC Finance Corporation-------------------------------------------------------------------------------- interest income in our Canadian operations due to growth in customer loans. Netinterest margin increased in 2006 primarily due to lower cost of funds partiallyoffset by the change in receivable mix resulting from the sale of our U.K.credit card business in December 2005. Other operating income decreased in 2006, in part, due to the aforementionedsale of the U.K. credit card business which resulted in lower credit card feeincome partially offset by higher servicing fee income from affiliates. Otheroperating income was also lower in 2006 due to lower income from our insuranceoperations. ROA was .37 percent in 2006 and 3.52 percent in 2005. These ratios have beenimpacted by the gains on asset sales to affiliates. Excluding the gain on salefrom both periods, ROA was essentially flat as ROA was .11 percent in 2006 and.12 percent in 2005. In November 2006, we sold the capital stock of our operations in the CzechRepublic, Hungary, and Slovakia to a wholly owned subsidiary of HBEU, a U.K.based subsidiary of HSBC, for an aggregate purchase price of approximately $46million. The International segment recorded a gain on sale of $29 million as aresult of this transaction. As the fair value adjustments related to purchaseaccounting resulting from our acquisition by HSBC and the related amortizationare allocated to Corporate, which is included in the "All Other" caption withinour segment disclosures, the gain recorded in the International segment does notinclude the goodwill write-off resulting from this transaction of $15 million onan IFRS Management Basis. In December 2005, we sold our U.K. credit card business, including $2.5 billionof customer loans, and the associated cardholder relationships to HBEU for anaggregate purchase price of $3.0 billion. In 2005, the International segmentrecorded a gain on sale of $464 million as a result of this transaction. As thefair value adjustments related to purchase accounting resulting from ouracquisition by HSBC and the related amortization are allocated to Corporate,which is included in the "All Other" caption within our segment disclosures, thegain recorded in the International segment does not include the goodwill andintangible write-off resulting from this transaction of $288 million. Customer loans Customer loans for our International segment can be furtheranalyzed as follows: INCREASES (DECREASES) FROM ---------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, -------------- ---------------- 2007 $ % $ %------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Real estate secured......................... $ 4,202 $ 650 18.3% $ 1,168 38.5%Auto finance................................ 359 49 15.8 89 33.0Credit card................................. 315 69 28.0 145 85.3Private label............................... 2,907 677 30.4 749 34.7Personal non-credit card.................... 2,642 (540) (17.0) (1,054) (28.5) ------- ----- ----- ------- -----Total customer loans........................ $10,425 $ 905 9.5% $ 1,097 11.8% ======= ===== ===== ======= ===== Customer loans of $10.4 billion at December 31, 2007 increased 10 percentcompared to $9.5 billion at December 31, 2006. The increase was primarily as aresult of foreign exchange impacts. Applying constant currency rates, customerloans at December 31, 2007 would have been approximately $907 million lower.Excluding the positive foreign exchange impacts, higher customer loans in ourCanadian business were offset by the impact of lower customer loans in our U.K.operations. The increase in our Canadian business is due to growth in the realestate secured and credit card portfolios. Lower personal non-credit card loansin the U.K. reflect lower volumes as the U.K. branch network has placed agreater emphasis on secured lending. However, as discussed above, we haveimplemented numerous actions in both our U.K. and Canadian operations which willresult in lower origination volumes in 2008. Customer loans of $9.5 billion at December 31, 2006 increased 2 percent comparedto $9.3 billion at December, 2005. Our Canadian operations experienced stronggrowth in its receivable portfolios. Branch expansions, the 74 HSBC Finance Corporation-------------------------------------------------------------------------------- addition of 1,000 new auto dealer relationships and the successful launch of aMasterCard credit card program in Canada in 2005 resulted in growth in both thesecured and unsecured receivable portfolios. The increases in our Canadianportfolio were partially offset by lower customer loans in our U.K. operations.Our U.K. based unsecured customer loans decreased due to continuing lower retailsales volume