3rd Mar 2008 14:00
HSBC Holdings PLC03 March 2008 PART 4 HSBC FINANCE CORPORATION AND SUBSIDIARIES NET INTEREST MARGIN - 2007 COMPARED TO 2006 FINANCE AND INCREASE/(DECREASE) DUE AVERAGE INTEREST INCOME/ TO: OUTSTANDING(1) AVERAGE RATE INTEREST EXPENSE ----------------------- -------------------- -------------- ------------------ VOLUME 2007 2006 2007 2006 2007 2006 VARIANCE VARIANCE(2)--------------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Receivables: Real estate secured.. $ 93,787 $92,351 8.5% 8.6% $ 7,964 $ 7,912 $ 52 $122 Auto finance......... 12,901 11,660 12.3 12.0 1,582 1,405 177 152 Credit card.......... 28,646 25,065 16.5 16.3 4,723 4,086 637 590 Private label........ 2,646 2,492 10.5 9.6 279 238 41 15 Personal non-credit card.............. 21,215 20,611 18.7 18.9 3,963 3,886 77 113 Commercial and other............. 154 195 0.0 2.1 - 4 (4) (1) Purchase accounting adjustments....... (54) - - - (49) (124) 75 75 -------- -------- ---- ---- ------- ------- ------ ----Total receivables...... 159,295 152,374 11.6 11.4 18,462 17,407 1,055 800Noninsurance investments.......... 4,022 2,676 5.5 5.8 221 155 66 74 -------- -------- ---- ---- ------- ------- ------ ----Total interest-earning assets (excluding insurance investments)......... $163,317 $155,050 11.4% 11.3% $18,683 $17,562 $1,121 $944Insurance investments.. 2,567Other assets........... 9,312 11,410 -------- --------TOTAL ASSETS........... $175,196 $169,565 ======== ========Debt: Commercial paper..... $ 10,987 $12,344 5.5% 5.0% $ 608 $ 612 $ (4) $(71) Bank and other borrowings........ 34 494 4.0((6)) 3.0(6) 1 16 (15) (18) Due to affiliates.... 15,150 15,459 6.5 6.0 992 929 63 (19) Long term debt (with original maturities over one year)......... 123,254 115,583 5.3 5.0 6,531 5,817 714 404 -------- -------- ---- ---- ------- ------- ------ ----Total debt............. $149,425 $143,880 5.4% 5.1% $ 8,132 $ 7,374 $ 758 $291Other liabilities...... 6,454 5,231 -------- --------Total liabilities...... 155,879 149,111Preferred securities... 575 575Common shareholder's equity............... 18,742 19,879 -------- --------TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY............... $175,196 $169,565 ======== ========NET INTEREST MARGIN(3)(5)......... 6.5% 6.6% $10,551 $10,188 $ 363 $653 ==== ==== ======= ======= ====== ====INTEREST SPREADS(4).... 6.0% 6.2% ==== ==== INCREASE/(- DECREASE) DUE TO: ----------- RATE VARIANCE(2)------------------------------------- (DOLLARS ARE IN MILLIONS)Receivables: Real estate secured.. $ (70) Auto finance......... 25 Credit card.......... 47 Private label........ 26 Personal non-credit card.............. (36) Commercial and other............. (3) Purchase accounting adjustments....... - -----Total receivables...... 255Noninsurance investments.......... (8) -----Total interest-earning assets (excluding insurance investments)......... $ 177Insurance investments..Other assets...........TOTAL ASSETS...........Debt: Commercial paper..... $ 67 Bank and other borrowings........ 3 Due to affiliates.... 82 Long term debt (with original maturities over one year)......... 310 -----Total debt............. $ 467Other liabilities......Total liabilities......Preferred securities...Common shareholder's equity...............TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY...............NET INTEREST MARGIN(3)(5)......... $(290) =====INTEREST SPREADS(4).... -------- (1) Nonaccrual loans are included in average outstanding balances. (2) Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total interest variance. For total receivables, total interest-earning assets and total debt, the rate and volume variances are calculated based on the relative weighting of the individual components comprising these totals. These totals do not represent an arithmetic sum of the individual components. (3) Represents net interest income as a percent of average interest-earning assets (4) Represents the difference between the yield earned on interest-earning assets and the cost of the debt used to fund the assets (5) The net interest margin analysis includes the following for foreign businesses: 2007 2006------------------------------------------------------------------------------------Average interest-earning assets................................. $10,157 $9,657Average interest-bearing liabilities............................ 8,461 8,150Net interest income............................................. 718 691Net interest margin............................................. 7.1% 7.2% (6) Average rate does not recompute from the dollar figures presented due to rounding. 116 HSBC FINANCE CORPORATION AND SUBSIDIARIES NET INTEREST MARGIN - 2006 COMPARED TO 2005 FINANCE AND AVERAGE AVERAGE INTEREST INCOME/ INCREASE/(DECREASE) DUE TO: OUTSTANDING(1) RATE INTEREST EXPENSE ------------------------------------ ------------------- ----------- -------------------- VOLUME RATE 2006 2005 2006 2005 2006 2005 VARIANCE VARIANCE(2) VARIANCE(2)----------------------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Receivables: Real estate secured..... $ 92,351 $ 73,097 8.6% 8.4% $ 7,912 $ 6,155 $1,757 $1,646 $ 111 Auto finance............ 11,660 9,074 12.0 11.8 1,405 1,067 338 311 27 Credit card............. 25,065 17,823 16.3 13.9 4,086 2,479 1,607 1,129 478 Private label........... 2,492 2,948 9.6 9.4 238 278 (40) (44) 4 Personal non-credit card................. 20,611 17,558 18.9 18.4 3,886 3,226 660 574 86 Commercial and other.... 195 255 2.1 2.4 4 6 (2) (1) (1) Purchase accounting adjustments.......... - 134 - - (124) (139) 15 15 - -------- -------- ---- ---- ------- ------- ------ ------ ------Total receivables......... 152,374 120,889 11.4 10.8 17,407 13,072 4,335 3,563 772Noninsurance investments.. 2,676 3,694 5.8 3.9 155 144 11 (47) 58 -------- -------- ---- ---- ------- ------- ------ ------ ------Total interest-earning assets (excluding insurance investments).. $155,050 $124,583 11.3% 10.6% $17,562 $13,216 $4,346 $3,403 $ 943Insurance investments..... 3,105 3,159Other assets.............. 11,410 12,058 -------- --------TOTAL ASSETS.............. $169,565 $139,800 ======== ========Debt: Commercial paper........ $ 12,344 $ 11,877 5.0% 3.4% $ 612 $ 399 $ 213 $ 16 $ 197 Bank and other borrowings........... 494 111 3.3(6) 2.5(6) 16 3 13 12 1 Due to affiliates....... 15,459 16,654 6.0 4.3 929 713 216 (54) 270 Long term debt (with original maturities over one year)....... 115,583 86,207 5.0 4.3 5,817 3,717 2,100 1,416 684 -------- -------- ---- ---- ------- ------- ------ ------ ------Total debt................ $143,880 $114,849 5.1% 4.2% $ 7,374 $ 4,832 $2,542 $1,364 $1,178Other liabilities......... 5,231 6,649 -------- --------Total liabilities......... 149,111 121,498Preferred securities...... 575 1,366Common shareholder's equity.................. 19,879 16,936 -------- --------TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY.... $169,565 $139,800 ======== ========NET INTEREST MARGIN OPERATIONS(3)(5)........ 6.6% 6.7% $10,188 $ 8,384 $1,804 $2,039 $ (235) ==== ==== ======= ======= ====== ====== ======INTEREST SPREADS(4)....... 6.2% 6.4% ==== ==== -------- (1) Nonaccrual loans are included in average outstanding balances. (2) Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total interest variance. For total receivables, total interest-earning assets and total debt, the rate and volume variances are calculated based on the relative weighting of the individual components comprising these totals. These totals do not represent an arithmetic sum of the individual components. (3) Represents net interest income as a percent of average interest-earning assets (4) Represents the difference between the yield earned on interest-earning assets and the cost of the debt used to fund the assets (5) The net interest margin analysis includes the following for foreign businesses: 2006 2005------------------------------------------------------------------------------------Average interest-earning assets................................. $9,657 $12,098Average interest-bearing liabilities............................ 8,150 10,231Net interest income............................................. 691 754Net interest margin............................................. 7.2% 6.2% (6) Average rate does not recompute from the dollar figures presented due to rounding. 117 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES Our consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States ("U.S. GAAP"). In addition tothe U.S. GAAP financial results reported in our consolidated financialstatements, MD&A includes reference to the following information which ispresented on a non-U.S. GAAP basis: OPERATING RESULTS, PERCENTAGES AND RATIOS Certain percentages and ratios havebeen presented on an operating basis and have been calculated using "operatingnet income", a non-U.S. GAAP financial measure. "Operating net income" is netincome excluding certain nonrecurring items. These nonrecurring items are alsoexcluded in calculating our operating basis efficiency ratios. We believe thatexcluding these items helps readers of our financial statements to understandbetter the results and trends of our underlying business. IFRS MANAGEMENT BASIS A non-U.S. GAAP measure of reporting results in accordancewith IFRSs and assumes the private label and real estate secured receivablestransferred to HSBC Bank USA have not been sold and remain on our balance sheet.IFRS Management Basis also assumes that all purchase accounting fair valueadjustments reflecting our acquisition by HSBC have been "pushed down" to HSBCFinance Corporation. EQUITY RATIOS In managing capital, we develop targets for tangibleshareholder's(s') equity plus owned loss reserves to tangible managed assets("TETMA + Owned Reserves") and tangible common equity to tangible managed assetsexcluding HSBC acquisition purchase accounting adjustments. These ratio targetsare based on discussions with HSBC and rating agencies, risks inherent in theportfolio, the projected operating environment and related risks, and anyacquisition objectives. We and certain rating agencies monitor ratios excludingthe impact of the HSBC acquisition purchase accounting adjustments as we believethat they represent non-cash transactions which do not affect our businessoperations, cash flows or ability to meet our debt obligations. These ratiosalso exclude the equity impact of SFAS No. 115, "Accounting for CertainInvestments in Debt and Equity Securities," the equity impact of SFAS No. 133,"Accounting for Derivative Instruments and Hedging Activities," and the impactof the adoption of SFAS No. 159, "The Fair Value Option for Financial Assets andLiabilities," including the subsequent changes in fair value recognized inearnings associated with credit risk on 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. Our targets may change from time to time to accommodate changes in theoperating environment or other considerations such as those listed above. In thefourth quarter of 2007, Moody's, Standard & Poor's and Fitch changed the totaloutlook on our issuer default rating from "positive" to "stable." QUANTITATIVE RECONCILIATIONS OF NON-U.S. GAAP FINANCIAL MEASURES TO U.S. GAAPFINANCIAL MEASURES For a reconciliation of IFRS Management Basis results to thecomparable owned basis amounts, see Note 21, "Business Segments," to theaccompanying consolidated financial statements. Reconciliations of selectedoperating basis financial ratios and our equity ratios follow. 118 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES SELECTED FINANCIAL DATA AND STATISTICS 2007 2006 2005 2004 2003-------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)RETURN ON AVERAGE COMMON SHAREHOLDER'S EQUITY:Net income (loss)............................ $ (4,906) $ 1,443 $ 1,772 $ 1,940 $ 1,603 Dividends on preferred stock............... (37) (37) (83) (72) (76) -------- -------- -------- -------- --------Net income (loss) available to common shareholders............................... $ (4,943) $ 1,406 $ 1,689 $ 1,868 $ 1,527Gain on bulk sale of private label receivables................................ - - - (423) -Adoption of FFIEC charge-off policies for domestic private label(excluding retail sales contracts) and credit card portfolios............................ - - - 121 -HSBC acquisition related costs and other merger related items incurred by HSBC Finance Corporation........................ - - - - 167 -------- -------- -------- -------- --------Operating net income (loss) available to common shareholders........................ $ (4,943) $ 1,406 $ 1,689 $ 1,566 $ 1,694 -------- -------- -------- -------- --------Average common shareholder's equity.......... $ 18,587 $ 19,879 $ 16,936 $ 17,003 $ 14,022 -------- -------- -------- -------- --------Return on average common shareholder's equity..................................... (26.59)% 7.07% 9.97% 10.99% 10.89%Return on average common shareholder's equity, operating basis.................... (26.59) 7.07 9.97 9.21 12.08 ======== ======== ======== ======== ========RETURN ON AVERAGE ASSETS:Net income (loss)............................ $ (4,906) $ 1,443 $ 1,772 $ 1,940 $ 1,603Operating net income (loss).................. (4,906) 1,443 1,772 1,638 1,770 -------- -------- -------- -------- --------Average owned assets......................... $175,042 $170,013 $139,793 $123,921 $110,097 -------- -------- -------- -------- --------Return on average assets..................... (2.80)% .85% 1.27% 1.57% 1.46%Return on average assets, operating basis.... (2.80) .85 1.27 1.32 1.61 ======== ======== ======== ======== ========EFFICIENCY RATIO:Total costs and expenses less policyholders' benefits................................... $ 11,354 $ 6,293 $ 5,685 $ 5,279 $ 4,853 HSBC acquisition related costs and other merger related items incurred by HSBC Finance Corporation..................... - - - - (198) -------- -------- -------- -------- -------- Total costs and expenses less policyholders' benefits, excluding nonrecurring items...................... $ 11,354 $ 6,293 $ 5,685 $ 5,279 $ 4,655 -------- -------- -------- -------- --------Net interest income and other revenues less policyholders' benefits.................... $ 16,529 $ 15,144 $ 12,891 $ 12,553 $ 11,295Nonrecurring items: Gain on bulk sale of private label receivables........................... - - - (663) - Adoption of FFIEC charge-off policies for domestic private label (excluding retail sales contracts) and credit card portfolios....................... - - - 151 - -------- -------- -------- -------- -------- Net interest income and other revenues less policyholders' benefits, excluding nonrecurring items...................... $ 16,529 $ 15,144 $ 12,891 $ 12,041 $ 11,295Efficiency ratio............................. 68.69% 41.55% 44.10% 42.05% 42.97%Efficiency ratio, operating basis............ 68.69 41.55 44.10 43.84 41.21 ======== ======== ======== ======== ======== 119 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES EQUITY RATIOS 2007 2006 2005 2004 2003-------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)TANGIBLE COMMON EQUITY:Common shareholder's equity.................. $ 13,584 $ 19,515 $ 18,904 $ 15,841 $ 16,391Exclude: Fair value option adjustment............... (545) - - - - Unrealized (gains) losses on cash flow hedging instruments..................... 718 61 (260) (119) 10 Minimum pension liability.................. 3 1 - 4 - Unrealized gains on investments and interest-only strip receivables......... 13 23 3 (53) (167) Intangibles assets......................... (1,107) (2,218) (2,480) (2,705) (2,856) Goodwill................................... (2,827) (7,010) (7,003) (6,856) (6,697) -------- -------- -------- -------- --------Tangible common equity....................... 9,839 10,372 9,164 6,112 6,681Purchase accounting adjustments.............. 267 1,105 1,441 2,227 2,548 -------- -------- -------- -------- --------Tangible common equity, excluding HSBC acquisition purchase accounting adjustments................................ $ 10,106 $ 11,477 $ 10,605 $ 8,339 $ 9,229 ======== ======== ======== ======== ========TANGIBLE SHAREHOLDER'S(S') EQUITY:Tangible common equity....................... $ 9,839 $ 10,372 $ 9,164 $ 6,112 $ 6,681Preferred stock.............................. 575 575 575 1,100 1,100Mandatorily redeemable preferred securities of Household Capital Trusts................ 1,275 1,275 1,679 994 1,031 -------- -------- -------- -------- --------Tangible shareholder's(s') equity............ 11,689 12,222 11,418 8,206 8,812HSBC acquisition purchase accounting adjustments................................ 267 1,105 1,438 2,208 2,492 -------- -------- -------- -------- --------Tangible shareholder's(s') equity, excluding purchase accounting adjustments............ $ 11,956 $ 13,327 $ 12,856 $ 10,414 $ 11,304 ======== ======== ======== ======== ========TANGIBLE SHAREHOLDER'S(S') EQUITY PLUS OWNED LOSS RESERVES:Tangible shareholder's(s') equity............ $ 11,689 $ 12,222 $ 11,418 $ 8,206 $ 8,812Owned loss reserves.......................... 10,905 6,587 4,521 3,625 3,793 -------- -------- -------- -------- --------Tangible shareholder's(s') equity plus owned loss reserves.............................. 22,594 18,809 15,939 11,831 12,605HSBC acquisition purchase accounting adjustments................................ 267 1,105 1,438 2,208 2,492 -------- -------- -------- -------- --------Tangible shareholder's(s') equity plus owned loss reserves, excluding purchase accounting adjustments..................... $ 22,861 $ 19,914 $ 17,377 $ 14,039 $ 15,097 ======== ======== ======== ======== ========TANGIBLE MANAGED ASSETS:Owned assets................................. $165,504 $179,218 $156,522 $130,190 $119,052Receivables serviced with limited recourse... 