HSBC Finance Corp. 2Q 10Q - 2

30th Jul 2007 11:57

HSBC Holdings PLC30 July 2007 Part 2 of 2 39 HSBC Finance Corporation -------------------------------------------------------------------------------- RECEIVABLES REVIEW-------------------------------------------------------------------------------- The following table summarizes receivables at June 30, 2007 and increases(decreases) over prior periods: INCREASES (DECREASES) FROM -------------------------------- MARCH 31, JUNE 30, 2007 2006 JUNE 30, -------------- --------------- 2007 $ % $ %------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Real estate secured(1)....................... $ 92,296 $(4,033) (4.2)% $(1,597) (1.7)%Auto finance................................. 12,933 300 2.4 1,210 10.3Credit card.................................. 28,594 1,301 4.8 3,635 14.6Private label................................ 2,553 53 2.1 31 1.2Personal non-credit card(2).................. 21,277 76 .4 613 3.0Commercial and other......................... 152 (6) (3.8) (46) (23.2) -------- ------- ---- ------- -----Total owned receivables...................... $157,805 $(2,309) (1.4)% $ 3,846 2.5% ======== ======= ==== ======= ===== -------- ()(1) Mortgage Services has historically purchased receivables originated by other lenders referred to as correspondents. In December, the business was aligned under common executive management with our Consumer Lending business. In March 2007, we announced that Mortgage Services was ceasing new correspondent channel acquisitions of receivables subject to fulfilling earlier commitments, which were immaterial. Consumer Lending is a distinct business that sources, underwrites and closes loans through a network of 1,364 branch offices located throughout the United States. The Mortgage Services and Consumer Lending businesses comprise the majority of our real estate secured portfolio as shown in the following table: INCREASES (DECREASES) FROM ---------------------------------- MARCH 31, JUNE 30, 2007 2006 JUNE 30, --------------- ---------------- 2007 $ % $ %------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Mortgage Services................................. $39,224 $(5,450) (12.2)% $(10,230) (20.7)%Consumer Lending.................................. 49,088 1,164 2.4 7,988 19.4Foreign and all other............................. 3,984 253 6.8 645 19.3 ------- ------- ----- -------- -----Total real estate secured......................... $92,296 $(4,033) (4.2)% $ (1,597) (1.7)% ======= ======= ===== ======== ===== -------- ()(2) Personal non-credit card receivables are comprised of the following: INCREASES (DECREASES) FROM ---------------------------- MARCH 31, JUNE 30, 2007 2006 JUNE 30, ----------- -------------- 2007 $ % $ %---------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Domestic personal non-credit card.................... $14,056 $185 1.3% $1,496 11.9%Union Plus personal non-credit card.................. 200 (13) (6.1) (67) (25.1)Personal homeowner loans............................. 4,136 (45) (1.1) (113) (2.7)Foreign personal non-credit card..................... 2,885 (51) (1.7) (703) (19.6) ------- ---- ---- ------ -----Total personal non-credit card....................... $21,277 $ 76 .4% $ 613 3.0% ======= ==== ==== ====== ===== 40 HSBC Finance Corporation -------------------------------------------------------------------------------- Real estate secured receivables can be further analyzed as follows: INCREASES (DECREASES) FROM -------------------------------- MARCH 31, JUNE 30, 2007 2006 JUNE 30, -------------- --------------- 2007 $ % $ %------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Real estate secured:Closed-end: First lien.................................. $73,953 $(3,248) (4.2)% $ 34 -% Second lien................................. 14,295 (461) (3.1) (526) (3.5)Revolving: First lien.................................. 499 (10) (2.0) (49) (8.9) Second lien................................. 3,549 (314) (8.1) (1,056) (22.9) ------- ------- ---- ------- -----Total real estate secured..................... $92,296 $(4,033) (4.2)% $(1,597) (1.7)% ======= ======= ==== ======= ===== The following table summarizes various real estate secured receivablesinformation for our Mortgage Services and Consumer Lending businesses: JUNE 30, MARCH 31, JUNE 30, 2007 2007 2006 ------------------- ------------------- ------------------- MORTGAGE CONSUMER MORTGAGE CONSUMER MORTGAGE CONSUMER SERVICES LENDING SERVICES LENDING SERVICES LENDING-------------------------------------------------------------------------------------------------- (IN MILLIONS) Fixed rate....................... $20,679(1) $45,672(2) $20,518(1) $44,236(2) $21,283(1) $39,068(2)Adjustable rate.................. 18,545 3,416 24,156 3,688 28,171 2,032 ------- ------- ------- ------- ------- -------Total............................ $39,224 $49,088 $44,674 $47,924 $49,454 $41,100 ======= ======= ======= ======= ======= =======First lien....................... $31,083 $42,486 $35,630 $41,294 $38,326 $35,495Second lien...................... 8,141 6,602 9,044 6,630 11,128 5,605 ------- ------- ------- ------- ------- -------Total............................ $39,224 $49,088 $44,674 $47,924 $49,454 $41,100 ======= ======= ======= ======= ======= =======Adjustable rate.................. $12,822 $ 3,416 $18,141 $ 3,688 $21,159 $ 2,032Interest only.................... 5,723 - 6,015 - 7,012 - ------- ------- ------- ------- ------- -------Total adjustable rate............ $18,545 $ 3,416 $24,156 $ 3,688 $28,171 $ 2,032 ======= ======= ======= ======= ======= =======Total stated income.............. $ 9,442 $ - $11,063 $ - $13,136 $ - ======= ======= ======= ======= ======= ======= -------- ()(1) Includes fixed rate interest-only loans of $473 million at June 30, 2007, $528 million at March 31, 2007 and $435 million at June 30, 2006. ()(2) Includes fixed rate interest-only loans of $52 million at June 30, 2007, $54 million at March 31, 2007 and $8 million at June 30, 2006. The following table summaries the lien position of Mortgage Services' realestate secured loans originated and acquired subsequent to December 31, 2004which were outstanding as of the following dates: MORTGAGE SERVICES' RECEIVABLES ORIGINATED OR ACQUIRED AFTER DECEMBER 31, 2004---------------------------------------------------------------------------------------AS OF FIRST LIEN SECOND LIEN--------------------------------------------------------------------------------------- June 30, 2007................................................ 81% 90%March 31, 2007............................................... 73% 88%June 30, 2006................................................ 67% 88% 41 HSBC Finance Corporation -------------------------------------------------------------------------------- RECEIVABLE INCREASES (DECREASES) SINCE JUNE 30, 2006 Real estate securedreceivables decreased from the year-ago period driven by lower receivablebalances in our Mortgage Services business resulting from revisions to itsbusiness plan. In the second half of 2006 we reduced purchases of second lienand selected higher risk products and in March 2007 we discontinued newcorrespondent channel acquisitions subject to fulfilling earlier commitments,which were immaterial. These decisions resulted in attrition in the MortgageServices portfolio as of June 30, 2007 and we anticipate the attrition willcontinue for the remainder of 2007. Additionally, during the second quarter of2007, we sold $2.2 billion of loans from our Mortgage Services loan portfolio tothird parties. The decrease in our Mortgage Services portfolio was partiallyoffset by growth in our Consumer Lending branch business. Growth in our branch-based Consumer Lending business improved due to higher sales volumes as wecontinue to emphasize real estate secured loans, including a near-prime mortgageproduct, as well as a decline in loan prepayments due to the higher interestrate environment which resulted in lower run-off rates. Also contributing to theincrease in our Consumer Lending business was the acquisition of the $2.5billion Champion portfolio in November 2006. We have also experienced strongreal estate secured growth in our foreign real estate secured receivables as aresult of our continuing Canadian branch operation expansions. Auto finance receivables increased over the year-ago period due to organicgrowth principally in the near-prime portfolio as a result of growth in theconsumer direct loan program. Continued growth from the expansion of an autofinance program in Canada also contributed to the increase as compared to theyear-ago period. Credit card receivables reflect strong domestic organic growthin our Union Privilege, Metris and non-prime portfolios, as well as continuedgrowth in our Canadian credit card receivables. Private label receivablesincreased as compared to June 30, 2006 as a result of growth in our Canadianbusiness and changes in the foreign exchange rate since June 30, 2006, partiallyoffset by the termination of new domestic retail sales contract originations inOctober 2006 by our Consumer Lending business. Personal non-credit cardreceivables increased as a result of increased marketing, including severallarge direct mail campaigns. RECEIVABLE INCREASES (DECREASES) SINCE MARCH 31, 2007 Real estate securedreceivables have decreased since March 31, 2007. As discussed above, actionstaken at our Mortgage Services business combined with normal portfolio attritionand the sale of $2.2 billion of loans in the second quarter of 2007 haveresulted in a decline in the overall portfolio balance at our Mortgage Servicesbusiness since March 31, 2007. These decreases were partially offset by realestate secured growth in our Consumer Lending business. In addition, the declinein loan prepayments has continued during the first half of 2007 which hasresulted in lower run-off rates for our real estate secured portfolio. Growth inour auto finance portfolio reflects growth in our direct to consumer business.The increase in our credit card receivables is due to growth in our GeneralMotors, Union Privilege, Metris and non-prime portfolios. Private labelreceivables increased as a result of growth in our Canadian private labelportfolio partially offset by the termination of new domestic retail salescontract originations in October 2006. Personal non-credit card receivablesincreased primarily due to higher levels of domestic personal non-credit cardreceivables, partially offset by a reduction in new loan volume due to atightening in underwriting standards. RESULTS OF OPERATIONS-------------------------------------------------------------------------------- Unless noted otherwise, the following discusses amounts reported in ourconsolidated statement of income. NET INTEREST INCOME The following table summarizes net interest income: INCREASE (DECREASE) ---------------THREE MONTHS ENDED JUNE 30, 2007 (1) 2006 (1) AMOUNT %-------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Finance and other interest income........ $4,685 11.53% $4,311 11.27% $374 8.7%Interest expense......................... 2,028 4.99 1,762 4.61 266 15.1 ------ ----- ------ ----- ---- ----Net interest income...................... $2,657 6.54% $2,549 6.66% $108 4.2% ====== ===== ====== ===== ==== ==== 42 HSBC Finance Corporation -------------------------------------------------------------------------------- INCREASE (DECREASE) ---------------SIX MONTHS ENDED JUNE 30, 2007 (1) 2006 (1) AMOUNT %-------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Finance and other interest income........ $9,397 11.47% $8,398 11.19% $999 11.9%Interest expense......................... 4,099 5.00 3,385 4.51 714 21.1 ------ ----- ------ ----- ---- ----Net interest income...................... $5,298 6.47% $5,013 6.68% $285 5.7% ====== ===== ====== ===== ==== ==== -------- ()(1) % Columns: comparison to average owned interest-earning assets. The increases in net interest income during the quarter and year-to-date periodswere due to higher average receivables and higher overall yields, partiallyoffset by higher interest expense. Overall yields increased due to increases inour rates on fixed and variable rate products which reflected market movementsand various other repricing initiatives. Yields were also favorably impacted byreceivable mix with increased levels of higher yielding products such as creditcards, due in part to reduced securitization levels and higher levels of averagecredit card and personal non-credit card receivables. Overall yield improvementswere partially offset by the impact of growth in non-performing assets. Thehigher interest expense in both periods, which contributed to lower net interestmargin, was due to a larger balance sheet and a significantly higher cost offunds due to a rising interest rate environment. This was partially offset bythe adoption of SFAS No. 159, which resulted in $82 million of realized lossesin the quarter and $158 million of realized losses in the year-to-date period onswaps which previously were accounted for as effective hedges under SFAS No. 133and reported as interest expense now being reported in other revenues. Inaddition, as part of our overall liquidity management strategy, we continue toextend the maturity of our liability profile which results in higher interestexpense. Our purchase accounting fair value adjustments include bothamortization of fair value adjustments to our external debt obligations andreceivables. Amortization of purchase accounting fair value adjustmentsincreased net interest income by $65 million during the three months ended June30, 2007 and $111 million during the six month period ended June 30, 2007.Amortization of purchase accounting fair value adjustments increased netinterest income by $115 million during the three months ended June 30, 2006 and$229 million during the six month period ended June 30, 2006. Net interest margin decreased during the three and six months ended June 30,2007 as the improvement in the overall yield on our receivable portfolio, asdiscussed above, was more than offset by the higher funding costs. The followingtable shows the impact of these items on net interest margin at June 30, 2007: THREE MONTHS SIX MONTHS ENDED ENDED-------------------------------------------------------------------------------------- Net interest margin - June 30, 2006........................ 6.66% 6.68%Impact to net interest margin resulting from: Receivable pricing....................................... .27 .29 Receivable mix........................................... .17 .09 Growth in non-performing assets.......................... (.16) (.14) Cost of funds............................................ (.38) (.50) Other.................................................... (.02) .05 ---- ----Net interest margin - June 30, 2007........................ 6.54% 6.47% ==== ==== 43 HSBC Finance Corporation -------------------------------------------------------------------------------- The varying maturities and repricing frequencies of both our assets andliabilities expose us to interest rate risk. When the various risks inherent inboth the asset and the debt do not meet our desired risk profile, we usederivative financial instruments to manage these risks to acceptable interestrate risk levels. See "Risk Management" for additional information regardinginterest rate risk and derivative financial instruments. PROVISION FOR CREDIT LOSSES The following table summarizes provision for creditlosses: INCREASE (DECREASE) --------------- 2007 2006 AMOUNT %--------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Three months ended June 30,......................... $1,947 $1,248 $ 699 56.0%Six months ended June 30,........................... 3,647 2,114 1,533 72.5% Our provision for credit losses increased significantly during both periods dueto higher levels of receivables due in part to lower securitization levels,higher levels of delinquency driven by growth, normal portfolio seasoning andthe progression of portions of our Mortgage Services portfolio purchased in 2005and 2006 into various stages of delinquency and charge-off, a higher mix ofunsecured loans such as credit cards and personal non-credit card receivables,increased levels of personal bankruptcy filings as compared to the exceptionallylow filing levels experienced in the first half of 2006 as a result of the newbankruptcy law in the United States which went into effect in October 2005,weaker early stage performance in certain Consumer Lending real estate securedloans originated since late 2005 consistent with the industry trends for fixedrate mortgages and, for the three month period, higher loss estimates forrestructured loans in our U.K. operations. Beginning in the second quarter of 2006, we began to experience a deteriorationin the performance of mortgage loans acquired in 2005 by our Mortgage Servicesbusiness, particularly in the second lien and portions of the first lienportfolio which, later in the year, began to affect the same components of loansoriginated in 2006 by this business, which resulted in higher delinquency,charge-offs and loss estimates in these portfolios. In the first half of 2007,we have seen higher levels of net charge-off in these components as the higherdelinquency we began to experience in the prior year is now beginning to migrateto charge-off. We are continuing to experience higher than normal delinquencylevels in the first half of 2007 although the rate of increase in delinquency in2007 has slowed from the rate of increase experienced in the prior year. Ourprovision for credit losses also reflects higher loss estimates in second lienloans purchased in 2004 through the third quarter of 2006 by our ConsumerLending business as part of a second lien bulk acquisition program which hassubsequently been discontinued, which increased credit loss reserves by $87million during the year-to-date period. At June 30, 2007, the outstandingprincipal balance of these second lien loans acquired by the Consumer Lendingbusiness was approximately $1.3 billion. Our provision for credit losses in the six months ended June 30, 2007 alsoreflects the impact from a refinement in the methodology used to calculate rollrate percentages at our United Kingdom business which increased credit lossreserves $93 million in the first half of 2007 which we believe reflects abetter estimate of probable losses currently inherent in the loan portfolio andhigher loss estimates in second lien loans purchased in 2004 through the thirdquarter of 2006 by our Consumer Lending business as part of a second lien bulkacquisition program which has been subsequently discontinued. At June 30, 2007,the outstanding principal balance of the second lien loans acquired by theConsumer Lending business was approximately $1.3 billion. The provision as a percent of average receivables, annualized, was 4.86 percentin the current quarter and 4.53 percent year-to-date, compared to 3.33 percentand 2.87 percent in the year-ago periods. In 2007, credit loss reservesincreased as the provision for credit losses was $360 million greater than netcharge-offs in the second quarter of 2007 and $572 million greater than netcharge-offs in the year-to-date period. In 2006, credit loss reserves increasedas the provision for credit losses was $168 million greater than net charge-offsin the second quarter of 2006 and $106 million greater than net charge-offs inthe year-to-date period. The provision for credit losses may vary from quarterto quarter depending on the product mix and credit quality of loans in ourportfolio. See "Credit Quality" included in this MD&A for further discussion offactors affecting the provision for credit losses. 