3rd Mar 2008 14:00
HSBC Holdings PLC03 March 2008 PART 5 FVO. The adoption of FVO has impacted the way we report realized gains andlosses on the swaps associated with this debt which previously qualified aseffective hedges under SFAS No. 133. Upon the adoption of SFAS No. 159 forcertain fixed rate debt, we eliminated hedge accounting on these swaps and, as aresult, realized gains and losses are no longer reported in interest expense butinstead are reported as "Gain on debt designated at fair value and relatedderivatives" within other revenues. In 2007, we recorded a net gain from fair value changes on our fixed rate debtaccounted for under FVO of $622 million which is included in "Gain on debtdesignated at fair value and related derivatives" as a component of otherrevenues in the consolidated statement of income (loss). "Gain on debtdesignated at fair value and related derivatives" in the consolidated statementof income (loss) also includes the mark-to-market adjustment on derivativesrelated to the debt designated at fair value as well as net realized gains orlosses on these derivatives. The components of "Gain on debt designated at fairvalue and related derivatives" are as follows: YEAR ENDED DECEMBER 31, 2007---------------------------------------------------------------------------------Interest rate component............................................ $ (994)Credit risk component.............................................. 1,616 ------Total mark-to-market on debt designated at fair value.............. 622Mark-to-market on the related derivatives.......................... 971Net realized losses on the related derivatives..................... (318) ------Gain on debt designated at fair value and related derivatives...... $1,275 ====== The movement in the fair value reflected in "Gain on debt designated at fairvalue and related derivatives" includes the effect of credit spread changes andinterest rate changes, including any ineffectiveness in the relationship betweenthe related swaps and our debt. As credit spreads narrow, accounting losses arebooked and the reverse is true if credit spreads widen. Differences arisebetween the movement in the fair value of our debt and the fair value of therelated swap due to the different credit characteristics. The size and directionof the accounting consequences of such changes can be volatile from period toperiod but do not alter the cash flows intended as part of the documentedinterest rate management strategy. The changes in the interest rate component reflect a decrease in the LIBOR curvesince January 1, 2007. Changes in the credit risk component of the debt weresignificant during 2007 due to a general widening of credit spreads across alldomestic bond market sectors as well as the general lack of liquidity in thesecondary bond market in the second half of 2007. Weighted-average interest rates on long term debt were 5.2 percent at December31, 2007 and 5.5 percent at December 31, 2006 (excluding HSBC acquisitionpurchase accounting adjustments). Interest expense for long term debt was $6.5billion in 2007, $5.8 billion in 2006 and $3.7 billion in 2005. The mostrestrictive financial covenant contained in the back-up line agreements thatcould restrict availability is an obligation to maintain a minimumshareholder's(s') equity plus the outstanding trust preferred stock of $11.0billion. At December 31, 2007, minimum shareholder's(s') equity balance plusoutstanding trust preferred stock was $15.4 billion which is substantially abovethe required minimum balance. Debt denominated in a foreign currency is includedin the applicable rate category based on the effective U.S. dollar equivalentrate as summarized in Note 14, "Derivative Financial Instruments." In 2002, we issued $541 million of 8.875 percent Adjustable Conversion-RateEquity Security Units. Each Adjustable Conversion-Rate Equity Security Unitconsisted initially of a contract to purchase, for $25, a number of shares ofHSBC Finance Corporation (formerly known as Household International, Inc.)common stock on February 15, 2006 and a senior note issued by our then whollyowned subsidiary, Household Finance Corporation, with a principal amount of $25.In November 2005 we remarketed the notes and reset the rate. All remaining stockpurchase contracts matured on February 15, 2006 and HSBC issued ordinary sharesfor the remaining stock purchase contracts on that date. 155 The following table summarizes our junior subordinated notes issued to capitaltrusts ("Junior Subordinated Notes") and the related company obligatedmandatorily redeemable preferred securities ("Preferred Securities"): HOUSEHOLD CAPITAL TRUST IX ("HCT IX")------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS)JUNIOR SUBORDINATED NOTES: Principal balance............................................. $ 1,031 Interest rate................................................. 5.91% Redeemable by issuer.......................................... November 2015 Stated maturity............................................... November 2035PREFERRED SECURITIES: Rate.......................................................... 5.91% Face value.................................................... $ 1,000 Issue date.................................................... November 2005 In the first quarter of 2006, we redeemed the junior subordinated notes issuedto Household Capital Trust VI with an outstanding principal balance of $206million. In the fourth quarter of 2006, we redeemed the junior subordinatednotes issued to Household Capital Trust VII with an outstanding principalbalance of $206 million. The Preferred Securities must be redeemed when the Junior Subordinated Notes arepaid. The Junior Subordinated Notes have a stated maturity date, but areredeemable by us, in whole or in part, beginning on the dates indicated above atwhich time the Preferred Securities are callable at par ($25 per PreferredSecurity) plus accrued and unpaid dividends. Dividends on the PreferredSecurities are cumulative, payable quarterly in arrears, and are deferrable atour option for up to five years. We cannot pay dividends on our preferred andcommon stocks during such deferments. The Preferred Securities have aliquidation value of $25 per preferred security. Our obligations with respect tothe Junior Subordinated Notes, when considered together with certainundertakings of HSBC Finance Corporation with respect to the Trusts, constitutefull and unconditional guarantees by us of the Trusts' obligations under therespective Preferred Securities. Maturities of long term debt at December 31, 2007, including secured financingsand conduit facility renewals, were as follows: (IN MILLIONS)------------------------------------------------------------------------------------2008................................................................ $ 32,8442009................................................................ 23,8212010................................................................ 15,7562011................................................................ 12,7672012................................................................ 11,365Thereafter.......................................................... 26,709 --------Total............................................................... $123,262 ======== Certain components of our long term debt may be redeemed prior to its statedmaturity. 14. DERIVATIVE FINANCIAL INSTRUMENTS-------------------------------------------------------------------------------- Our business activities involve analysis, evaluation, acceptance and managementof some degree of risk or combination of risks. Accordingly, we havecomprehensive risk management policies to address potential financial risks,which include credit risk (which includes counterparty credit risk), liquidityrisk, market risk, and operational risks. Our risk management policy is designedto identify and analyze these risks, to set appropriate limits and controls, andto monitor the risks and limits continually by means of reliable and up-to-dateadministrative and information systems. Our risk management policies areprimarily carried out in accordance with practice and limits set by the HSBCGroup Management Board. The HSBC Finance Corporation Asset Liability Committee("ALCO") meets regularly to review risks and approve appropriate risk managementstrategies within the limits established by 156 the HSBC Group Management Board. Additionally, our Audit Committee receivesregular reports on our liquidity positions in relation to the establishedlimits. In accordance with the policies and strategies established by ALCO, inthe normal course of business, we enter into various transactions involvingderivative financial instruments. These derivative financial instrumentsprimarily are used to manage our market risk. For further information on ourstrategies for managing interest rate and foreign exchange rate risk, see the"Risk Management" section within our Management's Discussion and Analysis ofFinancial Condition and Results of Operations. OBJECTIVES FOR HOLDING DERIVATIVE FINANCIAL INSTRUMENTS Market risk (whichincludes interest rate and foreign currency exchange risks) is the possibilitythat a change in interest rates or foreign exchange rates will cause a financialinstrument to decrease in value or become more costly to settle. Customer demandfor our receivable products shifts between fixed rate and floating rateproducts, based on market conditions and preferences. These shifts in loanproducts result in different funding strategies and produce different interestrate risk exposures. We maintain an overall risk management strategy that uses avariety of interest rate and currency derivative financial instruments tomitigate our exposure to fluctuations caused by changes in interest rates andcurrency exchange rates. We manage our exposure to interest rate risk primarilythrough the use of interest rate swaps, but also use forwards, futures, options,and other risk management instruments. We manage our exposure to foreigncurrency exchange risk primarily through the use of currency swaps, options andforwards. We do not use leveraged derivative financial instruments for interestrate risk management. Interest rate swaps are contractual agreements between two counterparties forthe exchange of periodic interest payments generally based on a notionalprincipal amount and agreed-upon fixed or floating rates. The majority of ourinterest rate swaps are used to manage our exposure to changes in interest ratesby converting floating rate debt to fixed rate or by converting fixed rate debtto floating rate. We have also entered into currency swaps to convert bothprincipal and interest payments on debt issued from one currency to theappropriate functional currency. Forwards are agreements between two parties, committing one to sell and theother to buy a specific quantity of an instrument on some future date. Theparties agree to buy or sell at a specified price in the future, and theirprofit or loss is determined by the difference between the arranged price andthe level of the spot price when the contract is settled. We have used bothinterest rate and foreign exchange rate forward contracts. We use foreignexchange rate forward contracts to reduce our exposure to foreign currencyexchange risk. Interest rate forward contracts are used to hedge resets ofinterest rates on our floating rate assets and liabilities. Cash requirementsfor forward contracts include the receipt or payment of cash upon the sale orpurchase of the instrument. Purchased options grant the purchaser the right, but not the obligation, toeither purchase or sell a financial instrument at a specified price within aspecified period. The seller of the option has written a contract which createsan obligation to either sell or purchase the financial instrument at the agreed-upon price if, and when, the purchaser exercises the option. We use caps tolimit the risk associated with an increase in rates and floors to limit the riskassociated with a decrease in rates. CREDIT RISK By utilizing derivative financial instruments, we are exposed tocounterparty credit risk. Counterparty credit risk is our primary exposure onour interest rate swap portfolio. Counterparty credit risk is the risk that thecounterparty to a transaction fails to perform according to the terms of thecontract. We control the counterparty credit (or repayment) risk in derivativeinstruments through established credit approvals, risk control limits,collateral, and ongoing monitoring procedures. Our exposure to credit risk forfutures is limited as these contracts are traded on organized exchanges. Eachday, changes in futures contract values are settled in cash. In contrast, swapagreements and forward contracts have credit risk relating to the performance ofthe counterparty. We utilize an affiliate, HSBC Bank USA, as the primaryprovider of domestic derivative products. We have never suffered a loss due tocounterparty failure. At December 31, 2007, most of our existing derivative contracts are with HSBCsubsidiaries, making them our primary counterparty in derivative transactions.Most swap agreements require that payments be made to, or received from, thecounterparty when the fair value of the agreement reaches a certain level.Generally, third-party swap counterparties provide collateral in the form ofcash which is recorded in our balance sheet as other assets or derivativerelated liabilities. At December 31, 2007, we provided third party swapcounterparties with $51 million collateral. At December 31, 2006, third partycounterparties had provided $158 million in collateral to us. Beginning with thesecond quarter of 2006, when the fair value of our agreements with affiliatecounterparties 157 requires the posting of collateral by the affiliate, it is provided in the formof cash and recorded on the balance sheet, consistent with third partyarrangements. At December 31, 2007, the fair value of our agreements withaffiliate counterparties required the affiliate to provide cash collateral of$3.8 billion which is offset against the fair value amount recognized forderivative instruments that have been offset under the same master nettingarrangement and recorded in our balance sheet as a component of derivativerelated assets. At December 31, 2006, the fair value of our agreements withaffiliate counterparties required the affiliate to provide cash collateral of$1.0 billion which is offset against the fair value amount recognized forderivative instruments that have been offset under the same master nettingarrangement and recorded in our balance sheet as a component of derivativerelated assets. These collateral offsets have been recorded in accordance withFIN 39-1. At December 31, 2007, we had derivative contracts with a notionalvalue of approximately $94.7 billion, including $88.7 billion outstanding withHSBC Bank USA and $3.1 billion with other HSBC affiliates. Derivative financialinstruments are generally expressed in terms of notional principal or contractamounts which are much larger than the amounts potentially at risk fornonpayment by counterparties. FAIR VALUE AND CASH FLOW HEDGES To manage our exposure to changes in interestrates, we enter into interest rate swap agreements and currency swaps which havebeen designated as fair value or cash flow hedges under SFAS No. 133. Prior tothe acquisition by HSBC, the majority of our fair value and cash flow hedgeswere effective hedges which qualified for the shortcut method of accounting.Under the Financial Accounting Standards Board's interpretations of SFAS No.133, the shortcut method of accounting was no longer allowed for interest rateswaps which were outstanding at the time of the acquisition by HSBC. As a resultof the acquisition, we were required to reestablish and formally document thehedging relationship associated with all of our fair value and cash flow hedginginstruments and assess the effectiveness of each hedging relationship, both atinception of the hedge relationship and on an ongoing basis. Due to deficienciesin our contemporaneous hedge documentation at the time of acquisition, we lostthe ability to apply hedge accounting to our entire cash flow and fair valuehedging portfolio that existed at the time of acquisition by HSBC. During 2005,we reestablished hedge treatment under the long haul method of accounting for asignificant number of the derivatives in this portfolio. We currently utilizethe long-haul method to test effectiveness of all derivatives designated ashedges. Fair value hedges include interest rate swaps which convert our fixed rate debtto variable rate debt and currency swaps which convert debt issued from onecurrency into pay variable debt of the appropriate functional currency. Asdiscussed more fully below, during 2007 we substantially reduced the amount ofhedging relationships outstanding as a result of adopting SFAS No. 159. Hedgeineffectiveness associated with fair value hedges is recorded in other revenuesas derivative income and was a gain of $7 million ($4 million after tax) in2007, a gain of $252 million ($159 million after tax) in 2006 and a gain of $117million ($75 million after tax) in 2005. All of our fair value hedges wereassociated with debt during 2007, 2006 and 2005. We recorded fair valueadjustments for unexpired fair value hedges which increased the carrying valueof our debt by $28 million at December 31, 2007 and decreased the varying valueof our debt by $292 million at December 31, 2006. Cash flow hedges include interest rate swaps which convert our variable ratedebt to fixed rate debt and currency swaps which convert debt issued from onecurrency into pay fixed debt of the appropriate functional currency. Gains and(losses) on unexpired derivative instruments designated as cash flow hedges (netof tax) are reported in accumulated other comprehensive income and totaled aloss of $834 million ($525 million after tax) at December 31, 2007 and a gain of$256 million ($161 million after tax) at December 31, 2006. We expect $27million ($17 million after tax) of currently unrealized net losses will bereclassified to earnings within one year, however, these unrealized losses willbe offset by decreased interest expense associated with the variable cash flowsof the hedged items and will result in no significant net economic impact to ourearnings. Hedge ineffectiveness associated with cash flow hedges recorded inother revenues as derivative income was a loss of $56 million ($35 million aftertax) in 2007, a loss of $83 million ($53 million after tax) in 2006 and a lossof $76 million ($49 million after tax) in 2005. At December 31, 2007, $3,842 million of derivative instruments, at fair value,were included as derivative financial assets and $71 million as derivativerelated liabilities. At December 31, 2006, $1,461 million of derivativeinstruments, at fair value, were included as derivative financial assets and $58million as derivative related liabilities. 