124 949 4,074 14,225 26,201 -------- -------- -------- -------- --------Managed assets............................... 165,628 180,167 160,596 144,415 145,253Exclude: Intangible assets.......................... (1,107) (2,218) (2,480) (2,705) (2,856) Goodwill................................... (2,827) (7,010) (7,003) (6,856) (6,697) Derivative financial assets................ (48) (298) (87) (4,049) (3,016) -------- -------- -------- -------- --------Tangible managed assets...................... 161,646 170,641 151,026 130,805 132,684HSBC acquisition purchase accounting adjustments................................ (387) 64 (52) (202) (431) -------- -------- -------- -------- --------Tangible managed assets, excluding purchase accounting adjustments..................... $161,259 $170,705 $150,974 $130,603 $132,253 ======== ======== ======== ======== ========EQUITY RATIOS:Common and preferred equity to owned assets.. 8.56% 11.21% 12.44% 13.01% 14.69%Tangible common equity to tangible managed assets..................................... 6.09 6.08 6.07 4.67 5.04Tangible shareholder's(s') equity to tangible managed assets............................. 7.23 7.16 7.56 6.27 6.64Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets... 13.98 11.02 10.55 9.04 9.50Excluding HSBC acquisition purchase accounting adjustments: Tangible common equity to tangible managed assets.................................. 6.27 6.72 7.02 6.38 6.98 Tangible shareholder's(s') equity to tangible managed assets................. 7.41 7.81 8.52 7.97 8.55 Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets.................................. 14.18 11.67 11.51 10.75 11.42 ======== ======== ======== ======== ======== 120 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.-------------------------------------------------------------------------------- Information required by this Item is included in sections of Item 7.Management's Discussion and Analysis of Financial Condition and Results ofOperations on the following pages: "Liquidity and Capital Resources", pages 91-100, "Off Balance Sheet Arrangements and Secured Financings", pages 100-103 and"Risk Management", pages 103-108. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.-------------------------------------------------------------------------------- Our 2007 Financial Statements meet the requirements of Regulation S-X. The 2007Financial Statements and supplementary financial information specified by Item302 of Regulation S-K are set forth below. 121 HSBC Finance Corporation -------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and ShareholderHSBC Finance Corporation: We have audited HSBC Finance Corporation's internal control over financialreporting as of December 31, 2007, based on criteria established in InternalControl -- Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). HSBC Finance Corporation'smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting, included in Management's Assessment ofInternal Control over Financial Reporting. Our responsibility is to express anopinion on HSBC Finance Corporation's internal control over financial reportingbased on our audit. We conducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we planand perform the audit to obtain reasonable assurance about whether effectiveinternal control over financial reporting was maintained in all materialrespects. Our audit included obtaining an understanding of internal control overfinancial reporting, assessing the risk that a material weakness exists, andtesting and evaluating the design and operating effectiveness of internalcontrol based on the assessed risk. Our audit also included performing suchother procedures as we considered necessary in the circumstances. We believethat our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles. A company's internal control overfinancial reporting includes those policies and procedures that (1) pertain tothe maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2)provide reasonable assurance that transactions are recorded as necessary topermit preparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directors ofthe company; and (3) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company'sassets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reportingmay not prevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls may becomeinadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate. In our opinion, HSBC Finance Corporation maintained, in all material respects,effective internal control over financial reporting as of December 31, 2007,based on criteria established in Internal Control -- Integrated Framework issuedby the Committee of Sponsoring Organizations of the Treadway Commission. We also have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets ofHSBC Finance Corporation (a Delaware corporation), an indirect wholly-ownedsubsidiary of HSBC Holdings plc. and subsidiaries as of December 31, 2007 and2006 and the related consolidated statements of income(loss), changes inshareholder's(s') equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2007, and our report dated February 29, 2008 expressedan unqualified opinion on those consolidated financial statements. /s/ KPMG LLPChicago, IllinoisFebruary 29, 2008 122 HSBC Finance Corporation -------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and ShareholderHSBC Finance Corporation: We have audited the accompanying consolidated balance sheets of HSBC FinanceCorporation (a Delaware corporation), an indirect wholly-owned subsidiary ofHSBC Holdings plc, and subsidiaries as of December 31, 2007 and 2006 and therelated consolidated statements of income (loss), changes in shareholders'(s')equity, and cash flows for each of the years in the three-year period endedDecember 31, 2007. These consolidated financial statements are theresponsibility of HSBC Finance Corporation's management. Our responsibility isto express an opinion on these consolidated financial statements based on ouraudits. We conducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we planand perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion. In our opinion, the aforementioned consolidated financial statements presentfairly, in all material respects, the financial position of HSBC FinanceCorporation and subsidiaries as of December 31, 2007 and 2006, and the resultsof their operations and their cash flows for each of the years in the three-yearperiod ended December 31, 2007, in conformity with U.S. generally acceptedaccounting principles. We also have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), HSBC Finance Corporation's internalcontrol over financial reporting as of December 31, 2007, based on criteriaestablished in Internal Control -- Integrated Framework issued by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO), and our reportdated February 29, 2008 expressed an unqualified opinion on the effectiveness ofHSBC Financial Corporation's internal control over financing reporting. /s/ KPMG LLPChicago, IllinoisFebruary 29, 2008 123 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME (LOSS) YEAR ENDED DECEMBER 31, 2007 2006 2005--------------------------------------------------------------------------------------- (IN MILLIONS)Finance and other interest income...................... $18,683 $17,562 $13,216Interest expense: HSBC affiliates...................................... 992 929 713 Non-affiliates....................................... 7,140 6,445 4,119 ------- ------- -------NET INTEREST INCOME.................................... 10,551 10,188 8,384Provision for credit losses............................ 11,026 6,564 4,543 ------- ------- -------NET INTEREST INCOME (LOSS) AFTER PROVISION FOR CREDIT LOSSES............................................... (475) 3,624 3,841 ------- ------- -------Other revenues: Securitization revenue............................... 70 167 211 Insurance revenue.................................... 806 1,001 997 Investment income.................................... 145 274 134 Derivative (expense) income.......................... (79) 190 249 Gain on debt designated at fair value and related derivatives....................................... 1,275 - - Fee income........................................... 2,415 1,911 1,568 Enhancement services revenue......................... 635 515 338 Taxpayer financial services revenue.................. 247 258 277 Gain on receivable sales to HSBC affiliates.......... 419 422 413 Servicing and other fees from HSBC affiliates........ 536 506 440 Other (expense) income............................... (70) 179 336 ------- ------- -------TOTAL OTHER REVENUES................................... 6,399 5,423 4,963 ------- ------- -------Costs and expenses: Salaries and employee benefits....................... 2,342 2,333 2,072 Sales incentives..................................... 212 358 397 Occupancy and equipment expenses..................... 379 317 334 Other marketing expenses............................. 748 814 731 Other servicing and administrative expenses.......... 1,337 1,115 917 Support services from HSBC affiliates................ 1,192 1,087 889 Amortization of intangibles.......................... 253 269 345 Policyholders' benefits.............................. 421 467 456 Goodwill and other intangible asset impairment charges........................................... 4,891 - - ------- ------- -------TOTAL COSTS AND EXPENSES............................... 11,775 6,760 6,141 ------- ------- -------Income (loss) before income tax expense................ (5,851) 2,287 2,663Income tax expense (benefit)........................... (945) 844 891 ------- ------- -------NET INCOME (LOSS)...................................... $(4,906) $ 1,443 $ 1,772 ======= ======= ======= The accompanying notes are an integral part of the consolidated financialstatements. 124 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET YEAR ENDED DECEMBER 31, 2007 2006------------------------------------------------------------------------------------ (IN MILLIONS, EXCEPT SHARE DATA)ASSETSCash......................................................... $ 783 $ 871Interest bearing deposits with banks......................... 335 424Securities purchased under agreements to resell.............. 1,506 171Securities................................................... 3,152 4,695Receivables, net............................................. 147,455 157,386Intangible assets, net....................................... 1,107 2,218Goodwill..................................................... 2,827 7,010Properties and equipment, net................................ 415 426Real estate owned............................................ 1,023 670Derivative financial assets.................................. 48 298Other assets................................................. 6,853 5,049 -------- --------TOTAL ASSETS................................................. $165,504 $179,218 ======== ========LIABILITIESDebt: Commercial paper, bank and other borrowings................ $ 8,424 $ 11,055 Due to affiliates.......................................... 14,902 15,172 Long term debt (with original maturities over one year, including $32.9 billion at December 31, 2007 and $0 at December 31, 2006 carried at fair value)................ 123,262 127,590 -------- --------Total debt................................................... 146,588 153,817 -------- --------Insurance policy and claim reserves.......................... 1,001 1,319Derivative related liabilities............................... 20 6Liability for pension benefits............................... 390 355Other liabilities............................................ 3,346 3,631 -------- --------TOTAL LIABILITIES............................................ 151,345 159,128 -------- --------SHAREHOLDER'S(S') EQUITYRedeemable preferred stock, 1,501,100 shares authorized, Series B, $0.01 par value, 575,000 shares issued........... 575 575Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized; 57 shares issued........................................... - - Additional paid-in capital................................. 18,227 17,279 (Accumulated deficit) retained earnings.................... (4,423) 1,877 Accumulated other comprehensive income (loss).............. (220) 359 -------- --------TOTAL COMMON SHAREHOLDER'S EQUITY............................ 13,584 19,515 -------- --------TOTAL LIABILITIES AND SHAREHOLDER'S(S') EQUITY............... $165,504 $179,218 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 125 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005-------------------------------------------------------------------------------------------------- (IN MILLIONS)PREFERRED STOCK Balance at beginning of period................... $ 575 $ 575 $ 1,100 Issuance of Series B preferred stock............. - - 575 Exchange of Series A preferred stock for common stock......................................... - - (1,100) ------- ------- ------- Balance at end of period......................... $ 575 $ 575 $ 575 ======= ======= =======COMMON SHAREHOLDER'S EQUITY COMMON STOCK Balance at beginning of period................ $ - $ - $ - Exchange of common stock for Series A preferred stock............................. - - - ------- ------- ------- Balance at end of period...................... $ - $ - $ - ------- ------- ------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period................ $17,279 $17,145 $14,627 Premium on sale of European Operations to affiliate................................... - 13 - Premium on sale of U.K. credit card business to affiliate................................ - - 182 Exchange of common stock for Series A preferred stock............................. - - 1,112 Capital contribution from parent company...... 950 163 1,200 Return of capital to HSBC..................... (18) (49) (19) Employee benefit plans, including transfers and other................................... 16 7 59 Issuance costs of Series B preferred stock.... - - (16) ------- ------- ------- Balance at end of period...................... $18,227 $17,279 $17,145 ------- ------- ------- ACCUMULATED DEFICIT RETAINED EARNINGS Balance at beginning of period................ $ 1,877 $ 1,280 $ 571 Adjustment to initially apply the fair value method of accounting under FASB Statement No. 159, net of tax...... (538) - - Net income (loss)............................. (4,906) 1,443 1,772 Cash dividend equivalents on HSBC's Restricted Share Plan.................................. (7) - - Dividends: Preferred stock............................. (37) (37) (83) Common stock................................ (812) (809) (980) ------- ------- ------- Balance at end of period...................... $(4,423) $ 1,877 $ 1,280 ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) Balance at beginning of period................ $ 359 $ 479 $ 643 Net change in unrealized gains (losses) on: Derivatives classified as cash flow hedges................................. (657) (321) 141 Securities available for sale and interest-only strip receivables........ 10 (21) (56) Minimum pension liability................... - - 4 FASB Statement No. 158 adjustment, net of tax...................................... (2) - - Foreign currency translation adjustments.... 70 223 (253) ------- ------- ------- Other comprehensive (loss), net of tax........ (579) (119) (164) Adjustment to initially apply FASB Statement No. 158, net of tax......................... - (1) - ------- ------- ------- Balance at end of period...................... $ (220) $ 359 $ 479 ------- ------- -------TOTAL COMMON SHAREHOLDER'S EQUITY.................. $13,584 $19,515 $18,904 ======= ======= =======COMPREHENSIVE INCOMENet income (loss).................................. $(4,906) $ 1,443 $ 1,772Other comprehensive income (loss).................. (579) (119) (164) ------- ------- -------COMPREHENSIVE INCOME (LOSS)........................ $(5,485) $ 1,324 $ 1,608 ======= ======= =======PREFERRED STOCK Balance at beginning of period................... 575 575 1,100 Issuance of Series B preferred stock............. - - 575 Exchange of Series A preferred stock to common stock......................................... - - (1,100) ------- ------- ------- Balance at end of period......................... 575 575 575 ======= ======= =======COMMON STOCK ISSUED Balance at beginning of period................ 55 55 50 Issuance of common stock to parent............ 2 - 5 ------- ------- ------- Balance at end of period...................... 57 55 55 ------- ------- ------- The accompanying notes are an integral part of the consolidated financialstatements. 126 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005----------------------------------------------------------------------------------------------------CASH FLOWS FROM OPERATING ACTIVITIESNet income (loss).................................... $ (4,906) $ 1,443 $ 1,772Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for credit losses........................ 11,026 6,564 4,543 Gain on receivable sales to HSBC affiliates........ (419) (422) (413) (Gain) loss on real estate receivables sales with third parties................................... 22 - - Loss on sale of real estate owned, including lower of cost or market adjustments................... 