30th Jul 2007 11:57
HSBC Holdings PLC30 July 2007 Part 1 of 2 -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------ FORM 10-Q ------------ (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2007 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from_________to_________ COMMISSION FILE NUMBER 1-8198 ------------ HSBC FINANCE CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 86-1052062 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 2700 SANDERS ROAD, PROSPECT HEIGHTS, 60070 ILLINOIS (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (847) 564-5000 REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE ------------ Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes (X) No ( ) Indicate by check mark whether the registrant is a large accelerated filer,an accelerated filer, or a non-accelerated filer. See definition of "acceleratedfiler and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Checkone): Large accelerated filer ( ) Accelerated filer ( ) Non-acceleratedfiler (X) Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). Yes ( ) No (X) As of June 30, 2007, there were 56 shares of the registrant's common stockoutstanding, all of which are owned by HSBC Investments (North America) Inc. -------------------------------------------------------------------------------- HSBC FINANCE CORPORATION FORM 10-Q TABLE OF CONTENTS FINANCIALPART I. INFORMATION -------------------------------------- ConsolidatedItem 1. Financial Statements Statement of Income.............. 3 Balance Sheet....... 4 Statement of Changes in Shareholders' Equity.............. 5 Statement of Cash Flows............... 6 Notes to Consolidated Financial Statements.......... 7 Management's Discussion and Analysis of Financial Condition and Results ofItem 2. Operations Forward-Looking Statements.......... 28 Executive Overview.. 28 Basis of Reporting.. 33 Receivables Review.. 40 Results of Operations.......... 42 Segment Results - IFRS Management Basis.... 50 Credit Quality...... 57 Liquidity and Capital Resources... 64 Risk Management..... 69 Reconciliations to GAAP Financial Measures............ 71 Controls andItem 4. Procedures.......... 72 PART II. OTHER INFORMATION-------------------------------------- Item 1. Legal Proceedings... 72Item 6. Exhibits............ 74Signature .................... 75 2 PART I. FINANCIAL INFORMATION -------------------------------------------------------------------------------- ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, --------------- --------------- 2007 2006 2007 2006-------------------------------------------------------------------------------------- (IN MILLIONS) Finance and other interest income.................. $4,685 $4,311 $9,397 $8,398Interest expense: HSBC affiliates.................................. 217 173 451 326 Non-affiliates................................... 1,811 1,589 3,648 3,059 ------ ------ ------ ------NET INTEREST INCOME................................ 2,657 2,549 5,298 5,013Provision for credit losses........................ 1,947 1,248 3,647 2,114 ------ ------ ------ ------NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES........................................... 710 1,301 1,651 2,899 ------ ------ ------ ------Other revenues: Securitization related revenue................... 22 51 43 122 Insurance revenue................................ 193 226 423 470 Investment income................................ 32 34 58 68 Derivative (expense) income...................... (39) (7) (46) 50 Gain (loss) on debt designated at fair value and related derivatives........................... (130) - 14 - Fee income....................................... 629 429 1,202 811 Enhancement services revenue..................... 150 130 298 253 Taxpayer financial services revenue.............. 4 20 243 254 Gain on receivable sales to HSBC affiliates...... 109 97 204 182 Servicing and other fees from HSBC affiliates.... 132 116 265 234 Other (expense) income........................... (88) 79 (48) 152 ------ ------ ------ ------TOTAL OTHER REVENUES............................... 1,014 1,175 2,656 2,596 ------ ------ ------ ------Costs and expenses: Salaries and employee benefits................... 587 564 1,196 1,145 Sales incentives................................. 62 98 130 178 Occupancy and equipment expenses................. 85 79 163 162 Other marketing expenses......................... 220 176 440 349 Other servicing and administrative expenses...... 242 222 505 475 Support services from HSBC affiliates............ 299 270 584 522 Amortization of intangibles...................... 63 63 126 143 Policyholders' benefits.......................... 90 107 214 225 ------ ------ ------ ------TOTAL COSTS AND EXPENSES........................... 1,648 1,579 3,358 3,199 ------ ------ ------ ------Income before income tax expense................... 76 897 949 2,296Income tax expense................................. 13 329 345 840 ------ ------ ------ ------NET INCOME......................................... $ 63 $ 568 $ 604 $1,456 ====== ====== ====== ====== The accompanying notes are an integral part of the consolidated financialstatements. 3 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET JUNE 30, DECEMBER 31, 2007 2006------------------------------------------------------------------------------------ (IN MILLIONS, EXCEPT SHARE DATA) ASSETSCash....................................................... $ 882 $ 871Interest bearing deposits with banks....................... 45 424Securities purchased under agreements to resell............ 1 171Securities................................................. 3,462 4,695Receivables, net........................................... 152,621 157,262Intangible assets, net..................................... 2,092 2,218Goodwill................................................... 6,896 7,010Properties and equipment, net.............................. 442 426Real estate owned.......................................... 1,004 794Derivative financial assets................................ 358 298Other assets............................................... 5,550 5,049 -------- --------TOTAL ASSETS............................................... $173,353 $179,218 ======== ========LIABILITIESDebt: Commercial paper, bank and other borrowings.............. $ 12,057 $ 11,055 Due to affiliates........................................ 14,863 15,172 Long term debt (with original maturities over one year, including $32,085 million at June 30, 2007 and $0 at December 31, 2006 carried at fair value).............. 121,783 127,590 -------- --------Total debt................................................. 148,703 153,817 -------- --------Insurance policy and claim reserves........................ 1,009 1,319Derivative related liabilities............................. 29 6Liability for pension benefits............................. 369 355Other liabilities.......................................... 3,496 3,631 -------- -------- TOTAL LIABILITIES........................................ 153,606 159,128SHAREHOLDERS' EQUITYRedeemable preferred stock, 1,501,100 shares authorized, Series B, $0.01 par value, 575,000 shares issued......... 575 575Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized, 56 shares issued.................................... - - Additional paid-in capital............................ 17,460 17,279 Retained earnings..................................... 1,302 1,877 Accumulated other comprehensive income................ 410 359 -------- --------TOTAL COMMON SHAREHOLDER'S EQUITY.......................... 19,172 19,515 -------- --------TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY................. $173,353 $179,218 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 4 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY SIX MONTHS ENDED JUNE 30, 2007 2006--------------------------------------------------------------------------------- (IN MILLIONS) PREFERRED STOCK Balance at beginning and end of period...................... $ 575 $ 575 ======= =======COMMON SHAREHOLDER'S EQUITY ADDITIONAL PAID-IN CAPITAL Balance at beginning of period........................... $17,279 $17,145 Capital contribution from parent company................. 200 - Employee benefit plans, including transfers and other.... (19) (25) ------- ------- Balance at end of period................................. $17,460 $17,120 ------- ------- RETAINED EARNINGS Balance at beginning of period........................... $ 1,877 $ 1,280 Adjustment to initially apply the fair value method of accounting under FASB statement No. 159, net of tax.... (542) - Net income............................................... 604 1,456 Cash dividend equivalents on HSBC's Restricted Share Plan................................................... (4) - Dividends: Preferred stock........................................ (18) (18) Common stock........................................... (615) (423) ------- ------- Balance at end of period................................. $ 1,302 $ 2,295 ------- ------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period........................... $ 359 $ 479 Net change in unrealized gains (losses), net of tax, on: Derivatives classified as cash flow hedges............. 23 101 Securities available for sale and interest-only strip receivables......................................... (16) (60) Foreign currency translation adjustments................. 44 150 ------- ------- Other comprehensive income, net of tax................... 51 191 ------- ------- Balance at end of period................................. $ 410 $ 670 ------- -------TOTAL COMMON SHAREHOLDER'S EQUITY............................. $19,172 $20,085 ------- -------COMPREHENSIVE INCOME Net income.................................................. $ 604 $ 1,456 Other comprehensive income.................................. 51 191 ------- -------COMPREHENSIVE INCOME.......................................... $ 655 $ 1,647 ======= ======= The accompanying notes are an integral part of the consolidated financialstatements. 5 HSBC Finance Corporation -------------------------------------------------------------------------------- STATEMENT OF CASH FLOWS SIX MONTHS ENDED JUNE 30, 2007 2006------------------------------------------------------------------------------------ (IN MILLIONS) CASH FLOWS FROM OPERATING ACTIVITIESNet income..................................................... $ 604 $ 1,456Adjustments to reconcile net income to net cash provided by (used in) operating activities: Gain on receivable sales to HSBC affiliates.................. (204) (182) Loss on real estate secured loan sale to third party......... 20 - Provision for credit losses.................................. 3,647 2,114 Insurance policy and claim reserves.......................... (46) (135) Depreciation and amortization................................ 173 201 Net change in other assets................................... 11 162 Net change in other liabilities.............................. (297) 218 Net change in loans held for sale............................ (1,238) (419) Net change in derivative related assets and liabilities...... 212 (323) Net change in debt designated at fair value and related derivatives............................................... (172) - Excess tax benefits from share-based compensation arrangements.............................................. (1) (9) Other, net................................................... 559 336 -------- --------Net cash provided by (used in) operating activities............ 3,268 3,419 -------- --------CASH FLOWS FROM INVESTING ACTIVITIESSecurities: Purchased.................................................... (693) (1,166) Matured...................................................... 492 841 Sold......................................................... 95 135Net change in short-term securities available for sale......... 960 (170)Net change in securities purchased under agreements to resell.. 170 72Net change in interest bearing deposits with banks............. 257 (40)Receivables: Originations, net of collections............................. 165 (14,927) Purchases and related premiums............................... (201) (548)Cash received in portfolio sales to third party................ 2,147 -Cash received in sale of U.K. credit card business............. - 90Properties and equipment: Purchases.................................................... (65) (32) Sales........................................................ 2 12 -------- --------Net cash provided by (used in) investing activities............ 3,329 (15,733) -------- --------CASH FLOWS FROM FINANCING ACTIVITIESDebt: Net change in short-term debt and deposits................... 979 1,960 Net change in due to affiliates.............................. (395) (84) Long term debt issued........................................ 10,783 20,105 Long term debt retired....................................... (17,485) (9,488)Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts.................... - (206)Insurance: Policyholders' benefits paid................................. (159) (116) Cash received from policyholders............................. 129 188Capital contribution from parent............................... 200 -Shareholders' dividends........................................ (633) (441)Excess tax benefits from share-based compensation arrangements................................................. 1 9 -------- --------Net cash provided by (used in) financing activities............ (6,580) 11,927 -------- --------Effect of exchange rate changes on cash........................ (6) 10 -------- --------Net change in cash............................................. 11 (377)Cash at beginning of period.................................... 871 903 -------- --------CASH AT END OF PERIOD.......................................... $ 882 $ 526 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 6 HSBC Finance Corporation -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND BASIS OF PRESENTATION-------------------------------------------------------------------------------- HSBC Finance Corporation and subsidiaries is an indirect wholly owned subsidiaryof HSBC North America Holdings Inc. ("HSBC North America"), which is an indirectwholly owned subsidiary of HSBC Holdings plc ("HSBC"). The accompanyingunaudited interim consolidated financial statements of HSBC Finance Corporationand its subsidiaries have been prepared in accordance with accounting principlesgenerally accepted in the United States of America ("U.S. GAAP") for interimfinancial information and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the information andfootnotes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all normal and recurringadjustments considered necessary for a fair presentation of financial position,results of operations and cash flows for the interim periods have been made.HSBC Finance Corporation may also be referred to in this Form 10-Q as "we," "us"or "our." These unaudited interim consolidated financial statements should beread in conjunction with our Annual Report on Form 10-K for the year endedDecember 31, 2006 (the "2006 Form 10-K"). Certain reclassifications have beenmade to prior period amounts to conform to the current period presentation. The preparation of financial statements in conformity with U.S. GAAP requiresthe use of estimates and assumptions that affect reported amounts anddisclosures. Actual results could differ from those estimates. Interim resultsshould not be considered indicative of results in future periods. 