13th Nov 2006 11:04
HSBC Holdings PLC13 November 2006 Part 1 -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------ FORM 10-Q ------------ (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to _________ COMMISSION FILE NUMBER 1-8198 ------------ HSBC FINANCE CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 86-1052062 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 2700 SANDERS ROAD, PROSPECT HEIGHTS, 60070 ILLINOIS (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (847) 564-5000 REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE ------------ Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes (X) No ( ) Indicate by check mark whether the registrant is a large accelerated filer,an accelerated filer, or a non-accelerated filer. See definition of "acceleratedfiler and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Checkone): Large accelerated filer ( ) Accelerated filer ( ) Non-accelerated filer (X) Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). Yes ( ) No (X) As of October 31, 2006, there were 55 shares of the registrant's commonstock outstanding, all of which are owned by HSBC Investments (North America)Inc. -------------------------------------------------------------------------------- HSBC FINANCE CORPORATION FORM 10-Q TABLE OF CONTENTS PART I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements Statement of Income.............................................. 3 Balance Sheet.................................................... 4 Statement of Changes in Shareholders' Equity..................... 5 Statement of Cash Flows.......................................... 6 Notes to Consolidated Financial Statements....................... 7Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements....................................... 22 Executive Overview............................................... 22 Basis of Reporting............................................... 26 Receivables Review............................................... 34 Results of Operations............................................ 35 Segment Results - Managed Basis.................................. 43 Credit Quality................................................... 49 Liquidity and Capital Resources.................................. 55 Risk Management.................................................. 59 Reconciliations to GAAP Financial Measures....................... 61Item 4. Controls and Procedures.......................................... 65 PART II. OTHER INFORMATION----------------------------------------------------------------------------------- Item 1. Legal Proceedings................................................ 65Item 1A. Risk Factors..................................................... 67Item 6. Exhibits......................................................... 68Signature ................................................................. 69 2 PART I. FINANCIAL INFORMATION --------------------------------------------------------------------------------ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS HSBC Finance Corporation --------------------------------------------------------------------------------CONSOLIDATED STATEMENT OF INCOME THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, --------------- ---------------- 2006 2005 2006 2005--------------------------------------------------------------------------------------- (IN MILLIONS) Finance and other interest income.................. $4,535 $3,402 $12,933 $9,491Interest expense: HSBC affiliates............................... 283 222 609 507 Non-affiliates................................ 1,650 1,017 4,709 2,898 ------ ------ ------- ------NET INTEREST INCOME................................ 2,602 2,163 7,615 6,086Provision for credit losses........................ 1,384 1,361 3,498 3,233 ------ ------ ------- ------NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES........................................... 1,218 802 4,117 2,853 ------ ------ ------- ------Other revenues: Securitization revenue........................... 24 41 146 180 Insurance revenue................................ 280 274 779 809 Investment income................................ 31 33 99 99 Derivative income (expense)...................... 68 (53) 118 283 Fee income....................................... 559 439 1,393 1,099 Enhancement services revenue..................... 129 71 363 201 Taxpayer financial services revenue.............. 4 (1) 258 260 Gain on receivable sales to HSBC affiliates...... 101 99 283 308 Servicing and other fees from HSBC affiliates.... 121 109 355 329 Other income..................................... 48 135 221 250 ------ ------ ------- ------TOTAL OTHER REVENUES............................... 1,365 1,147 4,015 3,818 ------ ------ ------- ------Costs and expenses: Salaries and employee benefits................... 571 513 1,716 1,536 Sales incentives................................. 94 117 272 289 Occupancy and equipment expenses................. 78 83 240 252 Other marketing expenses......................... 197 196 546 561 Other servicing and administrative expenses...... 318 194 847 680 Support services from HSBC affiliates............ 261 226 783 652 Amortization of intangibles...................... 63 90 206 280 Policyholders' benefits.......................... 123 109 348 347 ------ ------ ------- ------TOTAL COSTS AND EXPENSES........................... 1,705 1,528 4,958 4,597 ------ ------ ------- ------Income before income tax expense................... 878 421 3,174 2,074Income tax expense................................. 327 140 1,167 695 ------ ------ ------- ------NET INCOME......................................... $ 551 $ 281 $ 2,007 $1,379 ====== ====== ======= ====== The accompanying notes are an integral part of the consolidated financialstatements. 3 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET SEPTEMBER 30, DECEMBER 31, 2006 2005---------------------------------------------------------------------------------------- (IN MILLIONS, EXCEPT SHARE DATA) ASSETSCash...................................................... $ 383 $ 903Interest bearing deposits with banks...................... 393 384Securities purchased under agreements to resell........... 1 78Securities................................................ 4,899 4,051Receivables, net.......................................... 153,746 136,989Intangible assets, net.................................... 2,274 2,480Goodwill.................................................. 7,038 7,003Properties and equipment, net............................. 422 458Real estate owned......................................... 740 510Derivative financial assets............................... 648 234Other assets.............................................. 3,736 3,579 -------- --------TOTAL ASSETS.............................................. $174,280 $156,669 ======== ======== LIABILITIESDebt: Commercial paper, bank and other borrowings............. $ 11,120 $ 11,454 Due to affiliates....................................... 14,692 15,534 Long term debt (with original maturities over one year)................................................ 122,266 105,163 -------- --------Total debt................................................ 148,078 132,151 -------- --------Insurance policy and claim reserves....................... 1,311 1,291Derivative related liabilities............................ 387 383Other liabilities......................................... 3,751 3,365 -------- -------- TOTAL LIABILITIES....................................... 153,527 137,190SHAREHOLDERS' EQUITYRedeemable preferred stock, 1,501,100 shares authorized, Series B, $0.01 par value, 575,000 shares issued........ 575 575Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized, 55 shares issued................................... - - Additional paid-in capital........................... 17,117 17,145 Retained earnings.................................... 2,644 1,280 Accumulated other comprehensive income............... 417 479 -------- --------TOTAL COMMON SHAREHOLDER'S EQUITY......................... 20,178 18,904 -------- --------TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY................ $174,280 $156,669 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 4 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 2006 2005---------------------------------------------------------------------------------- (in millions) PREFERRED STOCK Balance at beginning of period.............................. $ 575 $ 1,100 Issuance of Series B preferred stock........................ - 575 ------- ------- Balance at end of period.................................... $ 575 $ 1,675 ======= =======COMMON SHAREHOLDER'S EQUITY ADDITIONAL PAID-IN CAPITAL Balance at beginning of period........................... $17,145 $14,627 Issuance costs of Series B preferred stock............... - (16) Employee benefit plans, including transfers and other.... (28) 50 ------- ------- Balance at end of period................................. $17,117 $14,661 ------- ------- RETAINED EARNINGS Balance at beginning of period........................... $ 1,280 $ 571 Net income............................................... 2,007 1,379 Dividends: Preferred stock........................................ (27) (62) Common stock........................................... (616) - ------- ------- Balance at end of period................................. $ 2,644 $ 1,888 ------- ------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period........................... $ 479 $ 643 Net change in unrealized gains (losses), net of tax, on: Derivatives classified as cash flow hedges............. (238) 164 Securities available for sale and interest-only strip receivables......................................... 26 (29) Foreign currency translation adjustments................. 