44 HSBC Finance Corporation -------------------------------------------------------------------------------- Net charge-off dollars increased $507 million during the three months ended June30, 2007 as compared to the year-ago quarter and $1,067 million during the sixmonths ended June 30, 2007 as compared to the year-ago period. This increase wasdriven by our Mortgage Services business, as loans originated and acquired in2005 and early 2006 are progressing to charge-off as well as higher receivablelevels, portfolio seasoning in our credit card portfolio and increased levels ofpersonal bankruptcy filings as compared to the exceptionally low filing levelsexperienced in the first half of 2006 as a result of the new bankruptcy law inthe United States. The provision for credit losses may vary from quarter toquarter depending on the product mix and credit quality of loans in ourportfolio. See "Credit Quality" included in this MD&A for further discussion offactors affecting the provision for credit losses. OTHER REVENUES The following table summarizes other revenues: INCREASE (DECREASE) --------------THREE MONTHS ENDED JUNE 30, 2007 2006 AMOUNT %-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Securitization related revenue...................... $ 22 $ 51 $ (29) (56.9)%Insurance revenue................................... 193 226 (33) (14.6)Investment income................................... 32 34 (2) (5.9)Derivative (expense) income......................... (39) (7) (32) (100+)Gain (loss) on debt designated at fair value and related derivatives............................... (130) - (130) (100+)Fee income.......................................... 629 429 200 46.6Enhancement services revenue........................ 150 130 20 15.4Taxpayer financial services revenue................. 4 20 (16) (80.0)Gain on receivable sales to HSBC affiliates......... 109 97 12 12.4Servicing and other fees from HSBC affiliates....... 132 116 16 13.8Other (expense) income.............................. (88) 79 (167) (100+) ------ ------ ----- -----Total other revenues................................ $1,014 $1,175 $(161) (13.7)% ====== ====== ===== ===== INCREASE (DECREASE) --------------SIX MONTHS ENDED JUNE 30, 2007 2006 AMOUNT %-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Securitization related revenue...................... $ 43 $ 122 $ (79) (64.8)%Insurance revenue................................... 423 470 (47) (10.0)Investment income................................... 58 68 (10) (14.7)Derivative (expense) income......................... (46) 50 (96) (100+)Gain (loss) on debt designated at fair value and related derivatives............................... 14 - 14 100+Fee income.......................................... 1,202 811 391 48.2Enhancement services revenue........................ 298 253 45 17.8Taxpayer financial services revenue................. 243 254 (11) (4.3)Gain on receivable sales to HSBC affiliates......... 204 182 22 12.1Servicing and other fees from HSBC affiliates....... 265 234 31 13.2Other (expense) income.............................. (48) 152 (200) (100+) ------ ------ ----- -----Total other revenues................................ $2,656 $2,596 $ 60 2.3% ====== ====== ===== ===== 45 HSBC Finance Corporation -------------------------------------------------------------------------------- SECURITIZATION RELATED REVENUE is the result of the securitization of ourreceivables and includes the following: INCREASE (DECREASE) --------------THREE MONTHS ENDED JUNE 30, 2007 2006 AMOUNT %------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net replenishment gains(1)............................. $ 8 $ 4 $ 4 100.0%Servicing revenue and excess spread.................... 14 47 (33) (70.2) --- --- ---- -----Total.................................................. $22 $51 $(29) (56.9)% === === ==== ===== INCREASE (DECREASE) --------------SIX MONTHS ENDED JUNE 30, 2007 2006 AMOUNT %------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net replenishment gains(1)............................. $16 $ 19 $ (3) (15.8)%Servicing revenue and excess spread.................... 27 103 (76) (73.8) --- ---- ---- -----Total.................................................. $43 $122 $(79) (64.8)% === ==== ==== ===== -------- ()(1) Net replenishment gains reflect inherent recourse provisions of $4 million in the three months ended June 30, 2007 and $9 million in the six months ended June 30, 2007. Net replenishment gains reflect inherent recourse provisions of $16 million in the three months ended June 30, 2006 and $30 million in six months ended June 30, 2006. The decline in securitization related revenue in the three and six months endedJune 30, 2007 was due to decreases in the level of securitized receivables as aresult of our decision in the third quarter of 2004 to structure all newcollateralized funding transactions as secured financings. Because existingpublic credit card transactions were structured as sales to revolving truststhat require replenishments of receivables to support previously issuedsecurities, receivables continue to be sold to these trusts until the revolvingperiods end, the last of which is currently projected to occur in the fourthquarter of 2007. While the termination of sale treatment on new collateralizedfunding activity and the reduction of sales under replenishment agreementsreduced our reported net income, there is no impact on cash received fromoperations. Insurance revenue decreased in the three and six months ended June 30, 2007primarily due to lower insurance sales volumes in our U.K. operations, includinga planned phase out of the use of our largest external broker between Januaryand April 2007. This was partially offset in both periods by higher insurancerevenue in our domestic operations due to the introduction of lender placedproducts in our Mortgage Services and Auto Finance businesses as well as thenegotiation of lower commission payments in certain products offered by ourRetail Services business which was partially offset by the cancellationeffective January 1, 2007 of a policy whereby we pay for losses which exceed aspecified threshold. Investment income, which includes income on securities available for sale in ourinsurance business and realized gains and losses from the sale of securities,decreased in the three and six months ended June 30, 2007 primarily due to loweraverage investment levels. Derivative income includes realized and unrealized gains and losses onderivatives which do not qualify as effective hedges under SFAS No. 133 as wellas the ineffectiveness on derivatives which are qualifying hedges. Prior to theelection of FVO reporting for certain fixed rate debt, we accounted for therealized gains and losses on swaps associated with this debt which qualified aseffective hedges under SFAS No. 133 in interest expense and any ineffectivenesswhich resulted from changes in the fair value of the swaps as compared tochanges in the interest rate component value of the debt was recorded as acomponent of derivative income. With the adoption of SFAS No. 159 beginning inJanuary 2007, we eliminated hedge accounting on these swaps and as a result,realized and unrealized gains and losses on these derivatives and changes in theinterest rate component value of the aforementioned debt are now included inGain (loss) on debt designated at fair value and related derivatives in theconsolidated statement of income which impacts the comparability of derivativeincome between periods. 46 HSBC Finance Corporation -------------------------------------------------------------------------------- Derivative income is summarized in the table below: THREE MONTHS ENDED JUNE 30, 2007 2006------------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)....................................... $ (6) $ 2Mark-to-market on derivatives which do not qualify as effective hedges.......................................................... (11) (41)Ineffectiveness................................................... (22) 32 ---- ----Total............................................................. $(39) $ (7) ==== ==== SIX MONTHS ENDED JUNE 30, 2007 2006------------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)....................................... $(14) $ 6Mark-to-market on derivatives which do not qualify as effective hedges.......................................................... (6) (51)Ineffectiveness................................................... (26) 95 ---- ----Total............................................................. $(46) $ 50 ==== ==== Derivative income decreased during both periods due to changes in the interestrate curve and to the adoption of SFAS No. 159. Rising interest rates caused thenet outgoing payments on pay variable/received fix economic hedges to increaseas compared to the year-ago periods. Furthermore, as discussed above, the mark-to-market on the swaps associated with debt we have now designated at fairvalue, as well as the mark-to-market on the interest rate component of the debt,which accounted for the majority of the ineffectiveness recorded in 2006, is nowreported in the consolidated income statement as Gain (loss) on debt designatedat fair value and related derivatives. Additionally, in the second quarter of2006, we completed the redesignation of all remaining short cut hedgerelationships as hedges under the long-haul method of accounting. Redesignationof swaps as effective hedges reduces the overall volatility of reported mark-to-market income, although re-establishing such swaps as long-haul hedges createsvolatility as a result of hedge ineffectiveness. Net income volatility, whether based on changes in interest rates for swapswhich do not qualify for hedge accounting, the ineffectiveness recorded on ourqualifying hedges under the long haul method of accounting or the impact fromadopting SFAS No. 159, affects the comparability of our reported results betweenperiods. Accordingly, derivative income for the three and six months ended June30, 2007 should not be considered indicative of the results for any futureperiods. Gain (loss) on debt designated at fair value and related derivatives reflectsfair value changes on our fixed rate debt accounted for under FVO as a result ofadopting SFAS No. 159 effective January 1, 2007 as well as the fair valuechanges and realized gains (losses) on the related derivatives associated withdebt designated at fair value. Prior to the election of FVO reporting forcertain fixed rate debt, we accounted for the realized gains and losses on swapsassociated with this debt which qualified as effective hedges under SFAS No. 133in interest expense and any ineffectiveness which resulted from changes in thevalue of the swaps as compared to changes in the interest rate component valueof the debt was recorded in derivative income. These components are summarizedin the table below: THREE MONTHS ENDED JUNE 30, 2007 2006-------------------------------------------------------------------------------- (IN MILLIONS) Mark-to-market on debt designated at fair value: Interest rate component......................................... $ 515 $- Credit risk component........................................... (6) - ----- --Total mark-to-market on debt designated at fair value............. 509 -Mark-to-market on the related derivatives......................... (557) -Net realized gains (losses) on the related derivatives............ (82) - ----- --Total............................................................. $(130) $- ===== == 47 HSBC Finance Corporation -------------------------------------------------------------------------------- SIX MONTHS ENDED JUNE 30, 2007 2006-------------------------------------------------------------------------------- (IN MILLIONS) Mark-to-market on debt designated at fair value: Interest rate component......................................... $ 373 $- Credit risk component........................................... 238 - ----- --Total mark-to-market on debt designated at fair value............. 611 -Mark-to-market on the related derivatives......................... (439) -Net realized gains (losses) on the related derivatives............ (158) - ----- --Total............................................................. $ 14 $- ===== == The change in the fair value of the debt and the change in value of the relatedderivatives reflect the following: Interest rate curve -- During the second quarter of 2007, rates increasedsharply and the interest rate curve steepened. Rates decreased in the firstquarter and the curve was flatter. The rising interest rates caused the value ofour fixed rate FVO debt to fall thereby resulting in an Interest rate componentgain. The value of the receive fix/pay variable swaps fell in response to theserising interest rates and resulted in a loss in Mark-to-market on the relatedderivatives. Transaction costs -- The write off of debt issuance costs during the six monthperiod ended June 30, 2007 reduced the recorded Interest rate component gain by$10 million. Credit -- Changes in our credit spread were not significant during the threemonth period ended June 30, 2007 and, therefore, the impact in Credit riskcomponent was minimal. In the first quarter, however, credit spreads widenedsignificantly, resulting from the general widening of financial sector, fixedincome credit spreads and the more specific effect of spreads related to thesubprime mortgage sector. The FVO results are also affected by the differences in cash flows and valuationmethodologies for the debt and related derivative. The cash flows differprimarily due to the inclusion of the terminal payment on the debt. Cash flowson debt are discounted using a single discount rate from the bond yield curvewhile derivative cash flows are discounted using rates at multiple points alongthe LIBOR yield curve. The impacts of these differences vary as the shape ofthese interest rate curves change. Fee income, which includes revenues from fee-based products such as creditcards, increased in both periods due to higher credit card fees, particularlyrelating to our non-prime credit card portfolios due to higher levels of creditcard receivables. Enhancement services revenue, which consists of ancillary credit card revenuefrom products such as Account Secure Plus (debt protection) and IdentityProtection Plan, was higher in both periods primarily as a result of higherlevels of credit card receivables and higher customer acceptance levels. Taxpayer financial services ("TFS") revenue decreased during the six monthsended June 30, 2007 due to a restructured pricing, partially offset by higherloan volume in the 2007 tax season. Gain on receivable sales to HSBC affiliates includes the daily sales of domesticprivate label receivable originations (excluding retail sales contracts) andcertain credit card account originations to HSBC Bank USA. The increase in bothperiods reflects higher sales volumes of domestic private label receivable andcredit card account originations as well as higher premiums on our credit cardsales volumes. Servicing and other fees from HSBC represents revenue received under servicelevel agreements under which we service credit card and domestic private labelreceivables as well as real estate secured and auto finance receivables for HSBCaffiliates. The increases primarily relate to higher levels of receivables beingserviced on behalf of HSBC Bank USA. Other income decreased in both periods primarily due to losses on real estatesecured receivables held for sale by our Decision One mortgage operations of $79million in the three months ended June 30, 2007 and $91 million in 48 HSBC Finance Corporation -------------------------------------------------------------------------------- the year-to-date period. In 2006, Decision One recorded gains on real estatesecured receivables held for sale of $41 million in the three months ended June30, 2006 and gains of $63 million in the six months ended June 30, 2006. Loansale volumes in our Decision One mortgage operations have decreased from $5.5billion in the six months ended June 30, 2006 to $3.9 billion in the six monthsended June 30, 2007. Other income in the second quarter of 2007 also includes aloss of $20 million on the sale of $2.2 billion of real estate securedreceivables by our Mortgage Services business. As a result of this loan sale,however, the lower cost funding previously supporting the $2.2 billion of loanssold is available to be redeployed to fund new originators, which should resultin reduced overall funding costs in future periods. COSTS AND EXPENSES The following table summarizes total costs and expenses: INCREASE (DECREASE) --------------THREE MONTHS ENDED JUNE 30, 2007 2006 AMOUNT %-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Salaries and employee benefits...................... $ 587 $ 564 $ 23 4.1%Sales incentives.................................... 