2. SALE OF U.K. INSURANCE OPERATIONS-------------------------------------------------------------------------------- As part of our continuing evaluation of strategic alternatives with respect toour U.K. operations, we have entered into a non-binding agreement to sell thecapital stock of our U.K. insurance operations ("U.K. Insurance Operations") toa third party for cash. The sales price will be determined, in part, based onthe actual net book value of the assets sold at the time the sale is closedwhich is anticipated in the second half of 2007. The agreement also provides forthe purchaser to distribute insurance products through our U.K. branch networkfor which we will receive commission revenue. The sale is subject to theexecution of a definitive agreement and any regulatory approvals that may berequired. At June 2007, we have classified the U.K. Insurance Operations as"Held for Sale" and combined assets of $464 million and liabilities of $233million related to the U.K. Insurance Operations separately in our consolidatedbalance sheet within other assets and other liabilities. Our U.K. Insurance Operations are reported in the International Segment. As ourcarrying value for the U.K. Insurance Operations, including allocated goodwill,was more than the estimated sales price, we recorded an adjustment of $31million during the three months ended March 31, 2007 as a component of totalcosts and expenses to record our investment in these operations at the lower ofcost or market. No additional adjustment was determined to be necessary duringthe three months ended June 30, 2007. At June 30, 2007, the assets consistedprimarily of investments of $490 million, unearned credit insurance premiums andclaim reserves on consumer receivables of ($123) million and goodwill of $73million. The liabilities consist primarily of insurance reserves which totaled$224 million at June 30, 2007. The purchaser will assume all the liabilities ofthe U.K. Insurance Operations as a result of this transaction. Due to ourcontinuing involvement as discussed above, this transaction did not meet thediscontinued operation reporting requirements contained in SFAS No. 144,"Accounting for the Impairment and Disposal of Long-Lived Assets." 7 HSBC Finance Corporation -------------------------------------------------------------------------------- 3. SECURITIES-------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRJUNE 30, 2007 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities...................... $2,157 $4 $(55) $2,106Money market funds............................. 420 - - 420U.S. government sponsored enterprises(1)....... 326 - (4) 322U.S. government and Federal agency debt securities................................... 48 - (3) 45Non-government mortgage backed securities...... 309 - (1) 308Other.......................................... 230 - (3) 227 ------ -- ---- ------Subtotal....................................... 3,490 4 (66) 3,428Accrued investment income...................... 34 - - 34 ------ -- ---- ------Total securities available for sale............ $3,524 $4 $(66) $3,462 ====== == ==== ====== GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRDECEMBER 31, 2006 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities...................... $2,530 $11 $(40) $2,501Money market funds............................. 1,051 - - 1,051U.S. government sponsored enterprises(1)....... 369 1 (3) 367U.S. government and Federal agency debt securities................................... 43 - (1) 42Non-government mortgage backed securities...... 271 - - 271Other.......................................... 428 - (3) 425 ------ --- ---- ------Subtotal....................................... 4,692 12 (47) 4,657Accrued investment income...................... 38 - - 38 ------ --- ---- ------Total securities available for sale............ $4,730 $12 $(47) $4,695 ====== === ==== ====== -------- ()(1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Money market funds include $209 million at June 30, 2007 and $854 million atDecember 31, 2006 which are restricted for the sole purpose of paying downcertain secured financings at the established payment date. 8 HSBC Finance Corporation -------------------------------------------------------------------------------- The decrease in securities available for sale at June 30, 2007 is due to thereclassification to other assets of approximately $400 million of securitiesrelated to the U.K. Insurance Operation which at June 30, 2007 are classified as"Held for Sale," and included within other assets, as well as the use ofapproximately $650 million in money market funds to pay down secured financingsduring the second quarter. A summary of gross unrealized losses and related fairvalues as of June 30, 2007 and December 31, 2006, classified as to the length oftime the losses have existed follows: LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OFJUNE 30, 2007 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS---------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities.... 255 $(18) $693 455 $(37) $1,031U.S. government sponsored enterprises................ 56 (2) 169 37 (2) 116U.S. government and Federal agency debt securities..... 13 (1) 22 13 (2) 20Non-government mortgage backed securities.......... 23 (1) 178 7 - 5Other........................ 23 (1) 83 42 (2) 131 LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OFDECEMBER 31, 2006 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS---------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities.... 133 $(6) $465 511 $(34) $1,178U.S. government sponsored enterprises................ 30 -(1) 101 43 (3) 149U.S. government and Federal agency debt securities..... 8 -(1) 21 20 (1) 16Non-government mortgage backed securities.......... 10 -(1) 60 9 - 7Other........................ 16 -(1) 57 52 (3) 173 -------- ()(1) Less than $500 thousand. The gross unrealized losses on our securities available for sale have increasedduring the first half of 2007 due to increases in the intermediate and long-terminterest rates during the period and wider credit spreads. The contractual termsof these securities do not permit the issuer to settle the securities at a priceless than the par value of the investment. Since substantially all of thesesecurities are rated A- or better, and because we have the ability and intent tohold these investments until maturity or a market price recovery, thesesecurities are not considered other-than-temporarily impaired. 9 HSBC Finance Corporation -------------------------------------------------------------------------------- 4. RECEIVABLES-------------------------------------------------------------------------------- Receivables consisted of the following: JUNE 30, DECEMBER 31, 2007 2006------------------------------------------------------------------------------------ (IN MILLIONS) Real estate secured........................................ $ 92,296 $ 97,761Auto finance............................................... 12,933 12,504Credit card................................................ 28,594 27,714Private label.............................................. 2,553 2,509Personal non-credit card................................... 21,277 21,367Commercial and other....................................... 152 181 -------- --------Total receivables.......................................... 157,805 162,036HSBC acquisition purchase accounting fair value adjustments.............................................. (54) (60)Accrued finance charges.................................... 2,299 2,228Credit loss reserve for receivables........................ (7,157) (6,587)Unearned credit insurance premiums and claims reserves..... (301) (412)Interest-only strip receivables............................ 6 6Amounts due and deferred from receivable sales............. 23 51 -------- --------Total receivables, net..................................... $152,621 $157,262 ======== ======== HSBC acquisition purchase accounting fair value adjustments representadjustments which have been "pushed down" to record our receivables at fairvalue on March 28, 2003, the date we were acquired by HSBC. We have a subsidiary, Decision One Mortgage Company, LLC ("Decision One"), whichdirectly originates and sells mortgage loans sourced by mortgage brokers.Historically, Decision One sold all loans to affiliated and unaffiliatedsecondary market purchasers, including our Mortgage Services business. Wecontinue to originate mortgage loans through Decision One largely for resale toHSBC Bank USA to support the secondary market activities of our affiliates.Loans held for sale to external parties by this subsidiary totaled $.5 billionat June 30, 2007 and $1.7 billion at December 31, 2006 and are included in realestate secured receivables. Our Consumer Lending business also had loans heldfor sale totaling $11 million at June 30, 2007 and $32 million at December 31,2006 relating to its subsidiary, Solstice Capital Group Inc. ("Solstice"). In November 2006, we acquired $2.5 billion of real estate secured receivablesfrom Champion Mortgage ("Champion") a division of KeyBank, N.A. and on December1, 2005 we acquired $5.3 billion of receivables as part of our acquisition ofMetris Companies Inc. ("Metris"). The receivables acquired were subject to therequirements of Statement of Position 03-3, "Accounting for Certain Loans orDebt Securities Acquired in a Transfer" ("SOP 03-3") to the extent there wasevidence of deterioration of credit quality since origination and for which itwas probable, at acquisition, that all contractually required payments would notbe collected and in the case of Metris, that the associated line of credit hadbeen closed. The carrying amount of Champion real estate secured receivables subject to therequirements of SOP 03-3 was $89 million at June 30, 2007 and $116 million atDecember 31, 2006 and is included in the real estate secured receivables in thetable above. The outstanding contractual balance of these receivables was $112million at June 30, 2007 and $143 million at December 31, 2006. At June 30, 2007and December 31, 2006, no credit loss reserve for the portions of the acquiredreceivables subject to SOP 03-3 had been established as there had been nodecrease to the expected future cash flows since the acquisition. During thequarter ended June 30, 2007, there was a reclassification to accretable yieldfrom non-accretable difference representing an increase to the estimated cashflows to be collected on the underlying Champion portfolio. 10 HSBC Finance Corporation -------------------------------------------------------------------------------- The carrying amount of the Metris receivables which were subject to SOP 03-3 was$152 million as of June 30, 2007 and $223 million at December 31, 2006 and isincluded in the credit card receivables in the table above. The outstandingcontractual balance of these receivables was $226 million at June 30, 2007 and$334 million at December 31, 2006. At June 30, 2007 and December 31, 2006, nocredit loss reserve for the acquired receivables subject to SOP 03-3 had beenestablished as there had been no decrease to the expected future cash flowssince the acquisition. There were no additions to accretable yield orreclassifications from non-accretable yield during the quarter ended June 30,2007. During the quarter ended June 30, 2006 there was a reclassification toaccretable yield from non-accretable difference representing an increase to theestimated cash flows to be collected on the underlying Metris portfolio. The following summarizes the accretable yield on Metris and Champion receivablesat June 30, 2007 and June 30, 2006: THREE MONTHS ENDED JUNE 30, 2007 2006-------------------------------------------------------------------------------- (IN MILLIONS) Accretable yield beginning of period.............................. $(61) $ (92)Accretable yield amortized to interest income during the period... 13 32Reclassification from non-accretable difference................... (2) (51) ---- -----Accretable yield at end of period................................. $(50) $(111) ==== ===== SIX MONTHS ENDED JUNE 30, 2007 2006-------------------------------------------------------------------------------- (IN MILLIONS) Accretable yield beginning of period.............................. $(76) $(122)Accretable yield amortized to interest income during the period... 28 62Reclassification from non-accretable difference................... (2) (51) ---- -----Accretable yield at end of period................................. $(50) $(111) ==== ===== Real estate secured receivables are comprised of the following: JUNE 30, DECEMBER 31, 2007 2006------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured: Closed-end: First lien............................................. $73,953 $77,901 Second lien............................................ 14,295 15,090 Revolving: First lien............................................. 499 556 Second lien............................................ 3,549 4,214 ------- -------Total real estate secured receivables....................... $92,296 $97,761 ======= ======= 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. Our Decision One mortgage operation offers, among other products,interest-only loans largely for resale to HSBC Bank USA to support the secondarymarket activities of our affiliates. These interest-only loans allow customersto pay the interest only portion of the monthly payment for a period of timewhich results in lower payments during the initial loan period. However,subsequent events affecting a customer's financial position could affect theability of customers to repay the loan in the future when the principal paymentsare required. As with all our other non-conforming and non-prime loan products,we underwrite and price 11 HSBC Finance Corporation -------------------------------------------------------------------------------- interest-only loans in a manner that is intended to compensate us for theanticipated risk. At June 2007, the outstanding balance of our interest-onlyloans was $6.2 billion, or 4 percent of receivables. At December 31, 2006, theoutstanding balance of our interest-only loans was $6.7 billion, or 4 percent ofreceivables. Also due to customer demand, we offer adjustable rate mortgage loans under whichpricing adjusts on the receivable in line with market movements, in some cases,following an introductory fixed rate period. At June 30, 2007, we hadapproximately $22.0 billion in adjustable rate mortgage loans at our ConsumerLending and Mortgage Services businesses. At December 31, 2006, we hadapproximately $29.8 billion in adjustable rate mortgage loans at our ConsumerLending and Mortgage Services businesses. In the second half of 2007 andthroughout 2008, approximately $5.7 billion and $4.1 billion, respectively, ofour adjustable rate mortgage loans will experience their first interest ratereset based on receivable levels outstanding at June 30, 2007. In addition, ouranalysis indicates that a significant portion of the second lien mortgages inour Mortgage Services portfolio at June 30, 2007 are subordinated to first lienadjustable rate mortgages that will face a rate reset between now and 2009. Asinterest rates have risen over the last three years, many adjustable rate loansare expected to require a significantly higher monthly payment following theirfirst adjustment. A customer's financial situation at the time of the interestrate reset could affect our customer's ability to repay the loan after theadjustment. 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. Currently, our Decision One mortgage operation offersstated income loans largely for resale to HSBC Bank USA to support the secondarymarket activities of our affiliates. We price stated income loans in a mannerthat is intended to compensate us for their anticipated risk. The outstandingbalance of stated income loans in our real estate secured portfolio was $9.4billion at June 30, 2007 and $11.8 billion at December 31, 2006. The Federal Financial Regulatory Agencies (the "Agencies") recently issued afinal statement on subprime mortgage lending which reiterates many of theprinciples addressed in the existing guidance relating to risk managementpractices and consumer protection laws involving adjustable rate mortgageproducts and the underwriting process on stated income and interest-only loans.While we believe a significant portion of our business is already substantiallyin compliance with this final statement, we are currently assessing the fullimpact of this statement on our operations. Receivables serviced with limited recourse consisted of the following: JUNE 30, DECEMBER 31, 2007 2006-------------------------------------------------------------------------------------- (IN MILLIONS) Auto finance................................................. $ 98 $271Credit card.................................................. 500 500Personal non-credit card..................................... 13 178 ---- ----Total........................................................ $611 $949 ==== ==== 12 HSBC Finance Corporation -------------------------------------------------------------------------------- 5. CREDIT LOSS RESERVES-------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ----------------- ----------------- 2007 2006 2007 2006---------------------------------------------------------------------------------------- (IN MILLIONS) Credit loss reserves at beginning of period...... $ 6,798 $ 4,468 $ 6,587 $ 4,521Provision for credit losses...................... 1,947 1,248 3,647 2,114Charge-offs...................................... (1,837) (1,233) (3,520) (2,287)Recoveries....................................... 250 153 445 279Other, net....................................... (1) 13 (2) 22 ------- ------- ------- -------Credit loss reserves at end of period............ $ 7,157 $ 4,649 $ 7,157 $ 4,649 ======= ======= ======= ======= Provision and charge-off levels for the three and six month periods ended June30, 2007, reflect the impact of higher receivable levels, higher delinquencylevels due to growth and normal portfolio seasoning, increased levels ofpersonal bankruptcy filings compared to the exceptionally low filing levelsexperienced in the first half of 2006 as a result of the new bankruptcy law inthe United States which became effective October 2005, and the expectedprogression of portions of our Mortgage Services portfolio purchased in 2005 and2006 into various stages of delinquency and net charge-off. Further analysis of credit quality and credit loss reserves and our credit lossreserve methodology are presented in Item 2, "Management's Discussion andAnalysis of Financial Condition and Results of Operations" of this Form 10-Qunder the caption "Credit Quality." 6. INTANGIBLE ASSETS-------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYING GROSS AMORTIZATION VALUE---------------------------------------------------------------------------------------- (IN MILLIONS) JUNE 30, 2007Purchased credit card relationships and related programs............................................ $1,736 $ 649 $1,087Retail services merchant relationships................ 270 230 40Other loan related relationships...................... 333 151 182Trade names........................................... 717 13 704Technology, customer lists and other contracts........ 282 203 79 ------ ------ ------Total................................................. $3,338 $1,246 $2,092 ====== ====== ======DECEMBER 31, 2006Purchased credit card relationships and related programs............................................ $1,736 $ 580 $1,156Retail services merchant relationships................ 270 203 67Other loan related relationships...................... 333 135 198Trade names........................................... 717 13 704Technology, customer lists and other contracts........ 282 189 93 ------ ------ ------Total................................................. $3,338 $1,120 $2,218 ====== ====== ====== 13 HSBC Finance Corporation -------------------------------------------------------------------------------- Estimated amortization expense associated with our intangible assets for each ofthe following years is as follows: YEAR ENDING DECEMBER 31,----------------------------------------------------------------------------------- (IN MILLIONS) 2007................................................................ $2532008................................................................ 2112009................................................................ 1982010................................................................ 1692011................................................................ 169Thereafter.......................................................... 355 7. GOODWILL-------------------------------------------------------------------------------- Goodwill balances associated with our foreign businesses will change from periodto period due to movements in foreign exchange. During the second quarter of2007, the impact of movements in foreign exchange rates on our goodwill balanceswas immaterial. Changes in estimates of the tax basis in our assets andliabilities or other tax estimates recorded pursuant to Statement of FinancialAccounting Standards Number 109, "Accounting for Income Taxes," resulted in ourgoodwill balances decreasing by approximately $33 million in the three month andapproximately $65 million in the six month periods ended June 30, 2007, as aresult of such changes in tax estimates. In addition, goodwill of approximately$73 million allocated to our U.K. Insurance Operations was transferred to assetsheld for sale during the first quarter of 2007. 8. INCOME TAXES-------------------------------------------------------------------------------- Effective January 1, 2007, we adopted FASB Interpretation No. 48, "Accountingfor Uncertainty in Income Taxes -- an interpretation of FASB Statement No. 109"("FIN No. 48"). FIN No. 48 establishes threshold and measurement attributes forfinancial statement measurement and recognition of tax positions taken orexpected to be taken in a tax return. FIN No. 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. The adoption of FIN 48 did not have asignificant impact on our financial results and did not result in a cumulativeeffect adjustment to the January 1, 2007 balance of retained earnings. Theadoption 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. The total amount of unrecognized tax benefits was$273 million at January 1, 2007 and $215 million at June 30, 2007. The state taxportion of these amounts is reflected gross and not reduced by the federal taxeffect. The total amount of unrecognized tax benefits that, if recognized, wouldaffect the effective tax rate was $70 million at January 1, 2007 and $84million at June 30, 2007. We remain subject to Federal income tax examination for years 1998 and forwardand State income tax examinations for years 1996 and forward. The Company doesnot anticipate that any significant tax positions have a reasonable possibilityof being effectively settled within the next twelve months. It is our policy to recognize interest accrued related to unrecognized taxbenefits as a component of other servicing and administrative expenses in theconsolidated income statement. As of January 1, 2007, we had accrued $67 millionfor the payment of interest associated with uncertain tax positions. During thesix months ended June 30, 2007, we reduced our accrual for the payment ofinterest associated with uncertain tax positions by $6 million. Our effective tax rates were as follows THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, ----------- ----------- 2007 2006 2007 2006------------------------------------------------------------------------------------ Effective tax rate....................................... 17.1% 36.7% 36.4% 36.6% 14 HSBC Finance Corporation -------------------------------------------------------------------------------- The decrease in the effective tax rate for the three month period ended June 30,2007 was due to a decrease in pretax income with only slightly lower taxcredits. The decrease in the effective tax rate for the six month period endedJune 30, 2007 was primarily due to lower state taxes, partially offset by theadjustment recorded to reduce our investment in our U.K. Insurance Operations tothe lower of cost or market and the acceleration of tax from sales of leveragedleases. The effective tax rate differs from the statutory federal income taxrate primarily because of the effects of state and local income taxes, taxcredits, leveraged lease sales, and the lower of cost or market adjustment. 9. RELATED PARTY TRANSACTIONS-------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and itssubsidiaries. These transactions occur at prevailing market rates and terms andinclude funding arrangements, derivative execution, purchases and sales ofreceivables, servicing arrangements, information technology services, item andstatement processing services, banking and other miscellaneous services. Thefollowing tables present related party balances and the income and (expense)generated by related party transactions: JUNE 30, DECEMBER 31, 2007 2006------------------------------------------------------------------------------------- (IN MILLIONS) ASSETS, (LIABILITIES) AND EQUITY:Derivative financial assets (liability), net................ $ 340 $ 234Affiliate preferred stock received in sale of U.K. credit card business(1).......................................... 301 294Other assets................................................ 691 528Due to affiliates........................................... (14,863) (15,172)Other liabilities........................................... (474) (506)Premium on sale of European Operations in 2006 to an affiliate recorded as an increase to additional paid in capital................................................... - 13 -------- ()(1) Balance may fluctuate between periods due to foreign currency exchange rate impact. 15 HSBC Finance Corporation -------------------------------------------------------------------------------- THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, ------------- ------------- 2007 2006 2007 2006------------------------------------------------------------------------------------- (IN MILLIONS) INCOME/(EXPENSE):Interest expense on borrowings from HSBC and subsidiaries........................................ $(217) $(173) $(451) $(326)Interest income on advances to HSBC affiliates........ 8 6 15 11HSBC Bank USA, National Association ("HSBC Bank USA"): Real estate secured servicing, sourcing, underwriting and pricing revenues................ 2 3 4 6 Gain on daily sale of domestic private label receivable originations.......................... 94 88 178 165 Gain on daily sale of credit card receivables....... 15 9 26 17 Taxpayer financial services loan origination and other fees....................................... (1) (1) (19) (17) Domestic private label receivable servicing and related fees..................................... 98 95 199 193 Other servicing, processing, origination and support revenues......................................... 25 11 49 21Support services from HSBC affiliates, primarily HSBC Technology and Services (USA) Inc. ("HTSU")......... (299) (270) (584) (522)HTSU: Rental revenue...................................... 12 12 24 23 Administrative services revenue..................... 3 3 6 6 Servicing and other fees from other HSBC affiliates....................................... 4 4 7 8Stock based compensation expense with HSBC............ (28) (22) (60) (39) The notional value of derivative contracts outstanding with HSBC subsidiariestotaled $86.3 billion at June 30, 2007 and $82.8 billion at December 31, 2006.When the fair value of our agreements with affiliate counterparties requires theposting of collateral by the affiliate, it is provided in the form of cash andrecorded on our balance sheet, consistent with third party arrangements. Thelevel of the fair value of our agreements with affiliate counterparties abovewhich collateral is required to be posted is $75 million. At June 30, 2007, thefair value of our agreements with affiliate counterparties required theaffiliate to provide cash collateral of $1.1 billion which is offset against thefair value amount recognized for derivative instruments that have been offsetunder the same master netting arrangement and recorded in our balance sheet as acomponent of derivative related assets. At December 31, 2006, the fair value ofour agreements with affiliate counterparties required the affiliate to providecash collateral of $1.0 billion which is offset against the fair value amountrecognized for derivative instruments that have been offset under the samemaster netting arrangement and recorded in our balance sheet as a component ofderivative related assets. We had extended a line of credit of $2 billion to HSBC USA Inc. which expired inJuly of 2006 and was not renewed. No balances were outstanding under this lineat June 30, 2006. Annual commitment fees associated with this line of creditwere recorded in interest income and reflected as Interest income on advances toHSBC affiliates in the table above. We have extended a revolving line of credit to HTSU, which was increased to $.6billion on January 5, 2007. The balance outstanding under this line of creditwas $.6 billion at June 30, 2007 and $.5 billion at December 31, 2006 and isincluded in other assets. Interest income associated with this line of credit isrecorded in interest income and reflected as Interest income on advances to HSBCaffiliates in the table above. We extended a promissory note of $.2 billion to HSBC Securities (USA) Inc.("HSI") on December 28, 2005. This promissory note was repaid during January2006. At December 31, 2005, this promissory note was included in other assets.Interest income associated with this line of credit is recorded in interestincome and reflected as Interest income on advances to HSBC affiliates in thetable above. 16 HSBC Finance Corporation -------------------------------------------------------------------------------- We have extended revolving lines of credit to subsidiaries of HSBC Bank USA foran aggregate total of $2.3 billion. There are no balances outstanding under anyof these lines of credit at either June 30, 2007 or December 31, 2006. Due to affiliates includes amounts owed to subsidiaries of HSBC (other thanpreferred stock). At June 30, 2007 and December 31, 2006, we had a commercial paper back stopcredit facility of $2.5 billion from HSBC supporting domestic issuances and arevolving credit facility of $5.7 billion from HSBC Bank plc ("HBEU") to fundour operations in the U.K. As of June 30, 2007, $4.1 billion was outstandingunder the U.K. lines and no balances were outstanding on the domestic lines. Asof December 31, 2006, $4.3 billion was outstanding under the U.K. lines and nobalances were outstanding on the domestic lines. Annual commitment feerequirements to support availability of these lines are included as a componentof Interest expense on borrowings from HSBC and subsidiaries. In the six months ended June 30, 2007, we sold approximately $371 million ofreal estate secured receivables originated by our subsidiary, Decision One, toHSBC Bank USA. We recorded a pre-tax loss on these sales of $.4 million in theyear-to-date period. In the fourth quarter of 2006 we sold approximately $669million of real estate secured receivables originated by our subsidiary,Decision One, to HSBC Bank USA and recorded a pre-tax gain of $17 million on thesale. Each of these sales were effected as part of our strategy to originateloans through Decision One for sale and securitization through the mortgagetrading operations of HSBC Bank USA. On November 9, 2006, as part of our continuing evaluation of strategicalternatives with respect to our U.K. and European operations, we sold all ofthe capital stock of our operations in the Czech Republic, Hungary, and Slovakia(the "European Operations") to a wholly owned subsidiary of HBEU for anaggregate purchase price of approximately $46 million. Because the sale of thisbusiness was between affiliates under common control, the premium received inexcess of the book value of the stock transferred was recorded as an increase toadditional paid-in capital and was not reflected in earnings. The assetsconsisted primarily of $199 million of receivables and goodwill which totaledapproximately $13 million. The liabilities consisted primarily of debt whichtotaled $179 million. HBEU assumed all the liabilities of the EuropeanOperations as a result of this transaction. In December 2005, we sold our U.K. credit card business, including $2.5 billionof receivables, the associated cardholder relationships and the related retainedinterests in securitized credit card receivables to HBEU for an aggregatepurchase price of $3.0 billion. The purchase price, which was determined basedon a comparative 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 for a period of not less than two years to provide collection