150 (190) ------- ------- Other comprehensive income, net of tax................... (62) (55) ------- ------- Balance at end of period................................. $ 417 $ 588 ------- -------TOTAL COMMON SHAREHOLDER'S EQUITY............................. $20,178 $17,137 ------- -------COMPREHENSIVE INCOME Net income.................................................. $ 2,007 $ 1,379 Other comprehensive income.................................. (62) (55) ------- -------COMPREHENSIVE INCOME.......................................... $ 1,945 $ 1,324 ======= ======= The accompanying notes are an integral part of the consolidated financialstatements. 5 HSBC Finance Corporation -------------------------------------------------------------------------------- STATEMENT OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2006 2005------------------------------------------------------------------------------------ (IN MILLIONS) CASH FLOWS FROM OPERATING ACTIVITIESNet income..................................................... $ 2,007 $ 1,379Adjustments to reconcile net income to net cash provided by (used in) operating activities: Gain on receivable sales to HSBC affiliates.................. (283) (308) Provision for credit losses.................................. 3,498 3,233 Insurance policy and claim reserves.......................... (168) (146) Depreciation and amortization................................ 295 369 Net change in other assets................................... (39) (1,147) Net change in other liabilities.............................. 161 73 Net change in loans held for sale............................ 751 (485) Excess tax benefits from share-based compensation arrangements.............................................. (17) - Other, net................................................... 412 (261) -------- --------Net cash provided by (used in) operating activities............ 6,617 2,707 -------- --------CASH FLOWS FROM INVESTING ACTIVITIESSecurities: Purchased.................................................... (1,587) (656) Matured...................................................... 1,039 480 Sold......................................................... 136 154Net change in short-term securities available for sale......... (323) (335)Net change in securities purchased under agreements to resell.. 77 2,470Net change in interest bearing deposits with banks............. 16 179Receivables: Originations, net of collections............................. (20,537) (24,099) Purchases and related premiums............................... (702) (959) Net change in interest-only strip receivables................ - 217Cash received in sale of U.K. credit card business............. 90 -Properties and equipment: Purchases.................................................... (68) (60) Sales........................................................ 19 2 -------- --------Net cash provided by (used in) investing activities............ (21,840) (22,607) -------- --------CASH FLOWS FROM FINANCING ACTIVITIESDebt: Net change in short-term debt................................ (255) 2,596 Net change in time certificates.............................. - (2) Net change in due to affiliates.............................. (1,113) 4,763 Long term debt issued........................................ 30,655 28,199 Long term debt retired....................................... (13,853) (15,624)Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts.................... (206) (309)Insurance: Policyholders' benefits paid................................. (206) (196) Cash received from policyholders............................. 295 288Issuance of Series B preferred stock........................... - 559Shareholders' dividends........................................ (643) (8)Excess tax benefits from share-based compensation arrangements................................................. 17 - -------- --------Net cash provided by (used in) financing activities............ 14,691 20,266 -------- --------Effect of exchange rate changes on cash........................ 12 (14) -------- --------Net change in cash............................................. (520) 352Cash at beginning of period.................................... 903 392 -------- --------CASH AT END OF PERIOD.......................................... $ 383 $ 744 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 6 HSBC Finance Corporation -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND BASIS OF PRESENTATION-------------------------------------------------------------------------------- HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC NorthAmerica Holdings Inc. ("HNAH"), which is an indirect wholly owned subsidiary ofHSBC Holdings plc ("HSBC"). The accompanying unaudited interim consolidatedfinancial statements of HSBC Finance Corporation and its subsidiaries have beenprepared in accordance with accounting principles generally accepted in theUnited States of America ("U.S. GAAP") for interim financial information andwith the instructions to Form 10-Q and Article 10 of Regulation S-X.Accordingly, they do not include all of the information and footnotes requiredby generally accepted accounting principles for complete financial statements.In the opinion of management, all normal and recurring adjustments considerednecessary for a fair presentation of financial position, results of operationsand cash flows for the interim periods have been made. HSBC Finance Corporationmay also be referred to in this Form 10-Q as "we," "us" or "our." Theseunaudited interim consolidated financial statements should be read inconjunction with our Annual Report on Form 10-K for the year ended December 31,2005 (the "2005 Form 10-K") and our Form 10-Q for the quarterly period endedMarch 31, 2006. Certain reclassifications have been made to prior period amountsto conform to the current period presentation. The preparation of financial statements in conformity with U.S. GAAP requiresthe use of estimates and assumptions that affect reported amounts anddisclosures. Actual results could differ from those estimates. Interim resultsshould not be considered indicative of results in future periods. 2. SALE OF EUROPEAN OPERATIONS-------------------------------------------------------------------------------- In the third quarter of 2006, as part of our continuing evaluation of strategicalternatives with respect to our U.K. and European operations, we agreed to sellall of the capital stock of our operations in the Czech Republic, Hungary, andSlovakia (the "European Operations") to a wholly owned subsidiary of HSBC Bankplc ("HBEU"), a U.K. based subsidiary of HSBC, for an aggregate purchase priceof approximately $46 million. The sale closed in early November 2006. Becausethe sale of this business is between affiliates under common control, thepremium received in excess of the book value of the stock transferred will berecorded as an increase to additional paid-in capital and will not be reflectedin earnings. At September 30, 2006, we have classified the European Operationsas "Held for Sale" and combined assets of $207 million and liabilities of $178million related to the businesses separately in our consolidated balance sheetwithin other assets and other liabilities. Our European Operations are reported in the International Segment. The assetsconsist primarily of receivables which totaled $194 million and goodwill whichtotaled approximately $13 million at September 30, 2006. The liabilities consistprimarily of debt which totaled $171 million at September 30, 2006. HBEU willassume all the liabilities of the European Operations as a result of thistransaction. The following summarizes the operating results of our EuropeanOperations for the periods presented: THREE MONTHS NINE MONTHS ENDED SEPTEMBER ENDED SEPTEMBER 30, 30, ------------------ ------------------ 2006 2005 2006 2005--------------------------------------------------------------------------------------------- (IN MILLIONS) Net interest income and other revenues........... $ 7 $ 6 $23 $17Loss before income tax expense................... (3) (1) (5) (2)Income tax expense............................... 1 - 1 -Net loss......................................... (4) (1) (6) (2) 7 HSBC Finance Corporation -------------------------------------------------------------------------------- 3. SECURITIES-------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRSEPTEMBER 30, 2006 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities...................... $2,468 $14 $(42) $2,440Money market funds............................. 1,255 - - 1,255U.S. government sponsored enterprises(1)....... 56 - (1) 55U.S. government and Federal agency debt securities................................... 341 - (3) 338Non-government mortgage backed securities...... 292 - (1) 291Marketable equity securities................... 22 71 - 93Other.......................................... 395 1 (3) 393 ------ --- ---- ------Subtotal....................................... 4,829 86 (50) 4,865Accrued investment income...................... 34 - - 34 ------ --- ---- ------Total securities available for sale............ $4,863 $86 $(50) $4,899 ====== === ==== ====== GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRDECEMBER 31, 2005 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities...................... $2,337 $23 $(38) $2,322Money market funds............................. 315 - - 315U.S. government sponsored enterprises(1)....... 96 - (2) 94U.S. government and Federal agency debt securities................................... 744 - (4) 740Non-government mortgage backed securities...... 88 - (1) 87Other.......................................... 463 1 (5) 459 ------ --- ---- ------Subtotal....................................... 4,043 24 (50) 4,017Accrued investment income...................... 34 - - 34 ------ --- ---- ------Total securities available for sale............ $4,077 $24 $(50) $4,051 ====== === ==== ====== -------- (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Money market funds at September 30, 2006 include $949 million which isrestricted for the sole purpose of paying down certain secured financings at theestablished payment date. There were no such balances at December 31, 2005. 8 HSBC Finance Corporation -------------------------------------------------------------------------------- A summary of gross unrealized losses and related fair values as of September 30,2006 and December 31, 2005, classified as to the length of time the losses haveexisted follows: LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OFSEPTEMBER 30, 2006 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS---------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities.... 125 $(6) $313 518 $(36) $1,209U.S. government sponsored enterprises................ 10 -(1) 20 20 (1) 31U.S. government and Federal agency debt securities..... 7 -(1) 13 53 (3) 153Non-government mortgage...... 4 -(1) 20 20 (1) 35Other........................ 10 -(1) 61 49 (3) 193 LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OFDECEMBER 31, 2005 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS---------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities.... 272 $(14) $695 381 $(24) $898U.S. government sponsored enterprises................ 11 -(1) 28 25 (2) 64U.S. government and Federal agency debt securities..... 18 (1) 71 40 (3) 117Non-government mortgage...... 3 -(1) 4 16 (1) 22Other........................ 12 (1) 49 49 (4) 148 -------- (1) Less than $500 thousand. The gross unrealized losses on our securities available for sale are flat forthe nine months ended September 30, 2006. The contractual terms of thesesecurities do not permit the issuer to settle the securities at a price lessthan the par value of the investment. Since substantially all of thesesecurities are rated A- or better, and because we have the ability and intent tohold these investments until maturity or a market price recovery, thesesecurities are not considered other-than-temporarily impaired. 9 HSBC Finance Corporation -------------------------------------------------------------------------------- 4. RECEIVABLES-------------------------------------------------------------------------------- Receivables consisted of the following: SEPTEMBER 30, DECEMBER 31, 2006 2005---------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured....................................... $ 95,241 $ 82,826Auto finance.............................................. 12,182 10,704MasterCard(1)/Visa(1)..................................... 25,856 24,110Private label............................................. 2,431 2,520Personal non-credit card.................................. 21,034 19,545Commercial and other...................................... 185 208 -------- --------Total owned receivables................................... 156,929 139,913HSBC acquisition purchase accounting fair value adjustments............................................. (28) 63Accrued finance charges................................... 2,074 1,831Credit loss reserve for owned receivables................. (4,885) (4,521)Unearned credit insurance premiums and claims reserves.... (434) (505)Interest-only strip receivables........................... 4 23Amounts due and deferred from receivable sales............ 86 185 -------- --------Total owned receivables, net.............................. 153,746 136,989Receivables serviced with limited recourse................ 1,274 4,074 -------- --------Total managed receivables, net............................ $155,020 $141,063 ======== ======== -------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of VISA USA, Inc. HSBC acquisition purchase accounting fair value adjustments representadjustments which have been "pushed down" to record our receivables at fairvalue on March 28, 2003, the date we were acquired by HSBC. We have a subsidiary, Decision One Mortgage Company, LLC, which directlyoriginates mortgage loans sourced by mortgage brokers and sells all loans tosecondary market purchasers, including our Mortgage Services business. Loansheld for sale to external parties by this subsidiary totaled $1.0 billion atSeptember 30, 2006 and $1.7 billion at December 31, 2005 and are included inreal estate secured receivables. As part of our acquisition of Metris Companies, Inc. ("Metris") on December 1,2005, we acquired $5.3 billion of receivables. The receivables acquired weresubject to the requirements of Statement of Position 03-3, "Accounting forCertain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3") to theextent there was evidence of deterioration of credit quality since originationand for which it was probable, at acquisition, that all contractually requiredpayments would not be collected and that the associated line of credit had beenclosed. The carrying amount of such receivables was $263 million at September30, 2006 and $414 million at December 31, 2005 and is included in theMasterCard/Visa receivables in the table above. The outstanding contractualbalance of these receivables was $401 million at September 30, 2006 and $804million at December 31, 2005. At September 30, 2006, no credit loss reserve forthe acquired receivables subject to SOP 03-3 has been established as there hasbeen no decrease to the expected future cash flows since the acquisition. Therewas a reclassification to accretable yield from non-accretable difference. Thisreclassification from non-accretable difference represents an increase to theestimated cash flows to be collected on the underlying Metris portfolio. Therewere no other additions or disposals 10 HSBC Finance Corporation -------------------------------------------------------------------------------- to accretable yield during the quarter ended September 30, 2006. The followingsummarizes the accretable yield on these receivables at September 30, 2006: (IN MILLIONS)----------------------------------------------------------------------------------- Accretable yield at December 31, 2005............................... $(122)Accretable yield amortized to interest income during the period..... 86Reclassification from non-accretable difference..................... (35) -----Accretable yield at September 30, 2006.............................. $ (71) ===== Interest-only strip receivables are reported net of our estimate of probablelosses under the recourse provisions for receivables serviced with limitedrecourse. Receivables serviced with limited recourse consisted of the following: SEPTEMBER 30, DECEMBER 31, 2006 2005---------------------------------------------------------------------------------------- (IN MILLIONS) Auto finance.............................................. $ 479 $1,192MasterCard/Visa........................................... 500 1,875Personal non-credit card.................................. 295 1,007 ------ ------Total..................................................... $1,274 $4,074 ====== ====== The combination of receivables owned and receivables serviced with limitedrecourse, which comprises our managed portfolio, is shown below: SEPTEMBER 30, DECEMBER 31, 2006 2005---------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured....................................... $ 95,241 $ 82,826Auto finance.............................................. 12,661 11,896MasterCard/Visa........................................... 26,356 25,985Private label............................................. 2,431 2,520Personal non-credit card.................................. 21,329 20,552Commercial and other...................................... 185 208 -------- --------Total..................................................... $158,203 $143,987 ======== ======== 11 HSBC Finance Corporation -------------------------------------------------------------------------------- 5. CREDIT LOSS RESERVES-------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: THREE MONTHS NINE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, ------------------- ------------------- 2006 2005 2006 2005 ----------------------------------------- (IN MILLIONS) Owned receivables: Credit loss reserves at beginning of period.. $ 4,649 $ 3,756 $ 4,521 $ 3,625 Provision for credit losses.................. 1,384 1,361 3,498 3,233 Charge-offs.................................. (1,333) (1,020) (3,620) (2,934) Recoveries................................... 195 118 474 325 Other, net................................... (10) 5 12 (29) -------- -------- -------- -------- Credit loss reserves for owned receivables... 4,885 4,220 4,885 4,220 -------- -------- -------- --------Receivables serviced with limited recourse: Credit loss reserves at beginning of period.. 91 525 215 890 Provision for credit losses.................. - (23) (21) 59 Charge-offs.................................. (36) (165) (156) (637) Recoveries................................... 6 15 23 48 Other, net................................... - (1) - (9) -------- -------- -------- -------- Credit loss reserves for receivables serviced with limited recourse..................... 61 351 61 351 -------- -------- -------- --------Credit loss reserves for managed receivables... $ 4,946 $ 4,571 $ 4,946 $ 4,571 ======== ======== ======== ======== Further analysis of credit quality and credit loss reserves and our credit lossreserve methodology are presented in Item 2, "Management's Discussion andAnalysis of Financial Condition and Results of Operations" of this Form 10-Qunder the caption "Credit Quality." 6. INTANGIBLE ASSETS-------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYING GROSS AMORTIZATION VALUE---------------------------------------------------------------------------------------- (IN MILLIONS) SEPTEMBER 30, 2006Purchased credit card relationships and related programs............................................ $1,736 $ 545 $1,191Retail services merchant relationships................ 