304 155 164 Gain on sale of investment in Kanbay International, Inc. ........................................... - (123) - Insurance policy and claim reserves................ (73) (240) (222) Depreciation and amortization...................... 345 385 457 Change in mark-to-market on debt designated at fair value and related derivatives................... (1,593) - - Gain on sale of MasterCard Class B shares.......... (115) - - Goodwill and other intangible asset impairment charges......................................... 4,891 - - Deferred income tax (benefit) provision............ (1,066) (560) (366) Net change in other assets......................... (744) (1,538) 326 Net change in other liabilities.................... (290) 1,131 393 Net change in loans held for sale.................. 1,661 78 (672) Foreign exchange and SFAS No. 133 movements on long term debt and net change in non-FVO related derivative assets and liabilities............... 3,342 884 (524) Excess tax benefits from share-based compensation arrangements.................................... (8) (16) - Other, net......................................... 281 (72) (177) -------- -------- --------Net cash provided by (used in) operating activities.. 12,658 7,669 5,281 -------- -------- --------CASH FLOWS FROM INVESTING ACTIVITIESSecurities: Purchased.......................................... (1,214) (2,071) (852) Matured............................................ 879 1,847 646 Sold............................................... 173 492 429Net change in short-term securities available for sale............................................... 1,324 (606) (472)Net change in securities purchased under agreements to resell.......................................... (1,335) (93) 2,573Net change in interest bearing deposits with banks... 28 (5) 187Receivables: Originations, net of collections................... (6,290) (24,511) (34,096) Purchases and related premiums..................... (220) (3,225) (1,053) Initial securitizations............................ - - - Proceeds from sales of real estate owned........... 1,588 1,178 1,032 Net change in interest-only strip receivables...... 6 (5) 253Cash received in sale of mortgage receivables to third party........................................ 2,692 - -Cash received in sale of MasterCard Class B shares... 115 - -Cash received in sale of European Operations......... - 46 -Cash received in sale of U.K. insurance operations... 206 - -Cash received in sale of U.K. credit card business... - 90 2,627Net cash paid for acquisition of Metris.............. - - (1,572)Net cash paid for acquisition of Solstice............ - (50) -Properties and equipment: Purchases.......................................... (135) (102) (78) Sales.............................................. 38 26 7 -------- -------- --------Net cash provided by (used in) investing activities.. (2,145) (26,989) (30,369) -------- -------- --------CASH FLOWS FROM FINANCING ACTIVITIESDebt: Net change in short-term debt and deposits......... (2,708) (411) 2,381 Net change in due to affiliates.................... (362) (846) 2,435 Long term debt issued.............................. 18,490 41,138 40,214 Long term debt retired............................. (26,063) (19,663) (20,967) Issuance of company obligated mandatorily redeemable preferred securities of subsidiary trusts to HSBC.................................. - - 1,031 Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts.......................................... - (412) (309)Insurance: Policyholders' benefits paid....................... (246) (264) (250) Cash received from policyholders................... 187 393 380Capital contribution from parent..................... 950 163 1,200Shareholder's dividends.............................. (849) (846) (1,063)Issuance of preferred stock.......................... - - 559Excess tax benefits from share-based compensation arrangements....................................... 8 16 - -------- -------- --------Net cash provided by (used in) financing activities.. (10,593) 19,268 25,611 -------- -------- --------Effect of exchange rate changes on cash.............. (8) 20 (12) -------- -------- --------Net change in cash................................... (88) (32) 511Cash at beginning of period.......................... 871 903 392 -------- -------- --------CASH AT END OF PERIOD................................ $ 783 $ 871 $ 903 ======== ======== ========SUPPLEMENTAL CASH FLOW INFORMATION:Interest paid........................................ $ 8,466 $ 7,454 $ 5,233Income taxes paid.................................... 737 1,437 1,173 -------- -------- --------SUPPLEMENTAL NONCASH FINANCING AND CAPITAL ACTIVITIES:Affiliate preferred stock received in sale of U.K. credit card business............................... $ - $ - $ 261Exchange of preferred for common stock............... - - 1,112Transfer of receivables to Real Estate Owned......... 2,219 1,435 994 ======== ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 127 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION-------------------------------------------------------------------------------- HSBC Finance Corporation (formerly Household International, Inc.) and itssubsidiaries were acquired by a wholly owned subsidiary of HSBC Holdings plc("HSBC") on March 28, 2003 in a purchase business combination recorded under the"push-down" method of accounting, which resulted in a new basis of accountingfor the "successor" period beginning March 29, 2003. HSBC Finance Corporation and subsidiaries, is an indirect wholly ownedsubsidiary of HSBC North America Holdings Inc. ("HSBC North America"), which isan indirect wholly-owned subsidiary of HSBC. HSBC Finance Corporation providesmiddle-market consumers with several types of loan products in the UnitedStates, the United Kingdom, Canada, and the Republic of Ireland. HSBC FinanceCorporation may also be referred to in these notes to the consolidated financialstatements as "we," "us" or "our." Our lending products include real estatesecured loans, auto finance loans, MasterCard*, Visa*, American Express* andDiscover* credit card loans ("Credit Card"), private label credit card loans andpersonal non-credit card loans. We also initiate tax refund anticipation loansand other related products in the United States and offer credit and specialtyinsurance in the United States, Canada, and prior to November 1, 2007, theUnited Kingdom. The insurance operations in the United Kingdom were sold onNovember 1, 2007 to Aviva plc and its subsidiaries ("Aviva"). Subsequent toNovember 1, 2007, we distribute insurance products in the United Kingdom throughour branch network which are underwritten by Aviva. We have three reportablesegments: Consumer, Credit Card Services, and International. Our Consumersegment consists of our branch-based consumer lending, mortgage services, retailservices, and auto finance businesses. Our Credit Card Services segment consistsof our domestic credit card business. Our International segment consists of ourforeign operations in Canada, the United Kingdom ("U.K."), the Republic ofIreland and prior to November 9, 2006 our operations in Slovakia, the CzechRepublic and Hungary. During 2004, Household International, Inc. ("Household") rebranded the majorityof its U.S. and Canadian businesses to the HSBC brand. Businesses previouslyoperating under the Household name are now called HSBC. Our consumer lendingbusiness retained the HFC and Beneficial brands in the United States,accompanied by the HSBC Group's endorsement signature, "Member HSBC Group." Thesingle brand has allowed HSBC in North America to better align its businesses,provided a stronger platform to service customers and advanced growth. The HSBCbrand also positions us to expand the products and services offered to ourcustomers. As part of this initiative, Household changed its name to HSBCFinance Corporation in December 2004. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-------------------------------------------------------------------------------- BASIS OF PRESENTATION The consolidated financial statements include the accountsof HSBC Finance Corporation and all subsidiaries including all variable interestentities in which we are the primary beneficiary as defined by FinancialAccounting Standards Board Interpretation No. 46 (Revised). Unaffiliated truststo which we have transferred securitized receivables which are qualifyingspecial purpose entities ("QSPEs") as defined by Statement of FinancialAccounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicingof Financial Assets and Extinguishments of Liabilities," are not consolidated.All significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the amounts reported in the financialstatements and accompanying notes. Actual results could differ from thoseestimates. Certain reclassifications have been made to prior year amounts toconform to the current period presentation. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL Securities purchased underagreements to resell are treated as collateralized financing transactions andare carried at the amounts at which the securities were acquired plus accruedinterest. Interest income earned on these securities is included in net interestincome. ----------* MasterCard is a registered trademark of MasterCard International, Incorporated; VISA is a registered trademark of Visa, Inc; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc. 128 INVESTMENT SECURITIES We maintain investment portfolios (comprised primarily ofcorporate debt securities) in both our noninsurance and insurance operations.Our entire investment securities portfolio was classified as available-for-saleat December 31, 2007 and 2006. Available-for-sale investments are intended to beinvested for an indefinite period but may be sold in response to events weexpect to occur in the foreseeable future. These investments are carried at fairvalue. Unrealized holding gains and losses on available-for-sale investments arerecorded as adjustments to common shareholder's equity in accumulated othercomprehensive income, net of income taxes. Any decline in the fair value ofinvestments which is deemed to be other than temporary is charged againstcurrent period earnings. Cost of investment securities sold is determined using the specificidentification method. Interest income earned on the noninsurance investmentportfolio is classified in the statements of income in net interest income.Realized gains and losses from the investment portfolio and investment incomefrom the insurance portfolio are recorded in investment income. Accruedinvestment income is classified with investment securities. RECEIVABLES Finance receivables are carried at amortized cost which representsthe principal amount outstanding, net of any unearned income, charge-offs,unamortized deferred fees and costs on originated loans, purchase accountingfair value adjustments and premiums or discounts on purchased loans. Financereceivables are further reduced by credit loss reserves and unearned creditinsurance premiums and claims reserves applicable to credit risks on ourconsumer receivables. Receivables held for sale are carried at the lower ofaggregate cost or market value and remain presented as receivables in theconsolidated balance sheet. Finance income is recognized using the effectiveyield method. Premiums and discounts, including purchase accounting adjustmentson receivables, are recognized as adjustments to the yield of the relatedreceivables. Origination fees, which include points on real estate securedloans, are deferred and generally amortized to finance income over the estimatedlife of the related receivables, except to the extent they offset directlyrelated lending costs. Net deferred origination fees, excluding MasterCard andVisa, totaled $146 million at December 31, 2007 and $128 million at December 31,2006. MasterCard and Visa annual fees are netted with direct lending costs,deferred, and amortized on a straight-line basis over one year. DeferredMasterCard and Visa annual fees, net of direct lending costs related to thesereceivables, totaled $249 million at December 31, 2007 and $233 million atDecember 31, 2006. Insurance reserves and unearned premiums applicable to credit risks on consumerreceivables are treated as a reduction of receivables in the balance sheet,since payments on such policies generally are used to reduce outstandingreceivables. PROVISION AND CREDIT LOSS RESERVES Provision for credit losses on ownedreceivables is made in an amount sufficient to maintain credit loss reserves ata level considered adequate, but not excessive, to cover probable losses ofprincipal, interest and fees, including late, overlimit and annual fees, in theexisting loan portfolio. We estimate probable losses for consumer receivablesusing a roll rate migration analysis that estimates the likelihood that a loanwill progress through the various stages of delinquency, or buckets, andultimately charge-off. This analysis considers delinquency status, lossexperience and severity and takes into account whether loans are in bankruptcy,have been restructured, rewritten, or are subject to forbearance, an externaldebt management plan, hardship, modification, extension or deferment. Our creditloss reserves also take into consideration the loss severity expected based onthe underlying collateral, if any, for the loan in the event of default.Delinquency status may be affected by customer account management policies andpractices, such as the restructure of accounts, forbearance agreements, extendedpayment plans, modification arrangements, loan rewrites and deferments. Whencustomer account management policies or changes thereto, shift loans from a"higher" delinquency bucket to a "lower" delinquency bucket, this will bereflected in our roll rates statistics. To the extent that restructured accountshave a greater propensity to roll to higher delinquency buckets, this will becaptured in the roll rates. Since the loss reserve is computed based on thecomposite of all these calculations, this increase in roll rate will be appliedto receivables in all respective buckets, which will increase the overallreserve level. In addition, loss reserves on consumer receivables are maintainedto reflect our judgment of portfolio risk factors which may not be fullyreflected in the statistical roll rate calculation. Risk factors considered inestablishing loss reserves on consumer receivables include recent growth,product mix, bankruptcy trends, geographic concentrations, unemployment rates,loan product features such as adjustable rate loans, economic conditions such asnational and local trends in housing markets and interest rates, portfolioseasoning, account management policies and practices, current levels of charge-offs and delinquencies, changes in laws and regulations and other items whichcan affect consumer payment patterns on 129 outstanding receivables such as natural disasters and global pandemics. Forcommercial loans, probable losses are calculated using estimates of amounts andtiming of future 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 appropriate allowances exist for products with longer charge-off periods.We also consider key ratios such as reserves to nonperforming loans, reserves asa percentage of net charge-offs and months coverage ratios in developing ourloss reserve estimate. Loss reserve estimates are reviewed periodically andadjustments are reported in earnings when they become known. As these estimatesare influenced by factors outside our control, such as consumer payment patternsand economic conditions, there is uncertainty inherent in these estimates,making it reasonably possible that they could change. CHARGE-OFF AND NONACCRUAL POLICIES AND PRACTICES Our consumer charge-off andnonaccrual policies vary by product and are summarized below: CHARGE-OFF POLICIES AND NONACCRUAL POLICIES ANDPRODUCT PRACTICES PRACTICES(1)-------------------------------------------------------------------------------------------------Real estate secured(2) Carrying values in excess of Interest income accruals are net realizable value are suspended when principal or charged-off at or before the interest payments are more time foreclosure is completed than three months or when settlement is reached contractually past due and with the borrower. If resumed when the receivable foreclosure is not pursued becomes less than three months (which frequently occurs on contractually past due. loans in the second lien position) and there is no reasonable expectation for recovery (insurance claim, title claim, pre-discharge bankrupt account), generally the account will be charged- off no later than by the end of the month in which the account becomes eight months contractually delinquent.Auto finance(3)(5) Carrying values in excess of Interest income accruals are net realizable value are suspended and the portion of charged off at the earlier of previously accrued interest the following: expected to be uncollectible is written off when principal - the collateral has been payments are more than two repossessed and sold, months contractually past due and resumed when the - the collateral has been in receivable becomes less than our possession for more than two months contractually past 30 days (prior to December due. 2006, 90 days), or - the loan becomes 150 days contractually delinquent. Credit card(4) Generally charged-off by the Interest generally accrues end of the month in which the until charge-off. account becomes six months contractually delinquent. 