62 98 (36) (36.7)Occupancy and equipment expenses.................... 85 79 6 7.6Other marketing expenses............................ 220 176 44 25.0Other servicing and administrative expenses......... 242 222 20 9.0Support services from HSBC affiliates............... 299 270 29 10.7Amortization of intangibles......................... 63 63 - -Policyholders' benefits............................. 90 107 (17) (15.9) ------ ------ ---- -----Total costs and expenses............................ $1,648 $1,579 $ 69 4.4% ====== ====== ==== ===== INCREASE (DECREASE) --------------SIX MONTHS ENDED JUNE 30, 2007 2006 AMOUNT %-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Salaries and employee benefits...................... $1,196 $1,145 $ 51 4.5%Sales incentives.................................... 130 178 (48) (27.0)Occupancy and equipment expenses.................... 163 162 1 .6Other marketing expenses............................ 440 349 91 26.1Other servicing and administrative expenses......... 505 475 30 6.3Support services from HSBC affiliates............... 584 522 62 11.9Amortization of intangibles......................... 126 143 (17) (11.9)Policyholders' benefits............................. 214 225 (11) (4.9) ------ ------ ---- -----Total costs and expenses............................ $3,358 $3,199 $159 5.0% ====== ====== ==== ===== Salaries and employee benefits increased in both periods as a result ofadditional staffing, primarily in our Consumer Lending, Retail Services andCanadian operations as well as in our corporate functions to support the growthwhich has occurred since June 2006 and increased collection activities. Theseincreases were partially offset by lower salary expense in our Credit CardServices and Mortgage Services operations. Lower salary in our Credit CardServices operations was due to efficiencies from the integration of the Metrisacquisition which occurred in December 2005 and efficiencies derived from theuse of support services from HSBC affiliates. As part of the decision in March2007 to discontinue new correspondent channel acquisitions, salary expense waslower for our Mortgage Services operations as a result of the termination ofemployees associated with loan origination activities, partially offset byincreased collection activities and during the six month period by employeeseverance costs. 49 HSBC Finance Corporation -------------------------------------------------------------------------------- Sales incentives decreased in both periods due to lower origination volumes inour correspondent and Decision One mortgage operations due to the decision toreduce purchases including second lien and selected higher risk products in thesecond half of 2006. As Mortgage Services terminates loan acquisitions, salesincentives will continue to decrease in the future. Occupancy and equipment expenses increased in the three and six months endedJune 30, 2007 due to repair and maintenance costs offset by lower depreciationexpense. Other marketing expenses includes payments for advertising, direct mail programsand other marketing expenditures. The increases in both periods were primarilydue to increased domestic credit card and co-branded credit card marketingexpenses. Other servicing and administrative expenses increased during both periods due tohigher professional services fees, higher REO expenses and lower deferrals fororigination costs due to lower volumes, partially offset by lower insuranceoperating expense in our domestic operations. Other servicing and administrativeexpenses were also higher in the six month period ended June 30, 2007 resultingfrom a valuation adjustment of $31 million to record our investment in the U.K.Insurance Operations at the lower of cost or market as a result of designatingthis operations as "Held for Sale," partially offset by an increase in ourestimate of interest receivable of approximately $68 million in the year-to-dateperiod relating to various contingent tax items with the taxing authority. Support services from HSBC affiliates includes technology and other servicescharged to us by HSBC Technology and Services (USA) Inc. ("HTSU"), whichincreased in the three and six months ended June 30, 2007 primarily due togrowth. Amortization of intangibles was flat in the three months ended June 30, 2007 andlower in the year-to-date period as an individual contractual relationshipbecame fully amortized in the first quarter of 2006. Policyholders' benefits decreased in both periods due to lower policyholders'benefits in our U.K. operations, partially offset by higher policyholders'benefits in our domestic operations. The decrease in our U.K. operations was dueto lower sales volumes, partially offset by higher claims in the currentquarter. The increase in our domestic operations was due to an increase inclaims reserves for expected losses. Efficiency ratio The following table summarizes our owned basis efficiencyratio: 2007 2006-------------------------------------------------------------------------------- Three months ended June 30....................................... 43.51% 40.70%Six months ended June 30......................................... 40.62% 40.28% 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. SEGMENT RESULTS -- IFRS MANAGEMENT BASIS-------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services andInternational. Our Consumer segment consists of our Consumer Lending, MortgageServices, Retail Services and Auto Finance businesses. Our Credit Card Servicessegment consists of our domestic MasterCard, Visa and Discover credit cardbusiness. Our International segment consists of our foreign operations in theUnited Kingdom, Canada, 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. 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. 50 HSBC Finance Corporation -------------------------------------------------------------------------------- Our segment results are presented on an IFRS Management Basis (a non-U.S. GAAPfinancial measure) as operating results are monitored and reviewed, trends areevaluated and decisions about allocating resources such as employees are madealmost exclusively on an IFRS Management Basis 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. A summary of the significant differences betweenU.S. GAAP and IFRSs as they impact our results are summarized in Note 11,"Business Segments." CONSUMER SEGMENT The following table summarizes the IFRS Management Basisresults for our Consumer segment: INCREASE (DECREASE) ---------------THREE MONTHS ENDED JUNE 30 2007 2006 AMOUNT %---------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income....................................... $ 120 $ 539 $ (419) (77.7)%Net interest income.............................. 2,143 2,189 (46) (2.1)Other operating income........................... 173 349 (176) (50.4)Loan impairment charges.......................... 1,382 894 488 54.6Operating expenses............................... 748 793 (45) (5.7)Intersegment revenues............................ 65 63 2 3.2Customer loans................................... 138,976 138,685 291 .2Assets........................................... 138,281 140,991 (2,710) (1.9)Net interest margin, annualized.................. 6.04% 6.42% - -Return on average assets......................... .34 1.56 - - INCREASE (DECREASE) --------------SIX MONTHS ENDED JUNE 30 2007 2006 AMOUNT %-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income.......................................... $ 358 $1,258 $ (900) (71.5)%Net interest income................................. 4,301 4,371 (70) (1.6)Other operating income.............................. 365 587 (222) (37.8)Loan impairment charges............................. 2,602 1,444 1,158 80.2Operating expenses.................................. 1,507 1,530 (23) (1.5)Intersegment revenues............................... 123 120 3 2.5Net interest margin, annualized..................... 6.02% 6.52% - -Return on average assets............................ .50 1.85 - - Our Consumer segment reported lower net income in the three and six monthperiods ended June 30, 2007 due to higher loan impairment charges, lower netinterest income and lower other operating income, partially offset by loweroperating expenses. Loan impairment charges for the Consumer segment increased significantly duringthe three and six months of June 30, 2007 as compared to the year-ago periods.The increase in loan impairment charges was due to higher loss estimates at ourConsumer Lending business due to receivable growth and portfolio seasoning aswell as, during the six months ended June 30, 2007, higher loss estimates insecond lien loans purchased in 2004 through the third quarter of 2006 as part ofa second lien bulk acquisition program which has subsequently been discontinued,which increased credit loss reserves $87 million during the year-to-date period.At June 30, 2007, the outstanding principal balance of these second lien loansacquired by the Consumer Lending business was approximately $1.3 billion. The 51 HSBC Finance Corporation -------------------------------------------------------------------------------- increase was also a result of the progression of mortgage loans acquired in 2005and 2006 by our Mortgage Services business, particularly in the second lien andportions of the first lien portfolios, to various stages of delinquency and tocharge-off. Loan impairment charges during the first half of 2006 benefited fromhistorically low levels of bankruptcy filings following the enactment of newbankruptcy law in the United States which became effective in the fourth quarterof 2005. In 2007, credit loss reserves increased as the provision for creditlosses was $186 million greater than net charge-offs in the second quarter of2007 and $325 million greater than net charge-offs in the year-to-date period.In 2006, credit loss reserves increased as the provision for credit losses was$93 million greater than net charge-offs in the second quarter of 2006 anddecreased in the year-to-date period as net charge-offs were $163 milliongreater than the provision for credit losses. Net interest income decreased during the three and six months ended June 30,2007 as higher finance and other interest income primarily due to higher averagecustomer loans and higher overall yields was more than offset by higher interestexpense. Overall yields reflect growth in real estate secured customer loans atcurrent market rates and a greater mix of higher yielding personal non-creditcard customer loans due to growth. Overall yield improvements were partiallyoffset by the impact of growth in non-performing assets. The higher interestexpense was due to a larger balance sheet and a significantly higher cost offunds due to a rising interest rate environment. The decrease in net interestmargin in both periods was a result of the cost of funds increasing more rapidlythan our ability to increase receivable yields. The decrease in other operatingincome in the three and six months ended June 30, 2007 was primarily due tolosses on sales of real estate secured receivables by our Decision One mortgageoperations and the loss on the sale of $2.2 billion of loans from the MortgageServices portfolio, partially offset by higher late and overlimit feesassociated with our co-branded credit card portfolio. Operating expenses werelower in the three and six months ended June 30, 2007 primarily due to lowersalary and employee benefits resulting from the termination of employees as partof the decision to discontinue new correspondent channel acquisitions and lowerprofessional services fees, partially offset by lower deferred loan originationcosts as mortgage origination volumes have declined and, during the six monthperiod, higher employee severance costs. Customer loans for our Consumer segment can be further analyzed as follows: INCREASES (DECREASES) FROM ------------------------------- MARCH 31, JUNE 30, 2007 2006 JUNE 30, -------------- -------------- 2007 $ % $ %------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Real estate secured........................... $ 90,152 $(4,007) (4.3)% $(2,154) (2.3)%Auto finance.................................. 12,706 149 1.2 597 4.9Private label, including co-branded cards..... 17,817 340 1.9 946 5.6Personal non-credit card...................... 18,301 87 .5 902 5.2 -------- ------- ---- ------- ----Total customer loans.......................... $138,976 $(3,431) (2.4)% $ 291 .2% ======== ======= ==== ======= ==== -------- ()(1) Real estate secured receivables are comprised of the following: INCREASES (DECREASES) FROM ---------------------------------- MARCH 31, JUNE 30, 2007 2006 JUNE 30, --------------- ---------------- 2007 $ % $ %------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Mortgage Services................................. $41,383 $(5,172) (11.1)% $(10,064) (19.6)%Consumer Lending.................................. 48,769 1,165 2.4 7,910 19.4 ------- ------- ----- -------- -----Total real estate secured......................... $90,152 $(4,007) (4.3)% $ (2,154) (2.3)% ======= ======= ===== ======== ===== Customer loans decreased 2 percent at June 30, 2007 as compared to $142.4billion at March 31, 2007. Real estate secured loans decreased at June 30, 2007as compared to the prior quarter. The decrease in real estate secured loans inthe quarter was primarily in our Mortgage Services portfolio as a result of thedecision in March 2007 to 52 HSBC Finance Corporation -------------------------------------------------------------------------------- discontinue new correspondent channel acquisitions subject to fulfilling earliercommitments, which were immaterial. We anticipate the attrition in the MortgageServices portfolio will continue for the remainder of 2007. Additionally, wesold $2.2 billion of loans in the second quarter of 2007 from our MortgageServices loan portfolio. The decreases in real estate secured loans at ourMortgage Services business were partially offset by increases in the real estatesecured portfolio at our Consumer Lending business as a result of neworiginations in excess of run-off. In addition, the decline in loan prepaymentshas continued during the first half of 2007 which has resulted in lower run-offrates for our real estate secured portfolio. Growth in our auto financeportfolio reflects growth in our direct to consumer business. The increase inour private label portfolio is due to growth in the co-branded card portfoliolaunched by our Retail Services operations during 2006. Compared to June 30, 2006, customer loans increased .2 percent. The decrease inreal estate secured loans from the year-ago period was primarily in our MortgageServices portfolio due to reductions in purchases of second lien and selectedhigher risk products in the second half of 2006 as well as the decision in March2007 to discontinue new correspondent channel acquisitions subject to fulfillingearlier commitments, which were immaterial, and the sale of $2.2 billion ofloans in the second quarter of 2007. These decreases were partially offset byhigher real estate secured receivables in our branch-based Consumer Lendingbusiness as a result of strong growth since June 2006. Growth in our branch-based Consumer Lending business reflects strong sales volumes as we continue toemphasize real estate secured loans, including a near-prime mortgage product.Real estate secured customer loans also increased as a result of the acquisitionof the $2.5 billion Champion portfolio in November 2006. In addition, a declinein loan prepayments in 2006 resulted in lower run-off rates for our real estatesecured portfolio which also contributed to overall growth. Our Auto Financebusiness also reported organic growth, principally in the near-prime portfolio,from increased volume in the consumer direct loan program. The private labelportfolio increased from the year-ago quarter due to organic growth and the co-branded card portfolio launched by our Retail Services operations during 2006.Growth in our personal non-credit card portfolio was the result of increasedmarketing, including several large direct mail campaigns. ROA was .34 percent for the three months ended June 30, 2007 and .50 percent forthe six months ended June 30, 2007, compared to 1.56 percent in the three monthsended June 30, 2006 and 1.85 percent in the six months ended June 30, 2006. Thedecrease in the ROA ratio in these periods is primarily due to the increase inloan impairment charges as discussed above, as well as higher average assets. CREDIT CARD SERVICES SEGMENT The following table summarizes the IFRS ManagementBasis results for our Credit Card Services segment: INCREASE (DECREASE) ----------------THREE MONTHS ENDED JUNE 30 2007 2006 AMOUNT %---------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income........................................ $ 284 $ 423 $ (139) (32.9)%Net interest income............................... 827 872 (45) (5.2)Other operating income............................ 755 563 192 34.1Loan impairment charges........................... 640 328 312 95.1Operating expenses................................ 494 435 59 13.6Intersegment revenues............................. 5 5 - -Customer loans.................................... 29,106 25,726 3,380 13.1Assets............................................ 28,933 26,931 2,002 7.4Net interest margin, annualized................... 11.59% 13.49% - -Return on average assets.......................... 4.01 6.51 - - 53 HSBC Finance Corporation -------------------------------------------------------------------------------- INCREASE (DECREASE) ----------------SIX MONTHS ENDED JUNE 30 2007 2006 AMOUNT %--------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income......................................... $ 673 $ 755 $(82) (10.9)%Net interest income................................ 1,648 1,604 44 2.7Other operating income............................. 1,453 1,041 412 39.6Loan impairment charges............................ 1,060 577 483 83.7Operating expenses................................. 977 869 108 12.4Intersegment revenues.............................. 10 10 - -Net interest margin, annualized.................... 11.66% 12.45% - -Return on average assets........................... 4.77 5.74 - - Our Credit Card Services segment reported lower net income in the three and sixmonths ended June 30, 2007. The decrease in net income was primarily due tohigher loan impairment charges, higher operating expenses and during the threemonths ended June 30, 2007, lower net interest income, partially offset byhigher other operating income and during the six months ended June 30, 2007higher net interest income. Loan impairment charges were higher in the three andsix month periods ended June 30, 2007 due to higher net charge-off reflectingreceivable growth and portfolio seasoning as well as an increase in bankruptcyfilings as compared to the year-ago periods which benefited from reduced levelsof personal bankruptcy filings following the enactment of new bankruptcy law inthe United States which went into effect in October 2005. We increased lossreserves by recording loss provision greater than net charge-off of $185 millionin the three months ended June 30, 2007 and $158 million in the year-to-dateperiod as overall consumer loans outstanding increased due to strong organicreceivable growth and higher levels of personal bankruptcy filings as discussedabove. We increased loss reserves by recording loss provision greater than netcharge-off of $55 million in the three months ended June 30, 2006 and $62million in the six months ended June 30, 2006. Net interest income increased in the six months ended and decreased in the threemonths ended June 30, 2007. The decrease in net interest income during thecurrent quarter is due to the fact that net interest income during the threemonths ended June 30, 2006 benefited from the implementation of a methodologyfor calculating the effective interest rate for introductory rate credit cardcustomer loans under IFRSs over the expected life of the product. Of the amountrecognized, $131 million increased net interest income during the second quarterof 2006 which otherwise would have been recorded in prior periods. Excludingthis amount from the prior quarter and prior year-to-date period, net interestincome increased in both the three and six month periods due to higher overallyields due in part to higher levels of non-prime customer loans, partiallyoffset by higher interest expense. Excluding the impact of the above from netinterest margin, net interest margin increased in both periods primarily due tohigher overall yields due to increases in non-prime customer loans, higherpricing on variable rate products and other pricing initiatives, partiallyoffset by a higher cost of funds. Increases in other operating income resulted from portfolio growth whichresulted in higher late fees and overlimit fees and higher enhancement servicesrevenue from products such as Account Secure Plus (debt protection) and IdentityProtection Plan. Higher operating expenses were also incurred to supportreceivable growth including increases in marketing expenses. Customer loans increased 5 percent to $29.1 billion compared to $27.8 billion atMarch 31, 2007. The increase during the quarter was due to growth in our GeneralMotors, Union Privilege, Metris and non-prime portfolios. Compared to June 30,2006, customer loans increased 13 percent. The increase also reflects strongdomestic organic growth in our Union Privilege, Metris and other non-primeportfolios. The decrease in ROA in the three and six months ended June 30, 2007 is primarilydue to the lower net income as discussed above, including higher average assets. We are currently considering the possibility of transferring our General MotorsMasterCard and Visa portfolio to HSBC Bank USA in the future based uponcontinuing evaluation of capital and liquidity at each entity and obtaining 54 HSBC Finance Corporation -------------------------------------------------------------------------------- the necessary regulatory approval. We would, however, maintain the customeraccount relationships and, subsequent to the initial receivable sale, additionalvolume would be sold to HSBC Bank USA on a daily basis. At June 30, 2007, the GMPortfolio had an outstanding receivable balance of approximately $6.9 billion. INTERNATIONAL SEGMENT The following table summarizes the IFRS Management Basisresults for our International segment: INCREASE (DECREASE) --------------THREE MONTHS ENDED JUNE 30 2007 2006 AMOUNT %-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income........................................ $ (31) $ 19 $ (50) (100+)%Net interest income............................... 217 201 16 8.0Other operating income............................ 48 74 (26) (35.1)Loan impairment charges........................... 161 124 37 29.8Operating expenses................................ 142 119 23 19.3Intersegment revenues............................. 6 9 (3) (33.3)Customer loans.................................... 9,853 9,637 216 2.2Assets............................................ 10,669 11,127 (458) (4.1)Net interest margin, annualized................... 8.80% 7.91% - -Return on average assets.......................... (1.15) .67 - - INCREASE (DECREASE) --------------SIX MONTHS ENDED JUNE 30 2007 2006 AMOUNT %-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income........................................... $ (121) $ 41 $(162) (100+)%Net interest income.................................. 421 411 10 2.4Other operating income............................... 95 115 (20) (17.4)Loan impairment charges.............................. 409 228 181 79.4Operating expenses................................... 270 231 39 16.9Intersegment revenues................................ 11 16 (5) (31.3)Net interest margin, annualized...................... 8.50% 8.23% - -Return on average assets............................. (2.30) .73 - - Our International segment reported net losses in both periods primarily due tohigher loan impairment charges, higher operating expenses and lower otheroperating income, partially offset by higher net interest income. Applyingconstant currency rates, which uses the average rate of exchange for the 2006quarter to translate current period net income, the net loss would not have beenmaterially different for the three month period ended June 30, 2007 and wouldhave been lower by $42 million for the six months ended June 30, 2007. Loan impairment charges increased during the three and six month periods endedJune 30, 2007 due to higher loss estimates in our U.K. operations forrestructured loans which increased loan impairment charges by $68 million and inour Canadian operations due to receivable growth, partially offset in thequarter by improvements in delinquency and charge-off in our U.K. operations.Additionally during the six month period, loan impairment charges increased dueto a refinement in the methodology used to calculate roll rate percentages byour U.K. operations; this refinement increased credit loss reserves $93 millionat June 30, 2007 which we believe reflects a better estimate of probable lossescurrently inherent in the loan portfolio. Net interest income increased during the three and six months ended June 30,2007 primarily as a result of higher receivable levels in our Canadiansubsidiary, partially offset by lower receivable levels in our U.K. subsidiaryand higher interest expense. The lower receivable levels in our U.K. subsidiarywere due to decreased sales volumes resulting from a continuing challengingcredit environment in the U.K. as well as the sale of our European 55 HSBC Finance Corporation -------------------------------------------------------------------------------- Operations in November 2006. This was partially offset by higher net interestincome in our Canadian operations due to growth in customer loans. Net interestmargin increased in the three and six months ended June 30, 2007 primarily dueto higher yields on customer loans, partially offset by the impact of the saleof the European Operations in November 2006 as well as a higher cost of funds. Other operating income decreased in the three and six months ended June 30,2007, due to lower insurance revenues in the U.K. due to lower sales volumes anda planned phase out of the use of a specific broker between January and April2007, partially offset by higher credit card fee income in our Canadianoperations. Operating expenses increased to support receivable growth in ourCanadian operations and higher marketing expenses related to our private labelportfolio in our U.K. subsidiary. Customer loans for our International segment can be further analyzed as follows: INCREASES (DECREASES) FROM --------------------------- MARCH 31, JUNE 30, 2007 2006 JUNE 30, ----------- ------------- 2007 $ % $ %----------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Real estate secured.............................. $3,973 $256 6.9% $ 646 19.4%Auto finance..................................... 325 22 7.3 29 9.8Credit card...................................... 275 42 18.0 56 25.6Private label.................................... 2,357 102 4.5 183 8.4Personal non-credit card......................... 2,923 (75) (2.5) (698) (19.3) ------ ---- ---- ----- -----Total customer loans............................. $9,853 $347 3.7% $ 216 2.2% ====== ==== ==== ===== ===== Customer loans were $9.9 billion at June 30, 2007 and $9.5 billion at March 31,2007. Applying constant currency rates, customer loans at June 30, 2007 wouldhave been lower by approximately $478 million using March 31, 2007 exchangerates. Excluding the foreign exchange impact, lower personal non-credit cardloans in our U.K. operations due to lower retail sales were partially offset bygrowth in the real estate secured and credit card portfolios in our Canadianoperations. Compared to June 30, 2006, receivables increased 2 percent primarily as a resultof foreign exchange impacts. Applying constant currency rates, customer loans atJune 30, 2007 would have been approximately $627 million lower. Excluding thepositive foreign exchange impacts, higher customer loans in our Canadianbusiness were partially offset by the impact of lower customer loans in our U.K.operations. The increase in our Canadian business is due to growth in the realestate secured and credit card portfolios. Our U.K. based private label loansdecreased due to continuing lower retail sales volume. Lower personal non-creditcard loans in the U.K. reflect lower volumes as the U.K. branch network hasplaced a greater emphasis on secured lending. Additionally, receivable levels atJune 30, 2007 reflect the sale in November 2006 of $203 million of customerloans related to our European operations. ROA was (1.15) percent for the three months ended June 30, 2007 and (2.30)percent for the six months ended June 30, 2007 compared to .67 percent in thethree months ended June 30, 2006 and .73 in the six months ended June 30, 2006.The decrease in the ROA ratio in both periods is primarily due to the increasein loan impairment charges as discussed above, partially offset by lower averageassets. 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 to a third party for cash. Thesales price will be determined, in part, based on the actual net book value ofthe assets sold at the time the sale is closed which is anticipated in thesecond half of 2007. The agreement also provides for the purchaser to distributeinsurance products through our U.K. branch network for which we will receivecommission revenue. The sale is subject to the execution of a definitiveagreement, and any regulatory approvals that may be required. At June 30, 2007,we have classified the U.K. Insurance Operations as "Held for Sale" whichincluded $464 million of assets and liabilities of $233 million within theInternational segment. After taking into consideration the goodwill allocated tothe U.K. Insurance Operations of $79 million, which is included in the "AllOther" caption within our 56 HSBC Finance Corporation -------------------------------------------------------------------------------- segment disclosures, the carrying value of the U.K. Insurance Operations washigher than the estimated sales price. The adjustment to record our investmentin these operations at the lower of cost or market of $31 million was recordedin the "All Other" caption in the first quarter of 2007 and no additionaladjustments have occurred subsequent to March 31, 2007. We continue to evaluatethe scope of our other U.K. operations. CREDIT QUALITY-------------------------------------------------------------------------------- CREDIT LOSS RESERVES We maintain credit loss reserves to cover probable losses of principal, interestand fees, including late, overlimit and annual fees. Credit loss reserves arebased on a range of estimates and are intended to be adequate but not excessive.We estimate probable losses for consumer receivables using a roll rate migrationanalysis that estimates the likelihood that a loan will progress through thevarious stages of delinquency, or buckets, and ultimately charge-off. Thisanalysis considers delinquency status, loss experience and severity and takesinto account whether loans are in bankruptcy, have been restructured orrewritten, or are subject to forbearance, an external debt management plan,hardship, modification, extension or deferment. Our credit loss reserves alsotake into consideration the loss severity expected based on the underlyingcollateral, if any, for the loan in the event of default. Delinquency status maybe affected by customer account management policies and practices, such as therestructure of accounts, forbearance agreements, extended payment plans,modification arrangements, external debt management programs, loan rewrites anddeferments. If customer account management policies, or changes thereto, shiftloans from a "higher" delinquency bucket to a "lower" delinquency bucket, thiswill be reflected in our roll rate statistics. To the extent that restructuredaccounts have a greater propensity to roll to higher delinquency buckets, thiswill be captured in the roll rates. Since the loss reserve is computed based onthe composite of all of these calculations, this increase in roll rate will beapplied to receivables in all respective delinquency buckets, which willincrease the overall reserve level. In addition, loss reserves on consumerreceivables are maintained to reflect our judgment of portfolio risk factorsthat may not be fully reflected in the statistical roll rate calculation. Riskfactors considered in establishing loss reserves on consumer receivables includerecent growth, product mix, bankruptcy trends, geographic concentrations, loanproduct features such as adjustable rate loans, economic conditions, such asnational and local trends in housing markets and interest rates, portfolioseasoning, account management policies and practices, current levels of charge-offs and delinquencies, changes in laws and regulations and other items whichcan affect consumer payment patterns on outstanding receivables, such as naturaldisasters and global pandemics. While our credit loss reserves are available to absorb losses in the entireportfolio, we specifically consider the credit quality and other risk factorsfor each of our products. We recognize the different inherent losscharacteristics in each of our products as well as customer account managementpolicies and practices and risk management/collection practices. Charge-offpolicies are also considered when establishing loss reserve requirements toensure the appropriate reserves exist for products with longer charge-offperiods. We also consider key ratios such as reserves to nonperforming loans,reserves as a percentage of net charge-offs and number of months charge-offcoverage in developing our loss reserve estimate. Loss reserve estimates arereviewed periodically and adjustments are reported in earnings when they becomeknown. As these estimates are influenced by factors outside of our control, suchas consumer payment patterns and economic conditions, there is uncertaintyinherent in these estimates, making it reasonably possible that they couldchange. 