following a slow down in retail consumer spending as well as thesale of $203 million of customer loans related to our European operations inNovember 2006. Applying constant currency rates, which uses the December 31,2005 rate of exchange to translate current customer loan balances, customerloans would have been lower by $708 million at December 31, 2006. RECONCILIATION OF SEGMENT RESULTS As previously discussed, segment results arereported on an IFRS Management Basis. See Note 21, "Business Segments," to theaccompanying financial statements for a discussion of the differences betweenIFRSs and U.S. GAAP. For segment reporting purposes, intersegment transactionshave not been eliminated. We generally account for transactions between segmentsas if they were with third parties. Also see Note 21, "Business Segments," inthe accompanying consolidated financial statements for a reconciliation of ourIFRS Management Basis segment results to U.S. GAAP consolidated totals. CREDIT QUALITY-------------------------------------------------------------------------------- DELINQUENCY AND CHARGE-OFF POLICIES AND PRACTICES Our delinquency and netcharge-off ratios reflect, among other factors, changes in the mix of loans inour portfolio, the quality of our receivables, the average age of our loans, thesuccess of our collection and customer account management efforts, bankruptcytrends, general economic conditions such as national and local trends in housingmarkets, interest rates, unemployment rates and significant catastrophic eventssuch as natural disasters and global pandemics. The levels of personalbankruptcies also have a direct effect on the asset quality of our overallportfolio and others in our industry. Our credit and portfolio management procedures focus on risk-based pricing andeffective collection and customer account management efforts for each loan. Webelieve our credit and portfolio management process gives us a reasonable basisfor predicting the credit quality of new accounts although in a changingexternal environment this has become more difficult than in the past. Thisprocess is based on our experience with numerous marketing, credit and riskmanagement tests. However, in 2006 and 2007 we found consumer behavior deviatedfrom historical patterns due to the housing market deterioration, creatingincreased difficulty in predicting credit quality. As a result, we have enhancedour processes to emphasize more recent experience, key drivers of performance,and a forward-view of expectations of credit quality. We also believe that ourfrequent and early contact with delinquent customers, as well as restructuring,modification and other customer account management techniques which are designedto optimize account relationships, are helpful in maximizing customercollections and has been particularly appropriate in the unstable market. SeeNote 2, "Summary of Significant Accounting Policies," in the accompanyingconsolidated financial statements for a description of our charge-off andnonaccrual policies by product. Our charge-off policies focus on maximizing the amount of cash collected from acustomer while not incurring excessive collection expenses on a customer whowill likely be ultimately uncollectible. We believe our policies are responsiveto the specific needs of the customer segment we serve. Our real estate and autofinance charge-off policies consider customer behavior in that initiation offoreclosure or repossession activities often prompts repayment of delinquentbalances. Our collection procedures and charge-off periods, however, aredesigned to avoid ultimate foreclosure or repossession whenever it is reasonablyeconomically possible. Our credit card charge-off policy is consistent withindustry practice. Charge-off periods for our personal non-credit card productand, prior to December 2004 when it was sold, our domestic private label creditcard product were designed to be responsive to our customer needs and maytherefore be longer than bank competitors who serve a different market. Ourpolicies have generally been consistently applied in all material respects. Ourloss reserve estimates consider our charge-off policies to ensure appropriatereserves exist. We believe our current charge-off policies are appropriate andresult in proper loss recognition. 