130 CHARGE-OFF POLICIES AND NONACCRUAL POLICIES ANDPRODUCT PRACTICES PRACTICES(1)------------------------------------------------------------------------------------------------- Private label(4) Our domestic private label Interest generally accrues receivable portfolio until charge-off, except for (excluding retail sales retail sales contracts at our contracts at our Consumer Consumer Lending business. Lending business) was sold to Interest income accruals for HSBC Bank USA on December 29, retail sales contracts are 2004. Prior to December 2004, suspended when principal or receivables were generally interest payments are more charged-off the month than three months following the month in which contractually delinquent. the account became nine months After suspension, interest contractually delinquent. income is generally recorded However, receivables as collectible. originated through new domestic merchant relationships beginning in the fourth quarter of 2002 were charged off by the end of the month in which the account became six months contractually delinquent. Retail sales contracts at our Consumer Lending business generally charge-off the month following the month in which the account becomes nine months contractually delinquent and no payment is received in six months, but in no event to exceed 12 months contractually delinquent. Personal non-credit card(4) Generally charged-off the Interest income accruals are month following the month in suspended when principal or which the account becomes nine interest payments are more months contractually than three months delinquent and no payment contractually delinquent. For received in six months, but in PHLs, interest income accruals no event to exceed 12 months resume if the receivable contractually delinquent becomes less than three months (except in our United Kingdom contractually past due. For business which does not all other personal non- credit include a recency factor and, card receivables, interest prior to December 31, 2006, income is generally recorded may be longer). as collected. -------- (1) For our United Kingdom business, interest income accruals are suspended when principal or interest payments are more than three months contractually delinquent.(2) For our United Kingdom business, real estate secured carrying values in excess of net realizable value are charged-off at the time of sale.(3) Our Auto Finance charge-off policy was changed in December 2006. Prior to December 2006, carrying values in excess of net realizable value were charged-off at the earlier of: a) sale; b) the collateral having been in our possession for more than 90 days; or c) the loan becoming 150 days contractually delinquent. Charge-offs of $24 million were recorded in December 2006 to reflect this policy change. Our Canada business made a similar charge in March 2007. The impact to charge-off was not material.(4) For our United Kingdom business, delinquent MasterCard/Visa accounts (prior to their sale in December 2005) were charged-off the month following the month in which the account becomes six months contractually delinquent. Delinquent private label receivables in the United Kingdom are charged-off the month following the month in which the account becomes nine months contractually delinquent. Retail sales contracts in the United Kingdom for which bankruptcy notification has been received are charged off after five months of delinquency or in the month received if greater than five months delinquent at that time. For our Canada business, delinquent private label and personal non credit card receivables are charged off when no payment is received in six months but in no event is an account to exceed 12 months contractually delinquent.(5) For our Canada business, interest income accruals on auto loans are suspended and the portion of previously accrued interest expected to be uncollectible is written off when principal payments are more than three months contractually past due and resumed when the receivables become less than three months contractually past due. 131 Charge-off involving a bankruptcy for our domestic MasterCard and Visareceivables occurs by the end of the month 60 days after notification or 180days delinquent, whichever is sooner. For auto finance receivables, bankruptaccounts are charged off no later than the end of the month in which the loanbecomes 210 days contractually delinquent. RECEIVABLES SOLD AND SERVICED WITH LIMITED RECOURSE AND SECURITIZATION RELATEDREVENUE Prior to July 2004, certain auto finance, MasterCard and Visa andpersonal non-credit card receivables were securitized and sold to investors withlimited recourse. We retained the servicing rights to these receivables.Recourse is limited to our rights to future cash flow and any subordinatedinterest retained. Upon sale, these receivables were removed from the balancesheet and a gain on sale was recognized for the difference between the carryingvalue of the receivables and the adjusted sales proceeds. The adjusted salesproceeds include cash received and the present value estimate of future cashflows to be received over the lives of the sold receivables. Future cash flowswere based on estimates of prepayments, the impact of interest rate movements onyields of receivables and securities issued, delinquency of receivables sold,servicing fees and other factors. The resulting gain was also adjusted by aprovision for estimated probable losses under the recourse provisions. Thisprovision and the related reserve for receivables serviced with limited recoursewas established at the time of sale to cover all probable credit losses over-the-life of the receivables sold based on historical experience and estimates ofexpected future performance. The reserves are reviewed periodically byevaluating the estimated future cash flows of each securitized pool to ensurethat there is sufficient remaining cash flow to cover estimated future creditlosses. Any changes to the estimates for the reserve for receivables servicedwith limited recourse are made in the period they become known. Gains on salenet of recourse provisions, servicing income and excess spread relating tosecuritized receivables are reported in the accompanying consolidated statementsof income as securitization revenue. In connection with these transactions, an interest-only strip receivable wasrecorded, representing our contractual right to receive interest and other cashflows from our securitization trusts. Our interest-only strip receivables arereported at fair value using discounted cash flow estimates as a separatecomponent of receivables net of our estimate of probable losses under therecourse provisions. Cash flow estimates include estimates of prepayments, theimpact of interest rate movements on yields of receivables and securitiesissued, delinquency of receivables sold, servicing fees and estimated probablelosses under the recourse provisions. Unrealized gains and losses are recordedas adjustments to common shareholder's equity in accumulated other comprehensiveincome, net of income taxes. Our interest-only strip receivables are reviewedfor impairment quarterly or earlier if events indicate that the carrying valuemay not be recovered. Any decline in the fair value of the interest-only stripreceivable which is deemed to be other than temporary is charged against currentearnings. We have also, in certain cases, retained other subordinated interests in thesesecuritizations. Neither the interest-only strip receivables nor the othersubordinated interests are in the form of securities. In order to align our accounting treatment with that of HSBC initially underU.K. GAAP and now under International Financial Reporting Standards ("IFRS"),starting in the third quarter of 2004 we began to structure all newcollateralized funding transactions as secured financings. However, becauseexisting public credit card transactions were structured as sales to revolvingtrusts that require replenishments to support previously issued securities,receivables continued to be sold to these trusts until the revolving periodsended, the last of which occurred in the fourth quarter of 2007. PROPERTIES AND EQUIPMENT, NET Properties and equipment are recorded at cost, netof accumulated depreciation and amortization. As a result of our acquisition byHSBC, the amortized cost of our properties and equipment was adjusted to fairmarket value and accumulated depreciation and amortization on a "predecessor"basis was eliminated at the time of the acquisition. For financial reportingpurposes, depreciation is provided on a straight-line basis over the estimateduseful lives of the assets which generally range from 3 to 40 years. Leaseholdimprovements are amortized over the lesser of the economic useful life of theimprovement or the term of the lease. Maintenance and repairs are expensed asincurred. REPOSSESSED COLLATERAL Real estate owned is valued at the lower of cost or fairvalue less estimated costs to sell. These values are periodically reviewed andreduced, if necessary. Costs of holding real estate and related gains and losseson disposition are credited or charged to operations as incurred as a componentof operating expense. 132 Repossessed vehicles, net of loss reserves when applicable, are recorded at thelower of the estimated fair market value or the outstanding receivable balance. INSURANCE Insurance revenues on monthly premium insurance policies arerecognized when billed. Insurance revenues on the remaining insurance contractsare recorded as unearned premiums and recognized into income based on the natureand terms of the underlying contracts. Liabilities for credit insurance policiesare based upon estimated settlement amounts for both reported and incurred butnot yet reported losses. Liabilities for future benefits on annuity contractsand specialty and corporate owned life insurance products are based on actuarialassumptions as to investment yields, mortality and withdrawals. INTANGIBLE ASSETS Intangible assets consist of purchased credit cardrelationships and related programs, retail services merchant relationships,other loan related relationships, trade names, technology and customer lists.The trade names are not subject to amortization, as we believe they haveindefinite lives. The remaining intangible assets are being amortized over theirestimated useful lives either on a straight-line basis or in proportion to theunderlying revenues generated. These useful lives range from 5 years for retailservices merchant relationships to approximately 10 years for certain loanrelated relationships. Intangible assets are reviewed for impairment usingdiscounted cash flows annually, or earlier if events indicate that the carryingamounts may not be recoverable. We consider significant and long-term changes inindustry and economic conditions to be our primary indicator of potentialimpairment. Impairment charges, when required, are calculated using discountedcash flows. GOODWILL Goodwill represents the excess purchase price over the fair value ofidentifiable assets acquired less liabilities assumed from businesscombinations. Goodwill is not amortized, but is reviewed for impairment annuallyusing discounted cash flows but impairment may be reviewed earlier ifcircumstances indicate that the carrying amount may not be recoverable. Weconsider significant and long-term changes in industry and economic conditionsto be our primary indicator of potential impairment. DERIVATIVE FINANCIAL INSTRUMENTS All derivatives are recognized on the balancesheet at their fair value. At the inception of a hedging relationship, wedesignate the derivative as a fair value hedge, a cash flow hedge, or if thederivative does not qualify in a hedging relationship, a non-hedging derivative.Fair value hedges include hedges of the fair value of a recognized asset orliability and certain foreign currency hedges. Cash flow hedges include hedgesof the variability of cash flows to be received or paid related to a recognizedasset or liability and certain foreign currency hedges. Changes in the fairvalue of derivatives designated as fair value hedges, along with the change infair value on the hedged risk, are recorded in current period earnings. Changes in the fair value of derivatives designated as cash flow hedges, to theextent effective as a hedge, are recorded in accumulated other comprehensiveincome and reclassified into earnings in the period during which the hedged itemaffects earnings. Changes in the fair value of derivative instruments notdesignated as hedging instruments and ineffective portions of changes in thefair value of hedging instruments are recognized in other revenue as derivativeincome in the current period. Realized gains and losses as well as changes inthe fair value of derivative instruments associated with fixed rate debt we havedesignated at fair value are recognized in other revenues as Gain on debtdesignated at fair value and related derivatives in the current period. For derivative instruments designated as hedges, we formally document allrelationships between hedging instruments and hedged items. This documentationincludes our risk management objective and strategy for undertaking varioushedge transactions, as well as how hedge effectiveness and ineffectiveness willbe measured. This process includes linking derivatives to specific assets andliabilities on the balance sheet. We also formally assess, both at the hedge'sinception and on a quarterly basis, whether the derivatives that are used inhedging transactions are highly effective in offsetting changes in fair valuesor cash flows of hedged items. This assessment is conducted using statisticalregression analysis. When as a result of the quarterly assessment, it isdetermined that a derivative is not highly effective as a hedge or that it hasceased to be a highly effective hedge, we discontinue hedge accounting as of thebeginning of the quarter in which such determination was made. When hedge accounting is discontinued because it is determined that thederivative no longer qualifies as an effective hedge, the derivative willcontinue to be carried on the balance sheet at its fair value, with changes inits fair value recognized in current period earnings. For fair value hedges, theformerly hedged asset or liability will no longer be adjusted for changes infair value and any previously recorded adjustments to the carrying value of the 133 hedged asset or liability will be amortized in the same manner that the hedgeditem affects income. For cash flow hedges, amounts previously recorded inaccumulated other comprehensive income will be reclassified into income in thesame manner that the hedged item affects income. If the hedging instrument is terminated early, the derivative is removed fromthe balance sheet. Accounting for the adjustments to the hedged asset orliability or adjustments to accumulated other comprehensive income are the sameas described above when a derivative no longer qualifies as an effective hedge. If the hedged asset or liability is sold or extinguished, the derivative willcontinue to be carried on the balance sheet at its fair value, with changes inits fair value recognized in current period earnings. The hedged item, includingpreviously recorded mark-to-market adjustments, is derecognized immediately as acomponent of the gain or loss upon disposition. FOREIGN CURRENCY TRANSLATION We have foreign subsidiaries located in the UnitedKingdom and Canada. The functional currency for each foreign subsidiary is itslocal currency. Assets and liabilities of these subsidiaries are translated atthe rate of exchange in effect on the balance sheet date. Translationadjustments resulting from this process are accumulated in common shareholder'sequity as a component of accumulated other comprehensive income. Income andexpenses are translated at the average rate of exchange prevailing during theyear. Effects of foreign currency translation in the statements of cash flows areoffset against the cumulative foreign currency adjustment, except for the impacton cash. Foreign currency transaction gains and losses are included in income asthey occur. STOCK-BASED COMPENSATION We account for all of our stock based compensationawards including share options, restricted share awards and the employee stockpurchase plan using the fair value method of accounting under Statement ofFinancial Accounting Standards No. 123(Revised 2004), "Share-Based Payment"("SFAS 123(R)"). The fair value of the rewards granted is recognized as expenseover the vesting period, generally either three or four years for options andthree or five years for restricted share awards. The fair value of each optiongranted, measured at the grant date, is calculated using a binomial latticemethodology that is based on the underlying assumptions of the Black-Scholesoption pricing model. Compensation expense relating to restricted share awards is based upon themarket value of the share on the date of grant. INCOME TAXES HSBC Finance Corporation is included in HSBC North America'sconsolidated federal income tax return and in various state income tax returns.HSBC Finance Corporation has entered into tax allocation agreements with HSBCNorth America and its subsidiary entities included in the consolidated returnwhich govern the timing and amount of income tax payments required by thevarious entities. Generally, such agreements allocate taxes to members of theaffiliated group based on the calculation of tax on a separate return basis,adjusted for the utilization or limitation of credits of the consolidated group.In