158 Information related to deferred gains and losses before taxes on terminatedderivatives was as follows: 2007 2006------------------------------------------------------------------------------------- (IN MILLIONS)Deferred gains................................................ $ 42 $ 156Deferred losses............................................... 50 176Weighted-average amortization period: Deferred gains.............................................. 4 YEARS 7 years Deferred losses............................................. 9 YEARS 6 yearsIncreases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt.............................................. $ (22) $ (47) Accumulated other comprehensive income...................... 14 27Information related to deferred gains and losses before taxes on discontinued hedges was as follows: 2007 2006------------------------------------------------------------------------------------- (IN MILLIONS)Deferred gains................................................ $ 135 $ 269Deferred losses............................................... 555 1,052Weighted-average amortization period: Deferred gains.............................................. 5 YEARS 5 years Deferred losses............................................. 5 YEARS 5 yearsIncreases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt.............................................. $ (109) $ (941) Accumulated other comprehensive income...................... (311) 158 Amortization of net deferred gains (losses) totaled $(9) million in 2007, ($80)million in 2006 and ($12) million in 2005. NON-QUALIFYING HEDGING ACTIVITIES We may use forward rate agreements, interestrate caps, exchange traded options, and interest rate and currency swaps whichare not designated as hedges under SFAS No. 133, either because they do notqualify as effective hedges or because we lost the ability to apply hedgeaccounting following our acquisition by HSBC as discussed above. These financialinstruments are economic hedges but do not qualify for hedge accounting and areprimarily used to minimize our exposure to changes in interest rates andcurrency exchange rates. Unrealized and realized gains (losses) on derivativeswhich were not designated as hedges are reported in other revenues as derivativeincome and totaled $(31) million ($(19) million after tax) in 2007, $21 million($14 million after tax) in 2006 and $208 million ($133 million after tax) in2005. DERIVATIVES ASSOCIATED WITH DEBT CARRIED AT FAIR VALUE Effective January 1,2007, we elected the fair value option for certain issuances of our fixed ratedebt in order to align our accounting treatment with that of HSBC under IFRSs.As a result, we discontinued fair value hedge accounting for all interest rateand currency swaps associated with this debt. As of December 31, 2007, therecorded fair value of such interest rate and currency swaps was $588 million.During 2007, realized losses of $318 million and unrealized gains of $971million on the derivatives related to debt designated at fair value wererecorded as a component of Gain on debt designated at fair value and relatedderivatives in the consolidated statement of income (loss). DERIVATIVE INCOME Derivative income as discussed above includes realized andunrealized gains and losses on derivatives which do not qualify as effectivehedges under SFAS No. 133 as well as the ineffectiveness on derivatives whichare qualifying hedges. Prior to the election of FVO reporting for certain fixedrate debt, we accounted for the realized gains and losses on swaps associatedwith this debt which qualified as effective hedges under SFAS No. 133 ininterest expense and any ineffectiveness which resulted from changes in the fairvalue of the swaps as compared to changes in the interest rate component valueof the debt was recorded as a component of derivative income. With the adoptionof SFAS No. 159 beginning in January 2007, we eliminated hedge accounting onthese swaps and as a result, realized and unrealized gains and losses on thesederivatives and changes in the 159 interest rate component value of the aforementioned debt are now included inGain on debt designated at fair value and related derivatives in theconsolidated statement of income (loss) which impacts the comparability ofderivative income between periods. Derivative income is summarized in the tablebelow: 2007 2006 2005------------------------------------------------------------------------------------ (IN MILLIONS)Net realized gains (losses).................................. $(24) $ (7) $ 52Mark-to-market on derivatives which do not qualify as effective hedges........................................... (7) 28 156Ineffectiveness.............................................. (48) 169 41 ---- ---- ----Total........................................................ $(79) $190 $249 ==== ==== ==== Net income volatility, whether based on changes in interest rates for swapswhich do not qualify for hedge accounting or ineffectiveness recorded on ourqualifying hedges under the long-haul method of accounting, impacts thecomparability of our reported results between periods. Accordingly, derivativeincome for the year ended December 31, 2007 should not be considered indicativeof the results for any future periods. DERIVATIVE FINANCIAL INSTRUMENTS The following table summarizes derivativefinancial instrument activity: NON-EXCHANGE TRADED ---------------------------------------------------------------------------- EXCHANGE INTEREST RATE TRADED FOREIGN EXCHANGE FORWARD --------- INTEREST RATE CONTRACTS CONTRACTS CAPS OPTIONS RATE CURRENCY ------------------ --------------- AND PURCHASED SWAPS SWAPS PURCHASED SOLD PURCHASED SOLD FLOORS TOTAL----------------------------------------------------------------------------------------------------------------------- (IN MILLIONS)2007Notional amount, 2006......... $ 4,600 $ 57,000 $24,841 $ 1,074 $ 583 $ - $- $ 6,260 $ 94,358New contracts................. 6,651 - - - - - - - 6,651New contracts purchased from subsidiaries of HSBC........ - 25,331 2,877 8,509 6,122 - - - 42,839Matured or expired contracts.. (11,251) (7,887) (1,961) (9,038) (6,155) - - (2,475) (38,767)Terminated contracts.......... - (9,728) - - - - - (846) (10,574)Change in Notional amount..... - - - - - - - - -Change in foreign exchange rate........................ - 215 - (16) - - - - 199 -------- -------- ------- ------- ------- ------- -- ------- ----------Notional amount, 2007......... $ - $ 64,931 $25,757 $ 529 $ 550 $ - $- $ 2,939 $ 94,706 ======== ======== ======= ======= ======= ======= == ======= ==========Fair value, 2007(1): Fair value hedges........... $ - $ 13 $ 120 $ - $ - $ - $- $ - $ 133 Cash flow hedges............ - (440) 3,375 - - - - - 2,935 Fair value option related derivatives.............. - 261 327 - - - - - 588 Non-hedging derivatives..... - (50) 167 3 (5) - - - 115 -------- -------- ------- ------- ------- ------- -- ------- ---------- Total....................... $ - $ (216) $ 3,989 $ 3 $ (5) $ - $- $ - $ 3,771 ======== ======== ======= ======= ======= ======= == ======= ==========2006Notional amount, 2005......... $ 4,870 $ 49,468 $21,719 $ 1,633 $ 465 $ 172 $- $10,700 $ 89,027New contracts................. - - - - - - - - -(used in)New contracts purchased from subsidiaries of HSBC........ 20,205 61,205 8,687 2,071 5,694 1,344 - 65 99,271Matured or expired contracts.. (17,675) (5,319) (4,291) (2,851) (5,710) - - (4,505) (40,351)Terminated contracts.......... (2,800) (49,571) - - - (1,516) - - (53,887)Change in Notional amount..... - 1,217 (1,274) - - - - - (57)Change in foreign exchange rate........................ - - - 221 134 - - - 355 -------- -------- ------- ------- ------- ------- -- ------- ----------Notional amount, 2006......... $ 4,600 $ 57,000 $24,841 $ 1,074 $ 583 $ - $- $ 6,260 $ 94,358 ======== ======== ======= ======= ======= ======= == ======= ==========Fair value, 2006(1): 160 NON-EXCHANGE TRADED ---------------------------------------------------------------------------- EXCHANGE INTEREST RATE TRADED FOREIGN EXCHANGE FORWARD --------- INTEREST RATE CONTRACTS CONTRACTS CAPS OPTIONS RATE CURRENCY ------------------ --------------- AND PURCHASED SWAPS SWAPS PURCHASED SOLD PURCHASED SOLD FLOORS TOTAL----------------------------------------------------------------------------------------------------------------------- (IN MILLIONS) Fair value hedges........... $ - $ (740) $ (26) $ - $ - $ - $- $ - $ (766) Cash flow hedges............ - 14 1,976 - - - - - 1,990 Non-hedging derivatives..... - (64) 244 4 (6) - - 1 179 -------- -------- ------- ------- ------- ------- -- ------- ---------- Total....................... $ - $ (790) $ 2,194 $ 4 $ (6) $ - $- $ 1 $ 1,403 ======== ======== ======= ======= ======= ======= == ======= ==========2005Notional amount, 2004......... $ 1,691 $ 45,253 $18,150 $ 1,146 $ 614 $ 374 $- $ 4,380 $ 71,608New contracts................. - 1 - - - - - 30 31New contracts purchased from subsidiaries of HSBC........ 5,570 25,373 6,824 1,113 4,860 1,707 - 8,433 53,880Matured or expired contracts.. (2,391) (5,657) (3,255) (482) (4,762) - - (1,894) (18,441)Terminated contracts.......... - (15,502) - (144) (247) (1,909) - (249) (18,051) -------- -------- ------- ------- ------- ------- -- ------- ----------Notional amount, 2005......... $ 4,870 $ 49,468 $21,719 $ 1,633 $ 465 $ 172 $- $10,700 $ 89,027 ======== ======== ======= ======= ======= ======= == ======= ==========Fair value, 2005(1): Fair value hedges........... $ - $ (612) $ (178) $ - $ - $ - $- $ - $ (790) Cash flow hedges............ - 103 658 (22) - - - - 739 Non-hedging derivatives..... - (31) 24 - - - - - (7) -------- -------- ------- ------- ------- ------- -- ------- ---------- Total....................... $ - $ (540) $ 504 $ (22) $ - $ - $- $ - $ (58) ======== ======== ======= ======= ======= ======= == ======= ========== -------- (1) (Bracketed) unbracketed amounts represent amounts to be (paid) received by us had these positions been closed out at the respective balance sheet date. Bracketed amounts do not necessarily represent risk of loss as the fair value of the derivative financial instrument and the items being hedged must be evaluated together. See Note 23, "Fair Value Measurements," for further discussion of the relationship between the fair value of our assets and liabilities. 161 We operate in three functional currencies, the U.S. dollar, the British poundand the Canadian dollar. The U.S. dollar is the functional currency forexchange-traded interest rate futures contracts and options. Non-exchange tradedinstruments are restated in U.S. dollars by country as follows: FOREIGN EXCHANGE INTEREST RATE RATE CONTRACTS FORWARD OTHER RISK INTEREST RATE CURRENCY ----------------- CONTRACTS MANAGEMENT SWAPS SWAPS PURCHASED SOLD PURCHASED INSTRUMENTS--------------------------------------------------------------------------------------------------------------- (IN MILLIONS)2007United States................. $61,822 $25,757 $ 522 $540 $ - $ 2,939Canada........................ 1,705 - 7 10 - -United Kingdom................ 1,404 - - - - - ------- ------- ------ ---- ---- ------- $64,931 $25,757 $ 529 $550 $ - $ 2,939 ======= ======= ====== ==== ==== =======2006United States................. $54,703 $24,841 $1,068 $571 $ - $ 6,260Canada........................ 1,207 - 6 12 - -United Kingdom................ 1,090 - - - - - ------- ------- ------ ---- ---- ------- $57,000 $24,841 $1,074 $583 $ - $ 6,260 ======= ======= ====== ==== ==== =======2005United States................. $47,693 $21,175 $1,622 $465 $ - $10,700Canada........................ 855 - 11 - 172 -United Kingdom................ 920 544 - - - - ------- ------- ------ ---- ---- ------- $49,468 $21,719 $1,633 $465 $172 $10,700 ======= ======= ====== ==== ==== ======= Long term debt hedged using derivative financial instruments which qualify forhedge accounting at December 31, 2007 included debt of $28.4 billion hedged byinterest rate swaps and debt of $21.0 billion hedged by currency swaps. Thesignificant terms of the derivative financial instruments have been designed tomatch those of the related asset or liability. Additionally, long term debtdesignated at fair value under the fair value option at December 31, 2007,included debt of $29.4 billion with $29.0 billion notional of related interestrate swaps and debt of $3.5 billion with $3.5 billion of notional of relatedcurrency swaps. Movements in the fair value of the debt and related derivativesis recorded as a component of the revenues in Gain on debt designated at fairvalue and related derivatives. 162 The following table summarizes the maturities and related weighted-averagereceive/pay rates of interest rate swaps outstanding at December 31, 2007: 2008 2009 2010 2011 2012 2013 THEREAFTER TOTAL------------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS)PAY A FIXED RATE/RECEIVE A FLOATING RATE: Notional value............ $13,176 $12,191 $5,584 $ 153 $1,015 $ 390 $1,597 $34,106 Weighted-average receive rate................... 5.05% 4.89% 4.84% 1.50% 4.66% 1.50% 4.61% 4.87% Weighted-average pay rate................... 5.01 5.14 4.99 4.35 4.25 5.02 4.69 5.01 ------- ------- ------ ------ ------ ------ ------ -------PAY A FLOATING RATE/RECEIVE A FIXED RATE: Notional value............ $ 2,610 $ 5,727 $3,145 $5,564 $4,159 $1,286 $8,334 $30,825 Weighted-average receive rate................... 3.71% 4.19% 4.27% 4.55% 4.80% 4.09% 5.34% 4.61% Weighted-average pay rate................... 4.80 4.92 5.31 5.11 4.83 5.38 5.06 5.03 ------- ------- ------ ------ ------ ------ ------ ------- Total notional value...... $15,786 $17,918 $8,729 $5,717 $5,174 $1,676 $9,931 $64,931 ======= ======= ====== ====== ====== ====== ====== =======TOTAL WEIGHTED-AVERAGE RATES ON SWAPS: Receive rate.............. 4.83% 4.67% 4.64% 4.46% 4.77% 3.48% 5.22% 4.75% Pay rate.................. 4.98 5.07 5.10 5.09 4.72 5.29 5.00 5.02 The floating rates that we pay or receive are based on spot rates fromindependent market sources for the index contained in each interest rate swapcontract, which generally are based on either 1, 3 or 6-month LIBOR. Thesecurrent floating rates are different than the floating rates in effect when thecontracts were initiated. Changes in spot rates impact the variable rateinformation disclosed above. However, these changes in spot rates also impactthe interest rate on the underlying assets or liabilities. In addition to the information included in the tables above, we historically hadunused commitments to extend credit related to real estate secured loans. As ofDecember 31, 2007, we had no outstanding unused commitments to extend creditrelated to real estate secured loans. As of December 31, 2006, we had $1.4billion in outstanding unused commitments to extend credit related to realestate secured loans. Commitments to extend credit are agreements, with fixedexpiration dates, to lend to a customer as long as there is no violation of anycondition established in the agreement. These commitments are consideredderivative instruments in accordance with SFAS No. 149, "Amendment of Statement133 on Derivative Instruments and Hedging Activities" ("SFAS No. 149) and, as aresult, are recorded on our balance sheet at fair market value which resulted ina liability of $2.7 million at December 31, 2006. As of December 31, 2007, we had no outstanding forward sale commitments relatedto real estate secured loans. As of December 31, 2006, we had outstandingforward sales commitments related to real estate secured loans totaling $607million. Forward sales commitments are considered derivative instruments underSFAS No. 149 and, as a result, are recorded on our balance sheet at fair marketvalue which resulted in an asset of $1.4 million at December 31, 2006. 163 15. INCOME TAXES-------------------------------------------------------------------------------- Effective January 1, 2007, we adopted FASB Interpretation No. 48, "Accountingfor Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109."The adoption resulted in the reclassification of $65 million of deferred taxliability to current tax liability to account for uncertainty in the timing oftax benefits as well as the reclassification of $141 million of deferred taxasset to current tax asset to account for highly certain pending adjustments inthe timing of tax benefits. A reconciliation of the beginning and ending amountof unrecognized tax benefits is as follows: (IN MILLIONS)-----------------------------------------------------------------------------------Balance at January 1, 2007.......................................... $273Additions based on tax positions related to the current year........ 26Additions for tax positions of prior years.......................... 28Reductions for tax positions of prior years......................... (70)Settlements......................................................... (28)Reductions for lapse of statute of limitations...................... - ----Balance at December 31, 2007........................................ $229 ==== The state tax portion of these amounts is reflected gross and not reduced by thefederal tax effect. The total amount of unrecognized tax benefits that, ifrecognized, would affect the effective tax rate was $70 million at January 1,2007 and $98 million at December 31, 2007. We remain subject to Federal income tax examination for years 1998 and forwardand State income tax examinations for years 1996 and forward. The Company doesnot anticipate that any significant tax positions have a reasonable possibilityof being effectively settled within the next twelve months. It is our policy to recognize accrued interest and penalties related tounrecognized tax benefits as a component of other servicing and administrativeexpenses in the consolidated income statement. As of January 1, 2007, we hadaccrued $67 million for the payment of interest and penalties associated withuncertain tax positions. During the twelve months ended December 31, 2007, weincreased our accrual for the payment of interest and penalties associated withuncertain tax positions by $5 million. Total income taxes were as follows: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005------------------------------------------------------------------------------------------------ (IN MILLIONS)Provision for income taxes related to operations..................................... $ (945) $ 844 $891Income taxes related to adjustments included in common shareholder's equity: Unrealized gains (losses) on investments and interest-only strip receivables, net........ 6 (11) (29) Unrealized gains (losses) on cash flow hedging instruments................................. (385) (192) 74 Minimum pension liability...................... - - 2 Changes in funded status of pension and post retirement benefit plans.................... (1) 1 - Foreign currency translation adjustments....... 40 3 (5) Exercise of stock based compensation........... (11) (21) (9) Tax on sale of European Operations to affiliate................................... - 3 - Tax on sale of U.K. credit card business to affiliate................................... - - (21) ------- ----- ----Total............................................ $(1,296) $ 627 $903 ======= ===== ==== 164 Provisions for income taxes related to operations were: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005------------------------------------------------------------------------------------------------ (IN MILLIONS)CURRENTUnited States.................................... $ 161 $1,396 $1,253Foreign.......................................... (40) 8 4 ------- ------ ------Total current.................................... 121 1,404 1,257 ------- ------ ------DEFERREDUnited States.................................... (1,077) (541) (396)Foreign.......................................... 11 (19) 30 ------- ------ ------Total deferred................................... (1,066) (560) (366) ------- ------ ------Total income taxes............................... $ (945) $ 844 $ 891 ======= ====== ====== The significant components of deferred provisions attributable to income fromoperations were: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005------------------------------------------------------------------------------------------------ (IN MILLIONS)Deferred income tax (benefit) provision (excluding the effects of other components).... $(1,092) $(566) $(342)Adjustment of valuation allowance................ 25 2 (2)Change in operating loss carryforwards........... (1) 8 (12)Adjustment to statutory tax rate................. 2 (4) (10) ------- ----- -----Deferred income tax provision.................... $(1,066) $(560) $(366) ======= ===== =====Income before income taxes were: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005------------------------------------------------------------------------------------------------ (IN MILLIONS)United States.................................... $(5,746) $2,361 $2,560Foreign.......................................... (105) (74) 103 ------- ------ ------Total income before income taxes................. $(5,851) $2,287 $2,663 ======= ====== ====== A reconciliation of income tax expense (benefit) compared with the amounts atthe U.S. federal statutory rates was as follows: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005----------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Tax (benefit) at the U.S. federal statutory income tax rate........................... $(2,048) (35.0)% $800 35.0% $932 35.0%Increase (decrease) in rate resulting from: State and local taxes, net of Federal benefit................................ (55) (.9) 94 4.1 24 .9 Non-deductible goodwill................... 1,182 20.2 - - - - Low income housing and other tax credits.. (64) (1.1) (79) (3.5) (87) (3.2) Other..................................... 40 .6 29 1.3 22 .8 ------- ----- ---- ---- ---- ----Total income tax expense (benefit).......... $ (945) (16.2)% $844 36.9% $891 33.5% ======= ===== ==== ==== ==== ==== 165 Temporary differences which gave rise to a significant portion of deferred taxassets and liabilities were as follows: AT DECEMBER 31, ----------------- 2007 2006----------------------------------------------------------------------------------- (IN MILLIONS)DEFERRED TAX ASSETSCredit loss reserves........................................... $3,431 $2,053Market value adjustment........................................ 360 311Deferred compensation.......................................... 183 144Other.......................................................... 638 489 ------ ------Total deferred tax assets...................................... 4,612 2,997Valuation allowance............................................ (50) (25) ------ ------Total deferred tax assets net of valuation allowance........... 4,562 2,972 ------ ------DEFERRED TAX LIABILITIESIntangibles.................................................... 177 838Fee income..................................................... 742 568Deferred loan origination costs................................ 367 312Debt........................................................... 138 75Receivables sold............................................... 133 13Other.......................................................... 210 190 ------ ------Total deferred tax liabilities................................. 1,767 1,996 ------ ------Net deferred tax asset......................................... $2,795 $ 976 ====== ====== Based upon the level of historical taxable income, the reversal of the deferredtax liabilities over the periods over which the deferred tax assets aredeductible, the ability to carryback future reversals of deductible temporarydifferences to 2006 and 2007 and projections of future taxable income,management believes that it is more likely than not we would realize thebenefits of these deductible differences net of the valuation allowance notedabove, which primarily relates to certain state tax benefits and foreign taxcredit carry forwards. The American Jobs Creation Act of 2004 (the "AJCA") included provisions to allowa deduction of 85% of certain foreign earnings that are repatriated in 2004 or2005. We elected to apply this provision to a $489 million distribution inDecember 2005 by our U.K. subsidiary. Tax of $26 million related to thisdistribution is included as part of the current 2005 U.S. tax expense shownabove. At December 31, 2007, we had net operating loss carryforwards of $880 millionfor state tax purposes which expire as follows: $161 million in 2008-2012; $204million in 2013-2017; $238 million in 2018-2022 and $277 million in 2023 andforward. At December 31, 2007, we had foreign tax credit carryforwards of $10 million forfederal income tax purposes which expire as follows: $3 million in 2016 and $7million in 2017. 16. REDEEMABLE PREFERRED STOCK-------------------------------------------------------------------------------- On December 15, 2005, we issued four shares of common stock to HINO in exchangefor the Series A Preferred Stock. See Note 18, "Related Party Transactions," forfurther discussion. In June 2005, we issued 575,000 shares of 6.36 percent Non-Cumulative PreferredStock, Series B ("Series B Preferred Stock"). Dividends on the Series BPreferred Stock are non-cumulative and payable quarterly at a rate of 6.36percent commencing September 15, 2005. The Series B Preferred Stock may beredeemed at our option after June 23, 2010 at $1,000 per share, plus accrueddividends. The redemption and liquidation value is $1,000 per share plus accruedand unpaid dividends. The holders of Series B Preferred Stock are entitled topayment before any capital distribution is made to the common shareholder andhave no voting rights except for the right to elect two additional members tothe board of directors in the event that dividends have not been declared andpaid for six quarters, or as otherwise provided by law. Additionally, as long asany shares of the Series B Preferred Stock are outstanding, the authorization,creation or issuance of any class or series of stock which would rank prior tothe Series B Preferred Stock with respect to dividends or amounts payable uponliquidation or dissolution of HSBC 166 Finance Corporation must be approved by the holders of at least two-thirds ofthe shares of Series B Preferred Stock outstanding at that time. Relatedissuance costs of $16 million have been recorded as a reduction of additionalpaid-in capital. In 2007 and 2006, we declared dividends totaling $37 million onthe Series B Preferred Stock which were paid prior to December 31, 2007 and2006. 17. ACCUMULATED OTHER COMPREHENSIVE INCOME-------------------------------------------------------------------------------- Accumulated other comprehensive income includes certain items that are reporteddirectly within a separate component of shareholders' equity. The followingtable presents changes in accumulated other comprehensive income balances. YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005------------------------------------------------------------------------------------------------ (IN MILLIONS)Unrealized gains (losses) on investments and interest-only strip receivables: Balance at beginning of period................. $ (23) $ (2) $ 54 Other comprehensive income for period: Net unrealized holding gains (losses) arising during period, net of tax of $6 million, $34 million and $(29) million, respectively.............................. 10 57 (56) Reclassification adjustment for gains realized in net income, net of tax of $- million, $(45) million and $- million, respectively.............................. - (78) - ----- ----- ----- Total other comprehensive income for period.... 10 (21) (56) ----- ----- ----- Balance at end of period....................... (13) (23) (2) ----- ----- -----Unrealized gains (losses) on cash flow hedging instruments: Balance at beginning of period................. (61) 260 119 Other comprehensive income for period: Net gains (losses) arising during period, net of tax of $(372) million, $(124) million and $92 million, respectively..... (635) (204) 173 Reclassification adjustment for gains (losses) realized in net income, net of tax of $(13) million, $(68) million and $(18) million, respectively............... (22) (117) (32) ----- ----- ----- Total other comprehensive income for period.... (657) (321) 141 ----- ----- ----- Balance at end of period....................... (718) (61) 260 ----- ----- -----Pension liability: Balance at beginning of period................. (1) - (4) Other comprehensive income for period: Minimum pension liability, net of tax of $- million, $- million and $2 million, respectively.............................. - - 4 FASB Statement No. 158 adjustment, net of tax of $(1) million, $- million and $- million, respectively..................... (2) - - ----- ----- ----- Total other comprehensive income for period.... (2) - 4 Adjustment to initially apply FASB Statement No. 158, net of tax of $- million, $1 million and $- million, respectively........ - (1) - ----- ----- ----- Balance at end of period....................... (3) (1) - ----- ----- -----Foreign currency translation adjustments: Balance at beginning of period................. 444 221 474 Other comprehensive income for period: Translation gains (losses), net of tax of $40 million, $3 million and $(5) million, respectively.............................. 70 223 (253) ----- ----- ----- Total other comprehensive income for period.... 70 223 (253) ----- ----- ----- Balance at end of period....................... 514 444 221 ----- ----- -----Total accumulated other comprehensive income (loss) at end of period........................ $(220) $ 359 $ 479 ===== ===== ===== 167 18. RELATED PARTY TRANSACTIONS-------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and itssubsidiaries. These transactions occur at prevailing market rates and terms andinclude funding arrangements, derivative execution, purchases and sales ofreceivables, servicing arrangements, information technology services, item andstatement processing services, banking and other miscellaneous services. Thefollowing tables present related party balances and the income and (expense)generated by related party transactions: AT DECEMBER 31, 2007 2006------------------------------------------------------------------------------------ (IN MILLIONS)ASSETS, (LIABILITIES) AND EQUITY:Derivative financial assets (liability), net................. $ 29 $ 234Affiliate preferred stock received in sale of U.K. credit card business(1)........................................... 301 294Other assets................................................. 631 528Due to affiliates............................................ (14,902) (15,172)Other liabilities............................................ (528) (506)Premium on sale of European Operations to affiliates recorded as an increase to additional paid in capital............... - 13 -------- (1) Balance will fluctuate due to foreign currency exchange rate impact. FOR THE YEAR ENDED DECEMBER 31, 2007 2006 2005---------------------------------------------------------------------------------------INCOME/(EXPENSE):Interest expense on borrowings from HSBC and subsidiaries........................................... $ (992) $ (929) $(713)Interest income from HSBC affiliates..................... 43 26 38Dividend income from affiliate preferred stock........... 21 18 -HSBC Bank USA: Real estate secured servicing, sourcing, underwriting and pricing revenues................................ 9 12 19 Gain on daily sale of domestic private label receivable originations........................................ 374 367 379 Gain on daily sale of credit card receivables.......... 61 38 34 Loss on sale of real estate secured receivables........ (16) - - Gain on bulk sales of real estate secured receivables.. - 17 - Taxpayer financial services loan origination and other fees................................................ (19) (18) (15) Domestic private label receivable servicing and related fees................................................ 406 393 368 Other servicing, processing, origination and support revenues............................................ 93 73 28Support services from HSBC affiliates.................... (1,192) (1,087) (889)HSBC Technology & Services (USA) Inc. ("HTSU"): Rental revenue......................................... 48 45 42 Administrative services revenue........................ 13 12 14Servicing and other fees from other HSBC affiliates...... 15 16 11Stock based compensation expense with HSBC............... (102) (100) (66) The notional value of derivative contracts outstanding with HSBC subsidiariestotaled $91.8 billion at December 31, 2007 and $87.4 billion at December 31,2006. When the fair value of our agreements with affiliate counterpartiesrequires the posting of collateral by the affiliate, it is provided in the formof cash and recorded on our balance sheet, consistent with third partyarrangements. The level of the fair value of our agreements with affiliatecounterparties above which collateral is required to be posted is $75 million.At December 31, 2007, the fair value of our agreements with affiliatecounterparties required the affiliate to provide cash collateral of $3.8 billionwhich is offset against the fair value amount recognized for derivativeinstruments that have been offset under the same master netting arrangement andrecorded in our balance sheet as a component of derivative related assets. At 168 December 31, 2006, the fair value of our agreements with affiliatecounterparties required the affiliate to provide cash collateral of $1.0 billionwhich is offset against the fair value amount recognized for derivativeinstruments that have been offset under the same master netting arrangement andrecorded in our balance sheet as a component of derivative related assets. We extended a line of credit of $2 billion to HSBC USA Inc. There were nobalances outstanding under this line of credit at December 31, 2006. This lineexpired in July of 2006 and was not renewed. We extended a revolving line of credit of $.5 billion to HTSU on June 28, 2005,which was increased to $.8 billion on October 25, 2007. The balance outstandingunder this line of credit was $.6 billion and $.5 billion at December 31, 2007and 2006, respectively, and is included in other assets. Interest incomeassociated with this line of credit is recorded in interest income and reflectedas Interest income from HSBC affiliates in the table above. We have extended revolving lines of credit to subsidiaries of HSBC Bank USA foran aggregate total of $1.0 billion. There are no balances outstanding under anyof these lines of credit at either December 31, 2007 or 2006. Due to affiliates includes amounts owed to subsidiaries of HSBC as a result ofdirect debt issuances (other than preferred stock). We purchase from HSBC Securities, Inc. ("HSI") securities under agreement toresell. Outstanding balances totaled $415 million at December 31, 2007 and $70million at December 31, 2006. Interest income recognized on these securitiestotaled $11 million in 2007 and $1 million in 2006 and 2005, respectively, andare reflected as Interest income from HSBC affiliates in the table above. At December 31, 2007 and 2006, we had a commercial paper back stop creditfacility of $2.5 billion from HSBC supporting domestic issuances and a revolvingcredit facility of $5.7 billion from HBEU to fund our operations in the U.K. InJanuary 2008, the revolving credit facility from HBEU decreased to $4.5 billion.At December 31, 2007, $3.5 billion was outstanding under the HBEU lines for theU.K. and no balances were outstanding under the domestic lines. As of December31, 2006, $4.3 billion was outstanding under the U.K. lines and no balances wereoutstanding on the domestic lines. Annual commitment fee requirements to supportavailability of these lines totaled $1 million in 2007 and 2006 and are includedas a component of Interest expense on borrowings from HSBC and subsidiaries. In 2007, we sold approximately $645 million of real estate secured receivablesoriginated by our subsidiary, Decision One, to HSBC Bank USA and recorded a pre-tax loss on these sales of $16 million. In the fourth quarter of 2006, we soldapproximately $669 million of real estate secured receivables originated by oursubsidiary, Decision One, to HSBC Bank USA and recorded a pre-tax gain of $17million on the sale. Each of these sales was effected as part of our thencurrent strategy to originate loans through Decision One for sale andsecuritization through the secondary mortgage market operations of ouraffiliates. Decision One has since ceased origination operations. In the second quarter of 2007, we sold $2.2 billion of loans from the MortgageServices portfolio to third parties. HSBC Markets (USA) Inc., a related HSBCentity, assisted in the transaction by soliciting interest and placing the loanswith interested third parties. Fees paid for these services totaled $4 millionand were included as a component of the approximately $20 million loss realizedon the sale of this loan portfolio. In the third quarter of 2007, we sold a portion of our MasterCard Class B shareportfolio to third parties. HSBC Bank USA assisted with one of the transactionsby placing shares with interested third parties. Fees paid to HSBC Bank USArelated to this sale were $2 million and were included as a component of theapproximately $115 million net gain realized on the sale of these shares. On November 9, 2006, as part of our continuing evaluation of strategicalternatives with respect to our U.K. and European operations, we sold all ofthe capital stock of our operations in the Czech Republic, Hungary, and Slovakia(the "European Operations") to a wholly owned subsidiary of HBEU for anaggregate purchase price of approximately $46 million. Because the sale of thisbusiness is between affiliates under common control, the premium received inexcess of the book value of the stock transferred was recorded as an increase toadditional paid-in capital and was not reflected in earnings. The assetsconsisted primarily of $199 million of receivables and goodwill which totaledapproximately $13 million. The liabilities consisted primarily of debt whichtotaled $179 million. HBEU assumed all the liabilities of the EuropeanOperations as a result of this transaction. 