75 HSBC Finance Corporation-------------------------------------------------------------------------------- DELINQUENCY Our policies and practices for the collection of consumer receivables, includingour customer account management policies and practices, permit us to reset thecontractual delinquency status of an account to current, based on indicia orcriteria which, in our judgment, evidence continued payment probability. When weuse a customer account management technique, we may treat the account as beingcontractually current and will not reflect it as a delinquent account in ourdelinquency statistics. However, if the account subsequently experiences paymentdefaults and becomes at least two months contractually delinquent, it will bereported in our delinquency ratios. At December 31, 2007 and 2006 our two-months-and-over contractual delinquency included $4.5 billion and $2.5 billionrespectively of restructured accounts that subsequently experienced paymentdefaults. See "Customer Account Management Policies and Practices" for furtherdetail of our practices. The following table summarizes two-months-and-over contractual delinquency (as apercent of consumer receivables): 2007 2006 ------------------------------------------ ------------------------------------------ DEC. 31 SEPT. 30 JUNE 30 MARCH 31 DEC. 31 SEPT. 30 JUNE 30 MARCH 31--------------------------------------------------------------------------------------------------------------------Real estate secured(1)... 7.08% 5.50% 4.28% 3.73% 3.54% 2.98% 2.52% 2.46%Auto finance(2).......... 3.67 3.40 2.93 2.32 3.18 3.16 2.73 2.17Credit card.............. 5.77 5.23 4.45 4.53 4.57 4.53 4.16 4.35Private label............ 4.26 4.86 5.12 5.27 5.31 5.61 5.42 5.50Personal non-credit card................... 14.13 11.90 10.72 10.21 10.17 9.69 8.93 8.86 ----- ----- ----- ----- ----- ---- ---- ----Total consumer(2)........ 7.41% 6.13% 5.08% 4.64% 4.59% 4.19% 3.71% 3.66% ===== ===== ===== ===== ===== ==== ==== ==== -------- (1) Real estate secured two-months-and-over contractual delinquency (as a percent of consumer receivables) are comprised of the following: 2007 2006 ------------------------------------------ ------------------------------------------ DEC. 31 SEPT. 30 JUNE 30 MARCH 31 DEC. 31 SEPT. 30 JUNE 30 MARCH 31----------------------------------------------------------------------------------------------------------------------Mortgage Services: First lien............... 10.91% 8.27% 6.39% 4.96% 4.48% 3.80% 3.10% 2.94% Second lien.............. 15.43 11.20 8.06 6.69 5.73 3.70 2.35 1.83 ----- ----- ---- ---- ---- ---- ---- ----Total Mortgage Services.... 11.80 8.86 6.74 5.31 4.74 3.78 2.93 2.70Consumer Lending: First lien............... 3.72 2.90 2.13 2.01 2.07 1.84 1.77 1.87 Second lien.............. 6.93 5.01 3.57 3.32 3.06 2.44 2.37 2.68 ----- ----- ---- ---- ---- ---- ---- ----Total Consumer Lending..... 4.15 3.19 2.33 2.20 2.21 1.92 1.85 1.99Foreign and all other: First lien............... 2.62 2.49 2.25 1.65 1.58 1.52 1.53 1.77 Second lien.............. 4.59 4.30 4.47 5.07 5.38 5.56 5.54 5.57 ----- ----- ---- ---- ---- ---- ---- ----Total Foreign and all other.................... 4.12 3.87 3.98 4.35 4.59 4.72 4.76 4.88 ----- ----- ---- ---- ---- ---- ---- ----Total real estate secured.. 7.08% 5.50% 4.28% 3.73% 3.54% 2.98% 2.52% 2.46% ===== ===== ==== ==== ==== ==== ==== ==== (2) In December 2006, our Auto Finance business changed its charge-off policy to provide that the principal balance of auto loans in excess of the estimated net realizable value will be charged-off 30 days (previously 90 days) after the financed vehicle has been repossessed if it remains unsold, unless it becomes 150 days contractually delinquent, at which time such excess will be charged off. This resulted in a one-time acceleration of charge-off which totaled $24 million in December 2006. In connection with this policy change our Auto Finance business also changed its methodology for reporting two- months-and-over contractual delinquency to include loan balances associated with repossessed vehicles which have not yet been written down to net realizable value, consistent with policy. These changes resulted in an increase of 44 basis points to the auto finance delinquency ratio and an increase of 3 basis points to the total consumer delinquency ratio at December 31, 2006. Prior period amounts have been restated to conform to the current year presentation. Compared to September 30, 2007, our total consumer delinquency increased 128basis points at December 31, 2007 to 7.41 percent. With the exception of ourprivate label portfolio, we experienced higher delinquency levels across allproducts. The real estate secured two-months-and-over contractual delinquencyratio was negatively impacted by higher delinquency levels in our MortgageServices and Consumer Lending businesses. This increase resulted from the weakhousing and mortgage industry, rising unemployment rates in certain markets, theweakening 76 HSBC Finance Corporation-------------------------------------------------------------------------------- MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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