57 HSBC Finance Corporation -------------------------------------------------------------------------------- The following table summarizes credit loss reserves: JUNE 30, MARCH 31, JUNE 30, 2007 2007 2006----------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Owned credit loss reserves.............................. $7,157 $6,798 $4,649Reserves as a percent of: Receivables........................................... 4.54% 4.25% 3.02% Net charge-offs(1).................................... 112.7 114.2 107.6 Nonperforming loans................................... 117.4 116.1 105.3 -------- ()(1) Quarter-to-date, annualized. Credit loss reserve levels at June 30, 2007 increased as compared to March 31,2007 as we recorded loss provision in excess of net charge-offs of $360 millionduring the three months ended June 30, 2007. This increase was largely due tohigher reserve requirements in our Consumer Lending business due to seasoning ofa growing portfolio and in our Credit Card Services business reflecting higherreceivable balances and normal seasonal patterns. Credit loss reserves at June 30, 2007 increased as compared to June 30, 2006primarily as a result of the higher delinquency and loss estimates at ourMortgage Services business. In addition, the higher credit loss reserve levelsare the result of higher levels of receivables due in part to lowersecuritization levels, higher dollars of delinquency in our other businessesdriven by growth and portfolio seasoning, weakening early stage performanceconsistent with the industry trend in certain Consumer Lending real estatesecured loans originated since late 2005, higher loss estimates in our U.K.operations attributable to a refinement in the methodology used to calculateroll rate percentages, higher loss estimates in second lien loans purchased from2004 through the third quarter of 2006 by our Consumer Lending business as partof a second lien bulk acquisition program which has subsequently beendiscontinued and increased levels of personal bankruptcy filings, particularlyat our Credit Card Services business, as compared to the exceptionally lowlevels experienced in the first half of 2006 following enactment of newbankruptcy legislation in the United States. As previously discussed, we are experiencing higher delinquency and lossestimates at our Mortgage Services business as compared to the year-ago period.Credit loss reserve levels of $2.1 billion at our Mortgage Services business atJune 30, 2007, which are consistent with our credit loss reserve levels atDecember 31, 2006 and March 31, 2007, reflect our best estimate of losses in theportfolio. Credit loss reserve levels at Mortgage Services remained flat at June30, 2007 as a significant portion of rate resets on first lien adjustable ratemortgage loans, including second lien customers with underlying first lienadjustable rate mortgages, has yet to occur and we remain cautious about lossesinherent in this portfolio due to economic factors beyond our control. Inestablishing these reserve levels we considered the severity of losses expectedto be incurred, particularly in our second lien portfolio, above our historicalexperience given the current housing market trends in the United States. We alsoconsidered the ability of borrowers to repay their first lien adjustable ratemortgage loans at higher contractual reset rates given increases in interestrates by the Federal Reserve Bank from June 2004 through June 2006, as well astheir ability to repay any underlying second lien mortgage outstanding. Becausefirst lien adjustable rate mortgage loans are generally well secured, ultimatelosses associated with such loans are dependent to a large extent on the statusof the housing market and interest rate environment. Therefore, although it isprobable that incremental losses will occur as a result of rate resets on firstlien adjustable rate mortgage loans, such losses are estimable and, therefore,included in our credit loss reserves only in situations where the payment haseither already reset or will reset in the near term. A significant portion ofthe Mortgage Services second lien mortgages are subordinate to a first lienadjustable rate loan. For customers with second lien mortgage loans that aresubordinate to a first lien adjustable rate mortgage loan, the probability ofrepayment of the second lien mortgage loan is significantly reduced. The impactof future changes, if any, in the housing market will not have a significantimpact on the ultimate loss expected to be incurred since these loans, based onhistory and other factors, are expected to behave like unsecured loans. As aresult, expected losses for these second lien loans held in our MortgageServices portfolio continue to be included in our credit loss reserve levels atJune 30, 2007. 58 HSBC Finance Corporation -------------------------------------------------------------------------------- Reserves as a percentage of receivables were higher than at June 30, 2006 andMarch 31, 2007 due to the impact of the additional reserve requirementsdiscussed above and, compared to March 31, 2007, lower receivable levels due toattrition and the second quarter loan sale at Mortgage Services. Reserves as apercentage of net charge-offs were higher than at June 30, 2006 as the increasein reserve levels outpaced the increase in net charge-off during the period.Reserves as a percentage of net charge-offs were lower as compared to March 31,2007 as net charge-offs in the quarter outpaced increases in reserve levelsprimarily due to the progression to charge-off of certain loans acquired in 2005and 2006 by Mortgage Services as well as higher charge-offs related to theseasoning of unsecured loans at Consumer Lending. Reserves as a percentage ofnonperforming loans increased as compared to June 30, 2006 and March 31, 2007 asreserve increased at a higher rate than the increase in non-accrual loans drivenby an increase in 30- and 60-day delinquency due to seasonality and seasoning inthe Consumer Lending and Credit Card Services businesses. DELINQUENCY The following table summarizes two-months-and-over contractual delinquency (as apercent of consumer receivables): JUNE 30, MARCH 31, JUNE 30, 2007 2007 2006----------------------------------------------------------------------------------------- Real estate secured(1).................................. 4.28% 3.73% 2.52%Auto finance............................................ 2.93 2.32 2.73Credit card............................................. 4.45 4.53 4.16Private label........................................... 5.12 5.27 5.42Personal non-credit card................................ 10.72 10.21 8.93 ----- ----- ----Total consumer.......................................... 5.09% 4.64% 3.71% ===== ===== ==== -------- ()(1) Real estate secured two-months-and-over contractual delinquency (as a percent of consumer receivables) are comprised of the following: JUNE 30, MARCH 31, JUNE 30, 2007 2007 2006------------------------------------------------------------------------------------------ Mortgage Services: First lien............................................. 6.42% 4.98% 3.10% Second lien............................................ 8.06 6.69 2.35 ---- ---- ----Total Mortgage Services.................................. 6.76 5.33 2.93Consumer Lending: First lien............................................. 2.14 2.01 1.77 Second lien............................................ 3.57 3.32 2.37 ---- ---- ----Total Consumer Lending................................... 2.33 2.20 1.85Foreign and all other: First lien............................................. 2.25 1.65 1.53 Second lien............................................ 4.47 5.07 5.54 ---- ---- ----Total Foreign and all other.............................. 3.98 4.35 4.76 ---- ---- ----Total real estate secured................................ 4.28% 3.73% 2.52% ==== ==== ==== Total delinquency increased 45 basis points, compared to the prior quarter. Theincrease was primarily due to higher real estate secured delinquency, primarilyat our Mortgage Services business as previously discussed, and higher personalnon-credit card and auto finance delinquency levels. The real estate securedtwo-months-and-over contractual delinquency ratio was also negatively impactedby lower real estate secured receivables growth driven largely by our strategyto discontinue new correspondent channel acquisitions by our Mortgage Servicesbusiness subject to fulfilling earlier commitments, which were immaterial, whichsignificantly reduced the outstanding principal balance of the Mortgage Servicesloan portfolio. Two-months-and-over contractual delinquency as a 59 HSBC Finance Corporation -------------------------------------------------------------------------------- percentage of consumer receivables for our Mortgage Services real estate securedportfolio was also impacted by the sale of $2.2 billion of loans, which did notinclude any loans that were 30 days or more contractually delinquent. Had thisloan sale not occurred, the delinquency ratio for the Mortgage Servicesportfolio would have been 36 basis points lower. Two-months-and-over contractualdelinquency as a percentage of consumer receivables was higher compared to theprior quarter in our auto finance portfolio ratio reflecting normal seasonaltrends and receivable growth in the quarter. The decrease in the credit carddelinquency ratio reflects the impact of strong receivable growth. The decreasein our private label portfolio (which primarily consists of our foreign privatelabel portfolio and domestic retail sales contracts that were not sold to HSBCBank USA in December 2004) reflects receivable growth in our foreign portfolios.The increase in delinquency in our personal non-credit card portfolio ratioreflects maturation of a growing domestic portfolio, and a slight deteriorationof certain customer groups in our domestic portfolio. Dollars of delinquencyincreased compared to the prior quarter reflecting the increases in delinquencyin our real estate secured portfolios as well as increases in other productsprimarily reflecting normal seasonal trends. Compared to the year-ago period, total delinquency increased 138 basis pointslargely due to higher real estate secured delinquency levels primarily at ourMortgage Services business as previously discussed. The real estate secured two-months-and-over contractual delinquency ratio was also negatively impacted bylower real estate secured receivables growth as discussed above. With theexception of our private label portfolio, all products reported higherdelinquency levels due to higher receivable levels. Additionally, the increasein the Consumer Lending real estate delinquency ratio reflects the addition ofthe Champion portfolio. While the Champion portfolio carries higher delinquency,its low loan-to-value ratios are expected to result in lower charge-offscompared to the existing portfolio. The increase in our auto finance and creditcard delinquency ratios is due to the seasoning of a growing portfolio. Theincrease in the credit card delinquency levels is also due to higher bankruptcylevels. The decrease in our private label portfolio (which primarily consists ofour foreign private label portfolio and domestic retail sales contracts thatwere not sold to HSBC Bank USA in December 2004) reflects receivable growth inour foreign portfolios. The increase in delinquency in our personal non-creditcard portfolio ratio reflects maturation of a growing domestic portfolio as wellas deterioration of certain customer groups in our domestic portfolio. NET CHARGE-OFFS OF CONSUMER RECEIVABLES The following table summarizes net charge-offs of consumer receivables (as apercent, annualized, of average consumer receivables): JUNE 30, MARCH 31, JUNE 30, 2007 2007 2006----------------------------------------------------------------------------------------- Real estate secured(1).................................. 2.18% 1.74% .97%Auto finance............................................ 3.16 3.64 2.43Credit card............................................. 6.85 7.08 5.80Private label........................................... 5.76 5.87 5.29Personal non-credit card................................ 8.44 7.96 7.92 ---- ---- ----Total(2)................................................ 3.96% 3.69% 2.88% ==== ==== ====Real estate secured net charge-offs and REO expense as a percent of average real estate secured receivables.... 2.27% 1.86% 1.04% -------- ()(1) Real estate secured net charge-off of consumer receivables as a percent, annualized, of average consumer receivables are comprised of the following: 60 HSBC Finance Corporation -------------------------------------------------------------------------------- JUNE 30, MARCH 31, JUNE 30, 2007 2007 2006------------------------------------------------------------------------------------------ Mortgage Services: First lien............................................. 1.20% 1.17% .73% Second lien............................................ 11.82 7.97 1.72 ----- ---- ----Total Mortgage Services.................................. 3.33 2.55 .94Consumer Lending: First lien............................................. .56 .80 .98 Second lien............................................ 5.37 1.93 1.25 ----- ---- ----Total Consumer Lending................................... 1.22 .96 1.02Foreign and all other: First lien............................................. 1.30 1.34 .99 Second lien............................................ 2.23 1.29 .81 ----- ---- ----Total Foreign and all other.............................. 2.03 1.30 .85 ----- ---- ----Total real estate secured................................ 2.18% 1.74% .97% ===== ==== ==== Net charge-offs as a percent, annualized, of average consumer receivablesincreased 27 basis points compared to the prior quarter primarily due to highercharge-offs in our real estate secured portfolios, in particular at our MortgageServices business. Net real estate secured charge-offs as a percent, annualized,of average real estate secured receivables was also negatively impacted by lowerreceivables 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. We expect the increase in the net charge-off ratio for our realestate secured portfolio will continue throughout 2007 as a portion of the loanspurchased by Mortgage Services in 2005 and 2006 continue to progress to variousstages of delinquency and ultimately charge-off. The increase in the ConsumerLending real estate secured net charge-off ratio was primarily due to portfolioseasoning as well as higher net charge-offs in second lien loans purchased in2004 through the third quarter of 2006 as part of a second lien bulk acquisitionprogram which has subsequently been discontinued. At June 30, 2007, theoutstanding principal balance of these second lien loans acquired by theConsumer Lending business was approximately $1.3 billion. The decrease in autofinance net charge-offs reflects a seasonal pattern related to higher charge-offs in the first quarter. The decrease in our credit card ratio reflects strongreceivable growth during the second quarter which offset higher bankruptcyrelated charge-offs. The personal non-credit card charge-off ratio increasedreflecting portfolio seasoning, a slight deterioration of certain customergroups in our domestic portfolio and receivable growth in the quarter. As compared to the prior year quarter, net charge-offs as a percent, annualized,of average consumer receivables increased 108 basis points primarily due tohigher charge-offs in our real estate secured portfolios, as discussed above, aswell as higher charge-offs in our credit card portfolio. Net real estate securedcharge-offs as a percent, annualized, of average real estate secured receivableswas also negatively impacted by lower receivables growth as discussed above. Theincrease in charge-offs in the credit card portfolio is due to increased levelsof personal bankruptcy filings as compared to the exceptionally low levelsexperienced in the first quarter of 2006 following enactment of the newbankruptcy law in the United States and higher receivable balances. The increasein the auto finance portfolio is due to seasoning of a growing portfolio. Theprivate label charge-off ratio increased compared to the prior year quarter dueto portfolio seasoning partially offset by higher levels of average receivablesin our foreign operations. The personal non-credit card charge-off ratioincreased reflecting portfolio seasoning as well as a slight deterioration ofcertain customer groups in our domestic portfolio. 61 HSBC Finance Corporation -------------------------------------------------------------------------------- NONPERFORMING ASSETS JUNE 30, MARCH 31, JUNE 30, 2007 2007 2006----------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Nonaccrual receivables(1)............................... $5,173 $4,945 $3,650Accruing consumer receivables 90 or more days delinquent............................................ 924 909 762Renegotiated commercial loans........................... 1 1 1 ------ ------ ------Total nonperforming receivables......................... 6,098 5,855 4,413Real estate owned....................................... 1,004 863 620 ------ ------ ------Total nonperforming assets.............................. $7,102 $6,718 $5,033 ====== ====== ======Credit loss reserves as a percent of nonperforming receivables........................................... 117.4% 116.1% 105.3% -------- ()(1) Nonaccrual receivables are comprised of the following: JUNE 30, MARCH 31, JUNE 30, 2007 2007 2006------------------------------------------------------------------------------------------ (IN MILLIONS) Real estate secured:Closed-end: First lien............................................. $2,139 $2,032 $1,365 Second lien............................................ 520 521 304Revolving: First lien............................................. 19 17 24 Second lien............................................ 236 225 88 ------ ------ ------Total real estate secured................................ 