169 In December 2005, we sold our U.K. credit card business, including $2.5 billionof receivables, the associated cardholder relationships and the related retainedinterests in securitized credit card receivables to HBEU for an aggregatepurchase price of $3.0 billion. The purchase price, which was determined basedon a comparative analysis of sales of other credit card portfolios, was paid ina combination of cash and $261 million of preferred stock issued by a subsidiaryof HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In additionto the assets referred to above, the sale also included the account originationplatform, including the marketing and credit employees associated with thisfunction, as well as the lease associated with the credit card call center andrelated leaseholds and call center employees to provide customer continuityafter the transfer as well as to allow HBEU direct ownership and control oforigination and customer service. We have retained the collection operationsrelated to the credit card operations and have entered into a service levelagreement to provide collection services and other support services, includingcomponents of the compliance, financial reporting and human resource functions,for the sold credit card operations to HBEU for a fee. We received $32 millionin 2007 and $30 million in 2006 under this service level agreement. Because thesale of this business is between affiliates under common control, the premiumreceived in excess of the book value of the assets transferred of $182 million,including the goodwill assigned to this business, was recorded as an increase toadditional paid in capital and has not been included in earnings. In December 2004, we sold our domestic private label receivable portfolio(excluding retail sales contracts at our Consumer Lending business), includingthe retained interests associated with our securitized domestic private labelreceivables to HSBC Bank USA for $12.4 billion. We continue to service the soldprivate label receivables and receive servicing and related fee income from HSBCBank USA for these services. As of December 31, 2007, we were servicing $19.2billion of domestic private label receivables for HSBC Bank USA and as ofDecember 31, 2006, we were servicing $18.1 billion of domestic private labelreceivables for HSBC Bank USA. We received servicing and related fee income fromHSBC Bank USA of $406 million in 2007 and $393 million in 2006. Servicing andrelated fee income is reflected as Domestic private label receivable servicingand related fees in the table above. We continue to maintain the relatedcustomer account relationships and, therefore, sell substantially all newdomestic private label receivable originations (excluding retail salescontracts) to HSBC Bank USA on a daily basis. We sold $22.7 billion of privatelabel receivables to HSBC Bank USA during 2007 and $21.6 billion during 2006.The gains associated with the sale of these receivables are reflected as Gain ondaily sale of domestic private label receivable originations in the table above. In 2003 and 2004, we sold a total of approximately $3.7 billion of real estatesecured receivables from our Mortgage Services business to HSBC Bank USA. Undera separate servicing agreement, we service all real estate secured receivablessold to HSBC Bank USA including loans purchased from correspondent lenders priorto September 1, 2005. As of December 31, 2007, we were servicing $2.5 billion ofreal estate secured receivables for HSBC Bank USA. The fee revenue associatedwith these receivables is recorded in servicing fees from HSBC affiliates and isreflected as Real estate secured servicing, sourcing, underwriting and pricingrevenues in the above table. Under multiple service level agreements, we also provide various services toHSBC Bank USA. These services include credit card servicing and processingactivities through our Credit Card Services business, loan servicing through ourAuto Finance business and other operational and administrative support. Feesreceived for these services are reported as servicing fees from HSBC affiliatesand are reflected as Other servicing, processing, origination and supportrevenues in the table above. Additionally, HSBC Bank USA services certain realestate secured loans on our behalf. Fees paid for these services are reported assupport services from HSBC affiliates and are reflected as Support services fromHSBC affiliates, in the table above. We currently use an HSBC affiliate located outside of the United States toprovide various support services to our operations including among other areas,customer service, systems, collection and accounting functions. We incurredcosts related to these services of $151 million in 2007 and $100 million in2006. The expenses related to these services are included as a component ofSupport services from HSBC affiliates in the table above. 170 During 2003, Household Capital Trust VIII issued $275 million in mandatorilyredeemable preferred securities to HSBC. The terms of this issuance were asfollows: (DOLLARS ARE IN MILLIONS)------------------------------------------------------------------------------------------Junior Subordinated Notes: Principal balance.......................................... $284 Redeemable by issuer....................................... September 26, 2008 Stated maturity............................................ November 15, 2033Preferred Securities: Rate....................................................... 6.375% Face value................................................. $275 Issue date................................................. September 2003 Interest expense recorded on the underlying junior subordinated notes totaled$18 million in 2007, 2006 and 2005. The interest expense for the HouseholdCapital Trust VIII is included in interest expense - HSBC affiliates in theconsolidated statement of income (loss) and is reflected as a component ofInterest expense on borrowings from HSBC and subsidiaries in the table above. Our Canadian business originates and services auto loans for an HSBC affiliatein Canada. Fees received for these services are included in other income and arereflected in Servicing and other fees from other HSBC affiliates in the abovetable. Since October 1, 2004, HSBC Bank USA became the originating lender for loansinitiated by our taxpayer financial services business for clients of variousthird party tax preparers. Starting on January 1, 2007, HSBC Trust Company(Delaware) N.A. ("HTCD") also began to serve as an originating lender for theseloans. We purchase the loans originated by HSBC Bank USA and HTCD daily for afee. Origination fees paid for these loans totaled $19 million in 2007 and $18million in 2006. These origination fees are included as an offset to taxpayerfinancial services revenue and are reflected as Taxpayer financial services loanorigination and other fees in the above table. On July 1, 2004, HSBC Bank Nevada, National Association ("HBNV"), formerly knownas Household Bank (SB), N.A., purchased the account relationships associatedwith $970 million of credit card receivables from HSBC Bank USA forapproximately $99 million, which are included in intangible assets. Thereceivables continue to be owned by HSBC Bank USA. We service these receivablesfor HSBC Bank USA and receive servicing and related fee income from HSBC BankUSA. As of December 31, 2007 and 2006, we were servicing $1.1 billion of creditcard receivables for HSBC Bank USA. Originations of new accounts and receivablesare made by HBNV and new receivables are sold daily to HSBC Bank USA. We sold$2.8 billion of credit card receivables to HSBC Bank USA in 2007, $2.3 billionin 2006 and $2.1 billion in 2005. The gains associated with the sale of thesereceivables are reflected in the table above and are recorded in Gain on dailysale of credit card receivables. Effective January 1, 2004, our technology services employees, as well astechnology services employees from other HSBC entities in North America, weretransferred to HTSU. In addition, technology related assets and softwarepurchased subsequent to January 1, 2004 are generally purchased and owned byHTSU. Technology related assets owned by HSBC Finance Corporation prior toJanuary 1, 2004 currently remain in place and were not transferred to HTSU. Inaddition to information technology services, HTSU also provides certain itemprocessing and statement processing activities to us pursuant to a masterservice level agreement. Support services from HSBC affiliates includes servicesprovided by HTSU as well as banking services and other miscellaneous servicesprovided by HSBC Bank USA and other subsidiaries of HSBC. We also receiverevenue from HTSU for rent on certain office space, which has been recorded as areduction of occupancy and equipment expenses, and for certain administrativecosts, which has been recorded as other income. In a separate transaction in December 2005, we transferred our informationtechnology services employees in the U.K. to a subsidiary of HBEU. Subsequent tothe transfer, operating expenses relating to information technology, which havepreviously been reported as salaries and fringe benefits or other servicing andadministrative expenses, are now billed to us by HBEU and reported as Supportservices from HSBC affiliates. Additionally, during the first 171 quarter of 2006, the information technology equipment in the U.K. was sold toHBEU for a purchase price equal to the book value of these assets of $8 million. In addition, we utilize HSBC Markets (USA) Inc., a related HSBC entity, to leadmanage the underwriting of a majority of our ongoing debt issuances. Fees paidfor such services totaled approximately $14 million in 2007, $48 million in 2006and $59 million in 2005. For debt not accounted for under the fair value option,these fees are amortized over the life of the related debt. Domestic employees of HSBC Finance Corporation participate in a defined benefitpension plan sponsored by HSBC North America. See Note 20, "Pension and OtherPostretirement Benefits," for additional information on this pension plan. Employees of HSBC Finance Corporation participate in one or more stockcompensation plans sponsored by HSBC. Our share of the expense of these planswas $102 million in 2007, $100 million in 2006 and $66 million in 2005. Theseexpenses are recorded in salary and employee benefits and are reflected in theabove table as Stock based compensation expense with HSBC. 19. STOCK OPTION PLANS-------------------------------------------------------------------------------- STOCK OPTION PLANS The HSBC Holdings Group Share Option Plan (the "Group ShareOption Plan"), which replaced the former Household stock option plans, was along-term incentive compensation plan available to certain employees prior to2005. Grants were usually made annually. At the 2005 HSBC Annual Meeting ofStockholders, HSBC adopted and the shareholders' approved the HSBC Share Plan("Group Share Plan") to replace this plan. Since 2004, no further options havebeen granted to employees although stock option grants from previous yearsremain in effect subject to the same conditions as before. In lieu of options,these employees received grants of shares of HSBC stock subject to certainvesting conditions as discussed further below. If the performance conditions arenot met by year 5, the options will be forfeited. Options granted to employeesin 2004 vest 100 percent upon the attainment of certain company performanceconditions and expire ten years from the date of grant. Such options weregranted at market value. Compensation expense related to the Group Share OptionPlan, which is recognized over the vesting period, totaled $3 million in 2007,$6 million in 2006 and $6 million in 2005. Information with respect to the Group Share Option Plan is as follows: 2007 2006 2005 --------------------- --------------------- --------------------- WEIGHTED- WEIGHTED- WEIGHTED- HSBC AVERAGE HSBC AVERAGE HSBC AVERAGE ORDINARY PRICE PER ORDINARY PRICE PER ORDINARY PRICE PER SHARES SHARE SHARES SHARE SHARES SHARE-----------------------------------------------------------------------------------------------------Outstanding at beginning of year........................ 6,060,800 $14.97 6,100,800 $14.97 6,245,800 $14.96Granted....................... - - - - - -Exercised..................... - - - - - -Transferred................... - - - - (105,000) 14.64Expired or canceled........... - - (40,000) 14.37 (40,000) 14.37 --------- ------ --------- ------ --------- ------Outstanding at end of year.... 6,060,800 14.97 6,060,800 14.97 6,100,800 14.97 ========= ====== ========= ====== ========= ======Exercisable at end of year.... 3,879,800 $15.31 2,909,850 $15.31 - $ - ========= ====== ========= ====== ========= ======Weighted-average fair value of options granted............. $ - $ - $ - ====== ====== ====== The transfers in 2005 shown above primarily relate to certain of our U.K.employees who were transferred to HBEU as part of the sale of our U.K. creditcard business in December 2005. 172 The following table summarizes information about stock options outstanding underthe Group Share Option Plan at December 31, 2007: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------- ------------------------ WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGERANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISEEXERCISE PRICES OUTSTANDING LIFE PRICE OUTSTANDING PRICE---------------------------------------------------------------------------------------------------------$12.51 - 15.00....................... 2,181,000 6.34 14.37 - $ -$15.01 - 17.50....................... 3,879,800 5.85 15.31 3,879,800 $15.31 Prior to our acquisition by HSBC, certain employees were eligible to participatein the former Household stock option plan. Employee stock options generallyvested equally over four years and expired 10 years from the date of grant. Uponcompletion of our acquisition by HSBC, all options granted prior to November2002 vested and became outstanding options to purchase HSBC ordinary shares.Options granted under the former Household plan subsequent to October 2002 wereconverted into options to purchase ordinary shares of HSBC, but did not vestunder the change in control. Compensation expense related to the formerHousehold plan totaled $2 million in 2007, $3 million in 2006 and $6 million in2005. All shares under the former Household plan are now fully vested. Information with respect to stock options granted under the former Householdplan is as follows: 2007 2006 2005 ---------------------- ---------------------- ---------------------- WEIGHTED- WEIGHTED- WEIGHTED- HSBC AVERAGE HSBC AVERAGE HSBC AVERAGE ORDINARY PRICE PER ORDINARY PRICE PER ORDINARY PRICE PER SHARES SHARE SHARES SHARE SHARES SHARE------------------------------------------------------------------------------------------------------Outstanding at beginning of year...................... 25,995,589 $17.34 36,032,006 $16.09 38,865,993 $15.71Granted..................... - - - - - -Exercised................... (4,877,586) 14.51 (9,825,954) 12.73 (2,609,665) 10.92Transferred in/(out)........ 172,976 18.66 47,580 8.62 (142,292) 12.15Expired or canceled......... (131,068) 10.24 (258,043) 16.78 (82,030) 7.97 ---------- ------ ---------- ------ ---------- ------Outstanding at end of year.. 21,159,911 $18.04 25,995,589 $17.34 36,032,006 $16.09 ========== ====== ========== ====== ========== ======Exercisable at end of year.. 21,159,911 $18.04 25,995,589 $17.34 34,479,337 $16.21 ========== ====== ========== ====== ========== ====== The transfers shown above primarily relate to employees who have transferredbetween HTSU and us during each year and to certain of our U.K. employees whowere transferred to HBEU as part of the sale of our U.K. credit card business inDecember 2005. The following table summarizes information about the number of HSBC ordinaryshares subject to outstanding stock options under the former Household plan, atDecember 31, 2007: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------- ----------------------- WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGERANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISEEXERCISE PRICES OUTSTANDING LIFE PRICE OUTSTANDING PRICE----------------------------------------------------------------------------------------------------$ 1.00 - $ 5.00...................... 7,251 .78 1.99 7,251 1.99$10.01 - $12.50...................... 