270 190 80Other loan related relationships...................... 326 127 199Trade names........................................... 717 13 704Technology, customer lists and other contracts........ 282 182 100 ------ ------ ------Total................................................. $3,331 $1,057 $2,274 ====== ====== ======DECEMBER 31, 2005Purchased credit card relationships and related programs............................................ $1,736 $ 442 $1,294Retail services merchant relationships................ 270 149 121Other loan related relationships...................... 326 104 222Trade names........................................... 717 13 704Technology, customer lists and other contracts........ 282 143 139 ------ ------ ------Total................................................. $3,331 $ 851 $2,480 ====== ====== ====== 12 HSBC Finance Corporation -------------------------------------------------------------------------------- Estimated amortization expense associated with our intangible assets for each ofthe following years is as follows: YEAR ENDING DECEMBER 31,----------------------------------------------------------------------------------- (IN MILLIONS) 2006................................................................ $2692007................................................................ 2522008................................................................ 2102009................................................................ 1972010................................................................ 168Thereafter.......................................................... 520 During the third quarter of 2006, we completed our annual impairment test ofintangible assets. As a result of our testing, we determined that the fair valueof each intangible asset exceeded its carrying value. Therefore, we haveconcluded that none of our intangible assets are impaired. 7. GOODWILL-------------------------------------------------------------------------------- Goodwill balances associated with our foreign businesses will change from periodto period due to movements in foreign exchange. Changes in estimates of the taxbasis in our assets and liabilities or other tax estimates recorded pursuant toStatement of Financial Accounting Standards Number 109, "Accounting for IncomeTaxes," may also result in changes to our goodwill balances. During the thirdquarter of 2006, we reduced our goodwill balance by approximately $.4 million asa result of such changes in tax estimates. In addition, goodwill ofapproximately $13 million associated with our European Operations wastransferred to assets held for sale. Also during the third quarter of 2006, we made an adjustment to our estimatedfair value related to Metris following an adverse judgment in litigationinvolving Metris that preceded the merger. This adjustment resulted in a netincrease to goodwill of approximately $25 million. During the third quarter of 2006, we completed our annual impairment test ofgoodwill. For purposes of this test, we assigned the goodwill to our reportingunits (as defined in SFAS No. 142, "Goodwill and Other Intangible Assets"). Thefair value of each of the reporting units to which goodwill was assignedexceeded its carrying value including goodwill. Therefore, we have concludedthat none of our goodwill is impaired. 8. INCOME TAXES-------------------------------------------------------------------------------- Our effective tax rates were as follows: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER SEPTEMBER 30, 30, ----------- ----------- 2006 2005 2006 2005 Effective tax rate....................................... 37.2% 33.3% 36.8% 33.5% The increase in the effective tax rate for both periods is due to higher stateincome taxes and lower tax credits as a percentage of income before taxes. Theincrease in state income taxes is primarily due to an increase in the blendedstatutory tax rate of our operating companies. The effective tax rate differsfrom the statutory federal income tax rate primarily because of the effects ofstate and local income taxes and tax credits. 9. RELATED PARTY TRANSACTIONS-------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and itssubsidiaries. These transactions occur at prevailing market rates and terms andinclude funding arrangements, derivative execution, purchases and sales ofreceivables, servicing arrangements, information technology services, item andstatement processing services, 13 HSBC Finance Corporation -------------------------------------------------------------------------------- banking and other miscellaneous services. The following tables present relatedparty balances and the income and (expense) generated by related partytransactions: SEPTEMBER 30, DECEMBER 31, 2006 2005---------------------------------------------------------------------------------------- (IN MILLIONS) ASSETS, (LIABILITIES) AND EQUITY:Derivative financial assets (liability), net.............. $ 369 $ (260)Affiliate preferred stock received in sale of U.K. credit card business........................................... 261 261Other assets.............................................. 550 518Due to affiliates......................................... (14,692) (15,534)Other liabilities......................................... (409) (271) THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, ------------- ------------- 2006 2005 2006 2005------------------------------------------------------------------------------------- (IN MILLIONS) INCOME/(EXPENSE):Interest expense on borrowings from HSBC and subsidiaries........................................ $(283) $(222) $(609) $(507)Interest income on advances to HSBC affiliates........ 7 15 18 26HSBC Bank USA, National Association ("HBUS"): Gain on daily sale of domestic private label receivable originations.......................... 92 91 257 283 Gain on sale of MasterCard/Visa receivables......... 9 8 26 25 Domestic private label receivable servicing and related fees..................................... 99 92 292 273 Real estate secured servicing, sourcing, underwriting and pricing revenues................ 3 5 9 15 Other servicing, processing, origination and support revenues......................................... 14 7 37 21 Taxpayer financial services loan origination and other fees....................................... - - (17) (15)Support services from HSBC affiliates, primarily HSBC Technology and Services (USA) Inc. ("HTSU")......... (261) (226) (783) (652)HTSU: Rental revenue...................................... 11 13 34 31 Administrative services revenue..................... 2 2 8 11Servicing and other fees from other HSBC affiliates... 3 3 9 9Stock based compensation expense with HSBC............ (20) (14) (59) (50) The notional value of derivative contracts outstanding with HSBC subsidiariestotaled $94.0 billion at September 30, 2006 and $72.2 billion at December 31,2005. Beginning in the second quarter of 2006, when the fair value of ouragreements with affiliate counterparties requires the posting of collateral bythe affiliate, it is provided in the form of cash and recorded on our balancesheet, consistent with third party arrangements. Previously, the posting ofcollateral by affiliates was provided in the form of securities, which were notrecorded on our balance sheet. At September 30, 2006, the fair value of ouragreements with affiliate counterparties required the affiliate to provide cashcollateral of $129 million which is recorded in our balance sheet as a componentof derivative related liabilities, while at December 31, 2005, the fair value ofour agreements with affiliate counterparties was below the level requiring theposting of collateral. We extended a line of credit of $2 billion to HSBC USA Inc which expired in Julyof 2006 and was not renewed. No balances were outstanding under this line atDecember 31, 2005. Annual commitment fees associated with this line of creditare recorded in interest income and reflected as Interest income on advances toHSBC affiliates in the table above. 14 HSBC Finance Corporation -------------------------------------------------------------------------------- We extended a revolving line of credit of $.5 billion to HTSU on June 28, 2005.The balance outstanding under this line of credit was $.5 billion at September30, 2006 and $.4 billion at December 31, 2005 and is included in other assets.Interest income associated with this line of credit is recorded in interestincome and reflected as Interest income on advances to HSBC affiliates in thetable above. We extended a promissory note of $.5 billion to HSBC Securities (USA) Inc.