2,914 2,795 1,781Auto finance............................................. 378 291 318Credit card.............................................. - - -Private label............................................ 72 77 77Personal non-credit card................................. 1,809 1,782 1,474Commercial and other..................................... - - - ------ ------ ------Total nonaccrual receivables............................. $5,173 $4,945 $3,650 ====== ====== ====== Compared to March 31, 2007, the increase in total nonperforming assets is due tohigher levels of real estate secured nonaccrual receivables at our MortgageServices business due to the progression of certain loans acquired in 2005 and2006 to various stages of delinquency as previously discussed. Real estatesecured nonaccrual loans included stated income loans at our Mortgage Servicesbusiness of $718 million at June 30, 2007, $682 million at March 31, 2007 and$272 million at June 30, 2006. Consistent with industry practice, accruingconsumer receivables 90 or more days delinquent includes domestic credit cardreceivables. ACCOUNT MANAGEMENT POLICIES AND PRACTICES Our policies and practices for the collection of consumer receivables, includingour customer account management policies and practices, permit us to reset thecontractual delinquency status of an account to current, based on indicia orcriteria which, in our judgment, evidence continued payment probability. Suchpolicies and practices vary by product and are designed to manage customerrelationships, maximize collection opportunities and avoid foreclosure orrepossession if reasonably possible. If the account subsequently experiencespayment defaults, it will again become contractually delinquent. The tables below summarize approximate restructuring statistics in our managedbasis domestic portfolio. Managed basis assumes that securitized receivableshave not been sold and remain on our balance sheet. We report our restructuringstatistics on a managed basis only because the receivables that we securitizeare subject to underwriting 62 HSBC Finance Corporation -------------------------------------------------------------------------------- standards comparable to our owned portfolio, are generally serviced andcollected without regard to ownership and result in a similar credit lossexposure for us. As the level of our securitized receivables have fallen overtime, managed basis and owned basis results have now largely converged. Aspreviously reported, in prior periods we used certain assumptions and estimatesto compile our restructure statistics. The systemic counters used to compile theinformation presented below exclude from the reported statistics loans that havebeen reported as contractually delinquent but have been reset to a currentstatus because we have determined that the loans should not have been considereddelinquent (e.g., payment application processing errors). When comparingrestructuring statistics from different periods, the fact that our restructurepolicies and practices will change over time, that exceptions are made to thosepolicies and practices, and that our data capture methodologies have beenenhanced, should be taken into account. TOTAL RESTRUCTURED BY RESTRUCTURE PERIOD - DOMESTIC PORTFOLIO(1) (MANAGED BASIS) JUNE 30, MARCH 31, JUNE 30, 2007 2007 2006---------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Never restructured..................................... 86.8% 87.9% 90.0%Restructured: Restructured in the last 6 months.................... 5.6 5.6 3.7 Restructured in the last 7-12 months................. 3.8 2.8 2.6 Previously restructured beyond 12 months............. 3.8 3.7 3.7 ------- ------- ------- Total ever restructured(2)........................... 13.2 12.1 10.0 ------- ------- -------Total.................................................. 100.0% 100.0% 100.0% ======= ======= =======TOTAL RESTRUCTURED BY PRODUCT - DOMESTIC PORTFOLIO(1)(MANAGED BASIS)Real estate secured.................................... $12,923 $11,779 $ 8,449Auto finance........................................... 1,953 1,919 1,735Credit card............................................ 799 802 928Private label(3)....................................... 30 30 27Personal non-credit card............................... 3,825 3,722 3,421 ------- ------- -------Total.................................................. $19,530 $18,252 $14,560 ======= ======= =======(AS A PERCENT OF MANAGED RECEIVABLES)Real estate secured.................................... 14.6% 12.7% 9.3%Auto finance........................................... 15.4 15.3 14.3Credit card............................................ 2.8 2.9 3.6Private label(3)....................................... 14.1 11.5 7.5Personal non-credit card............................... 20.8 20.3 19.5 ------- ------- -------Total(2)............................................... 13.2% 12.1% 10.0% ======= ======= ======= -------- ()(1) Excludes foreign businesses, commercial and other. ()(2) Total including foreign businesses was 12.7 percent at June 30, 2007, 11.7 percent at March 31, 2007, and 9.7 percent at June 30, 2006. ()(3) Only reflects consumer lending retail sales contracts which have historically been classified as private label. All other domestic private label receivables were sold to HSBC Bank USA in December 2004. The increase in restructured loans was primarily attributable to higher levelsof real estate secured restructures due to portfolio growth and seasoning,including higher restructure levels at our Mortgage Services business as wecontinue to work with our customers who, in our judgment, evidence continuedpayment probability. Additionally, 63 HSBC Finance Corporation -------------------------------------------------------------------------------- beginning in the fourth quarter of 2006, we expanded the use of accountmodification at our Mortgage Services business to modify the rate and/or paymenton a number of qualifying delinquent loans and restructured certain of thoseaccounts after receipt of one modified payment and if certain other criteriawere met. Such accounts are included in the above restructure statisticsbeginning in the fourth quarter of 2006. See "Credit Quality Statistics" for further information regarding owned basisand managed basis delinquency, charge-offs and nonperforming loans. The amount of domestic and foreign managed receivables in forbearance,modification (excluding Mortgage Services for June 30, 2007 and March 31, 2007),credit card services approved consumer credit counseling accommodations,rewrites or other customer account management techniques for which we have resetdelinquency and that is not included in the restructured or delinquencystatistics was approximately $.3 billion or .2 percent of managed receivables atJune 30, 2007 and March 31, 2007 and $.4 billion or .3 percent of managedreceivables at June 30, 2006. As part of our risk mitigation efforts relating to the affected components ofthe Mortgage Services portfolio, we are contacting customers who have adjustablerate mortgage loans nearing the first reset that we expect will be the mostimpacted by a rate adjustment in order to assess their ability to make theadjusted payment and, as appropriate and in accordance with defined policies,are modifying the loans. As a result of this specific risk mitigation effort, wehave modified $369 million of such loans in the three months ended June 30, 2007and $503 million in the year-to-date period. These loans are not included in thetable above, as we have not reset delinquency on these loans as they were notcontractually delinquent at the time of the modification. However, if the loanhad been restructured in the past for other reasons, it is included in the tableabove. LIQUIDITY AND CAPITAL RESOURCES-------------------------------------------------------------------------------- We continue to focus on balancing our use of affiliate and third party fundingsources to minimize funding expense while managing liquidity. During the firstquarter of 2007, we supplemented unsecured debt issuances with proceeds from thecontinuing sale of newly originated domestic private label receivables to HSBCBank USA, debt issued to affiliates and increased levels of secured financings. 64 HSBC Finance Corporation -------------------------------------------------------------------------------- Debt due to affiliates and other HSBC related funding are summarized in thefollowing table: JUNE 30, DECEMBER 31, 2007 2006-------------------------------------------------------------------------------------- (IN BILLIONS) Debt issued to HSBC subsidiaries: Drawings on bank lines in the U.K. and Europe.............. $ 4.1 $ 4.3 Term debt.................................................. 10.5 10.6 Preferred securities issued by Household Capital Trust VIII to HSBC................................................. .3 .3 ----- ----- Total debt outstanding to HSBC subsidiaries................ 14.9 15.2 ----- -----Debt outstanding to HSBC clients: Euro commercial paper...................................... 2.8 3.0 Term debt.................................................. 1.0 1.2 ----- ----- Total debt outstanding to HSBC clients..................... 3.8 4.2Cash received on bulk and subsequent sales of domestic private label credit card receivables to HSBC Bank USA, net (cumulative)............................................... 17.6 17.9Real estate secured receivable activity with HSBC Bank USA: Cash received on sales (cumulative)........................ 3.7 3.7 Direct purchases from correspondents (cumulative).......... 4.2 4.2 Reductions in real estate secured receivables sold to HSBC Bank USA................................................ (5.1) (4.7) ----- -----Total real estate secured receivable activity with HSBC Bank USA........................................................ 2.8 3.2 ----- -----Cash received from sale of European Operations to HBEU affiliate.................................................. -(1) -(1)Cash received from sale of U.K. credit card business to HBEU....................................................... 2.7 2.7Capital contribution by HSBC Investments (North America) Inc. ("HINO") (cumulative)...................................... 1.6 1.4 ----- -----Total HSBC related funding................................... $43.4 $44.6 ===== ===== -------- ()(1) Less than $100 million. Funding from HSBC, including debt issuances to HSBC subsidiaries and clients,represented 13 percent of our total and preferred stock funding at June 30, 2007and December 31, 2006. Cash proceeds of $46 million from the November 2006 sale of the EuropeanOperations and $2.7 billion from the December 2005 sale of our U.K. credit cardreceivables to HBEU were used to partially pay down drawings on bank lines fromHBEU for the U.K. and fund operations. Proceeds received from the bulk sale andsubsequent daily sales of domestic private label credit card receivables to HSBCBank USA of $17.9 billion were used to pay down short-term domestic borrowings,including outstanding commercial paper balances, and to fund operations. At June 30, 2007, we had a commercial paper back stop credit facility of $2.5billion from HSBC supporting domestic issuances and a revolving credit facilityof $5.7 billion from HBEU to fund our operations in the U.K. At June 30, 2007,$4.1 billion was outstanding under the HBEU lines for the U.K. and no balanceswere outstanding under the domestic lines. At June 30, 2007, we had derivativecontracts with a notional value of $86.3 billion, or approximately 93 percent oftotal derivative contracts, outstanding with HSBC affiliates. At December 31,2006, we had derivative contracts with a notional value of $82.8 billion, orapproximately 88 percent of total derivative contracts, outstanding with HSBCaffiliates. SECURITIES AND OTHER SHORT-TERM INVESTMENTS Securities totaled $3.5 billion atJune 30, 2007 and $4.7 billion at December 31, 2006. Securities purchased underagreements to resell totaled $1 million at June 30, 2007 and $171 million atDecember 31, 2006. Interest bearing deposits with banks totaled $45 million atJune 30, 2007 and $424 million at December 31, 2006. The decreases in securitiesand interest bearing deposits with banks are due to 65 HSBC Finance Corporation -------------------------------------------------------------------------------- the reclassification of the assets of the U.K. Insurance Operations which atJune 30, 2007 are classified as "Held for Sale" and included within other assetsas well as the use of money market funds to pay down secured financings duringthe second quarter of 2007. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS totaled $12.1 billion at June 30,2007 and $11.1 billion at December 31, 2006. Commercial paper balances werehigher at June 30, 2007 as a result of our strategy to increase the use ofcommercial paper funding as it is currently the least expensive source ofalternative short term funding available, partially offset by the cash proceedsfrom the sale of $2.2 billion of real estate secured receivables from ourMortgage Services business which was used to pay down outstanding commercialpaper balances and fund operations. Our funding strategy requires that bankcredit facilities will at all times exceed 85% of outstanding commercial paperand that the combination of bank credit facilities and undrawn committed conduitfacilities will, at all times, exceed 115% of outstanding commercial paper.Included in this total was outstanding Euro commercial paper sold to customersof HSBC of $2.8 billion at June 30, 2007 and $3.0 billion at December 31, 2006. LONG TERM DEBT (with original maturities over one year) decreased to $121.8billion at June 30, 2007 from $127.6 billion at December 31, 2006. The decreaseis due to lower funding requirements resulting from the lower asset levelsduring the first half of 2007. Significant issuances during the first half of2007 included the following: - $.4 billion of domestic and foreign medium-term notes - $1.3 billion of foreign currency-denominated bonds - $.4 billion of InterNotes(SM) (retail-oriented medium-term notes) - $3.0 billion of global debt - $5.7 billion of securities backed by real estate secured, auto finance, credit card and personal non-credit card receivables. For accounting purposes, these transactions were structured as secured financings. In the first quarter of 2006, we redeemed the junior subordinated notes, issuedto Household Capital Trust VI with an outstanding principal balance of $206million. In the fourth quarter of 2006 we redeemed the junior subordinatednotes, issued to Household Capital Trust VII with an outstanding principalbalance of $206 million. COMMON EQUITY In the first quarter of 2007, HINO made a capital contribution of$200 million to support ongoing operations. In 2006, in connection with ourpurchase of the Champion portfolio, HINO made a capital contribution of $163million. SELECTED CAPITAL RATIOS In managing capital, we develop targets for tangibleshareholder's(s') equity to tangible managed assets ("TETMA"), tangibleshareholder's(s') equity plus owned loss reserves to tangible managed assets("TETMA + Owned Reserves") and tangible common equity to tangible managedassets. These ratio targets are based on discussions with HSBC and ratingagencies, risks inherent in the portfolio, the projected operating environmentand related risks, and any acquisition objectives. These ratios exclude theequity impact of SFAS No. 115, "Accounting for Certain Investments in Debt andEquity Securities," the equity impact of SFAS No. 133, "Accounting forDerivative Instruments and Hedging Activities," and the impact of the adoptionof SFAS No. 159, "The Fair Value Option for Financial Assets and Liabilities,"including the subsequent changes in fair value recognized in earnings associatedwith credit risk on debt for which we elected the fair value option. Preferredsecurities issued by certain non-consolidated trusts are also considered equityin the TETMA and TETMA + Owned Reserves calculations because of their long-termsubordinated nature and our ability to defer dividends. Managed assets includeowned assets plus loans which we have sold and service with limited recourse. Weand certain rating agencies also monitor our equity ratios excluding the impactof the HSBC acquisition purchase accounting adjustments. We do so because webelieve that the HSBC acquisition purchase accounting adjustments represent non-cash transactions which do not affect our business operations, cash flows orability to meet our debt obligations. Our targets may change from time to timeto accommodate changes in the operating environment or other considerations suchas those listed above. 66 HSBC Finance Corporation -------------------------------------------------------------------------------- SELECTED CAPITAL RATIOS are summarized in the following table: JUNE 30, DECEMBER 31, 2007 2006-------------------------------------------------------------------------------------- TETMA(1)..................................................... 7.43% 7.16%TETMA + Owned Reserves(1).................................... 11.78 11.02Tangible common equity to tangible managed assets(1)......... 6.31 6.08Common and preferred equity to owned assets.................. 11.39 11.21Excluding purchase accounting adjustments: TETMA(1)................................................... 7.97% 7.81% TETMA + Owned Reserves(1).................................. 12.32 11.67 Tangible common equity to tangible managed assets(1)....... 