addition, HSBC Finance Corporation files some unconsolidated state taxreturns. Deferred tax assets and liabilities are determined based on differencesbetween financial reporting and tax bases of assets and liabilities and aremeasured using the enacted tax rates and laws that will be in effect. Investmenttax credits generated by leveraged leases are accounted for using the deferralmethod. Changes in estimates of the basis in our assets and liabilities or otherestimates recorded at the date of our acquisition by HSBC are adjusted againstgoodwill. TRANSACTIONS WITH RELATED PARTIES In the normal course of business, we enterinto transactions with HSBC and its subsidiaries. These transactions occur atprevailing market rates and terms and include funding arrangements, derivativeexecution, purchases and sales of receivables, servicing arrangements,information technology services, item processing and statement processingservices, banking and other miscellaneous services. NEW ACCOUNTING PRONOUNCEMENTS - In June 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 establishes threshold and measurement attributes for financial statement measurement and recognition of tax positions taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim 134 periods, disclosure and transition. The adoption of FIN 48 on January 1, 2007 did not have a material impact on our financial position or results of operations. See Note 15, "Income Taxes," for further discussion of the adoption of FIN 48. - In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, "Fair Value Measurements" ("SFAS No. 157"). SFAS 157 establishes a single authoritative definition of fair value, sets out a framework for measuring fair value, and requires additional disclosures about fair value measurements. We adopted SFAS 157 on January 1, 2007. The adoption of SFAS No. 157 did not have any impact on our financial position or results of operations. See Note 23, "Fair Value Measurements," for further discussion of SFAS No. 157. - In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS No. 159"), which creates an alternative measurement method for certain financial assets and liabilities. SFAS No. 159 permits fair value to be used for both the initial and subsequent measurements on a contract-by- contract election, with changes in fair value to be recognized in earnings as those changes occur. This election is referred to as the "fair value option". SFAS No. 159 also requires additional disclosures to compensate for the lack of comparability that will arise from the use of the fair value option. Effective January 1, 2007, we early adopted SFAS No. 159 for certain issuances of our fixed rate debt in order to align our accounting treatment with that of HSBC under IFRSs. Under IFRSs, an entity can only elect FVO accounting for financial assets and liabilities that meet certain eligibility criteria which are not present under SFAS No. 159. When we elected FVO reporting for IFRSs, in addition to certain fixed rate debt issuances which did not meet the eligibility criteria, there were also certain fixed rate debt issuances for which only a portion of the issuance met the eligibility criteria to qualify for FVO reporting. To align our U.S. GAAP and IFRSs accounting treatment, we have adopted SFAS No. 159 only for the fixed rate debt issuances which also qualify for FVO reporting under IFRSs. The following table presents information about the eligible instruments for which we elected FVO and for which a transition adjustment was recorded. BALANCE SHEET BALANCE SHEET JANUARY 1, JANUARY 1, 2007 2007 PRIOR TO ADOPTION NET GAIN (LOSS) AFTER ADOPTION OF FVO UPON ADOPTION OF FVO------------------------------------------------------------------------------------------------- (IN MILLIONS)Fixed rate debt designated at fair value... $(30,088) $(855) $(30,943) ======== ----- ========Pre-tax cumulative-effect of adoption of FVO...................................... (855)Increase in deferred tax asset............. 317 -----After-tax cumulative-effect of adoption of FVO adjustment to retained earnings...... $(538) ===== - In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, "Amendment of FASB Interpretation No. 39" ("FSP 39-1"). FSP 39-1 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 in accordance with FASB Interpretation No. 39. The guidance in FSP 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. Entities are required to recognize the effects of applying FSP 39-1 as a change in accounting principle through retrospective application for all financial statements presented unless it is impracticable to do so. We adopted FSP 39-1 during the second quarter of 2007 and retroactively applied its requirements to all prior periods as required by FSP 39-1. At December 31, 2007 and December 31, 2006, the fair value of derivatives included in derivative financial assets have been reduced by $3,794 million and $1,164 million, respectively, representing the payable recognized upon receipt of cash collateral for derivative instruments that have been offset under the same master netting arrangement in accordance with FSP 39-1. At December 31, 2007 and December 31, 2006, the fair value of derivatives included in derivative financial liabilities have been reduced by $51 million and $53 million, respectively, representing the receivable recognized upon payment of cash collateral for derivative instruments that have been offset under the same master netting arrangement in accordance with FSP 39-1. The adoption of FSP 39-1 had no impact on our results of operations or our cash flows. 135 - In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (Revised), "Business Combinations" ("SFAS No. 141(R)"). This replaces the guidance in Statement 141 which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. This statement requires an acquirer to recognize all the assets acquired, liabilities assumed and any noncontrolling interest in the acquiree at fair value as of the date of acquisition. SFAS No. 141(R) also changes the recognition and measurement criteria for certain assets and liabilities including those arising from contingencies, contingent consideration, and bargain purchases. SFAS No. 141(R) is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. - In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, "Noncontrolling Interests in Consolidated Financial Statements" ("SFAS No. 160"). This Statement amends ARB 51 and provides guidance on the accounting and reporting of noncontrolling interests in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 requires disclosure of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest on the face of the consolidated statement of income (loss). This Statement also requires expanded disclosures that identify and distinguish between parent and noncontrolling interests. SFAS No. 160 is effective from fiscal years beginning on or after December 15, 2008. We are currently evaluating the impact that SFAS No. 160 will have on our financial position or results of operations. 3. BUSINESS ACQUISITIONS AND DIVESTITURES-------------------------------------------------------------------------------- SALE OF U.K. INSURANCE OPERATIONS On November 1, 2007, we sold all of thecapital stock of our U.K. insurance operations ("U.K. Insurance Operations") toAviva plc and its subsidiaries for an aggregate purchase price of approximately$206 million in cash. The agreement also provides for the purchaser todistribute insurance products through our U.K. branch network for which we willreceive commission revenue. The assets consisted primarily of investments of$441 million, unearned credit insurance premiums and claim reserves on consumerreceivables of $(111) million and goodwill of $73 million at November 1, 2007.The liabilities consisted primarily of insurance reserves which totaled $207million at November 1, 2007. Aviva assumed all the liabilities of the U.K.Insurance Operations as a result of this transaction. In the first quarter of2007, we recorded an adjustment of $31 million as a component of total costs andexpenses to record our investment in these operations at the lower of cost ormarket. In the fourth quarter of 2007 we recorded a loss on sale of $4 millionfrom the true-up of the final purchase price. As we will continue to distributeinsurance products through our U.K. branch network and receive commissionrevenue, we have not reported this business as a discontinued operation inaccordance with SFAS No. 144, "Accounting for the Impairment or Disposal ofLong-Lived Assets." Our U.K. Insurance Operations are reported in theInternational Segment. The following summarizes the operating results of our U.K. Insurance Operationsfor the periods presented: PERIOD ENDED YEAR ENDED YEAR ENDED NOVEMBER 1, DECEMBER 31, DECEMBER 31, 2007 2006 2005--------------------------------------------------------------------------------------------- (IN MILLIONS)Insurance revenue................................ $556 $1,050 $1,161Policyholders' benefits.......................... 181 188 202Income (loss) before income tax expense.......... 42 (11) (24) SALE OF EUROPEAN OPERATIONS On November 9, 2006, as part of our continuingevaluation of strategic alternatives with respect to our U.K. and Europeanoperations, we sold all of the capital stock of our operations in the CzechRepublic, Hungary, and Slovakia (the "European Operations") to a wholly ownedsubsidiary of HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, for anaggregate purchase price of approximately $46 million. The assets consistedprimarily of $199 million of receivables and goodwill which totaledapproximately $13 million at November 9, 2006. The liabilities consistedprimarily of debt which totaled $179 million at November 9, 2006. HBEU assumedall the liabilities of the European Operations as a result of this transaction.Because the sale of this business is between affiliates under common control,the premium received in excess of the book value of the stock transferred of $13million, including the goodwill assigned to this business, was recorded as anincrease to 136 additional paid-in capital and will not be reflected in earnings. Our EuropeanOperations are reported in the International Segment. ACQUISITION OF SOLSTICE CAPITAL GROUP INC ("SOLSTICE") On October 4, 2006 ourConsumer Lending business purchased Solstice with assets of approximately $49million, in an all cash transaction for approximately $50 million. Solstice's2007 pre-tax income did not meet the required threshold requiring payment ofadditional consideration. Solstice markets a range of mortgage and home equityproducts to customers through direct mail. The results of Solstice are includedin our consolidated financial statements beginning October 4, 2006. ACQUISITION OF METRIS COMPANIES INC. On December 1, 2005, we acquired theoutstanding capital stock of Metris Companies Inc. ("Metris"), a provider offinancial products and services to middle market consumers throughout the UnitedStates, in an all-cash transaction for $1.6 billion. HSBC Investments (NorthAmerica) Inc. ("HINO") made a capital contribution of $1.2 billion to fund aportion of the purchase price. This acquisition expanded our presence in thenear-prime credit card market and strengthened our capabilities to serve thefull spectrum of credit card customers. The results of Metris are included inour consolidated financial statements beginning December 1, 2005. The purchase price was allocated to the assets and liabilities acquired based ontheir estimated fair values at the acquisition date. These preliminary fairvalues were estimated, in part, based on third party valuation data. Goodwillassociated with the Metris acquisition is not tax deductible. In the thirdquarter of 2006, we made an adjustment to our estimated fair value related toMetris following an adverse judgment in litigation involving Metris thatpreceded the merger. This adjustment resulted in a net increase to goodwill ofapproximately $25 million. Since the one-year anniversary of the Metrisacquisition was completed during the fourth quarter of 2006, no furtheracquisition-related adjustments to the purchase price will occur, except forchanges in estimates for the tax basis in our assets and liabilities or othertax estimates recorded at the date of the Metris acquisition pursuant toStatement of Financial Accounting Standards No. 109, "Accounting for IncomeTaxes." SALE OF U.K. CREDIT CARD BUSINESS In December 2005, we sold our U.K. credit cardbusiness, including $2.5 billion of receivables, the associated cardholderrelationships and the related retained interests in securitized credit cardreceivables to HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, for anaggregate purchase price of $3.0 billion. The purchase price, which wasdetermined based on a comparative analysis of sales of other credit cardportfolios, was paid in a combination of cash and $261 million of preferredstock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR,plus 1.30 percent. In addition to the assets referred to above, the sale alsoincluded the account origination platform, including the marketing and creditemployees associated with this function, as well as the lease associated withthe credit card call center and the related leaseholds and call center employeesto provide customer continuity after the transfer as well as to allow HBEUdirect ownership and control of origination and customer service. We haveretained the collection operations related to the credit card operations andhave entered into a service level agreement to provide collection services andother support services, including components of the compliance, financialreporting and human resource functions, for the sold credit card operations toHBEU for a fee. As a result of our continued involvement in this business, wehave not reported this business as a discontinued operation in accordance withSFAS No. 144. Because the sale of this business is between affiliates undercommon control, the premium received in excess of the book value of the assetstransferred of $182 million, including the goodwill assigned to this business,was recorded as an increase to additional paid in capital and has not beenincluded in earnings. As a result of this sale, our net interest income, feeincome and provision for credit losses related to the U.K. credit card businesshas been reduced, while other income has increased by the receipt of servicingand support services revenue from HBEU. The net effect of this sale did notresult in a material reduction of net income of our consolidated results. 4. RESTRUCTURING ACTIVITIES-------------------------------------------------------------------------------- We have completed several specific strategic reviews to ensure that ouroperations and product offerings continue to provide our customers with the mostvalue-added products and maximize risk adjusted returns to HSBC. When coupledwith the unprecedented developments in the mortgage industry in recent months,we have taken specific actions which we believe are in the best interests of ourstakeholders and will best position us for long-term success. 