("HSI") on June 27, 2005. This promissory note was repaid during July 2005. Wealso extended a promissory note of $.5 billion to HSI on September 29, 2005.This promissory note was repaid during October 2005. We extended an additionalpromissory note of $150 million to HSI on December 28, 2005. This note wasrepaid during January 2006. At each reporting date these promissory notes wereincluded in other assets. Interest income associated with this line of credit isrecorded in interest income and reflected as Interest income on advances to HSBCaffiliates in the table above. On March 31, 2005, we extended a line of credit of $.4 billion to HSBCInvestments (North America) Inc. ("HINO") which was repaid during the secondquarter of 2005. Interest income associated with this line of credit is recordedin interest income and reflected as Interest income on advances to HSBCaffiliates in the table above. Due to affiliates includes amounts owed to subsidiaries of HSBC (other thanpreferred stock). At September 30, 2006 and December 31, 2005, we had a commercial paper back stopcredit facility of $2.5 billion from HSBC supporting domestic issuances and arevolving credit facility of $5.3 billion from HBEU to fund our operations inthe U.K. As of September 30, 2006, $4.1 billion was outstanding under the U.K.lines and no balances were outstanding on the domestic lines. As of December 31,2005, $4.2 billion was outstanding under the U.K. lines and no balances wereoutstanding on the domestic lines. Annual commitment fee requirements to supportavailability of these lines are included as a component of Interest expense onborrowings from HSBC and subsidiaries. In December 2005, we sold our U.K. credit card business, including $2.5 billionof receivables ($3.1 billion on a managed basis), the associated cardholderrelationships and the related retained interests in securitized credit cardreceivables to HBEU, a U.K. based subsidiary of HSBC, for an aggregate purchaseprice of $3.0 billion. The purchase price, which was determined based on acomparative analysis of sales of other credit card portfolios, was paid in acombination of cash and $261 million of preferred stock issued by a subsidiaryof HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In additionto the assets referred to above, the sale also included the account originationplatform, including the marketing and credit employees associated with thisfunction, as well as the lease associated with the credit card call center andrelated leaseholds and call center employees to provide customer continuityafter the transfer as well as to allow HBEU direct ownership and control oforigination and customer service. We have retained the collection operationsrelated to the credit card operations and have entered into a service levelagreement for a period of not less than two years to provide collection servicesand other support services, including components of the compliance, financialreporting and human resource functions, for the sold credit card operations, toHBEU for a fee. We received $6 million during the three months ended September30, 2006 and $17 million during the nine months ended September 30, 2006 underthis service level agreement. Additionally, the management teams of HBEU and ourremaining U.K. operations are jointly involved in decision making involving cardmarketing to ensure that growth objectives are met for both businesses. Becausethe sale of this business is between affiliates under common control, thepremium of $182 million received in excess of the book value of the assetstransferred including the goodwill assigned to this business, was recorded as anincrease to additional paid in capital and was not included in earnings. In December 2004, we sold our domestic private label receivable portfolio(excluding retail sales contracts at our consumer lending business), includingthe retained interests associated with our securitized domestic private labelreceivables to HBUS. We continue to service the sold private label receivablesand receive servicing and related fee income from HBUS. As of September 30,2006, we were servicing $16.9 billion of domestic private label receivables forHBUS. We received servicing and related fee income from HBUS of $99 millionduring the three month period ended September 30, 2006 and $292 million duringthe nine month period ended September 30, 2006. We received servicing andrelated fee income from HBUS of $92 million during the three month period endedSeptember 30, 2005 and $273 million during the nine month period ended September30, 2005. Servicing and 15 HSBC Finance Corporation -------------------------------------------------------------------------------- related fee income is reflected as Domestic private label receivable servicingand related fees in the table above. We continue to maintain the relatedcustomer account relationships and, therefore, sell new domestic private labelreceivable originations (excluding retail sales contracts) to HBUS on a dailybasis. We sold $15,168 million of private label receivables to HBUS during thenine months ended September 30, 2006 and $14,825 million during the nine monthsended September 30, 2005. The gains associated with the sale of thesereceivables are reflected in the table above and are recorded in Gain on dailysale of domestic private label receivable originations. In 2003 and 2004, we sold approximately $3.7 billion of real estate securedreceivables from our mortgage services business to HBUS. Under a separateservicing agreement, we have agreed to service all real estate securedreceivables sold to HBUS including all business it purchased from ourcorrespondents. As of September 30, 2006, we were servicing $3.5 billion of realestate secured receivables for HBUS. During the nine months ended September 30,2005, we also received fees from HBUS pursuant to a service level agreementunder which we sourced, underwrote and priced $1.5 billion of real estatesecured receivables purchased by HBUS. Purchases of real estate securedreceivables from our correspondents by HBUS were discontinued effectiveSeptember 1, 2005. The fee revenue associated with these receivables isreflected as Real estate secured servicing, sourcing, underwriting and pricingrevenues in the above table. We continue to service the receivables HBUSpreviously purchased from our correspondents. Under various service level agreements, we also provide various services to HSBCaffiliates. These services include credit card servicing and processingactivities through our credit card services business, loan origination andservicing through our auto finance business and other operational andadministrative support. Fees received for these services are reflected as Otherservicing, processing, origination and support revenues in the table above. During 2003, Household Capital Trust VIII issued $275 million in mandatorilyredeemable preferred securities to HSBC. Interest expense recorded on theunderlying junior subordinated notes is included in Interest expense onborrowings from HSBC and subsidiaries in the table above. During the third quarter of 2004, our Canadian business began to originate andservice auto loans for an HSBC affiliate in Canada. Fees received for theseservices of $3 million for the three months ended September 30, 2006 and $9million for the nine months ended September 30, 2006 are included in otherincome and are reflected in the above table as Servicing and other fees fromother HSBC affiliates. Effective October 1, 2004, HBUS became the originating lender for loansinitiated by our taxpayer financial services business for clients of variousthird party tax preparers. We purchase the loans originated by HBUS daily for afee. We purchased loans of $16.1 billion in the nine month period endedSeptember 30, 2006 and $15.1 billion in the nine month period ended September30, 2005. Additionally, HBUS provides services to assist with the processing ofother products offered by our taxpayer financial services business. Originationand other fees paid to HBUS totaled $17 million during the nine months endedSeptember 30, 2006, and $15 million during the nine months ended September 30,2005. These fees are included as an offset to Taxpayer financial servicesrevenue and are reflected as Taxpayer financial services loan origination andother fees in the above table. On July 1, 2004, HSBC Bank Nevada, National Association ("HBNV"), formerly knownas Household Bank (SB), N.A., purchased the account relationships associatedwith $970 million of MasterCard/Visa credit card receivables from HBUS forapproximately $99 million, which are included in intangible assets. Thereceivables continue to be owned by HBUS. We service these receivables for HBUSand receive servicing and related fee income from HBUS. As of September 30,2006, we were servicing $1.2 billion of MasterCard/Visa receivables for HBUS.Originations of new accounts and receivables are made by HBNV and newreceivables are sold daily to HBUS. We sold $1,681 million of credit cardreceivables to HBUS during the nine months ended September 30, 2006 and $1,461million of credit card receivables to HBUS during the nine months endedSeptember 30, 2005. The gains associated with the sale of these receivables arereflected in the table above as Gain on sale of MasterCard/Visa receivables. Effective January 1, 2004, our technology services employees, as well astechnology services employees from other HSBC entities in North America, weretransferred to HTSU. In addition, technology related assets and softwarepurchased subsequent to January 1, 2004 are generally purchased and owned byHTSU. Technology related assets 16 HSBC Finance Corporation -------------------------------------------------------------------------------- owned by HSBC Finance Corporation prior to January 1, 2004 currently remain inplace and were not transferred to HTSU. In addition to information technologyservices, HTSU also provides certain item processing and statement processingactivities to us pursuant to a master service level agreement. Support servicesfrom HSBC affiliates includes services provided by HTSU as well as bankingservices and other miscellaneous services provided by HBUS and othersubsidiaries of HSBC. We also receive revenue from HTSU for rent on certainoffice space, which has been recorded as a reduction of occupancy and equipmentexpenses, and for certain administrative costs, which has been recorded as otherincome. In December 2005, we transferred our information technology services employeesin the U.K. to a subsidiary of HBEU. Subsequent to the transfer, operatingexpenses relating to information technology, which have previously been reportedas salaries and fringe benefits or other servicing and administrative expenses,are now billed to us by HBEU. We paid $28 million during the nine months endedSeptember 30, 2006 to HBEU for these services. Additionally, during the firstquarter of 2006, the information technology equipment in the U.K. was sold toHBEU for a purchase price equal to the book value of these assets of $8 million. In addition, we utilize HSBC Markets (USA) Inc., a related HSBC entity, to leadmanage the underwriting of a majority of our ongoing debt issuances. Fees paidfor such services totaled approximately $12 million for the three months endedSeptember 30, 2006 and