6.85 6.72 -------- ()(1) TETMA, TETMA + Owned Reserves and tangible common equity to tangible managed assets represent non-U.S.GAAP financial ratios that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See "Basis of Reporting" for additional discussion on the use of non-U.S.GAAP financial measures and "Reconciliations to U.S. GAAP Financial Measures" for quantitative reconciliations to the equivalent U.S.GAAP basis financial measure. SECURITIZATIONS AND SECURED FINANCINGS Securitizations (collateralized fundingtransactions structured to receive sale treatment under Statement of FinancialAccounting Standards No. 140, "Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities, a Replacement of FASBStatement No. 125," ("SFAS No. 140")) and secured financings (collateralizedfunding transactions which do not receive sale treatment under SFAS No. 140) ofconsumer receivables have been a source of funding and liquidity for us.Securitizations and secured financings have been used to limit our reliance onthe unsecured debt markets and often are more cost-effective than alternativefunding sources. Securitizations are treated as secured financings under both IFRS and U.K. GAAP.In order to align our accounting treatment with that of HSBC initially underU.K. GAAP and now under IFRS, we began to structure all new collateralizedfunding transactions as secured financings in the third quarter of 2004.However, because existing public credit card transactions were structured assales to revolving trusts that require replenishments of receivables to supportpreviously issued securities, receivables will continue to be sold to thesetrusts and the resulting replenishment gains recorded until the revolvingperiods end, the last of which is currently projected to occur in the fourthquarter of 2007. The termination of sale treatment on new collateralized fundingactivity reduced our reported net income under U.S. GAAP. There was no impact,however, on cash received from operations. Because we believe the market forsecurities backed by receivables is a reliable, efficient and cost-effectivesource of funds, we will continue to use secured financings of consumerreceivables as a source of our funding and liquidity. There were no securitizations (excluding replenishments of certificateholderinterests) during the first six months of 2007 or 2006. Secured financings aresummarized in the following table: THREE MONTHS ENDED JUNE 30 2007 2006--------------------------------------------------------------------------------- (IN MILLIONS) SECURED FINANCINGS:Real estate secured............................................. $1,595 $ -Credit card..................................................... 1,000 985Auto finance.................................................... - 944Personal non-credit card........................................ - 2,500 ------ ------Total........................................................... $2,595 $4,429 ====== ====== 67 HSBC Finance Corporation -------------------------------------------------------------------------------- SIX MONTHS ENDED JUNE 30 2007 2006--------------------------------------------------------------------------------- (IN MILLIONS) SECURED FINANCINGS:Real estate secured............................................. $1,595 $ 350Credit card..................................................... 2,890 2,105Auto finance.................................................... 1,069 944Personal non-credit card........................................ 110 2,500 ------ ------Total........................................................... $5,664 $5,899 ====== ====== Our securitized receivables totaled $611 million at June 30, 2007 compared to$949 million at December 31, 2006. As of June 30, 2007, outstanding securedfinancings of $21.4 billion were secured by $28.0 billion of real estatesecured, auto finance, credit card and personal non-credit card receivables.Secured financings of $21.8 billion at December 31, 2006 were secured by $28.1billion of real estate secured, auto finance, credit card and personal non-credit card receivables. At June 30, 2007, securitizations structured as salesrepresented less than 1 percent and secured financings represented 14 percent ofthe funding associated with our managed funding portfolio. At December 31, 2006,securitizations structured as sales represented 1 percent and secured financingsrepresented 14 percent of the funding associated with our managed fundingportfolio. COMMITMENTS We also enter into commitments to meet the financing needs of ourcustomers. In most cases, we have the ability to reduce or eliminate these openlines of credit. As a result, the amounts below do not necessarily representfuture cash requirements. JUNE 30, DECEMBER 31, 2007 2006-------------------------------------------------------------------------------------- (IN BILLIONS) Private label, and credit cards.............................. $189 $186Other consumer lines of credit............................... 8 7 ---- ----Open lines of credit(1)...................................... $197 $193 ==== ==== -------- ()(1) Includes an estimate for acceptance of credit offers mailed to potential customers prior to June 30, 2007 and December 31, 2006, respectively. At June 30, 2007, our Mortgage Services business had outstanding forward salescommitments relating to real estate secured loans totaling $78 million andunused commitments to extend credit relating to real estate secured loans tocustomers (as long as certain conditions are met), totaling $381 million. At March 31 2007, $72 million was outstanding under a commitment to lend up to$3.0 billion to H&R Block to fund its acquisition of a participation interest inrefund anticipation loans for the 2007. This balance was paid in full and thecommitment expired during the second quarter of 2007. 68 HSBC Finance Corporation -------------------------------------------------------------------------------- 2007 FUNDING STRATEGY Our current estimated domestic funding needs and sourcesfor 2007 are summarized in the table that follows: ACTUAL ESTIMATED JANUARY 1 JULY 1 THROUGH THROUGH ESTIMATED JUNE 30, DECEMBER 31, FULL YEAR 2007 2007 2007------------------------------------------------------------------------------------------- (IN BILLIONS) FUNDING NEEDS: Net asset growth................................. $(3) $ (7) - 0 $(10) - (3) Commercial paper, term debt and securitization maturities.................................... 27 3 - 9 30 - 36 Other............................................ (1) 2 - 4 1 - 3 --- --------- ----------- Total funding needs.............................. $23 $(2) - 13 $ 21 - 36 === ========= ===========FUNDING SOURCES: External funding, including commercial paper and portfolio sales............................... $22 $(2) - 11 $ 20 - 33 HSBC and HSBC subsidiaries....................... 1 0 - 2 1 - 3 --- --------- ----------- Total funding sources............................ $23 $(2) - 13 $ 21 - 36 === ========= =========== As previously discussed, we have experienced deterioration in the performance ofmortgage loan originations in our Mortgage Services business and in March 2007announced our decision to discontinue new correspondent channel acquisitions bythat business subject to fulfilling earlier commitments, which were immaterial.These actions, combined with normal portfolio attrition and risk mitigationefforts we began in the second half of 2006, will result in negative growth inour aggregate portfolio in 2007. As opportunities arise, we may also choose tosell selected portfolios, similar to the $2.2 billion sale of real estatesecured receivables completed during the second quarter of 2007. Futuredecisions to constrain growth in additional portfolios as well as decisions tosell selected portfolios would also result in negative year over year growth inthe balance sheet. RISK MANAGEMENT-------------------------------------------------------------------------------- CREDIT RISK There have been no significant changes in our approach to creditrisk management since December 31, 2006. At June 30, 2007, we had derivative contracts with a notional value ofapproximately $92.7 billion, including $86.3 billion outstanding with HSBCaffiliates. Most swap agreements, both with unaffiliated and affiliated thirdparties, require that payments be made to, or received from, the counterpartywhen the fair value of the agreement reaches a certain level. Generally, third-party swap counterparties provide collateral in the form of cash which isrecorded in our balance sheet as other assets or derivative related liabilitiesand totaled $0 at June 30, 2007 and $158 million at December 31, 2006 for third-party counterparties. Beginning with the second quarter of 2006, when the fairvalue of our agreements with affiliate counterparties require the posting ofcollateral by the affiliate, it is provided in the form of cash and recorded onthe balance sheet, consistent with third party arrangements. At June 30, 2007,the fair 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. LIQUIDITY RISK There have been no significant changes in our approach toliquidity risk since December 31, 2006. MARKET RISK HSBC has certain limits and benchmarks that serve as guidelines indetermining the appropriate levels of interest rate risk. One such limit isexpressed in terms of the Present Value of a Basis Point ("PVBP"), whichreflects the change in value of the balance sheet for a one basis point movementin all interest rates. Our PVBP limit 69 HSBC Finance Corporation -------------------------------------------------------------------------------- as of June 30, 2007 was $2 million, which includes the risk associated withhedging instruments. Thus, for a one basis point change in interest rates, thepolicy dictates that the value of the balance sheet shall not increase ordecrease by more than $2 million. As of June 30, 2007, we had a PVBP position of($0.1) million reflecting the impact of a one basis point increase in interestrates. As of December 31, 2006, we had a PVBP position of $1.1 million. The total PVBP position will not change as a result of the early adoption ofSFAS No. 159, however instruments previously accounted for on an accrual basiswill now be accounted for under the fair value option election. As a result, thePVBP risk for June 30, 2007, summarized in the table below, reflects arealignment of instruments from December 31, 2006, between accrual and mark-to-market. Total PVBP risk is lower as a result of normal risk management actions.The following table shows the components of PVBP: JUNE 30, DECEMBER 31, 2007 2006-------------------------------------------------------------------------------------- (IN MILLIONS) Risk related to our portfolio of balance sheet items marked- to-market.................................................. $ .8 $(1.8)Risk for all other remaining assets and liabilities.......... (.9) 2.9 ---- -----Total PVBP risk.............................................. $(.1) $ 1.1 ==== ===== We also monitor the impact that an immediate hypothetical increase or decreasein interest rates of 25 basis points applied at the beginning of each quarterover a 12 month period would have on our net interest income assuming a growingbalance sheet and the current interest rate risk profile. The following tablesummarizes such estimated impact: JUNE 30, DECEMBER 31, 2007 2006-------------------------------------------------------------------------------------- (IN MILLIONS) Decrease in net interest income following a hypothetical 25 basis points rise in interest rates applied at the beginning of each quarter over the next 12 months.......... $189 $180Increase in net interest income following a hypothetical 25 basis points fall in interest rates applied at the beginning of each quarter over the next 12 months.......... $127 $ 54 In the June 2007 scenario, as compared to December 2006, the timing of therepricing of the ARM portfolio is occurring earlier in the scenario, thus havinga greater impact on the results of the analysis for the twelve-month period.Further, a greater volume of ARMs will reset to higher rates and is expected toremain on book as a result of fewer refinancing options to subprime customers.As a result even in the declining rate scenario, the total benefit to netinterest income has increased significantly. These estimates include the impact of debt and the corresponding derivativeinstruments accounted for using the fair value option under SFAS No. 159. Theseestimates also assume we would not take any corrective actions in response tointerest rate movements and, therefore, exceed what most likely would occur ifrates were to change by the amount indicated. A principal considerationsupporting this analysis is the projected prepayment of loan balances for agiven economic scenario. Individual loan underwriting standards in combinationwith housing valuations and macroeconomic factors related to available mortgagecredit are the key assumptions driving these prepayment projections. While wehave utilized a number of sources to refine these projections, we can notcurrently project prepayment rates with a high degree of certainty in alleconomic environments given recent, significant changes in both subprimemortgage underwriting standards and property valuations across the country. OPERATIONAL RISK There has been no significant change in our approach tooperational risk management since December 31, 2006. COMPLIANCE RISK There has been no significant change in our approach tocompliance risk management since December 31, 2006. REPUTATIONAL RISK There has been no significant change in our approach toreputational risk management since December 31, 2006. 70 HSBC FINANCE CORPORATION RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES JUNE 30, DECEMBER 31, 2007 2006------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) TANGIBLE COMMON EQUITY:Common shareholder's equity................................. $ 19,172 $ 19,515Exclude: Fair value option adjustment.............................. 123 - Unrealized (gains) losses on cash flow hedging instruments............................................ 38 61 Minimum pension liability................................. 3 1 Unrealized gains on investments and interest-only strip receivables............................................ 39 23 Intangible assets......................................... (2,092) (2,218) Goodwill.................................................. (6,896) (7,010) -------- --------Tangible common equity...................................... 10,387 10,372HSBC acquisition purchase accounting adjustments............ 887 1,105 -------- --------Tangible common equity, excluding HSBC acquisition purchase accounting adjustments.................................... $ 11,274 $ 11,477 ======== ========TANGIBLE SHAREHOLDER'S(S') EQUITY:Tangible common equity...................................... $ 10,387 $ 10,372Preferred stock............................................. 575 575Mandatorily redeemable preferred securities of Household Capital Trusts............................................ 1,275 1,275 -------- --------Tangible shareholder's(s') equity........................... 12,237 12,222HSBC acquisition purchase accounting adjustments............ 887 1,105 -------- --------Tangible shareholder's(s') equity, excluding HSBC acquisition purchase accounting adjustments............... $ 13,124 $ 13,327 ======== ========TANGIBLE SHAREHOLDER'S(S') EQUITY PLUS OWNED LOSS RESERVES:Tangible shareholder's(s') equity........................... $ 12,237 $ 12,222Owned loss reserves......................................... 7,157 6,587 -------- --------Tangible shareholder's(s') equity plus owned loss reserves.. 19,394 18,809HSBC acquisition purchase accounting adjustments............ 887 1,105 -------- --------Tangible shareholder's(s') equity plus owned loss reserves, excluding HSBC acquisition purchase accounting adjustments............................................... $ 20,281 $ 19,914 ======== ========TANGIBLE MANAGED ASSETS:Owned assets................................................ $173,353 $179,218Receivables serviced with limited recourse.................. 611 949 -------- --------Managed assets.............................................. 173,964 180,167Exclude: Intangible assets......................................... (2,092) (2,218) Goodwill.................................................. (6,896) (7,010) Derivative financial assets............................... (358) (298) -------- --------Tangible managed assets..................................... 164,618 170,641HSBC acquisition purchase accounting adjustments............ (17) 64 -------- --------Tangible managed assets, excluding HSBC acquisition purchase accounting adjustments.................................... $164,601 $170,705 ======== ========EQUITY RATIOS:Common and preferred equity to owned assets................. 11.39% 11.21%Tangible common equity to tangible managed assets........... 6.31 6.08Tangible shareholder's(s') equity to tangible managed assets ("TETMA")................................................. 7.43 7.16Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves")..... 11.78 11.02Excluding HSBC acquisition purchase accounting adjustments: Tangible common equity to tangible managed assets......... 6.85 6.72 TETMA..................................................... 7.97 7.81 TETMA + Owned Reserves.................................... 