137 MORTGAGE SERVICES BUSINESS Our Mortgage Services business, which is part of ourConsumer Segment, has historically purchased non-conforming first and secondlien real estate secured loans from a network of unaffiliated third partylenders (i.e. correspondents) based on our underwriting standards. Our MortgageServices business has included the operations of Decision One Mortgage Company("Decision One") which has historically originated mortgage loans sourced byindependent mortgage brokers and sold such loans to secondary market purchasers,including Mortgage Services. Early in 2007, we decided to discontinue thecorrespondent channel acquisitions of our Mortgage Services business and in June2007 decided to limit Decision One's activities to the origination of loansprimarily for resale to the secondary market operations of our affiliates. As aresult of the decision to discontinue correspondent channel acquisitions, werecorded $5 million of one-time termination and other employee benefits, whichare included as a component of Salaries and employee benefits in theconsolidated statement of income (loss). These severance costs have been fullypaid to the affected employees and no further costs resulting from this decisionare anticipated. In the third quarter of 2007, the unprecedented developments in the mortgagelending industry resulted in a marked reduction in the secondary market demandfor subprime loans. Management concluded that a recovery of a secondary marketfor subprime loans was uncertain and at a minimum could not be expected tostabilize in the near term. As a result of the continuing deterioration in thesubprime mortgage lending industry, in September 2007, we announced that ourDecision One operations would cease. Additionally, we have begun closing ourMortgage Services' business headquarter offices in Fort Mill, South Carolina.The impact of the decision to close our Decision One operations, when coupledwith the previous decision related to discontinuing correspondent channelacquisitions resulted in the impairment of the goodwill allocated to theMortgage Services business. As a result, in the third quarter of 2007 werecorded a goodwill impairment charge of $881 million which represents all ofthe goodwill previously allocated to the Mortgage Services business. Inaddition, we recorded $14 million related to one-time termination and otheremployee benefits and $25 million of lease termination and associated costsrelating to the closing of Decision One, which is included as a component ofOccupancy and equipment expense in the consolidated statement of income (loss).The following summarizes the restructure liability in our Mortgage Servicesbusiness at December 31, 2007: ONE-TIME TERMINATION AND LEASE TERMINATION OTHER EMPLOYEE AND ASSOCIATED BENEFITS COSTS TOTAL---------------------------------------------------------------------------------------------- (IN MILLIONS)Restructuring costs recorded in 2007............. $ 19 $25 $ 44Restructuring costs paid during 2007............. (13) (4) (17) ---- --- ----Restructure liability at December 31, 2007....... $ 6 $21 $ 27 ==== === ==== We currently estimate an additional $3 million of one-time termination and otheremployee benefits associated with these activities will be recorded during 2008.Additionally in 2007, we recorded an $11 million non-cash charge as a componentof Occupancy and equipment expense in the consolidated statement of income(loss) relating to the write-off of certain fixed assets of our MortgageServices business which could not be used elsewhere in our operations. While ourMortgage Services business is currently operating in a run-off mode, we have notreported this business as a discontinued operation because of our continuinginvolvement. CONSUMER LENDING BUSINESS In the fourth quarter of 2007, we took several actionsin our Consumer Lending business, which is part of our Consumer Segment, toreduce risk including: the discontinuation of the Personal Homeowner Loanproduct, the elimination of guaranteed direct mail loans to new customers,reduction in loan-to-value ratios for both first and second lien loans,tightened underwriting criteria for first lien loans and for personal non-creditcard loans and eliminated the small volume of ARM loan originations. As theseactions will significantly reduce loan origination volumes going forward, webegan to evaluate the appropriate scope and geographic distribution of theConsumer Lending branch network and in the fourth quarter of 2007 we decided toreduce the size of the Consumer Lending network to approximately 1,000 branches.The right sizing of the branch network has also resulted in realignment ofstaffing in our Consumer Lending corporate functions. In 2007, we recorded $8million of one-time termination and other employee benefits and $17 million oflease termination and associated 138 costs as a result of the branch closures. The following summarizes therestructuring liability in our Consumer Lending business at December 31, 2007: ONE-TIME TERMINATION AND LEASE TERMINATION OTHER EMPLOYEE AND ASSOCIATED BENEFITS COSTS TOTAL---------------------------------------------------------------------------------------------- (IN MILLIONS)Restructuring costs recorded in 2007............. $ 8 $17 $25Restructuring costs paid during 2007............. (1) (3) (4) --- --- ---Restructure liability at December 31, 2007....... $ 7 $14 $21 === === === Additionally in 2007, we recorded a $6 million non-cash charge as a component ofOccupancy and equipment expense in the consolidated statement of income (loss)relating to the write-off of certain fixed assets in the closed Consumer Lendingbranches which could not be used elsewhere in our operations. No further costsresulting from this decision are anticipated. FACILITY IN CARMEL, INDIANA In the third quarter of 2007, we also decided toclose our loan underwriting, processing and collections center in Carmel,Indiana (the "Carmel Facility") to optimize our facility and staffing capacitygiven the overall reductions in business volumes. The Carmel Facility providedloan underwriting, processing and collection activities for the operations ofour Consumer Lending and Mortgage Services business, both of which are includedin our Consumer Segment. The collection activities performed in the CarmelFacility have been redeployed to other facilities in our Consumer Lendingbusiness. As a result of the decision to close the Carmel Facility, in 2007 werecorded $5 million of one-time termination and other employee benefits and $2million of lease termination and associated costs. At December 31, 2007, theoutstanding restructure liability related to the closure of the Carmel Facilitywas $6 million. No further costs resulting from this decision are anticipated. CANADIAN BUSINESS During the fourth quarter of 2007, we tightened underwritingcriteria for various real estate and unsecured products in our Canadianbusiness, which is part of our International Segment, which resulted in lowervolumes and decided to reduce the mortgage operations in Canada which closedloans sourced through brokers. As a result, we closed 29 branches prior toNovember 1, 2007. In 2007, we recorded $5 million related to one-timetermination and other employee benefits and $8 million of lease termination andassociated costs. No further costs resulting from this decision are anticipated.The following summarizes the restructure liability at December 31, 2007 for ourCanadian Business: ONE-TIME TERMINATION AND LEASE TERMINATION OTHER EMPLOYEE AND ASSOCIATED BENEFITS COSTS TOTAL---------------------------------------------------------------------------------------------- (IN MILLIONS)Restructuring costs recorded in 2007............. $ 5 $ 8 $13Restructuring costs paid during 2007............. (4) (4) (8) --- --- ---Restructure liability at December 31, 2007....... $ 1 $ 4 $ 5 === === === The following table summarizes for all restructuring activities the costsrecorded during 2007: ONE-TIME TERMINATION AND LEASE TERMINATION OTHER EMPLOYEE AND ASSOCIATED FIXED ASSET BENEFITS COSTS WRITE-OFF TOTAL---------------------------------------------------------------------------------------------------- (IN MILLIONS)RESTRUCTURING COSTS RECORDED IN 2007 Mortgage Services...................... $19 $25 $11 $ 55 Consumer Lending....................... 8 17 6 31 Carmel Facility........................ 5 2 - 7 Canadian Business...................... 5 8 - 13 --- --- --- ---- $37 $52 $17 $106 === === === ==== 139 5. SECURITIES-------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRDECEMBER 31, 2007 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------- (IN MILLIONS)Corporate debt securities...................... $2,173 $18 $(28) $2,163Money market funds............................. 194 - - 194U.S. government sponsored enterprises(1)....... 253 2 (2) 253U.S. government and Federal agency debt securities................................... 37 1 - 38Non-government mortgage backed securities...... 208 - (3) 205Other.......................................... 274 1 (9) 266 ------ --- ---- ------Subtotal....................................... 3,139 22 (42) 3,119Accrued investment income...................... 33 - - 33 ------ --- ---- ------Total securities available for sale............ $3,172 $22 $(42) $3,152 ====== === ==== ====== GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRDECEMBER 31, 2006 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------- (IN MILLIONS)Corporate debt securities...................... $2,530 $11 $(40) $2,501Money market funds............................. 1,051 - - 1,051U.S. government sponsored enterprises(1)....... 369 1 (3) 367U.S. government and Federal agency debt securities................................... 43 - (1) 42Non-government mortgage backed securities...... 271 - - 271Other.......................................... 428 - (3) 425 ------ --- ---- ------Subtotal....................................... 4,692 12 (47) 4,657Accrued investment income...................... 38 - - 38 ------ --- ---- ------Total securities available for sale............ $4,730 $12 $(47) $4,695 ====== === ==== ====== -------- (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Proceeds from the sale of available-for-sale investments totaled approximately$.2 billion in 2007, $.5 billion in 2006 and $.4 billion in 2005. We realizedgross gains of $1 million in 2007, $125 million in 2006 and $12 million in 2005.We realized gross losses of $2 million in 2007, $2 million in 2006 and $12million in 2005. Money market funds at December 31, 2006 include $854 million which is restrictedfor the sole purpose of paying down certain secured financings at theestablished payment date. There were no restricted money market funds atDecember 31, 2007. 140 A summary of gross unrealized losses and related fair values as of December 31,2007 and 2006, classified as to the length of time the losses have existed arepresented in the following tables: LESS THAN ONE YEAR GREATER THAN ONE YEAR ----------------------------------------- ----------------------------------------- GROSS AGGREGATE GROSS AGGREGATE NUMBER OF UNREALIZED FAIR VALUE OF NUMBER OF UNREALIZED FAIR VALUE OFDECEMBER 31, 2007 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS--------------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Corporate debt securities... 146 $(8) $445 340 $(20) $798U.S. government sponsored enterprises............... 3 -((1)) 15 38 (2) 75U.S. government and Federal agency debt securities.... - - - 4 -(1) 9Non-government mortgage..... 8 (1) 52 9 (2) 32Other....................... 46 (9) 79 35 -(1) 94 LESS THAN ONE YEAR GREATER THAN ONE YEAR ----------------------------------------- ----------------------------------------- GROSS AGGREGATE GROSS AGGREGATE NUMBER OF UNREALIZED FAIR VALUE OF NUMBER OF UNREALIZED FAIR VALUE OFDECEMBER 31, 2006 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS--------------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Corporate debt securities... 133 $(6) $465 511 $(34) $1,178U.S. government sponsored enterprises............... 30 -(1) 101 43 (3) 149U.S. government and Federal agency debt securities.... 8 -(1) 21 20 (1) 16Non-government mortgage..... 10 -(1) 60 9 - 7Other....................... 16 -(1) 57 52 (3) 173 -------- (1) Less than $500 thousand. The gross unrealized losses on our securities available for sale have remainedrelatively stable in 2007 as decreases in interest rates during the year werelargely offset by the impact of wider credit spreads. The contractual terms ofthese securities do not permit the issuer to settle the securities at a priceless than the par value of the investment. Since substantially all of thesesecurities are rated A- or better, and because we have the ability and intent tohold these investments until maturity or a market price recovery, thesesecurities are not considered other-than temporarily impaired. The amortized cost of our securities available for sale was adjusted to fairmarket value at the time of the merger with HSBC. See Note 23, "Fair ValueMeasurements," for further discussion of the relationship between the fair valueof our assets and liabilities. 141 Contractual maturities of and yields on investments in debt securities for thosewith set maturities were as follows: AT DECEMBER 31, 2007 ---------------------------------------------------- DUE AFTER 1 AFTER 5 WITHIN BUT WITHIN BUT WITHIN AFTER 1 YEAR 5 YEARS 10 YEARS 10 YEARS TOTAL------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS)Corporate debt securities: Amortized cost.......................... $ 463 $ 875 $ 248 $ 587 $2,173 Fair value.............................. 462 880 247 574 2,163 Yield(1)................................ 4.90% 4.74% 5.07% 5.52% 5.02%U.S. government sponsored enterprises: Amortized cost.......................... $ 15 $ 10 $ 55 $ 173 $ 253 Fair value.............................. 15 9 55 174 253 Yield(1)................................ 3.31% 6.17% 5.19% 5.06% 5.03%U.S. government and Federal agency debt securities: Amortized cost.......................... $ 11 $ 3 $ 12 $ 11 $ 37 Fair value.............................. 11 4 12 11 38 Yield(1)................................ 3.89% 4.86% 4.32% 4.69% 4.36% -------- (1) Computed by dividing annualized interest by the amortized cost of respective investment securities. 6. RECEIVABLES-------------------------------------------------------------------------------- Receivables consisted of the following: AT DECEMBER 31, ------------------- 2007 2006---------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured.......................................... $ 88,661 $ 97,885Auto finance................................................. 13,257 12,504Credit card.................................................. 30,390 27,714Private label................................................ 3,093 2,509Personal non-credit card..................................... 20,649 21,367Commercial and other......................................... 144 181 -------- --------Total receivables............................................ 156,194 162,160HSBC acquisition purchase accounting fair value adjustments.. (76) (60)Accrued finance charges...................................... 2,526 2,228Credit loss reserve for owned receivables.................... (10,905) (6,587)Unearned credit insurance premiums and claims reserves....... (286) (412)Interest-only strip receivables.............................. - 6Amounts due and deferred from receivable sales............... 2 51 -------- --------Total receivables, net....................................... $147,455 $157,386 ======== ======== HSBC acquisition purchase accounting fair value adjustments representadjustments which have been "pushed down" to record our receivables at fairvalue at the date of acquisition by HSBC. Loans held for sale to external parties in our Mortgage Services business net ofthe underlying valuation allowance totaled $71 million at December 31, 2007 and$1.7 billion at December 31, 2006. Our Consumer Lending business had loans heldfor sale net of the underlying valuation allowance totaling $9 million atDecember 31, 2007 and 142 $32 million at December 31, 2006 relating to its subsidiary, Solstice CapitalGroup Inc. ("Solstice"). Loans held for sale are included in receivables andcarried at the lower of cost or market. In November 2007, we sold our U.K. Insurance operations, including $111 millionof unearned credit insurance premiums and claims reserves to Aviva. See Note 3,"Business Acquisitions and Divestitures," for additional information regardingthese sales. In November 2006, we acquired $2.5 billion of real estate secured receivablesfrom Champion Mortgage ("Champion") a division of KeyBank, N.A. and as part ofour acquisition of Metris on December 1, 2005, we acquired $5.3 billion ofreceivables. These receivables acquired were subject to the requirements ofStatement of Position 03-3, "Accounting for Certain Loans or Debt SecuritiesAcquired in a Transfer" ("SOP 03-3") to the extent there was evidence ofdeterioration of credit quality since origination and for which it was probable,at acquisition, that all contractually required payments would not be collectedand that the associated line of credit had been closed. The carrying amount ofChampion real estate secured receivables subject to the requirements of SOP 03-3was $73 million at December 31, 2007 and $116 million at December 31, 2006 andis included in the real estate secured receivables in the table above. Theoutstanding contractual balance of these receivables was $92 million at December31, 2007 and $143 million at December 31, 2006. At December 31, 2007, no creditloss reserve for the acquired receivables subject to SOP 03-3 has beenestablished as there has been no decrease to the expected future cash flowssince the acquisition. There was a reclassification to accretable yield fromnon-accretable difference during 2007 representing an increase to the estimatedcash flows to be collected on the underlying Champion portfolio. As part of our acquisition of Metris on December 1, 2005, we acquired $5.3billion of receivables. The carrying amount of the credit card receivables whichwere subject to SOP 03-3 was $105 million at December 31, 2007 and $223 millionat December 31, 2006 and is included in the credit card receivables in the tableabove. The outstanding contractual balance of these receivables was $159 millionat December 31, 2007 and $334 million at December 31, 2006. At December 31,2007, no credit loss reserve for the acquired receivables subject to SOP 03-3has been established as there has been no decrease to the expected future cashflows since the acquisition. There was a reclassification to accretable yieldfrom non-accretable difference during 2007 and 2006. This reclassification fromnon-accretable difference represents an increase to the estimated cash flows tobe collected on the underlying Metris portfolio. The following summarizes the accretable yield on Metris and Champion receivablesat December 31, 2007 and 2006: YEAR ENDED DECEMBER 31, ------------ 2007 2006-------------------------------------------------------------------------------- (IN MILLIONS)Accretable yield at beginning of period........................... $(76) $(122)Accretable yield additions during the period...................... - (19)Accretable yield amortized to interest income during the period... 