servicesand other support services, including components of the compliance, financialreporting and human resource functions, for the sold credit card operations toHBEU for a fee. We received $8 million during the three months ended June 30,2007 and $16 million during the six months ended June 30, 2007 under thisservice level agreement. We received $3 million during the three months endedJune 30, 2006 and $11 million during the six months ended June 30, 2006 underthis service level agreement. Additionally, the management teams of HBEU and ourremaining U.K. operations will be jointly involved in decision making involvingcard marketing to ensure that growth objectives are met for both businesses.Because the sale of this business was between affiliates under common control,the premium received in excess of the book value of the assets transferred of$182 million, including the goodwill assigned to this business, was recorded asan increase to additional 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 June 30, 2007, we were 17 HSBC Finance Corporation -------------------------------------------------------------------------------- servicing $17.6 billion of domestic private label receivables for HSBC Bank USAand as of December 31, 2006, we were servicing $18.1 billion of domestic privatelabel receivables for HSBC Bank USA. We received servicing and related feeincome from HSBC Bank USA of $98 million during the three months ended June 30,2007 and $199 million during the six months ended June 30, 2007. We receivedservicing and related fee income from HSBC Bank USA of $95 million during thethree months ended June 30, 2006 and $193 million during the six months endedJune 30, 2006. Servicing and related fee income is reflected as Domestic privatelabel receivable servicing and related fees in the table above. We continue tomaintain the related customer account relationships and, therefore, sell newdomestic private label receivable originations (excluding retail salescontracts) to HSBC Bank USA on a daily basis. We sold $10.5 billion of privatelabel receivables to HSBC Bank USA during the six months ended June 30, 2007 and$10.0 billion during the six months ended June 30, 2006. The gains associatedwith the sale of these receivables are reflected in the table above and arerecorded in Gain on daily sale of domestic private label receivableoriginations. In 2003 and 2004, we sold approximately $3.7 billion of real estate securedreceivables from our Mortgage Services business to HSBC Bank USA. Under aseparate servicing agreement, we service all real estate secured receivablessold to HSBC Bank USA including loans purchased from correspondents prior toSeptember 1, 2005. As of June 30, 2007, we were servicing $2.8 billion of realestate secured receivables for HSBC Bank USA. The fee revenue associated withthese receivables is recorded in servicing fees from HSBC affiliates and isreflected as Real estate secured servicing, sourcing, underwriting and pricingrevenues in the above table. 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 placing the loans with interested thirdparties. Fees paid for these services totaled $4 million and were included as acomponent of the approximately $20 million loss realized on the sale of thisloan portfolio. As a result of the loan sales, however, the lower cost fundingpreviously supporting the $2.2 billion of loans sold is available to beredeployed to fund new originators, which should result in reduced overallfunding costs in future periods. Under various service level agreements, we also provide other services to HSBCBank USA. These services include credit card servicing and processing activitiesthrough our Credit Card Services business, loan servicing through our AutoFinance business and other operational and administrative support. Fees receivedfor these services are reported as servicing fees from HSBC affiliates and arereflected as Other servicing, processing, origination and support revenues inthe table above. Additionally, HSBC Bank USA services certain real estatesecured loans on our behalf. Fees paid for these services are reported assupport services from HSBC affiliates and are reflected as Support services fromHSBC affiliates, primarily HTSU in the table above. During 2003, Household Capital Trust VIII issued $275 million in mandatorilyredeemable preferred securities to HSBC. Interest expense recorded on theunderlying junior subordinated notes is included in Interest expense onborrowings from HSBC and subsidiaries in the table above. During 2004, our Canadian business began to originate and service auto loans foran HSBC affiliate in Canada. Fees received for these services are included inother income and are reflected in Servicing and other fees from other HSBCaffiliates in the table above. Since October 1, 2004, HSBC Bank USA has served as an originating lender forloans initiated by our Taxpayer Financial Services business for clients ofvarious third party tax preparers. Starting on January 1, 2007, HSBC TrustCompany (Delaware), N.A. ("HTCD") also began to serve as an originating lenderfor these loans. We purchase the loans originated by HSBC Bank USA or HTCD dailyfor a fee. Origination fees paid for these loans totaled $1 million during thethree months ended June 30, 2007 and $19 million during the six months endedJune 30, 2007. Origination fees paid to HSBC Bank USA or HTCD totaled $1 millionduring the three months ended June 30, 2006 and $17 million during the sixmonths ended June 30, 2006. These origination fees are included as an offset totaxpayer financial services revenue and are reflected as Taxpayer financialservices loan origination and other fees in the above table. On July 1, 2004, HSBC Bank Nevada, National Association ("HBNV"), formerly knownas Household Bank (SB), N.A., purchased the account relationships associatedwith $970 million of credit card receivables from HSBC Bank 18 HSBC Finance Corporation -------------------------------------------------------------------------------- USA for approximately $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 June 30, 2007 we were servicing $1.2 billion of credit cardreceivables for HSBC Bank USA. Originations of new accounts and receivables aremade by HBNV and new receivables are sold daily to HSBC Bank USA. We sold $1.3billion of credit card receivables to HSBC Bank USA during the six months endedJune 30, 2007 and $1.1 billion during the six months ended June 30, 2006. Thegains associated with the sale of these receivables are reflected in the tableabove and are recorded in Gain on daily sale 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. Additionally, in a separate transaction in December 2005, we transferred ourinformation technology services employees in the U.K. to a subsidiary of HBEU.Subsequent to the transfer, operating expenses relating to informationtechnology, which have previously been reported as salaries and fringe benefitsor other servicing and administrative expenses, are now billed to us by HBEU andreported as Support services from HSBC affiliates. Additionally, during thefirst quarter of 2006, the information technology equipment in the U.K. was soldto HBEU for a purchase price equal to the book value of these assets of $8million. 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 $8 million during the three months endedJune 30, 2007 and $11 million during the six months ended June 30, 2007. Feespaid for such services totaled approximately $7 million during the three monthsended June 30, 2006 and $22 million during the six months ended June 30, 2006.For debt not accounted for under the fair value option, these fees are amortizedover 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 10, "Pension and OtherPostretirement Benefits," for additional information on this pension plan. Employees of HSBC Finance Corporation participate in one or more stockcompensation plans sponsored by HSBC. Our share of the expense of these planswas $28 million during the three months ended June 30, 2007 and $60 millionduring the six months ended June 30, 2007. Our share of the expense of theseplans was $22 million during the three months ended June 30, 2006 and $39million for the six months ended June 30, 2006. These expenses are recorded insalary and employee benefits and are reflected in the above table as Stock basedcompensation expense with HSBC. 10. PENSION AND OTHER POSTRETIREMENT BENEFITS-------------------------------------------------------------------------------- Effective January 1, 2005, the two previously separate domestic defined benefitpension plans of HSBC Finance Corporation and HSBC Bank USA were combined into asingle HSBC North America defined benefit pension plan which facilitated thedevelopment of a unified employee benefit policy and unified employee benefitplan for HSBC companies operating in the United States. 19 HSBC Finance Corporation -------------------------------------------------------------------------------- The components of pension expense for the domestic defined benefit pension planreflected in our consolidated statement of income are shown in the table belowand reflect the portion of the pension expense of the combined HSBC NorthAmerica pension plan which has been allocated to HSBC Finance Corporation: THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, ----------- ----------- 2007 2006 2007 2006------------------------------------------------------------------------------------ (IN MILLIONS) Service cost - benefits earned during the period......... $ 13 $ 13 $ 26 $ 26Interest cost............................................ 16 15 32 30Expected return on assets................................ (21) (20) (42) (40)Recognized losses........................................ 1 3 2 6 ---- ---- ---- ----Net periodic benefit cost................................ $ 9 $ 11 $ 18 $ 22 ==== ==== ==== ==== We sponsor various additional defined benefit pension plans for our foreignbased employees. Pension expense for our foreign defined benefit pension planswas $.8 million for the three months ended June 30, 2007 and $1.6 million forthe six months ended June 30, 2007. Pension expense for our foreign definedbenefit pension plans was $.7 million for the three months ended June 30, 2006and $1.3 million for the six months ended June 30, 2006. Components of the net periodic benefit cost for our postretirement benefitsother than pensions are as follows: THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, ----------- ----------- 2007 2006 2007 2006------------------------------------------------------------------------------------- (IN MILLIONS) Service cost - benefits earned during the period.......... $1 $1 $2 $ 2Interest cost............................................. 4 4 7 8Expected return on assets................................. - - - -Recognized (gains) losses................................. - - - - -- -- -- ---Net periodic benefit cost................................. $5 $5 $9 $10 == == == === 11. BUSINESS SEGMENTS-------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services andInternational. Our Consumer segment consists of our Consumer Lending, MortgageServices, Retail Services and Auto Finance businesses. Our Credit Card Servicessegment consists of our domestic MasterCard(1) and Visa(1) and other credit cardbusiness. Our International segment consists of our foreign operations in theUnited Kingdom, Canada and the Republic of Ireland and, prior to November 9,2006, our operations in Slovakia, the Czech Republic and Hungary. The All Othercaption includes our Insurance and Taxpayer Financial Services and Commercialbusinesses, each of which falls below the quantitative threshold test under SFASNo. 131 for determining reportable segments, as well as our corporate andtreasury activities. In May 2007, we announced the planned integration of our Retail Services andCredit Card Services businesses. Combining Retail Services with Credit CardServices enhances our ability to provide a single credit card and private labelsolution for the market place. We are currently evaluating the impact thisintegration will have on our financial reporting in the future, includingsegment reporting. There have been no changes in the basis of our segmentationor any changes in the measurement of segment profit as compared with thepresentation in our 2006 Form 10-K. ----------(1) MasterCard is a registered trademark of MasterCard International,Incorporated and Visa is a registered trademark of Visa USA, Inc. 20 HSBC Finance Corporation -------------------------------------------------------------------------------- Our segment results are presented on an International Financial ReportingStandards ("IFRSs") management basis (a non-U.S. GAAP financial measure) ("IFRSManagement Basis") as operating results are monitored and reviewed, trends areevaluated and decisions about allocating resources, such as employees, are madealmost exclusively on an IFRS Management Basis as we report results to ourparent, HSBC, who prepares its consolidated financial statements in accordancewith IFRSs. IFRS Management Basis results are IFRSs results adjusted to assumethat the private label and real estate secured receivables transferred to HSBCBank USA have not been sold and remain on our balance sheet. Operations aremonitored and trends are evaluated on an IFRS Management Basis because thecustomer loan sales to HSBC Bank USA were conducted primarily to appropriatelyfund prime customer loans within HSBC and such customer loans continue to bemanaged and serviced by us without regard to ownership. However, we continue tomonitor capital adequacy, establish dividend policy and report to regulatoryagencies on a U.S. GAAP basis. Fair value adjustments related to purchase accounting resulting from ouracquisition by HSBC and related amortization have been allocated to Corporate,which is included in the "All Other" caption within our segment disclosure. 21 HSBC Finance Corporation -------------------------------------------------------------------------------- Reconciliation of our IFRS Management Basis segment results to the U.S. GAAPconsolidated totals are as follows: IFRS MANAGEMENT CREDIT ADJUSTMENTS/ BASIS MANAGEMENT CARD INTER- ALL RECONCILING CONSOLIDATED BASIS IFRS CONSUMER SERVICES NATIONAL OTHER ITEMS TOTALS ADJUSTMENTS(4) ADJUSTMENTS(5)------------------------------------------------------------------------------------------------------------------------ (IN MILLIONS) THREE MONTHS ENDED JUNE 30, 2007Net interest income... $ 2,143 $ 827 $ 217 $ (200) $ - $ 2,987 $ (328) $ 22Other operating income (Total other revenues)........... 173 755 48 25 (74)(1) 927 35 (104)Loan impairment charges (Provision for credit losses).. 1,382 640 161 - 2(2) 2,185 (215) (17)Operating expenses (Total costs and expenses)........... 748 494 142 131 - 1,515 (2) (3)Net income............ 120 284 (31) (139) (48) 186 (52) (71)Customer loans (Receivables)....... 138,976 29,106 9,853 153 - 178,088 (20,389) 95Assets................ 138,281 28,933 10,669 29,476 (8,204)(3) 199,155 (19,917) (4,973)Intersegment revenues............ 65 5 6 (2) (74)(1) - - - -------- ------- ------- ------- ------- -------- -------- -------THREE MONTHS ENDED JUNE 30, 2006Net interest income... $ 2,189 $ 872 $ 201 $ (211) $ - $ 3,051 $ (314) $ (156)Other operating income (Total other revenues)........... 349 563 74 111 (76)(1) 1,021 73 (77)Loan impairment charges (Provision for credit losses).. 894 328 124 (1) 1(2) 1,346 (153) 86Operating expenses (Total costs and expenses)........... 793 435 119 136 - 1,483 (3) (58)Net income............ 539 423 19 (156) (49) 776 (58) (150)Customer loans (Receivables)....... 138,685 25,726 9,637 196 - 174,244 (20,326) 41Assets................ 140,991 26,931 11,127 28,093 (8,197)(3) 198,945 (19,495) (5,644)Intersegment revenues............ 63 5 9 (1) (76)(1) - - - -------- ------- ------- ------- ------- -------- -------- -------SIX MONTHS ENDED JUNE 30, 2007Net interest income... $ 4,301 $ 1,648 $ 421 $ (427) $ - $ 5,943 $ (638) $ 26Other operating income (Total other revenues)........... 365 1,453 95 512 (141)(1) 2,284 75 (57)Loan impairment charges (Provision for credit losses).. 2,602 1,060 409 (1) 3(2) 4,073 (392) (28)Operating expenses (Total costs and expenses)........... 