2,307,172 4.90 10.66 2,307,172 10.66$12.51 - $15.00...................... 1,142,504 1.15 13.75 1,142,504 13.75$15.01 - $17.50...................... 4,518,173 1.83 16.95 4,518,173 16.95$17.51 - $20.00...................... 5,720,489 2.84 18.41 5,720,489 18.41$20.01 - $25.00...................... 7,464,322 3.87 21.37 7,464,322 21.37 173 RESTRICTED SHARE PLANS Subsequent to our acquisition by HSBC, key employeeshave been provided awards in the form of restricted shares ("RSRs") under HSBC'sRestricted Share Plan prior to 2005 and under the Group Share Plan beginning in2005. These shares have been granted as both time vested (3 year vesting) and/orperformance contingent (3 and 4 year vesting) awards. We also issue a smallnumber of off-cycle grants each year for recruitment and retention. These RSRawards vest over a varying period of time depending on the nature of the award,the longest of which vests over a five year period. Annual awards to employeesin 2004 vest over five years contingent upon the achievement of certain companyperformance targets. Information with respect to RSRs awarded under HSBC's Restricted SharePlan/Group Share Plan, all of which are in HSBC ordinary shares, is as follows: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005--------------------------------------------------------------------------------------------RSRs awarded.................................... 4,028,913 4,959,838 6,669,152Weighted-average fair market value per share.... $ 17.67 $ 16.96 $ 15.86RSRs outstanding at December 31................. 15,312,635 14,326,693 11,787,706Compensation cost: (in millions) Pre-tax....................................... $ 92 $ 82 $ 42 After-tax..................................... 58 52 27 Prior to the merger, Household's executive compensation plans also provided forissuance of RSRs which entitled an employee to receive a stated number of sharesof Household common stock if the employee satisfied the conditions set by theCompensation Committee for the award. Upon completion of the merger with HSBC,all RSRs granted under the former Household plan prior to November 2002 vestedand became outstanding shares of HSBC. RSRs granted under the former Householdplan subsequent to October 2002 were converted into rights to receive HSBCordinary shares. Upon vesting, the employee can elect to receive either HSBCordinary shares or American depository shares. Information with respect to RSRs awarded under the pre-merger Household plan,all of which are in HSBC ordinary shares, is as follows: 2007 2006 2005--------------------------------------------------------------------------------------RSRs awarded......................................... - - -Weighted-average fair market value per share......... $ - $ - $ -RSRs outstanding at December 31...................... 55,612 653,900 1,309,073Compensation cost: (in millions) Pre-tax............................................ $ 5 $ 4 $ 6 After-tax.......................................... 3 2 4 EMPLOYEE STOCK PURCHASE PLANS The HSBC Holdings Savings-Related Share OptionPlan (the "HSBC Sharesave Plan"), which replaced the former Household employeestock purchase plan, allows eligible employees to enter into savings contractsto save up to approximately $500 per month, with the option to use the savingsto acquire ordinary shares of HSBC at the end of the contract period. There arecurrently three types of plans offered which allow the participant to selectsaving contracts of a 1, 3 or 5 year length. The 1 year contract period wasoffered for the first time in 2006. The options for the 1 year plan areautomatically exercised if the current share price is at or above the strikeprice, which is at a 15 percent discount to the fair market value of the shareson grant date. If the current share price is below the strike price, theparticipants have the ability to exercise the option during the six monthsfollowing the maturity date if the share price rises. The options under the 3and 5 year plans are exercisable within six months following the third or fifthyear, respectively, of the commencement of the related savings contract, at a 20percent 174 discount for options granted in 2007, 2006 and 2005. HSBC ordinary sharesgranted and the related fair value of the options for 2007, 2006 and 2005 arepresented below: 2007 2006 2005 ------------------------ ------------------------ ------------------------- HSBC FAIR VALUE HSBC FAIR VALUE HSBC FAIR VALUE ORDINARY PER SHARE OF ORDINARY PER SHARE OF ORDINARY PER SHARE OF SHARES SHARES SHARES SHARES SHARES SHARES GRANTED GRANTED GRANTED GRANTED GRANTED GRANTED----------------------------------------------------------------------------------------------------------------1 year vesting period....... 389,066 $3.71 296,410 $2.60 - -3 year vesting period....... 894,149 4.25 598,814 3.43 1,064,168 $3.735 year vesting period....... 214,600 4.09 124,563 3.49 236,782 3.78 Compensation expense related to the grants under the HSBC Sharesave Plan totaled$7 million in 2007, $5 million in 2006 and $6 million in 2005. The fair value of each option granted under the HSBC Sharesave Plan wasestimated as of the date of grant using a third party option pricing model. Thesignificant assumptions used to estimate the fair value of the options grantedby year are as follows: 2007 2006 2005-------------------------------------------------------------------------------------------------Risk-free interest rate..................... 4.55% - 4.90% 4.99% - 5.01% 4.3%Expected life............................... 1, 3 OR 5 YEARS 1, 3 or 5 years 3 or 5 yearsExpected volatility......................... 17.0% 17.0% 20.0% 20. PENSION AND OTHER POSTRETIREMENT BENEFITS-------------------------------------------------------------------------------- DEFINED BENEFIT PENSION PLANS In November 2004, sponsorship of the domesticdefined benefit pension plan of HSBC Finance Corporation and the domesticdefined benefit pension plan of HSBC Bank USA were transferred to HSBC NorthAmerica. Effective January 1, 2005, the two separate plans were combined into asingle HSBC North America defined benefit pension plan which facilitates thedevelopment of a unified employee benefit policy and unified employee benefitplan administration for HSBC companies operating in the United States. As aresult, the pension liability relating to our domestic defined benefit plan wastransferred to HSBC North America as a capital transaction in the first quarterof 2005. The components of pension expense for the domestic defined benefit planreflected in our consolidated statement of income (loss) are shown in the tablebelow. Pension expense reflects the portion of the pension expense of thecombined HSBC North America pension plan which has been allocated to HSBCFinance Corporation. YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005------------------------------------------------------------------------------------------------ (IN MILLIONS)Service cost - benefits earned during the period......................................... $ 55 $ 48 $ 46Interest cost on projected benefit obligation.... 66 60 54Expected return on assets........................ (83) (77) (78)Amortization of prior service cost............... - - -Recognized losses (gains)........................ 9 15 4 ---- ---- ----Pension expense.................................. $ 47 $ 46 $ 26 ==== ==== ==== The assumptions used in determining pension expense of the domestic definedbenefit plan are as follows: 2007 2006 2005-------------------------------------------------------------------------------------Discount rate................................................. 5.90% 5.70% 6.00%Salary increase assumption.................................... 3.75 3.75 3.75Expected long-term rate of return on plan assets.............. 8.00 8.00 8.33 175 HSBC North America retains both an unrelated third party as well as an affiliateto provide investment consulting services. Given the plan's current allocationof equity and fixed income securities and using investment return assumptionswhich are based on long term historical data, the long term expected return forplan assets is reasonable. The funded status of the post-merger HSBC NorthAmerica pension plan and not the interests of HSBC Finance Corporation atDecember 31, 2007 was a liability of $130 million. A reconciliation of beginning and ending balances of the fair value of planassets associated with the domestic defined benefit pension plan is shown below.The activity shown below reflects the activity of the merged HSBC North Americaplan. YEAR ENDED DECEMBER 31, ---------------- 2007 2006----------------------------------------------------------------------------------- (IN MILLIONS)Fair value of plan assets at beginning of year.................. $2,567 $2,383Actual return on plan assets.................................... 186 246Employer contributions.......................................... - -Benefits paid................................................... (136) (62) ------ ------Fair value of plan assets at end of year........................ $2,617 $2,567 ====== ====== It is currently not anticipated that employer contributions to the domesticdefined benefit plan will be made in 2008. The allocation of the domestic pension plan assets at December 31, 2007 and 2006is as follows: PERCENTAGE OF PLAN ASSETS AT DECEMBER 31, ------------- 2007 2006----------------------------------------------------------------------------------Equity securities................................................. 68% 69%Debt securities................................................... 31 30Other............................................................. 1 1 --- ---Total............................................................. 100% 100% === === There were no investments in HSBC ordinary shares or American depository sharesat December 31, 2007 or 2006. The primary objective of the defined benefit pension plan is to provide eligibleemployees with regular pension benefits. Since the domestic plans are governedby the Employee Retirement Income Security Act of 1974 ("ERISA"), ERISAregulations serve as guidance for the management of plan assets. Consistent withprudent standards of preservation of capital and maintenance of liquidity, thegoals of the plans are to earn the highest possible rate of return consistentwith the tolerance for risk as determined by the investment committee in itsrole as a fiduciary. In carrying out these objectives, short-term fluctuationsin the value of plan assets are considered secondary to long-term investmentresults. Both a third party and an affiliate are used to provide investmentconsulting services such as recommendations on the type of funds to be investedin and monitoring the performance of fund managers. In order to achieve thereturn objectives of the plans, the plans are diversified to ensure that adverseresults from one security or security class will not have an unduly detrimentaleffect on the entire investment portfolio. Assets are diversified by type,characteristic and number of investments as well as by investment style ofmanagement organization. Equity securities are invested in large, mid and smallcapitalization domestic stocks as well as international stocks. A reconciliation of beginning and ending balances of the projected benefitobligation of the domestic defined benefit pension plan is shown below andreflects the projected benefit obligation of the merged HSBC North America plan. 176 YEAR ENDED DECEMBER 31, ----------------- 2007 2006----------------------------------------------------------------------------------- (IN MILLIONS)Projected benefit obligation at beginning of year.............. $2,698 $2,530Service cost................................................... 111 102Interest cost.................................................. 159 145Actuarial (gains) losses....................................... (85) (17)Benefits paid.................................................. (136) (62) ------ ------Projected benefit obligation at end of year.................... $2,747 $2,698 ====== ====== Our share of the projected benefit obligation was approximately $1.1 billion atDecember 31, 2007 and 2006. The accumulated benefit obligation for the post-merger domestic HSBC North America defined benefit pension plan was $2.4 billionat December 31, 2007 and 2006. Our share of the accumulated benefit obligationwas approximately $1.0 billion at December 31, 2007 and 2006. Estimated future benefit payments for the HSBC North America domestic definedbenefit plan and HSBC Finance Corporation's share of those payments are asfollows: HSBC HSBC FINANCE NORTH CORPORATION'S AMERICA SHARE--------------------------------------------------------------------------------------- (IN MILLIONS)2008........................................................ $ 133 $ 652009........................................................ 142 692010........................................................ 151 732011........................................................ 163 792012........................................................ 181 892013-2017................................................... 1,027 463 The assumptions used in determining the projected benefit obligation of thedomestic defined benefit plans at December 31 are as follows: 2007 2006 2005-------------------------------------------------------------------------------------Discount rate................................................. 6.55% 5.90% 5.70%Salary increase assumption.................................... 3.75 3.75 3.75 FOREIGN DEFINED BENEFIT PENSION PLANS We sponsor additional defined benefitpension plans for our foreign based employees. Pension expense for our foreigndefined benefit pension plans was $3 million in 2007 and $2 million in 2006 and2005. For our foreign defined benefit pension plans, the fair value of planassets was $183 million at December 31, 2007 and $160 million at December 31,2006. The projected benefit obligation for our foreign defined benefit pensionplans was $206 million at December 31, 2007 and $191 million at December 31,2006. SUPPLEMENTAL RETIREMENT PLAN A non-qualified supplemental retirement plan isalso provided. This plan, which is currently unfunded, provides eligibleemployees defined pension benefits outside the qualified retirement plan.Benefits are based on average earnings, years of service and age at retirement.The projected benefit obligation was $136 million at December 31, 2007 and $92million at December 31, 2006. Pension expense related to the supplementalretirement plan was $30 million in 2007 and $11 million in 2006 and 2005. DEFINED CONTRIBUTION PLANS Various 401(k) savings plans and profit sharing plansexist for employees meeting certain eligibility requirements. Under these plans,each participant's contribution is matched by the company up to a maximum of 6percent of the participant's compensation. Company contributions are in the formof cash. Total expense for these plans for HSBC Finance Corporation was $79million in 2007, $98 million in 2006 and $91 million in 2005. 177 Effective January 1, 2005, HSBC Finance Corporation's 401(k) savings plansmerged with the HSBC Bank USA's 401(k) savings plan under HSBC North America. POSTRETIREMENT PLANS OTHER THAN PENSIONS Our employees also participate in planswhich provide medical, dental and life insurance benefits to retirees andeligible dependents. These plans cover substantially all employees who meetcertain age and vested service requirements. We have instituted dollar limits onour payments under the plans to control the cost of future medical benefits. The net postretirement benefit cost included the following: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005------------------------------------------------------------------------------------------------ (IN MILLIONS)Service cost - benefits earned during the period......................................... $ 5 $ 6 $ 5Interest cost.................................... 14 14 15Expected return on assets........................ - - -Amortization of prior service cost............... - - -Recognized (gains) losses........................ (1) - - --- --- ---Net periodic postretirement benefit cost......... $18 $20 $20 === === === The assumptions used in determining the net periodic postretirement benefit costfor our domestic postretirement benefit plans are as follows: 2007 2006 2005-------------------------------------------------------------------------------------Discount rate................................................. 5.90% 5.70% 6.00%Salary increase assumption.................................... 3.75 3.75 3.75 A reconciliation of the beginning and ending balances of the accumulatedpostretirement benefit obligation is as follows: YEAR ENDED DECEMBER 31, ------------ 2007 2006--------------------------------------------------------------------------------- (IN MILLIONS)Accumulated benefit obligation at beginning of year............... $232 $242Service cost...................................................... 5 6Interest cost..................................................... 14 14Foreign currency exchange rate changes............................ 4 -Actuarial gains................................................... (3) (8)Benefits paid..................................................... (21) (22) ---- ----Accumulated benefit obligation at end of year..................... $231 $232 ==== ==== Our postretirement benefit plans are funded on a pay-as-you-go basis. Wecurrently estimate that we will pay benefits of approximately $16 millionrelating to our postretirement benefit plans in 2008. The funded status of ourpostretirement benefit plans was a liability of $231 million at December 31,2007. 178 Estimated future benefit payments for our domestic plans are as follows: (IN MILLIONS)------------------------------------------------------------------------------------2008............................................................... $162009............................................................... 172010............................................................... 172011............................................................... 172012............................................................... 182013-2017.......................................................... 