49 100Reclassification from non-accretable difference................... (9) (35) ---- -----Accretable yield at end of period................................. $(36) $ (76) ==== ===== 143 Real estate secured receivables are comprised of the following: AT DECEMBER 31, ----------------- 2007 2006--------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured: Closed-end: First lien............................................... $71,459 $78,024 Second lien.............................................. 13,672 15,091 Revolving: First lien............................................... 436 556 Second lien.............................................. 3,094 4,214 ------- ------- Total real estate secured receivables....................... $88,661 $97,885 ======= ======= Foreign receivables included in receivables were as follows: AT DECEMBER 31, --------------------------------------------------- UNITED KINGDOM AND THE REST OF EUROPE CANADA ------------------------ ------------------------ 2007 2006 2005 2007 2006 2005-------------------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured.................... $1,943 $1,786 $1,654 $2,257 $1,766 $1,380Auto finance........................... - - - 358 311 270Credit card............................ - - - 299 215 147Private label.......................... 1,513 1,333 1,330 1,433 887 834Personal non-credit card............... 1,804 2,425 3,038 800 697 607Commercial and other................... - - - - - - ------ ------ ------ ------ ------ ------Total.................................. $5,260 $5,544 $6,022 $5,147 $3,876 $3,238 ====== ====== ====== ====== ====== ====== Foreign receivables represented 7 percent of receivables at December 31, 2007and 6 percent of receivables at December 31, 2006. Receivables serviced with limited recourse consisted of the following: AT DECEMBER 31, ----------- 2007 2006------------------------------------------------------------------------------- (IN MILLIONS)Auto finance...................................................... $ - $271Credit card....................................................... 124 500Personal non-credit card.......................................... - 178 ---- ----Total............................................................. $124 $949 ==== ==== We maintain facilities with third parties which provide for the securitizationor secured financing of receivables on both a revolving and non-revolving basistotaling $17.4 billion, of which $11.2 billion were utilized at December 31,2007. The amount available under these facilities will vary based on the timingand volume of public securitization or secured financing transactions and ourgeneral liquidity plans. 144 Contractual maturities of our receivables were as follows: AT DECEMBER 31, 2007 -------------------------------------------------------------------- 2008 2009 2010 2011 2012 THEREAFTER TOTAL-------------------------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured......... $ 718 $ 515 $ 464 $ 517 $ 731 $85,716 $ 88,661Auto finance................ 3,287 2,960 2,616 2,163 1,501 730 13,257Credit card................. 24,057 4,587 1,227 356 110 53 30,390Private label............... 1,482 529 416 323 191 152 3,093Personal non-credit card.... 2,971 1,958 2,917 4,542 4,411 3,850 20,649Commercial and other........ - - 20 52 - 72 144 ------- ------- ------ ------ ------ ------- --------Total....................... $32,515 $10,549 $7,660 $7,953 $6,944 $90,573 $156,194 ======= ======= ====== ====== ====== ======= ======== A substantial portion of consumer receivables, based on our experience, will berenewed or repaid prior to contractual maturity. The above maturity scheduleshould not be regarded as a forecast of future cash collections. The following table summarizes contractual maturities of receivables due afterone year by repricing characteristic: AT DECEMBER 31, 2007 -------------------- OVER 1 BUT WITHIN OVER 5 YEARS 5 YEARS----------------------------------------------------------------------------------- (IN MILLIONS)Receivables at predetermined interest rates.................. $26,877 $70,374Receivables at floating or adjustable rates.................. 6,229 20,199 ------- -------Total........................................................ $33,106 $90,573 ======= ======= Nonaccrual consumer receivables totaled $7.6 billion (including $439 millionrelating to foreign operations) at December 31, 2007 and $4.8 billion (including$482 million relating to foreign operations) at December 31, 2006. Interestincome that would have been recorded if such nonaccrual receivables had beencurrent and in accordance with contractual terms was approximately $961 million(including $64 million relating to foreign operations) in 2007 and $639 million(including $72 million relating to foreign operations) in 2006. Interest incomethat was included in finance and other interest income prior to these loansbeing placed on nonaccrual status was approximately $520 million (including $31million relating to foreign operations) in 2007 and $338 million (including $36million relating to foreign operations) in 2006. For an analysis of reserves forcredit losses, see our "Analysis of Credit Loss Reserves Activity" inManagement's Discussion and Analysis and Note 7, "Credit Loss Reserves." 145 Provision for credit losses on consumer loans for which we have modified theterms of the loan as part of a troubled debt restructuring ("TDR Loans") aredetermined in accordance with SFAS No. 114, "Accounting by Creditors forImpairment of a Loan" ("SFAS No. 114"). Interest income on TDR Loans isrecognized in the same manner as loans which are not TDRs. The following tablepresents information about our TDR Loans: AT DECEMBER 31, --------------- 2007 2006--------------------------------------------------------------------------------- (IN MILLIONS)TDR Loans:Real estate secured: Mortgage Services............................................. $1,531 $ 107 Consumer Lending.............................................. 730 634 Foreign and all other......................................... 95 79 ------ ------Total real estate secured....................................... 2,356 820Auto finance.................................................... 144 176Credit card..................................................... 329 308Private label................................................... 5 7Personal non-credit card........................................ 862 908Commercial and other............................................ - 1 ------ ------Total TDR Loans................................................. $3,696 $2,220 ====== ======Credit loss reserves for TDR Loans:Real estate secured: Mortgage Services............................................. $ 84 $ 16 Consumer Lending.............................................. 65 55 Foreign and all other......................................... 28 24 ------ ------Total real estate secured....................................... 177 95Auto finance.................................................... 29 41Credit card..................................................... 56 62Private label................................................... 1 2Personal non-credit card........................................ 232 282Commercial and other............................................ - 1 ------ ------Total credit loss reserves for TDR Loans(1)..................... $ 495 $ 483 ====== ====== YEAR ENDED DECEMBER 31, ----------------------- 2007 2006 2005----------------------------------------------------------------------------------- (IN MILLIONS)Average balance of TDR Loans.............................. $2,850 $2082 $1,992Interest income recognized on TDR Loans................... 163 97 95 -------- (1) Included in credit loss reserves. Interest-only strip receivables are reported net of our estimate of probablelosses under the recourse provisions for receivables serviced with limitedrecourse. Reductions to our interest-only strip receivables in 2007 reflect theimpact of reduced securitization levels, including our decision in 2004 tostructure new collateralized funding transactions as secured financings. Amounts due and deferred from receivable sales include assets established forcertain receivable sales, including funds deposited in spread accounts, and netcustomer payments due from (to) the securitization trustee. 146 We issued securities backed by dedicated home equity loan receivables of $3.3billion in 2007 and $4.8 billion in 2006. We issued securities backed bydedicated auto finance loan receivables of $1.6 billion in 2007 and $2.8 billionin 2006. We issued securities backed by dedicated credit card receivables of$4.2 billion in 2007 and $4.8 billion in 2006. We issued securities backed bydedicated personal non-credit card receivables of $1.3 billion in 2007. Foraccounting purposes, these transactions were structured as secured financings,therefore, the receivables and the related debt remain on our balance sheet.Additionally, as part of the Metris acquisition in 2005, we assumed $4.6 billionof securities backed by credit card receivables which were accounted for assecured financings. Real estate secured receivables included closed-end realestate secured receivables totaling $10.5 billion at December 31, 2007 and $9.7billion at December 31, 2006 that secured the outstanding debt related to thesetransactions. Auto finance receivables totaling $4.9 billion at December 31,2007 and $6.0 billion at December 31, 2006 secured the outstanding debt relatedto these transactions. Credit card receivables totaling $11.5 billion atDecember 31, 2007 and $8.9 billion at December 31, 2006 secured the outstandingdebt related to these transactions. Personal non-credit card receivables of $4.0billion at December 31, 2007 and $3.5 billion at December 31, 2006 secured theoutstanding debt related to these transactions. 7. CREDIT LOSS RESERVES-------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: AT DECEMBER 31, --------------------------- 2007 2006 2005------------------------------------------------------------------------------------- (IN MILLIONS)Credit loss reserves at beginning of period............. $ 6,587 $ 4,521 $ 3,625Provision for credit losses............................. 11,026 6,564 4,543Charge-offs............................................. (7,606) (5,164) (4,100)Recoveries.............................................. 890 645 447Other, net.............................................. 8 21 6 ------- ------- -------Credit loss reserves at end of period................... $10,905 $ 6,587 $ 4,521 ------- ------- ------- Further analysis of credit quality and credit loss reserves is presented in Item7, "Management's Discussion and Analysis of Financial Condition and Results ofOperations" of Form 10-K under the caption "Credit Quality." 8. ASSET SECURITIZATIONS-------------------------------------------------------------------------------- We have sold receivables in various securitization transactions. We continue toservice and receive servicing fees on the outstanding balance of thesesecuritized receivables. We also retain rights to future cash flows arising fromthese receivables after the investors receive their contractual return. We havealso, in certain cases, retained other subordinated interests in thesesecuritizations. These transactions result in the recording of an interest-onlystrip receivable which represents the value of the future residual cash flowsfrom securitized receivables. The investors and the securitization trusts haveonly limited recourse to our assets for failure of debtors to pay. That recourseis limited to our rights to future cash flow and any subordinated interest weretain. Servicing assets and liabilities are not recognized in conjunction withour securitizations since we receive adequate compensation relative to currentmarket rates to service the receivables sold. See Note 2, "Summary ofSignificant Accounting Policies," for further discussion on our accounting forinterest-only strip receivables. In the third quarter of 2004, we began to structure all new collateralizedfunding transactions as secured financings. However, because existing publiccredit card transactions were structured as sales to revolving trusts thatrequire replenishments of receivables to support previously issued securities,receivables continued to be sold to these trusts until the revolving periodsended, the last of which occurred in September of 2007. Our remainingsecuritized receivable credit card trust began its amortization period inOctober 2007 and was completely amortized in January 2008. Securitization related revenue includes income associated with the current andprior period securitization of receivables with limited recourse structured assales. Such income includes gains on sales, net of our estimate of 147 probable credit losses under the recourse provisions, servicing income andexcess spread relating to those receivables. Securitization related revenue is summarized in the table below: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005---------------------------------------------------------------------------------------------Net initial gains................................ $ - $ - $ -Net replenishment gains(1)....................... 24 30 154Servicing revenue and excess spread.............. 46 137 57 --- ---- ----Total securitization related revenue............. $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. Certain securitization trusts, such as credit cards, are established at fixedlevels and require frequent sales of new receivables into the trust to replacereceivable run-off. These replenishments totaled $1.5 billion in 2007, $2.5billion in 2006 and $8.8 billion in 2005. Cash flows received from securitization trusts were as follows: PERSONAL AUTO CREDIT NON-CREDITYEAR ENDED DECEMBER 31, FINANCE CARD CARD TOTAL-------------------------------------------------------------------------------------------2007Servicing fees received............................. $ 3 $ 10 $ 1 $ 14Other cash flow received on retained interests(1)... 44 50 - 942006Servicing fees received............................. $16 $ 22 $10 $ 48Other cash flow received on retained interests(1)... 97 108 18 2232005Servicing fees received............................. $45 $ 97 $46 $188Other cash flow received on retained interests(1)... 40 243 52 335 -------- (1) Other cash flows include all cash flows from interest-only strip receivables, excluding servicing fees. At December 31, 2007, the sensitivity of the current fair value of the interest-only strip receivables to an immediate 10 percent and 20 percent unfavorablechange in assumptions used to measure the fair value would be less than $100thousand. These sensitivities are hypothetical and the effect of a variation ina particular assumption on the fair value of the residual cash flow iscalculated independently from any change in another assumption. In reality,changes in one factor may contribute to changes in another (for example,increases in market interest rates may result in lower prepayments) which mightmagnify or counteract the sensitivities. 148 Receivables and two-month-and-over contractual delinquency for our owned andserviced with limited recourse receivables were as follows: AT DECEMBER 31, ----------------------------------------------------- 2007 2006 ------------------------- ------------------------- RECEIVABLES DELINQUENT RECEIVABLES DELINQUENT OUTSTANDING RECEIVABLES OUTSTANDING RECEIVABLES-------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)OWNED RECEIVABLES: Real estate secured...................... $ 88,661 7.08% $ 97,885 3.54% Auto finance............................. 13,257 3.67 12,504 3.18 Credit card.............................. 30,390 5.77 27,714 4.57 Private label............................ 3,093 4.26 2,509 5.31 Personal non-credit card................. 20,649 14.13 21,367 10.17 Other(1)................................. 13 - 15 3.01 -------- ----- -------- ----- Total consumer........................... 156,063 7.41 161,994 4.59 Commercial............................... 131 - 166 - -------- ----- -------- -----Total owned receivables.................... $156,194 7.40% $162,160 4.58% ======== ===== ======== =====RECEIVABLES SERVICED WITH LIMITED RECOURSE: Auto finance............................. $ - -% $ 271 6.64% Credit card.............................. 124 2.42 500 2.00 Personal non-credit card................. - - 178 14.61 -------- ----- -------- -----Total receivables serviced with limited recourse................................. $ 124 2.42% $ 949 5.69% ======== ===== ======== ===== -------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. Average receivables and net charge-offs for our owned and serviced with limitedrecourse receivables were as follows: YEAR ENDED DECEMBER 31, ----------------------------------------------------- 2007 2006 AVERAGE NET AVERAGE NET RECEIVABLES CHARGE-OFFS RECEIVABLES CHARGE-OFFS--------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)OWNED RECEIVABLES: Real estate secured....................... $ 93,787 2.32% $ 92,351 1.00% Auto finance.............................. 12,901 4.10 11,660 3.67 Credit card............................... 28,646 7.28 25,065 5.56 Private label............................. 2,646 4.73 2,492 5.80 Personal non-credit card.................. 21,215 8.48 20,611 7.89 Other(1).................................. 14 1.70 18 1.28 -------- ---- -------- ----- Total consumer......................... 159,209 4.22 152,197 2.97 Commercial................................ 140 - 177 .43 -------- ---- -------- -----Total owned receivables..................... $159,349 4.21% $152,374 2.97% ======== ==== ======== =====RECEIVABLES SERVICED WITH LIMITED RECOURSE: Auto finance.............................. $ 139 6.47% $ 720 10.28% Credit card............................... 452 3.98 974 3.49 Personal non-credit card.................. 42 7.14 498 9.24 -------- ---- -------- -----Total receivables serviced with limited recourse.................................. $ 633 4.74% $ 2,192 7.03% ======== ==== ======== ===== -------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. 