1,507 977 270 286 - 3,040 (5) (4)Net income............ 358 673 (121) (17) (91) 802 (113) (85)Intersegment revenues............ 123 10 11 (3) (141)(1) - - - -------- ------- ------- ------- ------- -------- -------- -------SIX MONTHS ENDED JUNE 30, 2006Net interest income... $ 4,371 $ 1,604 $ 411 $ (462) $ - $ 5,924 $ (646) $ (202)Other operating income (Total other revenues)........... 587 1,041 115 447 (144)(1) 2,046 142 3Loan impairment charges (Provision for credit losses).. 1,444 577 228 (2) 3(2) 2,250 (294) 174Operating expenses (Total costs and expenses)........... 1,530 869 231 289 - 2,919 (8) (70)Net income............ 1,258 755 41 (173) (93) 1,788 (137) (195)Intersegment revenues............ 120 10 16 (2) (144)(1) - - - -------- ------- ------- ------- ------- -------- -------- ------- IFRS U.S. GAAP RECLASS- CONSOLIDATED IFICATIONS(6) TOTALS--------------------------------------------------- (IN MILLIONS) THREE MONTHS ENDED JUNE 30, 2007Net interest income... $ (24) $ 2,657Other operating income (Total other revenues)........... 156 1,014Loan impairment charges (Provision for credit losses).. (6) 1,947Operating expenses (Total costs and expenses)........... 138 1,648Net income............ - 63Customer loans (Receivables)....... 11 157,805Assets................ (912) 173,353Intersegment revenues............ - - ------- --------THREE MONTHS ENDED JUNE 30, 2006Net interest income... $ (32) $ 2,549Other operating income (Total other revenues)........... 158 1,175Loan impairment charges (Provision for credit losses).. (31) 1,248Operating expenses (Total costs and expenses)........... 157 1,579Net income............ - 568Customer loans (Receivables)....... - 153,959Assets................ (3,112) 170,694Intersegment revenues............ - - ------- --------SIX MONTHS ENDED JUNE 30, 2007Net interest income... $ (33) $ 5,298Other operating income (Total other revenues)........... 354 2,656Loan impairment charges (Provision for credit losses).. (6) 3,647Operating expenses (Total costs and expenses)........... 327 3,358Net income............ - 604Intersegment revenues............ - - ------- --------SIX MONTHS ENDED JUNE 30, 2006Net interest income... $ (63) $ 5,013Other operating income (Total other revenues)........... 405 2,596Loan impairment charges (Provision for credit losses).. (16) 2,114Operating expenses (Total costs and expenses)........... 358 3,199Net income............ - 1,456Intersegment revenues............ - - ------- -------- -------- ()(1) Eliminates intersegment revenues. ()(2) Eliminates bad debt recovery sales between operating segments. ()(3) Eliminates investments in subsidiaries and intercompany borrowings. ()(4) Management Basis Adjustments represent the private label and real estate secured receivables transferred to HBUS. ()(5) IFRS Adjustments consist of the accounting differences between U.S. GAAP and IFRSs which have been described more fully below. ()(6) Represents differences in balance sheet and income statement presentation between IFRSs and U.S. GAAP. 22 HSBC Finance Corporation -------------------------------------------------------------------------------- A summary of the significant differences between U.S. GAAP and IFRSs as theyimpact our results are summarized below: SECURITIZATIONS - On an IFRSs basis, securitized receivables are treated asowned. Any gains recorded under U.S. GAAP on these transactions are reversed. Anowned loss reserve is established. The impact from securitizations resulting inhigher net income under IFRSs is due to the recognition of income on securitizedreceivables under U.S. GAAP in prior periods. DERIVATIVES AND HEDGE ACCOUNTING (INCLUDING FAIR VALUE ADJUSTMENTS) - The IFRSsderivative accounting model is similar to U.S. GAAP requirements, but IFRSs doesnot permit use of the short-cut method of hedge effectiveness testing. Prior toJanuary 1, 2007, the differences between U.S. GAAP and IFRSs related primarilyto the fact that a different population of derivatives qualified for hedgeaccounting under IFRSs than U.S. GAAP and that HSBC Finance Corporation hadelected the fair value option under IFRSs on a significant portion of its fixedrate debt which was being hedged by receive fixed swaps. Prior to the issuanceof FASB Statement No. 159, "The Fair Value Option for Financial Assets andFinancial Liabilities," ("SFAS No. 159") in February 2007, U.S. GAAP did notpermit the use of the fair value option. As a result of our early adoption ofSFAS No. 159 which is more fully discussed in Note 12, "Fair Value Option,"effective January 1, 2007, we utilize fair value option reporting for the samefixed rate debt issuances under both U.S. GAAP and IFRSs. INTANGIBLE ASSETS - Intangible assets under IFRSs are significantly lower thanthose under U.S. GAAP as the newly created intangibles associated with ouracquisition by HSBC are reflected in goodwill for IFRSs therefore, amortizationof intangible assets is lower under IFRSs. PURCHASE ACCOUNTING ADJUSTMENTS - There are differences in the valuation ofassets and liabilities under U.K. GAAP (which were carried forward into IFRSs)and U.S. GAAP which result in a different amortization for the HSBC acquisition.Additionally there are differences in the valuation of assets and liabilitiesunder IFRSs and U.S. GAAP resulting from the Metris acquisition in December2005. DEFERRED LOAN ORIGINATION COSTS AND PREMIUMS - Under IFRSs, loan originationcost deferrals are more stringent and result in lower costs being deferred thanpermitted under U.S. GAAP. In addition, all deferred loan origination fees,costs and loan premiums must be recognized based on the expected life of thereceivables under IFRSs as part of the effective interest calculation whileunder U.S. GAAP they may be amortized on either a contractual or expected lifebasis. CREDIT LOSS IMPAIRMENT PROVISIONING - IFRSs requires a discounted cash flowmethodology for estimating impairment on pools of homogeneous customer loanswhich requires the incorporation of the time value of money relating to recoveryestimates. Also under IFRSs, future recoveries on charged-off loans are accruedfor on a discounted basis and interest is recorded based on collectibility. LOANS HELD FOR RESALE - IFRSs requires loans held for resale to be treated astrading assets and recorded at their fair market value. Under U.S. GAAP, loansheld for resale are designated as loans on the balance sheet and recorded at thelower of amortized cost or market. Under U.S. GAAP, the income and expensesrelated to loans held for sale are reported similarly to loans held forinvestment. Under IFRSs, the income and expenses related to loans held for saleare reported in other operating income. INTEREST RECOGNITION - The calculation of effective interest rates under IFRS 39requires an estimate of "all fees and points paid or recovered between partiesto the contract" that are an integral part of the effective interest rate beincluded. In June 2006, we implemented a methodology for calculating theeffective interest rate for introductory rate credit card receivables underIFRSs over the expected life of the product. In December 2006, we implemented amethodology to include prepayment penalities as part of the effective interestrate and recognized such penalties over the expected life of the receivables.U.S. GAAP generally prohibits recognition of interest income to the extent thenet interest in the loan would increase to an amount greater than the amount atwhich the borrower could settle the obligation. Also under U.S. GAAP, prepaymentpenalties are generally recognized as received. OTHER - There are other less significant differences between IFRSs and U.S. GAAPrelating to pension expense, changes in tax estimates and other miscellaneousitems. 23 HSBC Finance Corporation -------------------------------------------------------------------------------- See "Basis of Reporting" in Item 7. Management's Discussion and Analysis ofFinancial Condition and results of Operations in our Annual Report on Form 10-Kfor the year ended December 31, 2006 for a more complete discussion ofdifferences between U.S. GAAP and IFRSs. 12. FAIR VALUE OPTION-------------------------------------------------------------------------------- Effective January 1, 2007, we early adopted SFAS No. 159 which provides for afair value option election that allows companies to irrevocably elect fair valueas the initial and subsequent measurement attribute for certain financial assetsand liabilities, with changes in fair value recognized in earnings as theyoccur. SFAS No. 159 permits the fair value option election ("FVO") on aninstrument by instrument basis at the initial recognition of an asset orliability or upon an event that gives rise to a new basis of accounting for thatinstrument. We elected FVO for certain issuances of our fixed rate debt in orderto align our accounting treatment with that of HSBC under IFRSs. Under IFRSs, anentity can only elect FVO accounting for financial assets and liabilities thatmeet certain eligibility criteria which are not present under SFAS No. 159. Whenwe elected FVO reporting for IFRSs, in addition to certain fixed rate debtissuances which did not meet the eligibility criteria, there were also certainfixed rate debt issuances for which only a portion of the issuance met theeligibility criteria to qualify for FVO reporting. To align our U.S. GAAP andIFRSs accounting treatment, we have adopted SFAS No. 159 only for the fixed ratedebt issuances which also qualify for FVO reporting under IFRSs. The following table presents information about the eligible instruments forwhich we elected FVO and for which a transition adjustment was recorded. BALANCE SHEET BALANCE SHEET JANUARY 1, JANUARY 1, 2007 2007 PRIOR TO ADOPTION NET GAIN (LOSS) AFTER ADOPTION OF FVO UPON ADOPTION OF FVO--------------------------------------------------------------------------------------------------- (IN MILLIONS) Fixed rate debt designated at fair value..... $(30,088) $(855) $(30,943) ======== ----- ========Pre-tax cumulative-effect of adoption of FVO........................................ (855)Increase in deferred tax asset............... 313 -----After-tax cumulative-effect of adoption of FVO adjustment to retained earnings........ $(542) ===== Long term debt (with original maturities over one year) of $121.8 billion atJune 30, 2007, includes $32.1 billion of fixed rate debt accounted for underFVO. We did not elect FVO for $35.8 billion of fixed rate debt currently carriedon our balance sheet within long term debt for the reasons discussed above.Fixed rate debt accounted for under FVO at June 30, 2007 has an aggregate unpaidprincipal balance of $32.4 billion. The fair value of the fixed rate debt accounted for under FVO is determined by athird party and includes the full market price (credit and interest rate impact)based on observable market data. The adoption of FVO has not impacted howinterest expense is calculated and reported for the fixed rate debt instruments.The adoption of FVO has however impacted the way we report realized gains andlosses on the swaps associated with this debt which previously qualified aseffective hedges under SFAS No. 133. Upon the adoption of SFAS No. 159 forcertain fixed 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 (loss) on debt designated at fair value andrelated derivatives" within other revenues. During the three months ended June 30, 2007, we recorded a net gain from fairvalue changes on our fixed rate debt accounted for under FVO of $509 million anda net gain from fair value changes on our fixed rate debt accounted for underFVO of $611 million during the six months ended June 30, 2007 which is includedin "Gain (loss) on debt designated at fair value and related derivatives" as acomponent of other revenues in the consolidated statement of income. "Gain(loss) on debt designated at fair value and related derivatives" in theconsolidated statement of income also includes the mark-to-market adjustment onderivatives related to the debt designated at fair value as 24 HSBC Finance Corporation -------------------------------------------------------------------------------- well as net realized gains or losses on these derivatives. The components of"Gain (loss) on debt designated at fair value and related derivatives" are asfollows: THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, 2007 2007----------------------------------------------------------------------------------------- (IN MILLIONS) Interest rate component................................. $ 515 $ 373Credit risk component................................... (6) 238 ----- -----Total mark-to-market on debt designated at fair value... 509 611Mark-to-market on the related derivatives............... (557) (439)Net realized gains (losses) on the related derivatives.. (82) (158) ----- -----Gain (loss) on debt designated at fair value and related derivatives........................................... $(130) $ 14 ===== ===== The movement in the fair value reflected in "Gain (loss) on debt designated atfair value and related derivatives" includes the effect of credit spread changesand interest rate changes, including any ineffectiveness in the relationshipbetween the related swaps and our debt. As credit spreads narrow, accountinglosses are booked and the reverse is true if credit spreads widen. Differencesarise between the movement in the fair value of our debt and the fair value ofthe related swap due to the different credit characteristics coupled with thesensitivity of the floating leg of the swap due to changes in interest rates.The size and direction of the accounting consequences of such changes can bevolatile from period to period but do not alter the cash flows intended as partof the documented interest rate management strategy. The changes in the interest rate component for both periods reflect an increasein the LIBOR curve since December 31, 2006, although the increase in the LIBORcurve since March 31, 2007 was much greater than the increase since December 31,2006. Changes in the credit risk component of the debt were insignificant duringthe three month period ended June 30, 2007. For the six month period, thechanges in credit risk were due to a general widening of financial sector fixedincome credit spreads in combination with specific spread widening attributableto our participation in the subprime mortgage market. 13. FAIR VALUE MEASUREMENTS-------------------------------------------------------------------------------- Effective January 1, 2007, we elected to early adopt FASB Statement No. 157,"Fair Value Measurements," ("SFAS No. 157"). SFAS No. 157 establishes a singleauthoritative definition of value, sets out a framework for measuring fairvalue, and provides a hierarchal disclosure framework for assets and liabilitiesmeasured at fair value. The adoption of SFAS No. 157 did not have any impact onour financial position or results of operations. 25 HSBC Finance Corporation -------------------------------------------------------------------------------- The following table presents information about our assets and liabilitiesmeasured at fair value on a recurring basis as of June 30, 2007, and indicatesthe fair value hierarchy of the valuation techniques utilized to determine suchfair value. In general, fair values determined by Level 1 inputs use quotedprices (unadjusted) in active markets for identical assets or liabilities thatwe have the ability to access. Fair values determined by Level 2 inputs useinputs other than quoted prices included in Level 1 that are observable for theasset or liability, either directly or indirectly. Level 2 inputs include quotedprices for similar assets and liabilities in active markets, quoted prices foridentical or similar assets or liabilities in markets where there are fewtransactions and inputs other than quoted prices that are observable for theasset or liability, such as interest rates and yield curves that are observableat commonly quoted intervals. Level 3 inputs are unobservable inputs for theasset or liability and include situations where there is little, if any, marketactivity for the asset or liability. ASSETS (LIABILITIES) QUOTED PRICES IN MEASURED AT ACTIVE MARKETS FOR SIGNIFICANT OTHER SIGNIFICANT FAIR VALUE AT IDENTICAL ASSETS OBSERVABLE INPUTS UNOBSERVABLE INPUTS JUNE 30, 2007 (LEVEL 1) (LEVEL 2) (LEVEL 3)------------------------------------------------------------------------------------------------------------- (IN MILLIONS) Derivatives: Risk management related, net(1).................... $ 1,383 $ - $ 1,383 $- Loan and forward sales commitments............... -(3) - - -(3)Available for sale securities.. 