89 The assumptions used in determining the benefit obligation of our domesticpostretirement benefit plans at December 31 are as follows: 2007 2006 2005-------------------------------------------------------------------------------------Discount rate................................................. 6.55% 5.90% 5.70%Salary increase assumption.................................... 3.75 3.75 3.75 A 9.6 percent annual rate of increase in the gross cost of covered health carebenefits was assumed for 2007. This rate of increase is assumed to declinegradually to 5.0 percent in 2014. Assumed health care cost trend rates have an effect on the amounts reported forhealth care plans. A one-percentage point change in assumed health care costtrend rates would increase (decrease) service and interest costs and thepostretirement benefit obligation as follows: ONE PERCENT ONE PERCENT INCREASE DECREASE---------------------------------------------------------------------------------------- (IN MILLIONS)Effect on total of service and interest cost components.... $.6 $(.5)Effect on postretirement benefit obligation................ 7 (7) 21. BUSINESS SEGMENTS-------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services, andInternational. Our segments are managed separately and are characterized bydifferent middle-market consumer lending products, origination processes, andlocations. Our Consumer segment consists of our Consumer Lending, MortgageServices, Retail Services, and Auto Finance businesses. Our Credit Card Servicessegment consists of our domestic MasterCard, Visa, American Express and Discoverand other credit card business. Our International segment consists of ourforeign operations in Canada, the United Kingdom, the Republic of Ireland andprior to November 9, 2006, our operations in Slovakia, the Czech Republic andHungary. The Consumer segment provides real estate secured, automobile secured,personal non-credit card and private label loans. Loans are offered with bothrevolving and closed-end terms and with fixed or variable interest rates. Loansare originated through branch locations, direct mail, telemarketing, independentmerchants or automobile dealers. Prior to the first quarter of 2007, we acquiredloans through correspondent channels and prior to September 2007 we originatedloans through mortgage brokers. The Credit Card Services segment offersMasterCard, Visa, American Express and Discover and other credit card loansthroughout the United States primarily via strategic affinity and co-brandingrelationships, direct mail, and our branch network to non-prime customers. Wealso cross sell our credit cards to existing real estate secured, private label,auto finance and tax services customers. The International segment offerssecured and unsecured lines of credit and secured and unsecured closed-end loansprimarily in the United Kingdom, Canada and the Republic of Ireland. Theinsurance operations in the United Kingdom were sold on November 1, 2007 toAviva. Subsequent to November 1, 2007, we distribute insurance products in theUnited Kingdom through our branch network which are underwritten by Aviva. Allsegments offer products and service customers through the Internet. The AllOther caption includes our insurance and taxpayer financial services andcommercial businesses, each of which falls below the quantitative thresholdtests under Statement of Financial Accounting Standard No. 131, "Disclosuresabout Segments of an Enterprise and Related Information" ("SFAS No. 131"), fordetermining reportable segments, as well as our corporate and treasuryactivities. Fair value adjustments related to purchase accounting resulting from 179 our acquisition by HSBC and related amortization have been allocated toCorporate, which is included in the "All Other" caption within our segmentdisclosure. In May 2007, we decided to integrate our Retail Services and Credit CardServices businesses. Combining Retail Services with Credit Card Servicesenhances our ability to provide a single credit card and private label solutionfor the market place. We anticipate the integration of management reporting willbe completed in the first quarter of 2008 and at that time will result in thecombination of these businesses into one reporting segment in our financialstatements. There have been no changes in the basis of our segmentation or anychanges in the measurement of segment profit as compared with the presentationin our 2006 Form 10-K. Our segment results are presented on an IFRS Management Basis (a non-U.S. GAAPfinancial measure) as operating results are monitored and reviewed, trends areevaluated and decisions about allocating resources such as employees are madealmost exclusively on an IFRS Management Basis since we report results to ourparent, HSBC, who prepares its consolidated financial statements in accordancewith IFRSs. IFRS Management Basis results are IFRSs results adjusted to assumethat the private label and real estate secured receivables transferred to HSBCBank USA have not been sold and remain on our balance sheet. IFRS ManagementBasis also assumes that the purchase accounting fair value adjustments relatingto our acquisition by HSBC have been "pushed down" to HSBC Finance Corporation.Operations are monitored and trends are evaluated on an IFRS Management Basisbecause the customer loan sales to HSBC Bank USA were conducted primarily toappropriately fund prime customer loans within HSBC and such customer loanscontinue to be managed and serviced by us without regard to ownership. However,we continue to monitor capital adequacy, establish dividend policy and report toregulatory agencies on a U.S. GAAP basis. A summary of the significantdifferences between U.S. GAAP and IFRSs as they impact our results aresummarized below: Securitizations - On an IFRSs basis, securitized receivables are treated as owned. Any gains recorded under U.S. GAAP on these transactions are reversed. An owned loss reserve is established. The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. Derivatives and hedge accounting (including fair value adjustments) - The IFRSs derivative accounting model is similar to U.S. GAAP requirements. Prior to January 1, 2007, the differences between U.S. GAAP and IFRSs related primarily to the fact that a different population of derivatives qualified for hedge accounting under IFRSs than U.S. GAAP and that HSBC Finance Corporation had elected the fair value option under IFRSs on a significant portion of its fixed rate debt which was being hedged by receive fixed swaps. Prior to the issuance of FASB Statement No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," ("SFAS No. 159") in February 2007, U.S. GAAP did not permit the use of the fair value option. As a result of our early adoption of SFAS No. 159 which is more fully discussed in Note 12, "Fair Value Option," effective January 1, 2007, we utilize fair value option reporting for the same fixed rate debt issuances under both U.S. GAAP and IFRSs. Intangible assets and goodwill - Intangible assets under IFRSs are significantly lower than those under U.S. GAAP as the newly created intangibles associated with our acquisition by HSBC are reflected in goodwill for IFRSs which results in a higher goodwill balance under IFRSs. As a result, amortization of intangible assets is lower under IFRSs and the amount of goodwill allocated to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses and written off during 2007 is greater under IFRSs. Purchase accounting adjustments - There are differences in the valuation of assets and liabilities under U.K. GAAP (which were carried forward into IFRSs) and U.S. GAAP which result in a different amortization for the HSBC acquisition. Additionally there are differences in the valuation of assets and liabilities under IFRSs and U.S. GAAP resulting from the Metris acquisition in December 2005. Deferred loan origination costs and premiums - Under IFRSs, loan origination cost deferrals are more stringent and result in lower costs being deferred than permitted under U.S. GAAP. In addition, all deferred loan origination fees, costs and loan premiums must be recognized based on the expected life of the receivables under IFRSs as part of the effective interest calculation while under U.S. GAAP they may be amortized on either a contractual or expected life basis. 180 Credit loss impairment provisioning - IFRSs requires a discounted cash flow methodology for estimating impairment on pools of homogeneous customer loans which requires the incorporation of the time value of money relating to recovery estimates. Also under IFRSs, future recoveries on charged-off loans are accrued for on a discounted basis and interest is recorded based on collectibility. Loans held for resale - IFRSs requires loans held for resale to be treated as trading assets and recorded at their fair market value. Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet and recorded at the lower of amortized cost or market. Under U.S. GAAP, the income and expenses related to loans held for sale are reported similarly to loans held for investment. Under IFRSs, the income and expenses related to loans held for sale are reported in other operating income. Interest recognition - The calculation of effective interest rates under IFRS 39 requires an estimate of "all fees and points paid or recovered between parties to the contract" that are an integral part of the effective interest rate be included. In June 2006, we implemented a methodology for calculating the effective interest rate for introductory rate credit card receivables under IFRSs over the expected life of the product. In December 2006, we implemented a methodology to include prepayment penalties as part of the effective interest rate and recognized such penalties over the expected life of the receivables. U.S. GAAP generally prohibits recognition of interest income to the extent the net interest in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. Also under U.S. GAAP, prepayment penalties are generally recognized as received. Other - There are other less significant differences between IFRSs and U.S. GAAP relating to pension expense, severance and closure costs, changes in tax estimates and other miscellaneous items. See "Basis of Reporting" in Item 7. Management's Discussion and Analysis ofFinancial Condition and results of Operations in this 2006 Form 10-K for a morecomplete discussion of differences between U.S. GAAP and IFRSs. For segment reporting purposes, intersegment transactions have not beeneliminated. We generally account for transactions between segments as if theywere with third parties. 181 Reconciliation of our IFRS Management Basis segment results to the U.S. GAAPconsolidated totals are as follows: IFRS MANAGEMENT CREDIT ADJUSTMENTS/ BASIS MANAGEMENT CARD INTER- ALL RECONCILING CONSOLIDATED BASIS IFRS CONSUMER SERVICES NATIONAL OTHER ITEMS TOTALS ADJUSTMENTS(6) ADJUSTMENTS(5)---------------------------------------------------------------------------------------------------------------------------- (IN MILLIONS)YEAR ENDED DECEMBER 31, 2007Net interest income.... $ 8,447 $ 3,430 $ 844 $ (771) $ - $ 11,950 $ (1,404) $ 92Other operating income (Total other revenues)......... 523 3,078 231 2,050 (294)(1) 5,588 95 (202)Loan impairment charges (Provision for credit losses).............. 8,816 2,752 610 (1) 3(2) 12,180 (1,220) 73Operating expenses (Total costs and expenses)............ 3,027 1,872 548 6,503 - 11,950 11 (1,024)Income tax expense (benefit)............ (1,078) 700 (23) (21) (110)(3) (532) (19) (394)Net income (loss)...... (1,795) 1,184 (60) (5,202) (187) (6,060) (81) 1,235Customer loans (Receivables)........ 136,739 30,458 10,425 158 - 177,780 (21,719) 133Assets................. 132,602 30,005 10,607 27,631 (8,091)(4) 192,754 (20,948) (5,892)Intersegment revenues.. 265 18 17 (6) (294)(1) - - -Depreciation and amortization......... 55 63 19 98 - 235 - 162Goodwill............... - 530 13 3,543 - 4,086 - (1,259)Expenditures for long- lived assets(7)...... 16 - 16 103 - 135 - - -------- ------- ------- ------- ------- -------- -------- --------YEAR ENDED DECEMBER 31, 2006Net interest income.... $ 8,588 $ 3,151 $ 826 $ (768)(9) $ - $ 11,797 $ (1,254) $ (228)Other operating income (Total other revenues)......... 909 2,360 283 705 (291)(1) 3,966 299 180Loan impairment charges (Provision for credit losses).............. 4,983 1,500 535 (2) 6(2) 7,022 (646) 225Operating expenses (Total costs and expenses)............ 2,998 1,841 495 588 - 5,922 (22) (28)Income tax expense (benefit)............ 528 784 37 (326) (110)(3) 913 (89) 20Net income (loss)...... 988 1,386 42 (323) (187) 1,906 (198) (265)Customer loans (Receivables)........ 144,697 28,221 9,520 199 - 182,637 (21,372) 895Assets................. 146,395 28,780 10,764 29,931 (8,197)(4) 207,673 (21,933) (6,110)Intersegment revenues.. 242 20 33 (4) (291)(1) - - -Depreciation and amortization......... 34 67 17 120 - 238 - 179Goodwill............... 46 530 11 9,510 - 10,097 - (3,087)Expenditures for long- lived assets(7)...... 76 1 13 58 - 148 - - -------- ------- ------- ------- ------- -------- -------- --------YEAR ENDED DECEMBER 31, 2005Net interest income.... $ 8,401 $ 2,150 $ 971 $ (834) $ - $ 10,688 $ (1,438) $ (734)Other operating income (Total other revenues)......... 814 1,892 770 602 (140)(1) 3,938 500 (443)Loan impairment charges (Provision for credit losses).............. 3,362 1,453 620 (41) 9(2) 5,403 (629) (291)Operating expenses (Total costs and expenses)......... 2,757 1,315 635 574 - 5,281 (23) 107Income tax expense (benefit)............ 1,115 461 5 (364) (54)(3) 1,163 (94) (178)Net income (loss)...... 1,981 813 481 (401) (95) 2,779 (192) (815)Customer loans (Receivables)........ 128,095 25,979 9,328 211 - 163,613 (20,306) (3,394)Assets................. 130,375 28,453 10,905 26,634 (8,220)(4) 188,147 (20,247) (10,872)Intersegment revenues.. 108 21 17 (6) (140)(1) - - -Depreciation and amortization......... 44 26 30 143 - 243 - 275Goodwill............... - 521 11 9,464 - 9,996 - (2,993)Expenditures for long- lived assets(7)...... 24 525 32 28 - 609 - 2 -------- ------- ------- ------- ------- -------- -------- -------- IFRS U.S. GAAP RECLASS- CONSOLIDATED IFICATIONS(8) TOTALS---------------------------------------------------- (IN MILLIONS)YEAR ENDED DECEMBER 31, 2007Net interest income.... $ (87) $ 10,551Other operating income (Total other revenues)......... 918 6,399Loan impairment charges (Provision for credit losses).............. (7) 11,026Operating expenses (Total costs and expenses)............ 838 11,775Income tax expense (benefit)............ - (945)Net income (loss)...... - (4,906)Customer loans (Receivables)........ - 156,194Assets................. (410) 165,504Intersegment revenues.. - -Depreciation and amortization......... (52) 345Goodwill............... - 2,827Expenditures for long- lived assets(7)...... - 135 ----- --------YEAR ENDED DECEMBER 31, 2006Net interest income.... $(127) $ 10,188Other operating income (Total other revenues)......... 978 5,423Loan impairment charges (Provision for credit losses).............. (37) 6,564Operating expenses (Total costs and expenses)............ 888 6,760Income tax expense (benefit)............ - 844Net income (loss)...... - 1,443Customer loans (Receivables)........ - 162,160Assets................. (412) 179,218Intersegment revenues.. - -Depreciation and amortization......... (32) 385Goodwill............... - 7,010Expenditures for long- lived assets(7)...... - 148 ----- --------YEAR ENDED DECEMBER 31, 2005Net interest income.... $(132) $ 8,384Other operating income (Total other revenues)......... 968 4,963Loan impairment charges (Provision for credit losses).............. 60 4,543Operating expenses (Total costs and expenses)......... 776 6,141Income tax expense (benefit)............ - 891Net income (loss)...... - 1,772Customer loans (Receivables)........ - 139,913Assets................. (506) 156,522Intersegment revenues.. - -Depreciation and amortization......... (61) 457Goodwill............... - 7,003Expenditures for long- lived assets(7)...... - 611 ----- -------- -------- (1) Eliminates intersegment revenues. (2) Eliminates bad debt recovery sales between operating segments. (3) Tax benefit associated with items comprising adjustments/reconciling items. (4) Eliminates investments in subsidiaries and intercompany borrowings. (5) IFRS Adjustments, which have been described more fully above, consist of the following: 182 PROVISION TOTAL INCOME NET FOR COSTS TAX INTEREST OTHER CREDIT AND EXPENSE NET TOTAL INCOME REVENUES LOSSES EXPENSES (BENEFIT) INCOME RECEIVABLES ASSETS----------------------------------------------------------------------------------------------------------------------------- (IN MILLIONS)YEAR ENDED DECEMBER 31, 2007Securitizations...................... $ (63) $ 35 $ 11 $ - $ (15) $ (24) $ (244) $ (495)Derivatives and hedge accounting..... 280 (283) - - - (3) - (4,501)Goodwill and intangible assets....... - 37 - (875) (602) 1,514 - (113)Purchase accounting.................. 51 25 66 (40) 101 (51) 32 (1,652)Deferred loan origination costs and premiums........................... (160) (6) - (156) (4) (6) 388 388Credit loss impairment provisioning.. 15 13 (5) 36 (5) 2 (258) (304)Loans held for resale................ 56 (15) - 3 14 24 86 (6)Interest recognition................. (79) 1 - - (25) (53) (26) (24)Other................................ (8) (9) 1 8 142 (168) 155 815 ----- ----- ----- ------- ----- ------ ------- --------Total................................ $ 92 $(202) $ 73 $(1,024) $(394) $1,235 $ 133 $ (5,892) ===== ===== ===== ======= ===== ====== ======= ========YEAR ENDED DECEMBER 31, 2006Securitizations...................... $(244) $ 89 $ 25 $ - $ (62) $ (118) $ (948) $ (1,232)Derivatives and hedge accounting..... (31) 277 - - 91 155 - (4,181)Goodwill and intangible assets....... - - - 179 (66) (113) - (1,494)Purchase accounting.................. 202 64 195 (4) 25 50 118 (38)Deferred loan origination costs and premiums........................... (156) 2 - (199) 16 29 457 457Credit loss impairment provisioning.. (39) (3) 12 - (20) (34) (295) (298)Loans held for resale................ 125 (202) - (32) (17) (28) 1,584 38Interest recognition................. (38) (16) - - (20) (34) (53) (53)Other................................ (47) (31) (7) 28 73 (172) 32 691 ----- ----- ----- ------- ----- ------ ------- --------Total................................ $(228) $ 180 $ 225 $ (28) $ 20 $ (265) $ 895 $ (6,110) ===== ===== ===== ======= ===== ====== ======= ========YEAR ENDED DECEMBER 31, 2005Securitizations...................... $(900) $(137) $(315) $ - $(265) $ (457) $(5,415) $ (7,251)Derivatives and hedge accounting..... (41) (60) - - (43) (58) - (2,866)Goodwill and intangible assets....... - - - 272 (100) (172) - (1,222)Purchase accounting.................. 314 240 51 (15) 138 380 162 (114)Deferred loan origination costs and premiums........................... (197) 2 - (187) (2) (6) 430 430Credit loss impairment provisioning.. (55) 34 (42) - 10 11 (280) (232)Loans held for resale................ 126 (79) - 44 1 2 1,723 -Interest recognition................. - - - - - - - -Other................................ 19 (443) 15 (7) 83 (515) (14) 383 ----- ----- ----- ------- ----- ------ ------- --------Total................................ $(734) $(443) $(291) $ 107 $(178) $ (815) $(3,394) $(10,872) ===== ===== ===== ======= ===== ====== ======= ======== 183 (6) Management Basis Adjustments, which represent the private label and real estate secured receivables transferred to HBUS, consist of the following: PROVISION TOTAL INCOME NET FOR COSTS TAX INTEREST OTHER CREDIT AND EXPENSE NET TOTAL INCOME REVENUES LOSSES EXPENSES (BENEFIT) INCOME RECEIVABLES ASSETS----------------------------------------------------------------------------------------------------------------------------- (IN MILLIONS)YEAR ENDED DECEMBER 31, 2007Private label receivables......... $(1,349) $ 86 $(1,154) $ 15 $(29) $ (95) $(19,234) $(18,625)Real estate secured receivables... (57) 9 (66) (4) 8 14 (2,485) (2,477)Other............................. 2 - - - 2 - - 154 ------- ---- ------- ---- ---- ----- -------- --------Total............................. $(1,404) $ 95 $(1,220) $ 11 $(19) $ (81) $(21,719) $(20,948) ======= ==== ======= ==== ==== ===== ======== ========YEAR ENDED DECEMBER 31, 2006Private label receivables......... $(1,175) $287 $ (623) $(17) $(75) $(173) $(18,125) $(18,653)Real estate secured receivables... (99) 12 (23) (5) (21) (38) (3,247) (3,278)Other............................. 20 - - - 7 13 - (2) ------- ---- ------- ---- ---- ----- -------- --------Total............................. $(1,254) $299 $ (646) $(22) $(89) $(198) $(21,372) $(21,933) ======= ==== ======= ==== ==== ===== ======== ========YEAR ENDED DECEMBER 31, 2005Private label receivables......... $(1,310) $483 $ (594) $(22) $(66) $(145) $(15,762) $(15,673)Real estate secured receivables... (159) 17 (35) (1) (39) (67) (4,544) (4,571)Other............................. 31 - - - 11 20 - (3) ------- ---- ------- ---- ---- ----- -------- --------Total............................. $(1,438) $500 $ (629) $(23) $(94) $(192) $(20,306) $(20,247) ======= ==== ======= ==== ==== ===== ======== ======== (7) Includes goodwill associated with purchase business combinations other than the HSBC merger as well as capital expenditures. (8) Represents differences in balance sheet and income statement presentation between IFRS and U.S. GAAP. (9) In 2006, the "All Other" caption includes a cumulative adjustment to net interest income of approximately $207 million, largely to correct the amortization of purchase accounting adjustments related to certain debt that was not included in the fair value option adjustments under IFRSs in 2005. A portion of the amount recognized would otherwise have been recorded for the year ended December 31, 2005. 22. COMMITMENTS AND CONTINGENT LIABILITIES-------------------------------------------------------------------------------- LEASE OBLIGATIONS: We lease certain offices, buildings and equipment for periodswhich generally do not exceed 25 years. The leases have various renewal options.The office space leases generally require us to pay certain operating expenses.Net rental expense under operating leases was $195 million in 2007, $134 millionin 2006 and $132 million in 2005. We have lease obligations on certain office space which has been subleasedthrough the end of the lease period. Under these agreements, the sublessee hasassumed future rental obligations on the lease. Future net minimum lease commitments under noncancelable operating leasearrangements were: MINIMUM MINIMUM RENTAL SUBLEASEYEAR ENDING DECEMBER 31, PAYMENTS INCOME NET---------------------------------------------------------------------------------------- (IN MILLIONS)2008..................................................... $161 $37 $1242009..................................................... 127 27 1002010..................................................... 94 15 792011..................................................... 61 5 562012..................................................... 34 2 32Thereafter............................................... 107 -- 107 ---- --- ----Net minimum lease commitments............................ $584 $86 $498 ==== === ==== 184 In January 2006 we entered into a lease for a building in the Village ofMettawa, Illinois. The new facility will consolidate our Prospect Heights, MountProspect and Deerfield offices. Construction of the building began in the springof 2006 and the relocation is planned for the first and second quarters of 2008.The future lease payments for this building are currently estimated as follows: (IN MILLIONS)------------------------------------------------------------------------------------2008............................................................... $ 52009............................................................... 112010............................................................... 112011............................................................... 112012............................................................... 11Thereafter......................................................... 104 ---- $153 ==== LITIGATION: Both we and certain of our subsidiaries are parties to various legalproceedings resulting from ordinary business activities relating to our currentand/or former operations which affect all three of our reportable segments.Certain of these activities are or purport to be class actions seeking damagesin significant amounts. These actions include assertions concerning violationsof laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certainthat we will ultimately prevail in each instance. Also, as the ultimateresolution of these proceedings is influenced by factors that are outside of ourcontrol, it is reasonably possible our estimated liability under theseproceedings may change. However, based upon our current knowledge, our defensesto these actions have merit and any adverse decision should not materiallyaffect our consolidated financial condition, results of operations or cashflows. OTHER COMMITMENTS: At December 31, 2006, we had a commitment to lend up to $3.0billion to H&R Block to fund the purchase of a participation interest in refundanticipation loans. H&R Block borrowed funds under this commitment during the2007 tax season. All outstanding balances were paid in full and the commitmentexpired during the second quarter of 2007. In January 2008, we extended anotherline of credit to lend up to $3.0 billion to H&R Block to fund the purchase of aparticipation interest in refund anticipation loans. 23. FAIR VALUE MEASUREMENTS-------------------------------------------------------------------------------- Effective January 1, 2007, we elected to early adopt FASB Statement No. 157,"Fair Value Measurements," ("SFAS No. 157"). SFAS No. 157 establishes a singleauthoritative definition of value, sets out a framework for measuring fairvalue, and provides a hierarchal disclosure framework for assets and liabilitiesmeasured at fair value. The adoption of SFAS No. 157 did not have any impact onour financial position or results of operations. Presented below is informationabout assets and liabilities recorded in our consolidated balance sheet at fairvalue on a recurring basis, assets and liabilities recorded in our consolidatedbalance sheet at fair value on a nonrecurring basis and disclosures about thefair value of our financial instruments as required by FASB Statement No. 107,"Disclosures about Fair Value of Financial Instruments," ("SFAS No. 107"). 185 ASSETS AND LIABILITIES RECORDED AT FAIR VALUE ON A RECURRING BASIS The followingtable presents information about our assets and liabilities recorded in ourconsolidated balance sheet at their fair value on a recurring basis as ofDecember 31, 2007, and indicates the fair value hierarchy of the valuationtechniques utilized to determine such fair value. In general, fair valuesdetermined by Level 1 inputs use quoted prices (unadjusted) in active marketsfor identical assets or liabilities that we have the ability to access. Fairvalues determined by Level 2 inputs use inputs other than quoted prices includedin Level 1 that are observable for the asset or liability, either directly orindirectly. Level 2 inputs include quoted prices for similar assets andliabilities in active markets, quoted prices for identical or similar assets orliabilities in markets where there are few transactions and inputs other thanquoted prices that are observable for the asset or liability, such as interestrates and yield curves that are observable at commonly quoted intervals. Level 3inputs are unobservable inputs for the asset or liability and include situationswhere there is little, if any, market activity for the asset or liability. ASSETS (LIABILITIES) MEASURED AT QUOTED PRICES IN FAIR VALUE AT ACTIVE MARKETS FOR SIGNIFICANT OTHER SIGNIFICANT DECEMBER 31, IDENTICAL ASSETS OBSERVABLE INPUTS UNOBSERVABLE INPUTS 2007 (LEVEL 1) (LEVEL 2) (LEVEL 3)------------------------------------------------------------------------------------------------------------- (IN MILLIONS)Risk management related derivatives, net(1).......... $ 3,771 $ - $ 3,771 $-Securities purchased under agreements to resell......... 1,506 1,506 - -Available for sale securities.. 3,152 267 2,885 -Real estate owned(2)........... 1,151 - 1,151 -Repossessed vehicles(2)........ 83 - 83 -Long term debt carried at fair value........................ 32,896 - 32,896 - -------- (1) The fair value disclosed excludes swap collateral that we either receive or deposit with our interest rate swap counterparties. Such swap collateral is recorded on our balance sheet at an amount which "approximates fair value" as discussed in FASB Staff Position No. FIN 39-1, "Amendment of FASB Interpretation No. 39" and is netted on the balance sheet with the fair value amount recognized for derivative instruments. (2) The fair value disclosed is unadjusted for transaction costs as required by SFAS No. 157. The amounts recorded in the consolidated balance sheet are recorded net of transaction costs as required by FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The following summarizes the valuation techniques for assets recorded in ourconsolidated balance sheet at their fair value on a recurring basis: Risk management related derivative, net - Where practical, quoted market prices will be used to determine fair value of these instruments. For non- exchange traded contracts, fair value is determined using discounted cash flow modeling techniques in lieu of market value quotes. At December 31, 2007, none of our risk management related derivatives have been valued using quoted market prices. Securities purchased under agreements to resell - The fair value of securities purchased under agreements to resell generally approximates carrying value due to their short-term maturity. Available for sale securities - Fair value is determined by a third party valuation source. For U.S. Treasury securities, pricing is provided by market makers and inter-dealer brokers. For non-callable corporate securities, a credit spread scale is created for each issuer for maturities out to forty years. These spreads are then added to the equivalent maturity U.S. Treasury yield to determine current pricing. Credit spreads are obtained from the new issue market, secondary trading levels and dealer quotes. For securities with early redemption features, an option adjusted spread (OAS) model is incorporated to adjust the spreads determined above. Real estate owned - Fair value is determined based on third party appraisals obtained at the time we take title to the property and, if less than the carrying value of the loan, the carrying value of the loan is adjusted to the 186 fair value. After three months on the market, the carrying value is further reduced, if necessary, to reflect observable local market data, including local area sales data. Repossessed vehicles - Fair value is determined based on current Black Book values, which represent current observable prices in the auto auction market. Long term debt carried at fair value - Fair value, including the credit and interest risk components, are determined by a third party using discounted cash flow models which take into consideration changes in interest rates as well as relevant trade data. ASSETS AND LIABILITIES RECORDED AT FAIR VALUE ON A NON-RECURRING BASIS On a non-recurring basis, loans held for sale are recorded in our consolidated balancesheet at the lower of aggregate cost or fair value. At December 31, 2007, loansheld for sale which have been recorded at fair value totaled $71 million,excluding $9 million of loans held for sale for which the fair value exceeds ourcarrying value. Fair value is generally determined by estimating a gross premiumor discount. The estimated gross premium or discount is derived from loan salesdata over the last three months and pricing currently observable in the market,the weighted average coupon of the loans relative to market interest rates aswell as market liquidity and loan related credit characteristics. Loans held forsale are considered to be Level 2 in the fair value hierarchy of valuationtechniques. At December 31, 2007, loans held for sale with a carrying value of$129 million were written down to their current fair value resulting in animpairment charge of $58 million. In accordance with the provisions of SFAS No. 142, goodwill with a carryingamount of $881 million allocated to our Mortgage Services business was writtendown to its implied fair value of $0 during the third quarter of 2007.Additionally, goodwill with a carrying amount of $3,152 million allocated to ourConsumer Lending, Auto Finance and United Kingdom businesses was written down toits implied fair value of $0 during the fourth quarter of 2007. For purposes oftesting goodwill for impairment, we estimate the fair value of our reportingunits using discounted cash flow models, which include such variables as revenuegrowth rates, expense trends, interest rates and terminal values which are basedon evaluation of key data and market factors. The risk adjusted cost of capital,which is used to discount future cash flows, is generally derived from anappropriate capital asset pricing model, which itself depends on a number offinancial and economic variables. Goodwill is considered to be Level 3 in thefair value hierarchy of valuation techniques. Additionally, in accordance with SFAS No. 142, tradenames with a carrying amountof $700 million and customer relationships with a carrying amount of $158million relating to our Consumer Lending business were written down to theirimplied fair value of $0 during the fourth quarter of 2007. We estimate the fairvalue of tradenames using discounted cash flow models, which include assumptionsregarding revenue growth rates based on evaluation of key data and marketfactors as well as the risk adjusted cost of capital as discussed above. Weestimate the fair value of our customer relationships using discounted cash flowmodels which include assumptions regarding receivable growth rates, receivablerun-off rates and return on assets as well as the risk adjusted cost of capital.Intangible assets are considered to be Level 3 in the fair value hierarchy ofvaluation techniques. FAIR VALUE OF FINANCIAL INSTRUMENTS In accordance with SFAS No. 107, we havealso estimated the fair value of all financial instruments in our consolidatedbalance sheet, including those financial instruments carried at cost, aspresented in the table below. The fair value estimates, methods and assumptionsset forth below for our financial instruments are made solely to comply with therequirements of SFAS No. 107 and should be read in conjunction with thefinancial statements and notes in this Annual Report. The methodology we have historically utilized to estimate the fair value of ourreceivables, was not consistent with the framework for measuring fair value asoutlined by SFAS No. 157. SFAS No. 157 has defined fair value as "the price thatwould be received to sell an asset or paid to transfer a liability in an orderlytransaction between market participants at the measurement date." Accordingly,we have determined the fair value of our receivables in accordance with this newframework. The historical methodologies used to determine the fair value of allother financial instruments shown below is generally consistent with theframework for measuring fair value as outlined by SFAS No. 157. 187 The following is a summary of the carrying value and estimated fair value of ourfinancial instruments at December 31, 2007: CARRYING ESTIMATED VALUE(1) FAIR VALUE------------------------------------------------------------------------------------ (IN MILLIONS)ASSETS:Cash......................................................... $ 783 $ 783Interest bearing deposits with banks......................... 335 335Securities purchased under agreements to resell.............. 1,506 1,506Securities................................................... 3,152 3,152Consumer receivables: Mortgage Services: First lien.............................................. 25,712 19,339 Second lien............................................. 4,649 2,609 -------- -------- Total Mortgage Services................................. 30,361 21,948 Consumer Lending: First lien............................................ 42,870 30,890 Second lien........................................... 6,292 3,229 -------- -------- Total real estate secured............................... 49,162 34,119 Non-real estate secured................................. 16,277 10,351 -------- -------- Total Consumer Lending.................................. 65,439 44,470 Credit card................................................ 27,637 31,196 Auto Finance............................................... 11,797 10,998 International receivables.................................. 