approximately $34 million for the nine months endedSeptember 30, 2006. Fees paid for such services totaled approximately $19million for the three months ended September 30, 2005 and approximately $45million for the nine months ended September 30, 2005. These fees are amortizedover the life of the related debt. Domestic employees of HSBC Finance Corporation participate in a defined benefitpension plan sponsored by HNAH. See Note 10, "Pension and Other PostretirementBenefits," for additional information on this pension plan. Employees of HSBC Finance Corporation participate in one or more stockcompensation plans sponsored by HSBC. Our share of the expense of these planswas $20 million for the three months ended September 30, 2006 and $59 millionfor the nine months ended September 30, 2006. Our share of the expense of theseplans was $14 million for the three months ended September 30, 2005 and $50million for the nine months ended September 30, 2005. These expenses arereflected in the above table as Stock based compensation expense with HSBC. Asof September 30, 2006, our share of the total compensation cost related to non-vested stock based compensation awards was approximately $165 million and willbe recognized into compensation expense over a weighted-average period of 2.38years. A more complete description of these plans is included in the 2005 Form10-K. 10. PENSION AND OTHER POSTRETIREMENT BENEFITS-------------------------------------------------------------------------------- Effective January 1, 2005, the two previously separate domestic defined benefitpension plans of HSBC Finance Corporation and HBUS were combined into a singleHNAH defined benefit pension plan which facilitated the development of a unifiedemployee benefit policy and unified employee benefit plan for HSBC companiesoperating in the United States. 17 HSBC Finance Corporation -------------------------------------------------------------------------------- The components of pension expense for the domestic defined benefit pension planreflected in our consolidated statement of income are shown in the table belowand reflect the portion of the pension expense of the combined HNAH pension planwhich has been allocated to HSBC Finance Corporation: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER SEPTEMBER 30, 30, ----------- ----------- 2006 2005 2006 2005------------------------------------------------------------------------------------ (IN MILLIONS) Service cost - benefits earned during the period......... $ 13 $ 4 $ 39 $ 35Interest cost............................................ 15 9 45 40Expected return on assets................................ (18) (12) (58) (58)Recognized losses........................................ 3 2 9 3 ---- ---- ---- ----Net periodic benefit cost................................ $ 13 $ 3 $ 35 $ 20 ==== ==== ==== ==== We sponsor various additional defined benefit pension plans for our foreignbased employees. Pension expense for our foreign defined benefit pension planswas $.7 million for the three months ended September 30, 2006 and $2.0 millionfor the nine months ended September 30, 2006. Pension expense for our foreigndefined benefit pension plans was $.5 million for the three months endedSeptember 30, 2005 and $1.5 million for the nine months ended September 30,2005. Components of the net periodic benefit cost for our postretirement benefitsother than pensions are as follows: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, ------------- ------------- 2006 2005 2006 2005--------------------------------------------------------------------------------------- (IN MILLIONS) Service cost - benefits earned during the period........ $ 1 $ 1 $ 3 $ 4Interest cost........................................... 4 4 12 12Expected return on assets............................... - - - -Recognized (gains) losses............................... - - - - ----- ----- ----- -----Net periodic benefit cost............................... $ 5 $ 5 $ 15 $ 16 ===== ===== ===== ===== 11. BUSINESS SEGMENTS-------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services andInternational. Our Consumer segment consists of our consumer lending, mortgageservices, retail services and auto finance businesses. Our Credit Card Servicessegment consists of our domestic MasterCard and Visa credit card business. OurInternational segment consists of our foreign operations in the United Kingdom,Canada, Ireland and the remainder of Europe. The All Other caption includes ourinsurance and taxpayer financial services and commercial businesses, each ofwhich falls below the quantitative threshold test under SFAS No. 131 fordetermining reportable segments, as well as our corporate and treasuryactivities. There have been no changes in the basis of our segmentation or anychanges in the measurement of segment profit as compared with the presentationin our 2005 Form 10-K. We have historically monitored our operations and evaluated trends on a managedbasis (a non-GAAP financial measure), which assumes that securitized receivableshave not been sold and are still on our balance sheet. This is because thereceivables that we securitize are subjected to underwriting standardscomparable to our owned portfolio, are generally serviced by operating personnelwithout regard to ownership and result in a similar credit loss exposure for us.In addition, we fund our operations, and make decisions about allocating certainresources such as capital on a managed basis. When reporting on a managed basis,net interest income, provision for credit losses and fee income related toreceivables securitized are reclassified from securitization related revenue inour owned statement of income into the appropriate caption. 18 HSBC Finance Corporation -------------------------------------------------------------------------------- Fair value adjustments related to purchase accounting resulting from ouracquisition by HSBC and related amortization have been allocated to Corporate,which is included in the "All Other" caption within our segment disclosure.Reconciliations of our managed basis segment results to managed basis and ownedbasis consolidated totals are as follows: MANAGED CREDIT ADJUSTMENTS/ BASIS CARD RECONCILING CONSOLIDATED SECURITIZATION CONSUMER SERVICES INTERNATIONAL ALL OTHER ITEMS TOTALS ADJUSTMENTS------------------------------------------------------------------------------------------------------------------------ (IN MILLIONS) THREE MONTHS ENDED SEPTEMBER 30, 2006:Net interest income.... $ 1,872 $ 788 $ 184 $ (205) $ - $ 2,639 $ (37)(3)Securitization related revenue.............. (29) 1 - (1) - (29) 53(3)Fee and other income... 336 668 191 236 (74)(1) 1,357 (16)(3)Intersegment revenues.. 60 6 9 (1) (74)(1) - -Provision for credit losses............... 861 385 137 - 1(5) 1,384 -(3)Total costs and expenses............. 744 447 243 271 - 1,705 -Net income............. 376 404 (15) (166) (48) 551 -Receivables............ 122,288 26,434 9,300 181 - 158,203 (1,274)(4)Assets................. 123,009 26,731 10,231 24,054 (8,471)(2) 175,554 (1,274)(4) -------- ------- ------- ------- ------- -------- -------THREE MONTHS ENDED SEPTEMBER 30, 2005:Net interest income.... $ 1,733 $ 531 $ 228 $ (152) $ - $ 2,340 $ (177)(3)Securitization related revenue.............. (171) (42) 2 (6) - (217) 258(3)Fee and other income... 307 554 186 152 (35)(1) 1,164 (58)(3)Intersegment revenues.. 27 5 4 (1) (35)(1) - -Provision for credit losses............... 735 465 137 - 1(5) 1,338 23(3)Total costs and expenses............. 647 360 261 260 - 1,528 -Net income............. 308 138 12 (154) (23) 281 -Receivables............ 102,733 19,971 12,564 213 - 135,481 (6,759)(4)Assets................. 103,424 19,710 13,574 25,180 (8,555)(2) 153,333 (6,759)(4) -------- ------- ------- ------- ------- -------- ------- OWNED BASIS CONSOLIDATED TOTALS-------------------------------------- (IN MILLIONS) THREE MONTHS ENDED SEPTEMBER 30, 2006:Net interest income.... $ 2,602Securitization related revenue.............. 24Fee and other income... 1,341Intersegment revenues.. -Provision for credit losses............... 1,384Total costs and expenses............. 1,705Net income............. 551Receivables............ 156,929Assets................. 174,280 --------THREE MONTHS ENDED SEPTEMBER 30, 2005:Net interest income.... $ 2,163Securitization related revenue.............. 41Fee and other income... 1,106Intersegment revenues.. -Provision for credit losses............... 1,361Total costs and expenses............. 1,528Net income............. 281Receivables............ 128,722Assets................. 146,574 -------- 19 HSBC Finance Corporation -------------------------------------------------------------------------------- MANAGED CREDIT ADJUSTMENTS/ BASIS CARD RECONCILING CONSOLIDATED SECURITIZATION CONSUMER SERVICES INTERNATIONAL ALL OTHER ITEMS TOTALS ADJUSTMENTS------------------------------------------------------------------------------------------------------------------------- (IN MILLIONS) NINE MONTHS ENDED SEPTEMBER 30, 2006:Net interest income..... $5,545 $2,321 $544 $ (588) $ - $7,822 $(207)(3)Securitization related revenue............... (133) (18) - (3) - (154) 300(3)Fee and other income.... 966 1,755 519 919 (218)(1) 3,941 (72)(3)Intersegment revenues... 180 16 25 (3) (218)(1) - -Provision for credit losses................ 1,960 1,148 367 (2) 4(5) 3,477 21(3)Total costs and expenses.............. 2,170 1,308 673 807 - 4,958 -Net income.............. 1,428 1,019 (1) (298) (141) 2,007 - ------ ------ ---- ------ ----- ------ -----NINE MONTHS ENDED SEPTEMBER 30, 2005:Net interest income..... $5,125 $1,545 $680 $ (506) $ - $6,844 $(758)(3)Securitization related revenue............... (557) (161) 17 (41) - (742) 922(3)Fee and other income.... 884 1,465 542 1,073 (103)(1) 3,861 (223)(3)Intersegment revenues... 80 16 11 (4) (103)(1) - -Provision for credit losses................ 1,698 1,120 468 - 6(5) 3,292 (59)(3)Total costs and expenses.............. 