3,462 3,462 - -Real estate owned(2)........... 1,057 - 1,057 -Repossessed vehicles(2)........ 39 - 39 -Long term debt carried at fair value........................ 32,085 - 32,085 - -------- ()(1) The fair value disclosed excludes swap collateral that we either receive or deposit with our interest rate swap counterparties. Such swap collateral is recorded on our balance sheet at an amount which "approximates fair value" as discussed in FASB Staff Position No. FIN 39- 1, "Amendment of FASB Interpretation No. 39" and is netted on the balance sheet with the fair value amount recognized for derivative instruments. ()(2) The fair value disclosed is unadjusted for transaction costs as required by SFAS No. 157. The amounts recorded in the consolidated balance sheet are recorded net of transaction costs as required by FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." ()(3) Less than $500 thousand. The balances of our commitments which utilize significant unobservable inputs(Level 3) did not change significantly during the quarter. The following table presents information about our assets measured at fair valueon a non-recurring basis as of June 30, 2007 and indicates the fair valuehierarchy of the valuation techniques utilized to determine such fair value, asdefined by SFAS No. 157. ASSETS (LIABILITIES) QUOTED PRICES IN MEASURED AT ACTIVE MARKETS FOR SIGNIFICANT OTHER SIGNIFICANT FAIR VALUE AT IDENTICAL ASSETS OBSERVABLE INPUTS UNOBSERVABLE INPUTS JUNE 30, 2007 (LEVEL 1) (LEVEL 2) (LEVEL 3)------------------------------------------------------------------------------------------------------------- (IN MILLIONS) Loans held for sale............ $256(1) $- $ - $256Net investment in U.K. Insurance Operations held for sale......................... 231 - 231 - -------- ()(1) The fair value disclosed above excludes loans held for sale for which the fair value exceeds our carrying value. Loans held for sale are recorded at the lower of aggregate cost or fair value.At June 30, 2007, loans held for sale with a carrying value of $338 million werewritten down to their current fair value resulting in an impairment charge 26 HSBC Finance Corporation -------------------------------------------------------------------------------- of $82 million. Fair value is generally determined by estimating a gross premiumor discount. The estimated gross premium or discount is derived from historicalprices received on prior sales and commitments in relation to the 2-year swaprate, the weighted average coupon of the loans as well as market liquidity andloan related credit characteristics. The historical pricing data is based uponthe specific asset classes of loans. In accordance with the provisions of FASB Statement No. 144, "Accounting for theImpairment or Disposal of Long-Lived Assets," our U.K. Insurance Operations witha net carrying amount of $262 million, including the goodwill allocated to theseoperations, were written down to their fair value of $231 million, resulting ina loss of $31 million, which was included as a component of total costs andexpenses during the three months ended March 31, 2007. No additional adjustmentwas determined to be necessary during the three months ended June 30, 2007. Assets and liabilities which could also be measured at fair value on a non-recurring basis include goodwill and intangible assets. 14. NEW ACCOUNTING PRONOUNCEMENTS-------------------------------------------------------------------------------- In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, "Amendment ofFASB Interpretation No. 39" ("FSP 39-1"). FSP 39-1 allows entities that areparty to a master netting arrangement to offset the receivable or payablerecognized upon payment or receipt of cash collateral against fair value amountsrecognized for derivative instruments that have been offset under the samemaster netting arrangement in accordance with FASB Interpretation No. 39. Theguidance in FSP 39-1 is effective for fiscal years beginning after November 15,2007, with early adoption permitted. Entities are required to recognize theeffects of applying FSP 39-1 as a change in accounting principle throughretroactive application for all financial statements presented unless it isimpracticable to do so. We adopted FSP 39-1 during the second quarter of 2007and retroactively applied its requirements to all prior periods as required byFSP 39-1. At June 30, 2007 and December 31, 2006, the fair value of derivativesincluded in derivative financial assets have been reduced by $1,109 million and$1,164 million, respectively, representing the payable recognized upon receiptof cash collateral for derivative instruments that have been offset under thesame master netting arrangement in accordance with FSP 39-1. At June 30, 2007and December 31, 2006, the fair value of derivatives included in derivativefinancial liabilities have been reduced by $57 million and $53 million,respectively, representing the receivable recognized upon payment of cashcollateral for derivative instruments that have been offset under the samemaster netting arrangement in accordance with FSP 39-1. The adoption of FSP 39-1had no impact on our results of operations or our cash flows. 27 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS-------------------------------------------------------------------------------- FORWARD-LOOKING STATEMENTS-------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results ofOperations ("MD&A") should be read in conjunction with the consolidatedfinancial statements, notes and tables included elsewhere in this report andwith our Annual Report on Form 10-K for the year ended December 31, 2006 (the"2006 Form 10-K"). MD&A may contain certain statements that may be forward-looking in nature within the meaning of the Private Securities Litigation ReformAct of 1995. In addition, we may make or approve certain statements in futurefilings with the SEC, in press releases, or oral or written presentations byrepresentatives of HSBC Finance Corporation that are not statements ofhistorical fact and may also constitute forward-looking statements. Words suchas "may", "will", "should", "would", "could", "intend", "believe", "expect","estimate", "target", "plan", "anticipates", "goal" and similar expressions areintended to identify forward-looking statements but should not be considered asthe only means through which these statements may be made. These matters orstatements will relate to our future financial condition, results of operations,plans, objectives, performance or business developments and will involve knownand unknown risks, uncertainties and other factors that may cause our actualresults, performance or achievements to be materially different from that whichwas expressed or implied by such forward-looking statements. Forward-lookingstatements are based on our current views and assumptions and speak only as ofthe date they are made. HSBC Finance Corporation undertakes no obligation toupdate any forward-looking statement to reflect subsequent circumstances orevents. EXECUTIVE OVERVIEW-------------------------------------------------------------------------------- HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC Holdingsplc ("HSBC"). HSBC Finance Corporation may also be referred to in the MD&A as"we", "us", or "our". Pre-tax income was $76 million for the three months ended June 30, 2007, adecrease of 91 percent, compared to $873 million for the three months endedMarch 31, 2007. The primary drivers of this decrease are summarized below: ----------------------------------------------------------------------------------- (IN MILLIONS) Pre-tax income - March 31, 2007..................................... $ 873Higher provision for credit losses.................................. (247)Lower gain (loss) on debt designated at fair value and related derivatives....................................................... (274)Lower taxpayer financial services revenue........................... (235)Higher Decision One losses on loans held for sale................... (67)Other, net.......................................................... 26 -----Pre-tax income - June 30, 2007...................................... $ 76 ===== The increase in our provision for credit losses in the second quarter of 2007compared to the first quarter of 2007 was largely driven by our Credit CardServices and Consumer Lending businesses due to receivables growth, higherdelinquency levels due to growth, seasonality as customers used their taxrefunds in the first quarter to reduce their outstanding balances, and normalportfolio seasoning as well as higher loss estimates for restructured loans inour United Kingdom business. The increase was partially offset by a lowerprovision for credit losses in our United Kingdom business due to lowerreceivable levels and lower delinquency and charge-offs. Also, the first quartercredit loss provision for our United Kingdom business reflected a refinement inthe methodology to calculate roll rate percentages which led to an increase inthe provision for credit losses. The lower gain (loss) on debt designated atfair value and related derivatives in the second quarter reflects asignificantly lower mark-to-market adjustment related to credit risk on fairvalue option debt as the first quarter benefited from a general widening ofcredit spreads, including an adverse impact from the subprime mortgage markets.Taxpaper financial services revenue was significantly lower in the secondquarter due to the seasonal nature of this business which generates most of its 28 HSBC Finance Corporation -------------------------------------------------------------------------------- revenues through March. Losses on loans held for sale by our Decision Onemortgage operations were also much higher in the second quarter reflecting adeterioration of general market conditions in the quarter. Net income was $63 million for the three months ended June 30, 2007, a decreaseof 89 percent, compared to $568 million in the prior year quarter. Net incomewas $604 million for the six months ended June 30, 2007, a decrease of 59percent, compared to $1,456 million in the prior year period. The decrease innet income in both periods is largely due to a higher provision for creditlosses and the impact of lower receivable growth driven largely by our plannedreduction in real estate secured receivables at our Mortgage Services businessas more fully discussed below. The prior year credit loss provision benefitedfrom exceptionally low levels of personal bankruptcy filings in the UnitedStates as a result of the new bankruptcy law which took effect in October 2005,the impact of significant receivable growth in 2004 and 2005 which had not yetfully seasoned and an overall favorable credit environment in the United Stateswhich affects the comparability of the provision for credit losses betweenperiods. Higher costs and expenses to support growth as well as increasedcollection activities and for the three months ended June 30, 2007, lower otherrevenues also contributed to the decrease in net income, partially offset byhigher net interest income and in the year-to-date period, higher otherrevenues. When compared to the year-ago periods, the increase in provision forcredit losses in 2007 reflects higher loss estimates in our Credit Card Servicesbusiness due to higher levels of receivables, higher levels of delinquencydriven by growth and normal portfolio seasoning, increased levels of personalbankruptcy filings as discussed above, the progression of portions of ourMortgage Services portfolio purchased in 2005 and 2006 into various stages ofdelinquency and charge-off and, for the three month period, higher lossestimates on restructured loans in our United Kingdom business of $68 million.Provision for credit losses also increased during the year-to-date period due tohigher loss estimates at our United Kingdom business due to a refinement in themethodology used to calculate roll rate percentages which we believe results ina better estimate of probable losses currently inherent in the loan portfolioand higher loss estimates in second lien loans purchased in 2004 through thethird quarter of 2006 by our Consumer Lending business as part of a second lienbulk acquisition program which has subsequently been discontinued. At June 30,2007, the outstanding principal balance of these second lien loans acquired bythe Consumer Lending business was approximately $1.3 billion. As previously discussed, we are experiencing higher delinquency and lossestimates at our Mortgage Services business as compared to the year-ago periods.Reserve levels at our Mortgage Services business were as follows: THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, -------------- -------------- 2007 2006 2007 2006------------------------------------------------------------------------------------- (IN MILLIONS) Credit loss reserves at beginning of period......... $2,140 $ 426 $2,085 $ 421Provision for credit losses......................... 387 247 741 337Charge-offs......................................... (386) (119) (696) (209)Recoveries.......................................... 27 5 38 8Release of credit loss reserves related to loan sales............................................. (21) - (21) -Other, net.......................................... - (2) - - ------ ----- ------ -----Credit loss reserves at end of period............... $2,147 $ 557 $2,147 $ 557 ====== ===== ====== ===== Credit loss reserve levels at Mortgage Services remained relatively flat at June30, 2007 compared with March 31, 2007 and December 31, 2006 as a significantportion of rate resets on first lien adjustable rate mortgage loans, includingsecond lien loans that are subordinate to underlying first lien adjustable ratemortgages, has yet to occur and we remain cautious about losses inherent in thisportfolio due to economic factors beyond our control. The provision for creditlosses reflects our best estimate of losses which have been incurred in theperiods presented above. See "Credit Quality" included in this MD&A for furtherdiscussion on charge-off trends experienced by our Mortgage Services business in2007. 29 HSBC Finance Corporation -------------------------------------------------------------------------------- The increase in net interest income during both periods was due to growth inaverage receivables and an improvement in the overall yield on the portfolio,partly offset by a higher cost of funds. Changes in receivable mix alsocontributed to the increase in yield due to the impact of increased levels ofhigher yielding products due in part to lower securitization levels, and higherlevels of average credit card and personal non-credit card receivables ascompared to the year-ago periods. Overall yield improvements were partiallyoffset by the impact of growth in non-performing loans. Other revenues decreasedin the three month period reflecting lower derivative income, the impact ofadopting FASB Statement No. 159, "The Fair Value Option for Financial Assets andFinancial Liabilities," ("SFAS No. 159") and lower other income due to realizedlosses incurred on sales of real estate secured receivables by our Decision Onemortgage operations and the sale of a $2.2 billion Mortgage Services loanportfolio, partially offset by higher fee income as a result of higher volume inour credit card portfolios. Other revenues increased during the six month periodas lower derivative income and lower other income as explained above were morethan offset by higher fee income and the positive impact to revenue from SFASNo. 