9,917 9,857 -------- --------Total consumer receivables................................... 145,151 118,469Due from affiliates.......................................... 631 631Derivative financial assets.................................. 48 48 LIABILITIES:Commercial paper, bank and other borrowings.................. 8,424 8,424Due to affiliates............................................ 14,902 14,487Long term debt carried at fair value......................... 32,896 32,896Long term debt not carried at fair value..................... 90,366 88,408Insurance policy and claim reserves.......................... 1,001 989Derivative financial liabilities............................. 20 20 -------- (1) The carrying values for receivables reflect receivables less credit loss reserves. See Note 6, "Receivables," for a complete description of the other components which comprise receivables, net which is reported on the consolidated balance sheet. Receivable values presented in the table above were determined using theframework for measuring fair value as prescribed by SFAS No. 157, which is basedon our best estimate of the amount within a range of value we believe would bereceived in a sale as of the balance sheet date (i.e. exit price). In recentmonths, the unprecedented developments in the mortgage lending industry haveresulted in a marked reduction in the secondary market demand for subprimeloans. The estimated fair values at December 31, 2007 for our receivablesreflect this marketplace turmoil which implicitly assumes a significantly highercharge-off level than what we, as the servicer of these receivables, believewill ultimately be the case. This creates a value that is markedly lower thanwould otherwise be reported under more normal marketplace conditions.Accordingly, we do not believe the amounts reported above accurately reflect thetrue underlying long-term value of our receivables. 188 As required under generally accepted accounting principles, a number of otherassets recorded on the balance sheets (such as acquired credit cardrelationships, the value of consumer lending relationships for originatedreceivables and the franchise values of our business units) are not consideredfinancial instruments and, accordingly, are not valued for purposes of thisdisclosure. We believe there continues to be substantial value associated withthese assets based on current market conditions and historical experience.Accordingly, the estimated fair value of financial instruments, as disclosed,does not fully represent our entire value, nor the changes in our entire value. The following table summarizes the estimated fair values for financialinstruments at December 31, 2006 which were determined in accordance with theprevious framework for determining fair value as required by SFAS No. 107. CARRYING ESTIMATED VALUE FAIR VALUE------------------------------------------------------------------------------------ (IN MILLIONS)ASSETS:Cash......................................................... $ 871 $ 871Interest bearing deposits with banks......................... 424 424Securities purchased under agreements to resell.............. 171 171Securities................................................... 4,695 4,695Receivables.................................................. 157,386 154,982Due from affiliates.......................................... 528 528Derivative financial assets.................................. 298 298 LIABILITIES:Commercial paper, bank and other borrowings.................. 11,055 11,055Due to affiliates............................................ 15,172 15,308Long term debt............................................... 127,590 129,008Insurance policy and claim reserves.......................... 1,319 1,362Derivative financial liabilities............................. 6 6 The following summarizes the valuation methodology used to determine theestimated fair values for financial instruments. CASH: Carrying value approximates fair value due to cash's liquid nature. INTEREST BEARING DEPOSITS WITH BANKS: Carrying value approximates fair value dueto the asset's liquid nature. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL: The fair value of securitiespurchased under agreements to resell approximates carrying value due to theirshort-term maturity. SECURITIES: Securities are classified as available-for-sale and are carried atfair value on the balance sheets. Fair value is determined by a third partyvaluation source. For U.S. Treasury securities, pricing is provided by marketmakers and inter-dealer brokers. For non-callable corporate securities, a creditspread scale is created for each issuer for maturities out to forty years. Thesespreads are then added to the equivalent maturity U.S. Treasury yield todetermine current pricing. Credit spreads are obtained from the new issuemarket, secondary trading levels and dealer quotes. For bonds with earlyredemption features, an option adjusted spread (OAS) model is incorporated toadjust the spreads determined above. RECEIVABLES: For December 31, 2007, as determined in accordance with theframework for measuring fair value as outlined by SFAS No. 157, the estimatedfair value of our real estate secured and auto finance receivables wasdetermined by an HSBC affiliate using various sources of information whichreflects current estimated rating agency credit tranching levels with theassociated benchmark credit spreads, and trading input which includes observedprimary and secondary trades and general discussions with investors. Theremainder of our receivable portfolios were valued using a forward lookingdiscounted cash flow methodology using assumptions we believe are consistentwith those which would be used by market participants in valuing suchreceivables. For December 31, 2006 as determined in accordance with the previous frameworkfor determining fair value as required by SFAS No. 107, the estimated fair valueof adjustable rate receivables generally approximated carrying value becauseinterest rates on these receivables adjust with changing market interest rates.The fair value of fixed rate consumer receivables was estimated by discountingfuture expected cash flows at interest rates which 189 approximate the current interest rates that would achieve a similar return onassets with comparable risk characteristics. Receivables also includes ourinterest-only strip receivables. The interest-only strip receivables are carriedat fair value on our balance sheets. Fair value is based on an estimate of thepresent value of future cash flows associated with securitizations of certainreal estate secured, auto finance, credit card, private label and personal non-credit card receivables. DUE FROM AFFILIATES: Carrying value approximates fair value because the interestrates on these receivables adjust with changing market interest rates. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS: The fair value of these instrumentsapproximates existing carrying value because interest rates on these instrumentsadjust with changes in market interest rates due to their short-term maturity orrepricing characteristics. DUE TO AFFILIATES: The estimated fair value of our debt instruments due toaffiliates was determined by discounting future expected cash flows at currentinterest rates offered for similar types of debt instruments. Carrying value istypically used to estimate the fair value of floating rate debt. LONG TERM DEBT CARRIED AT FAIR VALUE: Fair value of FVO debt is determined by athird party using discounted cash flow models which take into considerationchanges in interest rates as well as relevant trade data. LONG TERM DEBT NOT CARRIED AT FAIR VALUE: The estimated fair value of our fixedrate and floating rate debt instruments not carried at fair value was determinedusing either quoted market prices or by discounting future expected cash flowsat current interest rates and credit spreads offered for similar types of debtinstruments. INSURANCE POLICY AND CLAIM RESERVES: The fair value of insurance reserves forperiodic payment annuities was estimated by discounting future expected cashflows at estimated market interest rates. DERIVATIVE FINANCIAL ASSETS AND LIABILITIES: All derivative financial assets andliabilities, which exclude amounts receivable from or payable to swapcounterparties, are carried at fair value on the balance sheet. Where practical,quoted market prices were used to determine fair value of these instruments. Fornon-exchange traded contracts, fair value was determined using discounted cashflow modeling techniques in lieu of market value quotes. We enter into foreignexchange contracts to hedge our exposure to currency risk on foreign denominateddebt. We also enter into interest rate contracts to hedge our exposure tointerest rate risk on assets and liabilities, including debt. As a result,decreases/increases in the fair value of derivative financial instruments whichhave been designated as effective hedges are offset by a correspondingincrease/decrease in the fair value of the individual asset or liability beinghedged. See Note 14, "Derivative Financial Instruments," for additionaldiscussion of the nature of these item 24. CONCENTRATION OF CREDIT RISK-------------------------------------------------------------------------------- A concentration of credit risk is defined as a significant credit exposure withan individual or group engaged in similar activities or having similar economiccharacteristics that would cause their ability to meet contractual obligationsto be similarly affected by changes in economic or other conditions. We generally serve non-conforming and non-prime consumers. Such customers areindividuals who have limited credit histories, modest incomes, high debt-to-income ratios or have experienced credit problems caused by occasionaldelinquencies, prior charge-offs, bankruptcy or other credit related actions. Asa result, the majority of our secured receivables have a high loan-to-valueratio. Prior to our decision to cease operations, our Decision One mortgageoperation offered, among other products, interest-only loans largely for resale,which beginning in June 2007 were primarily to HSBC Bank USA to support thesecondary market activities of our affiliates. Interest-only loans historicallyoriginated by our Consumer Lending business or acquired by our correspondentchannel are no longer offered. Our Solstice subsidiary also offers interest-onlyloans for resale to third parties. Interest-only loans allow customers to paythe interest only portion of the monthly payment for a period of time whichresults in lower payments during the initial loan period. However, subsequentevents affecting a customer's financial position could affect the ability ofcustomers to repay the loan in the future when the principal payments arerequired. At December 31, 2007, the outstanding balance of our interest-onlyloans was $4.1 billion, or 3 percent of receivables. At December 31, 2006, theoutstanding balance of our interest-only loans was $6.7 billion, or 4 percent ofreceivables. 190 Through the third quarter of 2007, we also offered adjustable rate mortgage("ARM") loans under which pricing adjusts on the receivable in line with marketmovements, in some cases, following an introductory fixed rate period. AtDecember 31, 2007, we had approximately $18.5 billion in adjustable ratemortgage loans at our Consumer Lending and Mortgage Services businesses. AtDecember 31, 2006, we had approximately $29.8 billion in adjustable ratemortgage loans at our Consumer Lending and Mortgage Services businesses. Themajority of our adjustable rate mortgages were acquired from correspondentlenders of our Mortgage Services business. In the first quarter of 2007, wediscontinued correspondent channel acquisitions subject to fulfilling earliercommitments and in the fourth quarter of 2007 we eliminated the small volume ofARM originations in our Consumer Lending business. Consequently, the percentageof adjustable rate real estate secured receivables will decrease significantlyover time. In 2008, approximately $3.7 billion of our adjustable rate mortgageloans will experience their first interest rate reset based on receivable levelsoutstanding at December 31, 2007. In addition, our analysis indicates that asignificant portion of the second lien mortgages in our Mortgage Servicesportfolio at December 31, 2007 are subordinated to first lien adjustable ratemortgages that will face a rate reset between now and 2009. As interest rateshave fluctuated over the last three years, certain adjustable rate loans mayrequire a higher monthly payment following their first adjustment. A customer'sfinancial situation at the time of the interest rate reset could affect ourcustomer's ability to repay the loan after the adjustment. As part of our risk mitigation efforts relating to the affected components ofthe Mortgage Services portfolio, in October 2006 we established a new programspecifically designed to meet the needs of select customers with ARMs. We areproactively writing and calling customers who have adjustable rate mortgageloans nearing the first reset that we expect will be the most impacted by a rateadjustment. Through a variety of means, we are assessing their ability to makethe adjusted payment and, as appropriate and in accordance with definedpolicies, are modifying the loans in most instances by delaying the firstinterest rate adjustment for twelve months, allowing time for the customer toseek alternative financing or improve their individual situation. In 2007, wehave made more than 33,000 outbound customer contacts and modified more than8,500 loans with an aggregate balance of $1.4 billion. Since the inception ofthis program we have made more than 41,000 outbound contacts and modified morethan 10,300 loans with an aggregate balance of $1.6 billion. These loans are notreflected in the interest rate reset volumes discussed in the precedingparagraph. Unless these customers who have benefited from a loan modificationare able to obtain other financing, these loans will also be subject to aninterest rate reset at the end of the modification period. During 2006 and 2005 we increased our portfolio of stated income loans. Statedincome loans are underwritten based on the loan applicant's representation ofannual income which is not verified by receipt of supporting documentation and,accordingly, carry a higher risk of default if the customer has not accuratelyreported their income. Prior to our decision to cease operations of DecisionOne, it offered stated income loans which, beginning in June 2007, were soldprimarily to HSBC Bank USA to support the secondary market activities of ouraffiliates. The outstanding balance of stated income loans in our real estatesecured portfolio was $7.9 billion at December 31, 2007 and $11.8 billion atDecember 31, 2006. Because we primarily lend to consumers, we do not have receivables from anyindustry group that equal or exceed 10 percent of total receivables at December31, 2007 and 2006. We lend nationwide and our receivables are distributed asfollows at December 31, 2007: PERCENT OF TOTAL DOMESTICSTATE/REGION RECEIVABLES-------------------------------------------------------------------------------------California....................................................... 12%Midwest (IL, IN, IA, KS, MI, MN, MO, NE, ND, OH, SD, WI)......... 23Southeast (AL, FL, GA, KY, MS, NC, SC, TN)....................... 20Middle Atlantic (DE, DC, MD, NJ, PA, VA, WV)..................... 15Southwest (AZ, AR, LA, NM, OK, TX)............................... 11Northeast (CT, ME, MA, NH, NY, RI, VT)........................... 11West (AK, CO, HI, ID, MT, NV, OR, UT, WA, WY).................... 8 191 The following table reflects the percentage of domestic consumer receivables bystate which individually account for 5 percent or greater of our domesticportfolio. PERCENT OF TOTAL DOMESTICSTATE RECEIVABLES-------------------------------------------------------------------------------------California....................................................... 12%Florida.......................................................... 7New York......................................................... 6Ohio............................................................. 5Pennsylvania..................................................... 5Texas............................................................ 5 25. GEOGRAPHIC DATA-------------------------------------------------------------------------------- The tables below summarize our owned basis assets, revenues and income beforeincome taxes by material country. Purchase accounting adjustments are reportedwithin the appropriate country. AT DECEMBER 31, --------------------------------------------------------- IDENTIFIABLE ASSETS LONG-LIVED ASSETS(1) ------------------------------ ------------------------ 2007 2006 2005 2007 2006 2005--------------------------------------------------------------------------------------------- (IN MILLIONS)United States..................... $154,739 $168,356 $145,808 $4,086 $9,046 $9,382United Kingdom.................... 5,180 6,592 7,006 70 452 403Canada............................ 5,502 4,181 3,479 193 157 153Europe............................ 83 89 229 - - 3 -------- -------- -------- ------ ------ ------Total............................. $165,504 $179,218 $156,522 $4,349 $9,655 $9,941 ======== ======== ======== ====== ====== ====== --------(1) Includes properties and equipment, goodwill and acquired intangibles. YEAR ENDED DECEMBER 31, ------------------------------------------------------- INCOME BEFORE INCOME REVENUES TAXES --------------------------- ------------------------- 2007 2006 2005 2007 2006 2005--------------------------------------------------------------------------------------------- (IN MILLIONS)United States....................... $23,406 $21,130 $15,961 $(5,288) $2,330 $2,609United Kingdom...................... 937 1,222 1,737 (709) (170) (37)Canada.............................. 739 601 450 141 129 96Europe.............................. - 32 31 5 (2) (5) ------- ------- ------- ------- ------ ------Total............................... $25,082 $22,985 $18,179 $(5,851) $2,287 $2,663 ======= ======= ======= ======= ====== ====== 192 HSBC Finance Corporation-------------------------------------------------------------------------------- MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock ExchangeRelated Shares:
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