149 9. PROPERTIES AND EQUIPMENT, NET-------------------------------------------------------------------------------- AT DECEMBER 31, ----------- DEPRECIABLE 2007 2006 LIFE------------------------------------------------------------------------------------ (IN MILLIONS)Land..................................................... $ 26 $ 29 -Buildings and improvements............................... 269 331 10-40 yearsFurniture and equipment.................................. 375 352 3-10 ---- ----Total.................................................... 670 712Accumulated depreciation and amortization................ 255 286 ---- ----Properties and equipment, net............................ $415 $426 ==== ==== Depreciation and amortization expense totaled $113 million in 2007, $115 millionin 2006 and $131 million in 2005. 10. INTANGIBLE ASSETS-------------------------------------------------------------------------------- Intangible assets consisted of the following: IMPAIRMENT ACCUMULATED CARRYINGDECEMBER 31, 2007 GROSS CHARGES AMORTIZATION VALUE--------------------------------------------------------------------------------------------- (IN MILLIONS)Purchased credit card relationships and related programs............................ $1,736 - $ 717 $1,019Retail services merchant relationships........ 270 - 257 13Other loan related relationships.............. 333 158 169 6Trade names................................... 717 713 - 4Technology, customer lists and other contracts................................... 282 - 217 65 ------ ---- ------ ------Total......................................... $3,338 $871 $1,360 $1,107 ====== ==== ====== ====== IMPAIRMENT ACCUMULATED CARRYINGDECEMBER 31, 2006 GROSS CHARGES AMORTIZATION VALUE--------------------------------------------------------------------------------------------- (IN MILLIONS)Purchased credit card relationships and related programs............................ $1,736 - $ 580 $1,156Retail services merchant relationships........ 270 - 203 67Other loan related relationships.............. 333 - 135 198Trade names................................... 717 13 - 704Technology, customer lists and other contracts................................... 282 - 189 93 ------ --- ------ ------Total......................................... $3,338 $13 $1,107 $2,218 ====== === ====== ====== During the third quarter of 2007, we completed our annual impairment test ofintangible assets. As a result of our testing, we determined that the fair valueof each intangible asset exceeded its carrying value. Therefore we concludedthat none of our intangible assets were impaired. As a result of the changes in the business climate, including the subprimemarketplace conditions and changes to our product offerings and businessstrategies completed through the fourth quarter of 2007, we performed an interimimpairment test for the Consumer Lending HFC and Beneficial tradenames andcustomer relationships associated with the HSBC acquisition. As a result ofthese tests, we concluded that the carrying value of the tradenames and customerrelationship intangibles exceeded their fair value and recorded an impairmentcharge of $858 million in the fourth quarter of 2007 representing all of theremaining value assigned to these intangibles and allocated to the ConsumerLending business. 150 Weighted-average amortization periods for our intangible assets as of December31, 2007 were as follows: (IN MONTHS)---------------------------------------------------------------------------------Purchased credit card relationships and related programs............ 106Retail services merchant relationships.............................. 60Other loan related relationships.................................... 62Technology, customer lists and other contracts...................... 85 Intangible amortization expense totaled $253 million in 2007, $269 million in2006 and $345 million in 2005. The trade names are not subject to amortization as we believe they haveindefinite lives. The remaining acquired intangibles are being amortized asapplicable over their estimated useful lives either on a straight-line basis orin proportion to the underlying revenues generated. These useful lives rangefrom 5 years for retail services merchant relationships to approximately 10years for certain loan related relationships. Our purchased credit cardrelationships are being amortized to their estimated residual values of $162million as of December 31, 2007. Estimated amortization expense associated with our intangible assets for each ofthe following years is as follows: YEAR ENDING DECEMBER 31, (IN MILLIONS)------------------------------------------------------------------------------------2008................................................................ $1812009................................................................ 1682010................................................................ 1462011................................................................ 1392012................................................................ 136Thereafter.......................................................... 172 11. GOODWILL-------------------------------------------------------------------------------- Goodwill balances associated with our foreign businesses will change from periodto period due to movements in foreign exchange. Changes in estimates of the taxbasis in our assets and liabilities or other tax estimates recorded at the dateof our acquisition by HSBC or our acquisition of Metris are adjusted againstgoodwill pursuant to Statement of Financial Accounting Standards No. 109,"Accounting for Income Taxes." Changes in the carrying amount of goodwill are as follows: 2007 2006----------------------------------------------------------------------------------- (IN MILLIONS)Balance at beginning of year................................... $ 7,010 $7,003Adjustment to Metris purchase price............................ - 21Acquisitions - 2006 Solstice................................... - 46Goodwill impairment related to the Mortgage Services business.. (881) -Goodwill impairment related to the Consumer Lending business... (2,462) -Goodwill impairment related to the Auto Finance business....... (312) -Goodwill impairment related to the United Kingdom business..... (378) -Goodwill allocated to our U.K. Insurance Operations sold to a third party.................................................. (73) -Goodwill allocated to our European Operations sold to HBEU..... - (13)Change in estimate of the tax basis of assets and liabilities recorded in the HSBC acquisition............................. (115) (89)Change in estimate of the tax basis of assets and liabilities recorded in the Metris acquisition........................... - (13)Impact of foreign currency translation......................... 38 55 ------- ------Balance at end of year......................................... $ 2,827 $7,010 ======= ====== 151 Goodwill established as a result of our acquisition by HSBC has not beenallocated to or included in the reported results of our reportable segments asthe acquisition by HSBC was outside of the ongoing operational activities of ourreportable segments. This is consistent with management's view of our reportablesegment results. Goodwill relating to acquisitions, such as Metris and Solsticeare included in the reported respective segment results as these acquisitionsspecifically related to the operations and is consistent with management's viewof the segment results. See Note 21, "Business Segments," for furtherinformation on goodwill by reportable segment. During the third quarter of 2007, we completed our annual impairment test ofgoodwill. For purposes of this test, we assign the goodwill to our reportingunits (as defined in SFAS No. 142, "Goodwill and Other Intangible Assets" (SFASNo. 142")). As discussed in Note 4, "Restructuring Activities", in the thirdquarter of 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, the fair value of each of thereporting units to which goodwill was assigned exceeded its carrying valueincluding goodwill. Therefore at the completion of our annual goodwillimpairment test, we concluded that none of the remaining goodwill was impaired.Goodwill is reviewed for impairment in interim periods if the circumstancesindicate that the carrying amount assigned to a reporting unit may not berecoverable. As a result of the strategic reviews and restructuring activities which occurredduring the fourth quarter of 2007 we have performed interim goodwill impairmenttests for the businesses where we believe significant changes in the businessclimate have occurred as required by SFAS No. 142. These tests revealed that thebusiness climate changes, including changes in subprime marketplace conditionswhen coupled with the changes to our product offerings and business strategiescompleted through the fourth quarter of 2007, have resulted in an impairment ofall goodwill allocated to our Consumer Lending (which includes Solstice) andAuto Finance businesses. Therefore, we recorded an impairment charge in thefourth quarter of 2007 of $2,462 million relating to our Consumer Lendingbusiness and $312 million relating to our Auto Finance business which representsall of the goodwill allocated to these businesses. In addition, the changes toour product offerings and business strategies completed through the fourthquarter of 2007 have also resulted in an impairment of the goodwill allocated toour United Kingdom business and an impairment charge of $378 million was alsorecorded in the fourth quarter of 2007 representing all of the goodwillpreviously allocated to this business. For all other businesses, the fair valueof each of these reporting units continues to exceed its carrying valueincluding goodwill. See Note 23, "Fair Value Measurements," for a description of the methodologyused to determine the fair value of our reporting units. 152 12. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS-------------------------------------------------------------------------------- COMMERCIAL BANK AND OTHER PAPER BORROWINGS TOTAL-------------------------------------------------------------------------------------------- (IN MILLIONS)2007Balance........................................... $ 8,396 $ 28 $ 8,424Highest aggregate month-end balance............... 16,373Average borrowings................................ 10,987 34 11,021Weighted-average interest rate: At year-end..................................... 4.8% 1.7% 4.7% Paid during year................................ 5.5 4.0 5.52006Balance........................................... $11,012 $ 43 $11,055Highest aggregate month-end balance............... 17,530Average borrowings................................ 12,344 494 12,838Weighted-average interest rate: At year-end..................................... 5.3% 2.8% 5.3% Paid during year................................ 5.0 3.3 4.92005Balance........................................... $11,360 $ 94 $11,454Highest aggregate month-end balance............... 14,801Average borrowings................................ 11,877 111 11,988Weighted-average interest rate: At year-end..................................... 4.2% 3.9% 4.2% Paid during year................................ 3.4 2.5 3.4 Commercial paper included obligations of foreign subsidiaries of $673 million atDecember 31, 2007, $223 million at December 31, 2006 and $442 million atDecember 31, 2005. Bank and other borrowings included obligations of foreignsubsidiaries of $26 million at December 31, 2007, $35 million at December 31,2006 and $55 million at December 31, 2005. At December 31, 2007 deposits of $26million, primarily held by our U.K. business, are classified as bank and otherborrowings due to their short-term nature. At December 31, 2006 deposits of $36million were classified as bank and other borrowings due to their short-termnature. Interest expense for commercial paper, bank and other borrowings totaled $609million in 2007, $628 million in 2006 and $402 million in 2005. We maintain various bank credit agreements primarily to support commercial paperborrowings and also to provide funding in the U.K. We had committed back-uplines and other bank lines of $17.5 billion at December 31, 2007, including $8.2billion with HSBC and subsidiaries and $17.0 billion at December 31, 2006,including $7.7 billion with HSBC and subsidiaries. Our U.K. subsidiary had drawn$3.5 billion at December 31, 2007 and $4.3 billion at December 31, 2006 on itsbank lines of credit which are included in Due to Affiliates for both periods.Formal credit lines are reviewed annually and expire at various dates through2010. Borrowings under these lines generally are available at a surcharge overLIBOR. The most restrictive financial covenant contained in the back-up lineagreements that could restrict availability is an obligation to maintain aminimum shareholder's(s') equity plus the outstanding trust preferred stock of$11.0 billion. At December 31, 2007, minimum shareholder's(s') equity balanceplus outstanding trust preferred stock was $15.4 billion which is substantiallyabove the required minimum balance. In 2008, $3.0 billion of back-up lines fromthird parties are scheduled to expire. Annual commitment fee requirements tosupport availability of these lines at December 31, 2007 and 2006 totaled $8million and included $1 million for the HSBC lines. 153 13. LONG TERM DEBT (WITH ORIGINAL MATURITIES OVER ONE YEAR)-------------------------------------------------------------------------------- Long term debt (with original maturities over one year) consisted of thefollowing: AT DECEMBER 31, --------------------- 2007 2006------------------------------------------------------------------------------------ (IN MILLIONS)SENIOR DEBT FIXED RATE: 8.875% Adjustable Conversion-Rate Equity Security Units................................................ $ 542 $ 542 Secured financings: 3.00% to 3.99%; due 2008............................. 100 195 4.00% to 4.99%; due 2008 to 2010..................... 762 1,312 5.00% to 5.99%; due 2008 to 2012..................... 3,632 3,956 Other fixed rate senior debt(1): 2.40% to 3.99%; due 2008 to 2032..................... 633 1,235 4.00% to 4.99%; due 2008 to 2032..................... 17,405 15,516 5.00% to 5.49%; due 2008 to 2032..................... 12,957 12,417 5.50% to 5.99%; due 2008 to 2024..................... 10,116 11,371 6.00% to 6.49%; due 2008 to 2033..................... 8,485 9,659 6.50% to 6.99%; due 2008 to 2033..................... 6,299 5,555 7.00% to 7.49%; due 2008 to 2032..................... 2,556 3,168 7.50% to 7.99%; due 2008 to 2032..................... 2,959 4,950 8.00% to 9.00%; due 2008 to 2013..................... 1,291 1,263VARIABLE INTEREST RATE: Secured financings - 4.92% to 7.38%; due 2008 to 2018.............................................. 18,692 16,364 Other variable interest rate senior debt - 2.16% to 6.99%; due 2008 to 2018........................... 35,728 38,354JUNIOR SUBORDINATED NOTES ISSUED TO CAPITAL TRUSTS.......... 1,031 1,031UNAMORTIZED DISCOUNT........................................ (150) (377)HSBC ACQUISITION PURCHASE ACCOUNTING FAIR VALUE ADJUSTMENTS............................................... 224 1,079 -------- --------TOTAL LONG TERM DEBT........................................ $123,262 $127,590 ======== ======== -------- (1) Includes $32.9 billion of fixed rate debt carried at fair value. HSBC acquisition purchase accounting fair value adjustments representadjustments which have been "pushed down" to record our long term debt at fairvalue at the date of our acquisition by HSBC. Secured financings of $23.2 billion at December 31, 2007 are secured by $30.9billion of real estate secured, auto finance, credit card and personal non-credit card receivables. Secured financings of $21.8 billion at December 31,2006 are secured by $28.1 billion of real estate secured, auto finance, creditcard and personal non-credit card receivables. At December 31, 2007, long term debt included carrying value adjustmentsrelating to derivative financial instruments which decreased the debt balance by$.1 billion and a foreign currency translation adjustment relating to ourforeign denominated debt which increased the debt balance by $4.4 billion. AtDecember 31, 2006, long term debt included carrying value adjustments relatingto derivative financial instruments which decreased the debt balance by $1.3billion and a foreign currency translation adjustment relating to our foreigndenominated debt which increased the debt balance by $2.4 billion. Long term debt (with original maturities over one year) at December 31, 2007includes $32.9 billion of fixed rate debt accounted for under FVO. We have notelected FVO for $34.3 billion of fixed rate debt currently carried on ourbalance sheet within long term debt. Fixed rate debt accounted for under FVO atDecember 31, 2007 has an aggregate unpaid principal balance of $33.2 billionwhich includes a foreign currency translation adjustment relating to our foreigndenominated FVO debt which increased the debt balance by $.5 billion. The fairvalue of the fixed rate debt accounted for under FVO is determined by a thirdparty and includes the full market price (credit and interest rate impact) basedon observable market data. See Note 23, "Fair Value Measurements," for adescription of the methods and significant assumptions used to estimate the fairvalue of our fixed rate debt accounted for under 154 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock ExchangeRelated Shares:
HSBC Holdings