159 due to the widening credit spreads experienced in the first quarter of2007 which stabilized in the second quarter. Based on the change in the fairvalue of the underlying fair value optioned debt related to credit risk, lowerderivative income was due to changes in the interest rate curve and to theadoption of SFAS No. 159. Rising interest rates caused the net outgoing paymentson pay variable/received fix economic hedges to increase as compared with thesame periods in 2006. Additionally, as a result of the adoption of SFAS No. 159,we eliminated hedge accounting for all fixed rate debt designated at fair value.The fair value change in the associated swaps, which accounted for the majorityof the derivative income in 2006, is now reported as "Gain (loss) on debtdesignated at fair value and related derivatives" in the consolidated statementof income along with the mark-to-market on the fixed rate debt. Our return on average owned assets ("ROA") was .14 percent for the quarter endedJune 30, 2007 and .68 percent for the six months ended June 30, 2007 compared to1.36 percent for the three months ended June 30, 2006 and 1.76 percent for thesix months ended June 30, 2006. ROA decreased during these periods as a resultof the lower net income during the period, as discussed above, and higheraverage assets. We continue to monitor the impact of several trends affecting the mortgagelending industry. Real estate markets in a large portion of the United Stateshave been affected by a general slowing in the rate of appreciation in propertyvalues, or an actual decline in some markets, while the period of time availableproperties remain on the market has increased. Additionally, the ability of someborrowers to repay their adjustable rate mortgage ("ARM") loans have beenimpacted as the interest rates on their loans increase as rates adjust undertheir contracts. Interest rate adjustments on first mortgages may also have adirect impact on a borrower's ability to repay any underlying second lienmortgage loan on a property. Similarly, as interest-only mortgage loans leavethe interest-only payment period, the ability of borrowers to make the increasedpayments may be impacted. The rating agencies have recently announced theirintention to downgrade a number of debt issuances secured by subprime mortgages.This could serve to further lessen liquidity in the marketplace for subprimemortgages, cause further tightening of lending standards, and cause highermortgage rates which would further reduce the refinancing opportunities of ourARM customers and increase expected defaults. Industry statistics and reportsindicate that mortgage loan originations throughout the industry from 2005 and2006 are performing worse than originations from prior periods. In 2005 and continuing into the first six months of 2006, second lien mortgageloans in our Mortgage Services business increased significantly as a percentageof total loans acquired when compared to prior periods. During the secondquarter of 2006, we began to witness deterioration in the performance ofmortgage loans acquired in 2005 by our Mortgage Services business, particularlyin the second lien and portions of the first lien portfolios. The deteriorationcontinued in the third quarter and fourth quarters of 2006 and began to affectthese same components of loans acquired in 2006 by this business. In the fourthquarter of 2006 deterioration of these components worsened considerably, largelyrelated to the first lien adjustable rate mortgage portfolio, as well as loansin the second lien portfolios. We are continuing to experience higher thannormal delinquency levels in the first half of 2007 in these portions of theMortgage Services business although the rate of increase in delinquency in 2007has slowed from the rate of increase in the prior year. A significant number ofour second lien customers have underlying adjustable rate first mortgages thatface repricing in the near-term which has impacted the probability of repaymenton the related second lien mortgage loan. As the interest rate adjustments willoccur in an environment of substantially higher interest rates, lower home valueappreciation and tightening credit, we expect the probability of default for 30 HSBC Finance Corporation -------------------------------------------------------------------------------- adjustable rate first mortgages subject to repricing as well as any second lienmortgage loans that are subordinate to an adjustable rate first lien held byanother lender will be greater than what we have historically experienced. Accordingly, while overall credit performance, as measured by delinquency andcharge-off is generally performing as expected across other parts of ourdomestic mortgage portfolio, we are continuing to report higher delinquency andlosses in the Mortgage Services business, largely as a result of the affected2005 and 2006 originations progressing to various stages of delinquency and tocharge-off. Numerous risk mitigation efforts have been implemented relating tothe affected components of the Mortgage Services portfolio. These includeenhanced segmentation and analytics to identify the higher risk portions of theportfolio and increased collections capacity. As appropriate and in accordancewith defined policies, we will restructure and/or modify loans if we believe thecustomer has the ability to pay for the foreseeable future under therestructured/modified terms. We are also contacting customers who haveadjustable rate mortgage loans nearing the first reset that we expect will bethe most impacted by a rate adjustment in order to assess their ability to makethe adjusted payment and, as appropriate, modify the loans. In the second halfof 2006, we slowed growth in this portion of the portfolio by implementingrepricing initiatives in selected origination segments and tighteningunderwriting criteria, especially for second lien, stated income and lowercredit scoring segments. In March 2007, we announced our decision to discontinuenew correspondent channel acquisitions by our Mortgage Services business subjectto fulfilling earlier commitments, which were immaterial. Our Decision Onemortgage operation, which originates loans sourced by brokers primarily forresale, continues to originate mortgage loans, largely for resale to HSBC BankUSA to support the secondary market activities of our affiliates. Our branch-based Consumer Lending business retail channel will continue with its currentoperating strategy. These actions, combined with normal portfolio attrition willcontinue to result in significant reductions in the principal balance of ourMortgage Services loan portfolio during 2007. As part of our effort to reduceexposure in this channel, during the second quarter of 2007 we sold $2.2 billionof real estate secured loans from the Mortgage Services loan portfolio, whichdid not include any loans that were 30 days or more contractually delinquent. Weexpect portions of the Mortgage Services portfolio to remain under pressure asthe 2005 and 2006 originations season further progressing to various stages ofdelinquency and ultimately to charge-off. Effective January 1, 2007, we early adopted SFAS No. 159 which provides for afair value option election that allows companies to irrevocably elect fair valueas the initial and subsequent measurement attribute for certain assets andliabilities, with changes in fair value recognized in earnings when they occur.SFAS No. 159 permits the fair value option election ("FVO") on an instrument byinstrument basis at the initial recognition of an asset or liability or upon anevent that gives rise to a new basis of accounting for that instrument. Weelected FVO for certain issuances of our fixed rate debt in order to align ouraccounting treatment with that of HSBC under International Financial ReportingStandards ("IFRSs"). The adoption of SFAS No. 159 resulted in a $542 millioncumulative-effect after-tax reduction to the January 1, 2007 opening balancesheet. In addition, the impact of the adoption of SFAS No. 159 on 2007 revenuebased on the change in the credit risk component of fair value optioned debt was($6) million in the three months ended June 30, 2007 and $238 million in theyear-to-date period. As part of our continuing evaluation of strategic alternatives with respect toour U.K. operations, we have entered into a non-binding agreement to sell thecapital stock of our U.K. insurance operations ("U.K. Insurance Operations") toa third party for cash. The sales price will be determined, in part, based onthe actual net book value of the assets sold at the time the sale is closedwhich is anticipated in the second half of 2007. The agreement also provides forthe purchaser to distribute insurance products through our U.K. branch networkfor which we will receive commission revenue. The sale is subject to theexecution of a definitive agreement and any regulatory approvals that may berequired. At June 30, 2007, we have classified the U.K. Insurance Operations as"Held for Sale" and combined assets of $464 million and liabilities of $233million related to the U.K. Insurance Operations separately in our consolidatedbalance sheet within other assets and other liabilities. Because our carryingvalue for the U.K. Insurance Operations, including allocated goodwill, was morethan the estimated sales price, we recorded an adjustment of $31 million tototal costs and expenses during the three months ended March 31, 2007 to recordour investment in these operations at the lower of cost or market value. Noadditional adjustment was determined to be necessary during the three monthsended June 30, 2007. We continue to evaluate the scope of our other U.K.operations. 31 HSBC Finance Corporation -------------------------------------------------------------------------------- We are currently considering the possibility of transferring our General MotorsMasterCard and Visa portfolio (the "GM Portfolio") to HSBC Bank USA in thefuture based upon continuing evaluation of capital and liquidity at each entityand obtaining the necessary regulatory approval. We would, however, maintain thecustomer account relationships and, subsequent to the initial receivable sale,additional volume would be sold to HSBC Bank USA on a daily basis. At June 30,2007, the GM Portfolio had an outstanding receivable balance of approximately$6.9 billion. In 2007, we began a strategic review of our Taxpayer Financial Services ("TFS")business to ensure that we offer only the most value-added tax products. As aresult, in March 2007 we announced that beginning with the 2008 tax season wewill discontinue pre-season and pre-file products. The discontinuation of thesespecific tax products will not have a material effect on our consolidatedresults of operations. The strategic review of our TFS business remains on-going. On June 29, 2007, the Federal Financial Regulatory Agencies (the "Agencies")issued a final statement on subprime mortgage lending which reiterates many ofthe principles addressed in the existing guidance relating to risk managementpractices and consumer protection laws involving adjustable rate mortgageproducts and the underwriting process on stated income and interest-only loans.While we believe a significant portion of our business is already substantiallyin compliance with this final statement, we are currently assessing the fullimpact of this statement on our operations. We anticipate being fully compliantwith these new guidelines by December 31, 2007. The financial information set forth below summarizes selected financialhighlights of HSBC Finance Corporation as of June 30, 2007 and 2006 and for thethree and six month periods ended June 30, 2007 and 2006. THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, --------------- --------------- 2007 2006 2007 2006-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income......................................... $ 63 $ 568 $ 604 $1,456Return on average owned assets..................... .14% 1.36% .68% 1.76%Return on average common shareholder's equity ("ROE").......................................... 1.13 11.19 6.14 14.62Net interest margin................................ 6.54 6.66 6.47 6.68Consumer net charge-off ratio, annualized.......... 3.96 2.88 3.82 2.73Efficiency ratio(1)................................ 43.51 40.70 40.62 40.28 AS OF JUNE 30, 2007 2006---------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Receivables.................................................. $157,805 $153,959Two-month-and-over contractual delinquency ratios............ 5.09% 3.71% -------- ()(1) Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits. Receivables were $157.8 billion at June 30, 2007, $160.1 billion at March 31,2007 and $154.0 billion at June 30, 2006. While real estate secured receivableshave been a primary driver of growth in recent years, in the first half of 2007real estate secured growth in our Consumer Lending business was more than offsetby lower receivable balances in our Mortgage Services business resulting fromthe decision in the second quarter of 2006 to reduce purchases of second lienand selected higher risk products in our Mortgage Services business and thedecision in March 2007 to discontinue new correspondent channel acquisitions byour Mortgage Services business subject to fulfilling earlier commitments, whichwere immaterial, as discussed above. Additionally, in the second quarter of2007, we sold $2.2 billion of real estate secured loans from our MortgageServices portfolio. These decisions will continue to result in a significantreduction in the receivable balance in the Mortgage Services portfolio on an on-going basis. Compared to March 31, 2007, receivable levels primarily reflectattrition in our Mortgage Services portfolio as discussed above, partiallyoffset by growth in our Consumer Lending and Credit Card businesses. Compared toJune 30, 2006, with the exception of real estate secured receivables due to thelower receivable balances at our Mortgage Services business, we experiencedgrowth in all of our receivable products. 32 HSBC Finance Corporation -------------------------------------------------------------------------------- Our two-months-and-over contractual delinquency ratio increased compared to boththe prior year quarter and prior quarter. Compared to both periods, with theexception of our private label portfolio, all products reported higherdelinquency levels due to higher receivable levels and normal seasonal trends,including higher real estate secured delinquency primarily at our MortgageServices business as discussed above. The two-months-and-over contractualdelinquency ratio was also negatively impacted by lower real estate securedreceivables growth driven largely by our strategy to discontinue newcorrespondent channel acquisitions by our Mortgage Services business subject tofulfilling earlier commitments, which were immaterial, which significantlyreduced the outstanding principal balance of the Mortgage Services loanportfolio. Net charge-offs as a percentage of average consumer receivables for the quarterincreased compared to both the prior year quarter and prior quarter. Compared tothe prior year quarter, net charge-offs as a percent, annualized, of averageconsumer receivables increased primarily due to higher charge-offs in our realestate secured portfolio in our Mortgage Services business, the impact of lowerreceivable levels driven by our planned reduction in correspondent purchases, aswell as higher charge-offs in our credit card portfolio. The increase in charge-offs in the credit card portfolio is due to increased levels of personalbankruptcy filings as compared to the exceptionally low levels experienced inthe first quarter of 2006 following enactment of the new bankruptcy law in theUnited States and higher receivable balances. Compared to the prior quarter,increases in net charge-offs as a percentage of average consumer receivables forour real estate secured and personal non-credit card portfolios were partiallyoffset by lower ratios in our other products. Our efficiency ratio deteriorated as compared to the prior year quarter and theyear-ago period. Excluding the change in fair value on the fixed rate debtrelated to credit risk resulting from the adoption of SFAS No. 159, theefficiency ratio deteriorated 274 basis points as compared to the prior yearquarter and 163 basis points as compared to the year-ago period. Thedeterioration was a result of higher costs and expenses to support receivablegrowth and increased collection activities as well as realized losses on realestate secured receivable