12.32 11.67 ======== ======== 71 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 4. CONTROLS AND PROCEDURES-------------------------------------------------------------------------------- We maintain a system of internal and disclosure controls and procedures designedto ensure that information required to be disclosed by HSBC Finance Corporationin the reports we file or submit under the Securities Exchange Act of 1934, asamended, (the "Exchange Act"), is recorded, processed, summarized and reportedon a timely basis. Our Board of Directors, operating through its auditcommittee, which is composed entirely of independent outside directors, providesoversight to our financial reporting process. We conducted an evaluation, with the participation of the Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of our disclosurecontrols and procedures as of the end of the period covered by this report.Based upon that evaluation, the Chief Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures were effective asof the end of the period covered by this report so as to alert them in a timelyfashion to material information required to be disclosed in reports we fileunder the Exchange Act. There have been no significant changes in our internal and disclosure controlsor in other factors which could significantly affect internal and disclosurecontrols subsequent to the date that we carried out our evaluation. HSBC Finance Corporation continues the process to complete a thorough review ofits internal controls as part of its preparation for compliance with therequirements of Section 404 of the Sarbanes-Oxley Act of 2002. Section 404requires our management to report on, and our external auditors to attest to,the effectiveness of our internal control structure and procedures for financialreporting. As a non-accelerated filer under Rule 12b-2 of the Exchange Act, ourfirst report under Section 404 will be contained in our Form 10-K for the periodended December 31, 2007. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS-------------------------------------------------------------------------------- GENERAL We are parties to various legal proceedings resulting from ordinary businessactivities relating to our current and/or former operations. Certain of theseactions are or purport to be class actions seeking damages in very largeamounts. These actions assert violations of laws and/or unfair treatment ofconsumers. Due to the uncertainties in litigation and other factors, we cannotbe certain that we will ultimately prevail in each instance. We believe that ourdefenses to these actions have merit and any adverse decision should notmaterially affect our consolidated financial condition. CONSUMER LITIGATION During the past several years, the press has widely reported certain industryrelated concerns that may impact us. Some of these involve the amount oflitigation instituted against lenders and insurance companies operating incertain states and the large awards obtained from juries in those states. Likeother companies in this industry, some of our subsidiaries are involved inlawsuits pending against them in these states. The cases, in particular,generally allege inadequate disclosure or misrepresentation of financing terms.In some suits, other parties are also named as defendants. Unspecifiedcompensatory and punitive damages are sought. Several of these suits purport tobe class actions or have multiple plaintiffs. The judicial climate in thesestates is such that the outcome of all of these cases is unpredictable. Althoughour subsidiaries believe they have substantive legal defenses to these claimsand are prepared to defend each case vigorously, a number of such cases havebeen settled or otherwise resolved for amounts that in the aggregate are notmaterial to our operations. Insurance carriers have been notified asappropriate, and from time to time reservations of rights letters have beenreceived. CREDIT CARD SERVICES LITIGATION Since June 2005, HSBC Finance Corporation, HSBC North America, and HSBC, as wellas other banks and the Visa and Master Card associations, were named asdefendants in four class actions filed in Connecticut and the Eastern Districtof New York; Photos Etc. Corp. et al. v. Visa U.S.A., Inc., et al. (D. Conn. No.3:05-CV-01007 (WWE)): National 72 HSBC Finance Corporation -------------------------------------------------------------------------------- Association of Convenience Stores, et al. v. Visa U.S.A., Inc., et al. (E.D.N.Y.No. 05-CV 4520 (JG)); Jethro Holdings, Inc., et al. v. Visa U.S.A., Inc. et al.(E.D.N.Y. No. 05-CV-4521 (JG)); and American Booksellers Ass'n v. Visa U.S.A.,Inc. et al. (E.D.N.Y. No. 05-CV-5391 (JG)). Numerous other complaints containingsimilar allegations (in which no HSBC entity is named) were filed across thecountry against Visa, MasterCard and other banks. These actions principallyallege that the imposition of a no-surcharge rule by the associations and/or theestablishment of the interchange fee charged for credit card transactions causesthe merchant discount fee paid by retailers to be set at supracompetitive levelsin violation of the Federal antitrust laws. In response to motions of theplaintiffs on October 19, 2005, the Judicial Panel on Multidistrict Litigation(the "MDL Panel") issued an order consolidating these suits and transferred allof the cases to the Eastern District of New York. The consolidated case is: Inre Payment Card Interchange Fee and Merchant Discount Antitrust Litigation, MDL1720, E.D.N.Y. A consolidated, amended complaint was filed by the plaintiffs onApril 24, 2006. Discovery has begun. At this time, we are unable to quantify thepotential impact from this action, if any. SECURITIES LITIGATION In August 2002, we restated previously reported consolidated financialstatements. The restatement related to certain MasterCard and Visa co-brandingand affinity credit card relationships and a third party marketing agreement,which were entered into between 1992 and 1999. All were part of our Credit CardServices segment. In consultation with our prior auditors, Arthur Andersen LLP,we treated payments made in connection with these agreements as prepaid assetsand amortized them in accordance with the underlying economics of theagreements. Our current auditor, KPMG LLP, advised us that, in its view, thesepayments should have either been charged against earnings at the time they weremade or amortized over a shorter period of time. The restatement resulted in a$155.8 million, after-tax, retroactive reduction to retained earnings atDecember 31, 1998. As a result of the restatement, and other corporate events,including, e.g., the 2002 settlement with 50 states and the District of Columbiarelating to real estate lending practices, HSBC Finance Corporation, and itsdirectors, certain officers and former auditors, have been involved in variouslegal proceedings, some of which purport to be class actions. A number of theseactions allege violations of Federal securities laws, were filed between Augustand October 2002, and seek to recover damages in respect of allegedly false andmisleading statements about our common stock. These legal actions have beenconsolidated into a single purported class action, Jaffe v. HouseholdInternational, Inc., et al., No. 02 C 5893 (N.D. Ill., filed August 19, 2002),and a consolidated and amended complaint was filed on March 7, 2003. On December3, 2004, the court signed the parties' stipulation to certify a class withrespect to the claims brought under sec. 10 and sec. 20 of the SecuritiesExchange Act of 1934. The parties stipulated that plaintiffs will not seek tocertify a class with respect to the claims brought under sec. 11 and sec. 15 ofthe Securities Act of 1933 in this action or otherwise. The amended complaint purports to assert claims under the Federal securitieslaws, on behalf of all persons who purchased or otherwise acquired oursecurities between October 23, 1997 and October 11, 2002, arising out of allegedfalse and misleading statements in connection with our collection, sales andlending practices, the 2002 state settlement agreement referred to above, therestatement and the HSBC merger. The amended complaint, which also names asdefendants Arthur Andersen LLP, Goldman, Sachs & Co., and Merrill Lynch, Pierce,Fenner & Smith, Inc., fails to specify the amount of damages sought. In May2003, we, and other defendants, filed a motion to dismiss the complaint. OnMarch 19, 2004, the Court granted in part, and denied in part the defendants'motion to dismiss the complaint. The Court dismissed all claims against MerrillLynch, Pierce, Fenner & Smith, Inc. and Goldman Sachs & Co. The Court alsodismissed certain claims alleging strict liability for alleged misrepresentationof material facts based on statute of limitations grounds. The claims thatremain against some or all of the defendants essentially allege the defendantsknowingly made a false statement of a material fact in conjunction with thepurchase or sale of securities, that the plaintiffs justifiably relied on suchstatement, the false statement(s) caused the plaintiffs' damages, and that someor all of the defendants should be liable for those alleged statements. OnFebruary 28, 2006, the Court also dismissed all alleged sec. 10 claims thatarose prior to July 30, 1999, shortening the class period by 22 months. The bulkof fact discovery concluded on January 31, 2007. Expert discovery is expected toconclude on December 21, 2007. Separately, one of the defendants, ArthurAndersen LLP, entered into a settlement of the claims against Arthur Andersen.This settlement received Court approval in April 2006. At this time we areunable to quantify the potential impact from this action, if any. 73 HSBC Finance Corporation -------------------------------------------------------------------------------- With respect to this securities litigation, we believe that we have not, and ourofficers and directors have not, committed any wrongdoing and in each instancethere will be no finding of improper activities that may result in a materialliability to us or any of our officers or directors. ITEM 6. EXHIBITS-------------------------------------------------------------------------------- Exhibits included in this Report: 12 Statement of Computation of Ratio of Earnings to Fixed Charges and to Combined Fixed Charges and Preferred Stock Dividends 31 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.1 Debt and Preferred Stock Securities Ratings 74 HSBC Finance Corporation -------------------------------------------------------------------------------- SIGNATURE-------------------------------------------------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized. HSBC FINANCE CORPORATION (Registrant) /s/ Beverley A. Sibblies ---------------------------------------- Beverley A. Sibblies Senior Vice President and Chief Financial Officer Date: July 30, 2007 75 HSBC Finance Corporation -------------------------------------------------------------------------------- EXHIBIT INDEX-------------------------------------------------------------------------------- 12 Statement of Computation of Ratio of Earnings to Fixed Charges and to Combined Fixed Charges and Preferred Stock Dividends 31 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.1 Debt and Preferred Stock Securities Ratings 76 HSBC Finance Corporation -------------------------------------------------------------------------------- EXHIBIT 12 COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES AND TO COMBINED FIXED CHARGES AND PREFERRED STOCK DIVIDENDS SIX MONTHS ENDED JUNE 30, 2007 2006--------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income...................................................... $ 604 $1,456Income tax expense.............................................. 345 840 ------ ------Income before income tax expense................................ 949 2,296 ------ ------Fixed charges: Interest expense.............................................. 4,099 3,385 Interest portion of rentals(1)................................ 29 29 ------ ------Total fixed charges............................................. 4,128 3,414 ------ ------Total earnings as defined....................................... $5,077 $5,710 ====== ======Ratio of earnings to fixed charges.............................. 1.23 1.67Preferred stock dividends(2).................................... 29 29Ratio of earnings to combined fixed charges and preferred stock dividends..................................................... 1.22 1.66 -------- ()(1) Represents one-third of rentals, which approximates the portion representing interest. ()(2) Preferred stock dividends are grossed up to their pretax equivalents. HSBC Finance Corporation -------------------------------------------------------------------------------- HSBC Finance Corporation -------------------------------------------------------------------------------- EXHIBIT 31 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION OF CHIEF EXECUTIVE OFFICER I, Brendan P. McDonagh, Chief Executive Officer of HSBC Finance Corporation,certify that: 1. I have reviewed this report on Form 10-Q of HSBC Finance Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: July 30, 2007 /s/ BRENDAN P. MCDONAGH ---------------------------------------- Brendan P. McDonagh Chief Executive Officer HSBC Finance Corporation -------------------------------------------------------------------------------- HSBC Finance Corporation -------------------------------------------------------------------------------- CERTIFICATION OF CHIEF FINANCIAL OFFICER I, Beverley A. Sibblies, Senior Vice President and Chief Financial Officer ofHSBC Finance Corporation, certify that: 1. I have reviewed this report on Form 10-Q of HSBC Finance Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: July 30, 2007 /s/ BEVERLEY A. SIBBLIES ---------------------------------------- Beverley A. Sibblies Senior Vice President and Chief Financial Officer HSBC Finance Corporation -------------------------------------------------------------------------------- HSBC Finance Corporation -------------------------------------------------------------------------------- EXHIBIT 32 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 The certification set forth below is being submitted in connection with the HSBCFinance Corporation (the "Company") Quarterly Report on Form 10-Q for the periodending June 30, 2007 as filed with the Securities and Exchange Commission on thedate hereof (the "Report") for the purpose of complying with Rule 13a-14(b) orRule 15d-14(b) of the Securities Exchange Act of 1934 (the "Exchange Act") andSection 1350 of Chapter 63 of Title 18 of the United States Code. I, Brendan P. McDonagh, Chief Executive Officer of the Company, certify that: 1. the Report fully complies with the requirements of Section 13(a) or 15(d) of the Exchange Act; and 2. the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of HSBC Finance Corporation. July 30, 2007 /s/ BRENDAN P. MCDONAGH ---------------------------------------- Brendan P. McDonagh Chief Executive Officer HSBC Finance Corporation -------------------------------------------------------------------------------- HSBC Finance Corporation -------------------------------------------------------------------------------- CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 The certification set forth below is being submitted in connection with the HSBCFinance Corporation (the "Company") Quarterly Report on Form 10-Q for the periodending June 30, 2007 as filed with the Securities and Exchange Commission on thedate hereof (the "Report") for the purpose of complying with Rule 13a-14(b) orRule 15d-14(b) of the Securities Exchange Act of 1934 (the "Exchange Act") andSection 1350 of Chapter 63 of Title 18 of the United States Code. I, Beverley A. Sibblies, Senior Vice President and Chief Financial Officer ofthe Company, certify that: 1. the Report fully complies with the requirements of Section 13(a) or 15(d) of the Exchange Act; and 2. the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of HSBC Finance Corporation. July 30, 2007 /s/ BEVERLEY A. SIBBLIES ---------------------------------------- Beverley A. Sibblies Senior Vice President and Chief Financial Officer This certification accompanies each Report pursuant to Section 906 of theSarbanes-Oxley Act of 2002 and shall not, except to the extent required by theSarbanes-Oxley Act of 2002, be deemed filed by HSBC Finance Corporation forpurposes of Section 18 of the Securities Exchange Act of 1934, as amended. Signed originals of these written statements required by Section 906 of theSarbanes-Oxley Act of 2002 have been provided to HSBC Finance Corporation andwill be retained by HSBC Finance Corporation and furnished to the Securities andExchange Commission or its staff upon request. HSBC Finance Corporation -------------------------------------------------------------------------------- HSBC Finance Corporation -------------------------------------------------------------------------------- EXHIBIT 99.1 DEBT AND PREFERRED STOCK SECURITIES RATINGS STANDARD & MOODY'S POOR'S INVESTORS CORPORATION SERVICE FITCH, INC. DBRS, INC.------------------------------------------------------------------------------------------------ AS OF JUNE 30, 2007HSBC Finance Corporation Senior debt.............................. AA- Aa3 AA- AA (low) Senior subordinated debt................. A+ A1 A+ * Commercial paper......................... A-1+ P-1 F1+ R-1 (middle) Series B preferred stock................. A-2 A2 A+ *HFC Bank Limited Senior debt.............................. AA- Aa3 AA- * Commercial paper......................... A-1+ P-1 F1+ *HSBC Financial Corporation Limited Senior notes and term loans.............. AA- Aa3 AA- AA (low) Commercial paper......................... * * * R-1 (middle) -------- ()(*) Not rated by this agency. This information is provided by RNS The company news service from the London Stock Exchange

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