sales, partially offset by higher net interest incomeand higher fee income due to higher levels of receivables. During the first half of 2007, we supplemented funding through unsecured debtissuances with proceeds from the continuing sale of newly originated domesticprivate label receivables to HSBC Bank USA and higher levels of commercialpaper. BASIS OF REPORTING-------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States ("U.S. GAAP"). Unless noted,the discussion of our financial condition and results of operations included inMD&A are presented on a U.S. GAAP basis of reporting. Certain reclassificationshave been made to prior year amounts to conform to the current yearpresentation. EQUITY RATIOS Tangible shareholder's equity to tangible managed assets("TETMA"), tangible shareholder's equity plus owned loss reserves to tangiblemanaged assets ("TETMA + Owned Reserves") and tangible common equity to tangiblemanaged assets are non-U.S. GAAP financial measures that are used by HSBCFinance Corporation management and certain rating agencies to evaluate capitaladequacy. These ratios exclude the equity impact of SFAS No. 115, "Accountingfor Certain Investments in Debt and Equity Securities," the equity impact ofSFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities,"and the impact of the adoption of SFAS No. 159 including the subsequent changesin fair value recognized in earnings associated with credit risk on debt forwhich we elected the fair value option. Preferred securities issued by certainnon-consolidated trusts are also considered equity in the TETMA and TETMA +Owned Reserves calculations because of their long-term subordinated nature andour ability to defer dividends. Managed assets include owned assets plus loanswhich we have sold and service with limited recourse. We and certain ratingagencies also monitor our equity ratios excluding the impact of the HSBCacquisition purchase accounting adjustments. We do so because we believe thatthe HSBC acquisition purchase accounting adjustments represent non-cashtransactions which do not affect our business operations, cash flows or abilityto meet our debt obligations. These ratios may differ from similarly namedmeasures presented by other companies. The most directly comparable U.S. GAAPfinancial measure is the common and preferred equity to owned assets ratio. Fora quantitative reconciliation of these non-U.S. GAAP 33 HSBC Finance Corporation -------------------------------------------------------------------------------- financial measures to our common and preferred equity to owned assets ratio, see"Reconciliations to U.S. GAAP Financial Measures." INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results inaccordance with IFRSs and IFRSs results are used in measuring and rewardingperformance of employees, our management also separately monitors net incomeunder IFRSs (a non-U.S. GAAP financial measure). The following table reconcilesour net income on a U.S. GAAP basis to net income on an IFRSs basis: THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, ----------- ------------- 2007 2006 2007 2006------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Net income - U.S. GAAP basis........................... $ 63 $568 $604 $1,456Adjustments, net of tax: Securitizations...................................... 9 13 8 34 Derivatives and hedge accounting (including fair value adjustments)................................ 18 (19) 1 (90) Intangible assets.................................... 25 26 51 62 Purchase accounting adjustments...................... 12 (19) 21 13 Loan origination..................................... (19) (1) (15) (21) Loan impairment...................................... (20) 10 (27) 19 Loans held for resale................................ 7 18 (22) 18 Interest recognition................................. 13 101 26 101 Lower of cost or market adjustment for U.K. Insurance Operations............................ - - (6) - Other................................................ 27 18 45 53 ---- ---- ---- ------Net income - IFRSs basis............................... $135 $715 $686 $1,645 ==== ==== ==== ====== Significant differences between U.S. GAAP and IFRSs are as follows: SECURITIZATIONS IFRSs - The recognition of securitized assets is governed by a three-step process, which may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows arising from securitized assets have been transferred to a third party and all the risks and rewards of the assets have been transferred, the assets concerned are derecognized. - If the rights to the cash flows are retained by HSBC but there is a contractual obligation to pay them to another party, the securitized assets concerned are derecognized if certain conditions are met such as, for example, when there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If some significant risks and rewards of ownership have been transferred, but some have also been retained, it must be determined whether or not control has been retained. If control has been retained, HSBC continues to recognize the asset to the extent of its continuing involvement; if not, the asset is derecognized. - The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. U.S. GAAP - SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity ("SPE") and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets. 34 HSBC Finance Corporation -------------------------------------------------------------------------------- - Control is surrendered over transferred assets if, and only if, all of the following conditions are met: - The transferred assets are put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. - When HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the SPE, HSBC recognizes this interest at fair value on sale of the assets to the SPE. DERIVATIVES AND HEDGE ACCOUNTING IFRSs - Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter ("OTC") derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models. - In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (that is the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (without modification or repackaging) or will be based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading gain or loss on inception of the derivative. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out. - Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. - Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net basis. - The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. 35 HSBC Finance Corporation -------------------------------------------------------------------------------- Hedge Accounting: - It is HSBC's policy to document, at the inception of a hedge, the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking the hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives used in the hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. Fair value hedge: - Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair values of the assets or liabilities or groups thereof that are attributable to the hedged risks. - If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item is amortized to the income statement based on a recalculated effective interest rate over the residual period to maturity, unless the hedged item has been derecognized whereby it is released to the income statement immediately. Cash flow hedge: - The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement. - Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect the income statement. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability. - When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. Net investment hedge: - Hedges of net investments in foreign operations are accounted for in a similar manner to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation. Hedge effectiveness testing: - IAS 39 requires that at inception and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness) to qualify for hedge accounting. Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis. - The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. - For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For retrospective effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective. Derivatives that do not qualify for hedge accounting: - All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement. 36 HSBC Finance Corporation -------------------------------------------------------------------------------- U.S. GAAP - The accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39, which HSBC has followed in its IFRSs reporting from January 1, 2005, as described above. However, specific assumptions regarding hedge effectiveness under U.S. GAAP are not permitted by IAS 39. - The requirements of SFAS No. 133 have been effective from January 1, 2001. - The U.S. GAAP 'shortcut method' permits an assumption of zero ineffectiveness in hedges of interest rate risk with an interest rate swap provided specific criteria have been met. IAS 39 does not permit such an assumption, requiring a measurement of actual ineffectiveness at each designated effectiveness testing date. As of June 30, 2007, we do not have any hedges accounted for under the shortcut method. - In addition, IFRSs allows greater flexibility in the designation of the hedged item. Under U.S. GAAP, all contractual cash flows must form part of the designated relationship, whereas IAS 39 permits the designation of identifiable benchmark interest cash flows only. - Under U.S. GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. These contracts do not meet the requirements for offset under IAS 32 and hence are presented gross on the balance sheet under IFRSs.DESIGNATION OF FINANCIAL ASSETS AND LIABILITIES AT FAIR VALUE THROUGH PROFIT ANDLOSS IFRSs - Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or a combination of both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. - Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it relates. Financial assets and financial liabilities are recognized using trade date accounting. - Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. U.S. GAAP - Prior to the adoption of SFAS No. 159, generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they were required to meet the definition of trading securities in SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities were usually reported at amortized cost under U.S. GAAP. - SFAS No. 159 was issued in February 2007, which provides for a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at the initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We adopted SFAS No. 159 retroactive to January 1, 2007. 37 HSBC Finance Corporation -------------------------------------------------------------------------------- GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES IFRSs - Prior to 1998, goodwill under U.K. GAAP was written off against equity. HSBC did not elect to reinstate this goodwill on its balance sheet upon transition to IFRSs. From January 1, 1998 to December 31, 2003 goodwill was capitalized and amortized over its useful life. The carrying amount of goodwill existing at December 31, 2003 under U.K. GAAP was carried forward under the transition rules of IFRS 1 from January 1, 2004, subject to certain adjustments. - IFRS 3 "Business Combinations" requires that goodwill should not be amortized but should be tested for impairment at least annually at the reporting unit level by applying a test based on recoverable amounts. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their market price on the date the transaction is completed. U.S. GAAP - Up to June 30, 2001, goodwill acquired was capitalized and amortized over its useful life which could not exceed 25 years. The amortization of previously acquired goodwill ceased with effect from December 31, 2001. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their average market price over a reasonable period before and after the date on which the terms of the acquisition are agreed and announced. LOAN ORIGINATION IFRSs - Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. U.S. GAAP - Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the income statement account over the life of the loan as an adjustment to interest income (SFAS No. 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) LOAN IMPAIRMENT IFRSs - Where statistical models, using historic loss rates adjusted for economic conditions, provide evidence of impairment in portfolios of loans, their values are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate. The calculations include a reasonable estimate of recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. U.S. GAAP - Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery, the loans are written off in full, or to recoverable value where collateral exists. Delinquency depends on the number of days payment is overdue. The delinquency status is applied consistently across similar loan products in accordance with HSBC's credit guidelines. When local regulators mandate the delinquency status at which write-off must occur for different retail loan products and these regulations reasonably reflect estimated recoveries on individual loans, this basis of measuring loan impairment is reflected in U.S. GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. 38 HSBC Finance Corporation -------------------------------------------------------------------------------- LOANS HELD FOR RESALE IFRSs - Under IAS 39, loans held for resale are treated as trading assets. - As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings. - Any gains realized on sales of such loans are recognized in current period earnings on the trade date. U.S. GAAP - Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet. - Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost. - Subsequent gains on sales of such loans are recognized in current period earnings on the settlement date. INTEREST RECOGNITION IFRSs - The calculation and recognition of effective interest rates under IAS 39 requires an estimate of "all fees and points paid or received between parties to the contract" that are an integral part of the effective interest rate be included. U.S. GAAP - FAS 91 also generally requires all fees and costs associated with originating a loan to be recognized as interest, but when the interest rate increases during the term of the loan it prohibits the recognition of interest income to the extent that the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. During the second quarter of 2006, we implemented a methodology for calculatingthe effective interest rate for introductory rate credit card receivables whichresulted in an increase to interest income under IFRSs of $154 million ($97million after-tax). Of the amounts recognized, approximately $58 million (after-tax) would otherwise have been recorded as an IFRSs opening balance sheetadjustment as at January 1, 2005. IFRS MANAGEMENT BASIS REPORTING Our segment results are presented on an IFRSsmanagement basis (a non-U.S. GAAP financial measure) ("IFRS Management Basis")as operating results are monitored and reviewed, trends are evaluated anddecisions about allocating resources, such as employees, are made almostexclusively on an IFRS Management Basis as we report results to our parent,HSBC, who prepares its consolidated financial statements in accordance withIFRSs. IFRS Management Basis results are IFRSs results adjusted to assume thatthe private label and real estate secured receivables transferred to HSBC BankUSA have not been sold and remain on our balance sheet. Operations are monitoredand trends are evaluated on an IFRS Management Basis because the customer loansales to HSBC Bank USA were conducted primarily to appropriately fund primecustomer loans within HSBC and such customer loans continue to be managed andserviced by us without regard to ownership. However, we continue to monitorcapital adequacy, establish dividend policy and report to regulatory agencies ona U.S. GAAP basis. A summary of the significant differences between U.S. GAAPand IFRSs as they impact our results are summarized in Note 11, "BusinessSegments." This information is provided by RNS The company news service from the London Stock Exchange Part 1 of 2, More to FollowRelated Shares:
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