1,893 1,018 779 907 - 4,597 -Net income.............. 1,182 452 (11) (173) (71) 1,379 - ------ ------ ---- ------ ----- ------ ----- OWNED BASIS CONSOLIDATED TOTALS--------------------------------------- NINE MONTHS ENDED SEPTEMBER 30, 2006:Net interest income..... $7,615Securitization related revenue............... 146Fee and other income.... 3,869Intersegment revenues... -Provision for credit losses................ 3,498Total costs and expenses.............. 4,958Net income.............. 2,007 ------NINE MONTHS ENDED SEPTEMBER 30, 2005:Net interest income..... $6,086Securitization related revenue............... 180Fee and other income.... 3,638Intersegment revenues... -Provision for credit losses................ 3,233Total costs and expenses.............. 4,597Net income.............. 1,379 ------ -------- (1) Eliminates intersegment revenues. (2) Eliminates investments in subsidiaries and intercompany borrowings. (3) Reclassifies net interest income, fee income and provision for credit losses relating to securitized receivables to other revenues. (4) Represents receivables serviced with limited recourse. (5) Eliminates bad debt recovery sales between operating segments. 12. NEW ACCOUNTING PRONOUNCEMENTS-------------------------------------------------------------------------------- Effective January 1, 2006, we adopted FASB Statement No. 123 (Revised), "Share-Based Payment," ("SFAS No. 123R"). Because we had previously adopted the fairvalue method of accounting for all equity based awards, the adoption of SFAS No.123R did not have a significant impact on our operations or cash flow.Substantially all of the disclosure requirements of SFAS No. 123R were includedin our 2005 Form 10-K. In addition to changes in the Statement of Cash Flows asrequired by SFAS No. 123R, other disclosure requirements which were not includedin our 2005 Form 10-K are included in Note 9, "Related Party Transactions." Effective January 1, 2006, we adopted FASB Statement No. 154, "AccountingChanges and Error Corrections: a replacement of APB Opinion No. 20 and FASBStatement No. 3" ("SFAS No. 154"). The adoption of SFAS No 154 did not have anyimpact on our financial position or results of operations. Effective January 1, 2006, we adopted FASB Staff Position Nos. FAS 115-1 and FAS124-1 ("FSP 115-1 and FSP 124-1"), "The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments," in response to EmergingIssues Task Force 03-1, "The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments." The adoption of the impairment guidancecontained in FSP 115-1 and FSP 124-1 did not have a material impact on ourfinancial position or results of operations. In February 2006, the FASB issued FASB Statement No. 155, "Accounting forCertain Hybrid Financial Instruments" ("SFAS No. 155"). SFAS No. 155 permitscompanies to elect to measure at fair value entire financial instrumentscontaining embedded derivatives that would otherwise have to be bifurcated andaccounted for separately. SFAS No. 155 also requires companies to identifyinterests in securitized financial assets that are free 20 HSBC Finance Corporation -------------------------------------------------------------------------------- standing derivatives or contain embedded derivatives that would have to beaccounted for separately, clarifies which interest- and principal-only stripsare subject to SFAS No. 133, and amends SFAS No 140 to revise the conditions ofa qualifying special purpose entity. SFAS No. 155 is effective for all financialinstruments acquired or issued after the beginning of a company's first fiscalyear that begins after September 15, 2006. Early adoption is permitted as of thebeginning of a company's fiscal year, provided the company has not yet issuedfinancial statements for that fiscal year. We elected to early adopt SFAS No.155 effective January 1, 2006. The adoption of SFAS No. 155 did not have asignificant impact on our financial position or results of operations. In March 2006, the FASB issued FASB Statement No. 156, "Accounting for Servicingof Financial Assets," ("SFAS No. 156"). SFAS No. 156, which is an amendment toSFAS No. 140, addresses the recognition and measurement of separately recognizedservicing assets and liabilities and provides an approach to simplify theefforts to obtain hedge-like (offset) accounting. SFAS No. 156 is effective forfinancial years beginning after September 15, 2006, with early adoptionpermitted. As we do not currently have servicing assets recorded on our balancesheet, SFAS No. 156 will not have any impact on our financial position orresults of operations. In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting forUncertainty in Income Taxes - an Interpretation of FASB Statement No. 109" ("FINNo. 48"). FIN No. 48 establishes threshold and measurement attributes forfinancial statement measurement and recognition of tax positions taken orexpected to be taken in a tax return. FIN No. 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. FIN No. 48 is effective for fiscal yearsbeginning after December 15, 2006. We are currently evaluating the impact thatadoption of FIN No. 48 will have on our financial position and results ofoperations. In September 2006, the FASB issued FASB Statement No. 157, "Fair ValueMeasurements," ("SFAS No. 157"). SFAS No. 157 establishes a single authoritativedefinition of value, sets out a framework for measuring fair value, and requiresadditional disclosures about fair-value measurements. SFAS No. 157 is effectivefor fiscal years beginning after November 15, 2007, and interim periods withinthose years. Early application is permissible only if no annual or interimfinancial statements have been issued for the earlier periods. We are currentlyevaluating the impact that adoption of SFAS No. 157 will have on our financialposition and results of operations. In September 2006, the FASB issued FASB Statement No. 158, "Employer'sAccounting for Defined Benefit Pension and Other Postretirement Plans," ("SFASNo. 158"). SFAS No. 158 requires balance sheet recognition of the funded statusof pension and other postretirement benefits with the offset to accumulatedother comprehensive income. Employers will recognize actuarial gains and losses,prior service cost, and any remaining transition amounts when recognizing aplan's funded status. SFAS No. 158 is effective for fiscal years ending afterDecember 15, 2006. Adoption is not expected to have a material impact on ourfinancial position. In September 2006, the U.S. Securities and Exchange Commission issued StaffAccounting Bulletin No. 108, "Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements" ("SAB 108"). SAB 108 addresses how the effects of prior yearuncorrected misstatements should be considered when quantifying misstatements incurrent year financial statements. SAB 108 requires companies to quantifymisstatements using both the balance sheet and income statement approaches andto evaluate whether either approach results in quantifying an error that ismaterial in light of relevant quantitative and qualitative factors. SAB 108 iseffective for fiscal years ending after November 15, 2006. Adoption of SAB 108is not expected to have an impact on our financial position or results ofoperations. 13. SUBSEQUENT EVENT-------------------------------------------------------------------------------- In October 2006, we entered into an agreement to sell our entire interest inKanbay International, Inc ("Kanbay"), a software development company operatingin India, to Capgemini S.A. in an all cash transaction for an aggregate purchaseprice of $145 million. This transaction is subject to regulatory approval and isexpected to close in the fourth quarter of 2006, and will result in a pre-taxgain on sale of approximately $123 million. 21 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-------------------------------------------------------------------------------- FORWARD-LOOKING STATEMENTS-------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results ofOperations ("MD&A") should be read in conjunction with the consolidatedfinancial statements, notes and tables included elsewhere in this report, withour Annual Report on Form 10-K for the year ended December 31, 2005 (the "2005Form 10-K") and Form 10-Q for the quarterly period ended March 31, 2006. MD&Amay contain certain statements that may be forward-looking in nature within themeaning of the Private Securities Litigation Reform Act of 1995. In addition, wemay make or approve certain statements in future filings with the SEC, in pressreleases, or oral or written presentations by representatives of HSBC FinanceCorporation that are not statements of historical fact and may also constituteforward-looking statements. Words such as "may", "will", "should", "would","could", "appears", "intends", "believe", "expects", "estimates", "targeted","plans", "anticipates", "goal" and similar expressions are intended to identifyforward-looking statements but should not be considered as the only meansthrough which these statements may be made. These matters or statements willrelate to our future financial condition, results of operations, plans,objectives, performance or business developments and will involve known andunknown risks, uncertainties and other factors that may cause our actualresults, performance or achievements to be materially different from that whichwas expressed or implied by such forward-looking statements. Forward-lookingstatements are based on our current views and assumptions and speak only as ofthe date they are made. HSBC Finance Corporation undertakes no obligation toupdate any forward-looking statement to reflect subsequent circumstances orevents. Unless noted, the discussion of our financial condition and results ofoperations included in MD&A are presented on an owned basis of reporting. EXECUTIVE OVERVIEW-------------------------------------------------------------------------------- HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC Holdingsplc ("HSBC"). HSBC Finance Corporation may also be referred to in MD&A as "we","us", or "our". In addition to owned basis reporting, we also monitor ouroperations and evaluate trends on a managed basis (a non-GAAP financialmeasure), which assumes that securitized receivables have not been sold and arestill on our balance sheet. See "Basis of Reporting" for further discussion ofthe reasons we use this non-GAAP financial measure. Net income was $551 million for the quarter ended September 30, 2006, anincrease of 96 percent, compared to $281 million in the prior year quarter. Netincome was $2,007 million for the first nine months of 2006, an increase of 46percent, compared to $1,379 million in the first nine months of 2005. Net incomeincreased in both periods due to higher net interest income and higher otherrevenues partially offset by higher provisions for credit losses and highercosts and expenses. Net income in 2005 was negatively impacted by incrementalcredit loss provisions in the third quarter of $180 million relating toHurricane Katrina ("Katrina") and $100 million relating to higher thananticipated bankruptcy filings in the period leading up to the October 17, 2005effective date of new bankruptcy legislation in the United States. The increasein net interest income was due to growth in average receivables and animprovement in the overall yield on the portfolio, partially offset by a higherinterest expense. Overall yields increased due to increases in our rates onvariable rate products which were in line with market movements and variousother repricing initiatives, such as reduced levels of promotional rate balancesin 2006. Changes in receivable mix also contributed to the increase in yield dueto the impact of increased levels of higher yielding MasterCard/Visa receivablesdue to lower securitization levels and our acquisition of Metris Companies, Inc.("Metris") in December 2005 which contributed $78 million of net income duringthe three months ended September 30, 2006 and $139 million of net income duringthe year-to-date period. Interest expense increased due to a larger balancesheet and a significantly higher cost of funds, reflecting market movements. Ournet interest margin was 6.56 percent for the three months ended September 30,2006 compared to 6.81 percent for the three months ended September 30, 2005. Netinterest margin was 6.64 percent for the nine months ended September 30, 2006compared to 6.77 percent for the nine months ended September 30, 2005. Netinterest margin decreased in both periods as the improvement in the overallyield on our receivable portfolio, as discussed above, was more than offset bythe higher funding costs. 22 HSBC Finance Corporation -------------------------------------------------------------------------------- Excluding the incremental credit loss provisions in 2005 due to Katrina andhigher bankruptcies, our provision for credit losses increased significantly inboth the current quarter and year-to-date period. This increase was largelydriven by higher delinquency and loss estimates at our Mortgage Servicesbusiness as loans originated and acquired in 2005 and 2006 in the second lienand portions of the first lien real estate secured portfolio are experiencinghigher delinquency and for loans originated and acquired in 2005, higher charge-offs. Also contributing to this increase was the impact of higher receivablelevels and portfolio seasoning. These increases were partially offset by lowerbankruptcy losses as a result of reduced filings following the spike inbankruptcy filings in the third quarter of 2005, the benefit of low unemploymentlevels in the United States and, as discussed more fully below, a reduction inthe estimated loss exposure resulting from Katrina that was established in thethird quarter of 2005. The increase in other revenues in the three months ended September 30, 2006 wasprimarily due to higher derivative and fee income and higher enhancementservices revenue partially offset by lower other income. The increase in otherrevenues during the year-to-date period was primarily due to higher fee incomeand higher enhancement services revenue, partially offset by lower derivativeand other income. Derivative income was higher in the current quarter due to adecrease in interest rates that caused an increase in the value of receivefixed, pay variable swaps that do not qualify for hedge accounting under SFASNo. 133. During the comparable period in 2005, interest rates increased reducingthe value of receive fixed, pay variable swaps that did not qualify for hedgeaccounting under SFAS No. 133. Derivative income was lower in the year-to-dateperiod due to a rising interest rate environment and a significant reductionduring 2005 in the population of interest rate swaps which did not qualify forhedge accounting under SFAS No. 133, the reduction of which decreases incomevolatility. Fee income and enhancement services revenue were higher in bothperiods as a result of higher volume in our MasterCard/Visa portfolios,primarily resulting from our acquisition of Metris in December 2005, partiallyoffset by the impact of FFIEC guidance which limits certain fee billings fornon-prime credit card accounts. Other income was lower in both periods primarilydue to lower asset sales. Costs and expenses increased in both periods primarilyto support receivables growth including our acquisition of Metris. Amortizationof purchase accounting fair value adjustments increased net income by $25million for the quarter ended September 30, 2006, which included $4 millionrelated to our acquisition of Metris, compared to an increase in net income of$38 million for the quarter ended September 30, 2005. Amortization of purchaseaccounting fair value adjustments increased net income by $81 million for thenine months ended September 30, 2006, which included $16 million related to ouracquisition of Metris, compared to an increase in net income of $59 million forthe nine months ended September 30, 2005. We continue to monitor the potential impact of several developing trendsaffecting the mortgage lending industry. Real estate markets in a large portionof the United States have continued to slow, as evidenced by a general slowingin the rate of appreciation, or actual decline in some markets, in propertyvalues and an increase in the period of time available properties remain on themarket. In a rising interest rate environment, the resulting increase inrequired payments on adjustable rate mortgage loans that reach reset dates mayhave an impact on the ability of borrowers to repay their loans. Similarly, asinterest-only mortgage loans leave the interest-only payment period, the abilityof borrowers to make the increased payments may be impacted. Numerous studieshave been published recently indicating that mortgage loan originations from2005 are performing worse than originations from prior years. In the second quarter of 2006 we began to experience deterioration in theperformance of 2005 mortgage loan originations in our Mortgage Servicesbusiness, particularly in the second lien and portions of the first lienportfolios which continued into the third quarter of 2006 and began to includeportions of 2006 originations in these portfolios. In 2005 and continuing into2006, second lien mortgage loan originations in our Mortgage Services businessincreased significantly as a percentage of total originations when compared toprior periods. The second lien mortgage loans originated and acquired in 2005and 2006 to date have underperformed our first lien mortgage loans from the sameperiods. Accordingly, while overall credit performance, as measured bydelinquency and charge-off remains stable across other parts of our domesticmortgage portfolio, we are reporting higher delinquency and losses this year inthe Mortgage Services business, largely as a result of the affected 2005originations. Numerous risk mitigation efforts are underway in this businessrelating to the affected components of the portfolio. These include increasedcollections capacity, enhanced segmentation and analytics to identify the higherrisk portions of the portfolio and early contact with customers who haveadjustable rate mortgage loans coming up for reset. Further, we have slowedgrowth in this portion of the portfolio by implementing repricing initiatives in 23 HSBC Finance Corporation -------------------------------------------------------------------------------- selected origination segments and tightening underwriting criteria, especiallyfor second lien, stated income (low documentation) and lower credit scoringsegments. These actions, combined with normal portfolio attrition, resulted innet attrition during the third quarter. We expect our Mortgage Services loanportfolio to remain under pressure as the 2005 and 2006 originations seasonfurther. Accordingly, we expect the increase in overall delinquency and charge-offs in our Mortgage Services business to continue. We continue to assess the financial impact of Katrina on our customers living inthe Katrina FEMA designated Individual Assistance disaster areas, including therelated payment patterns of these customers. As a result of these continuingassessments, including customer contact and the collection of more informationassociated with the properties located in the FEMA designated area, asapplicable, we have reduced our estimate of credit loss exposure byapproximately $35 million in the quarter ended September 30, 2006 andapproximately $90 million in the year-to-date period relating to the incrementalprovision that was established in the third quarter of 2005. We will continue toreview our estimate of credit loss exposure relating to Katrina and anyadjustments will be reported in earnings when they become known. In the third quarter of 2006, as part of our continuing evaluation of strategicalternatives with respect to our U.K. and European operations, we agreed to sellall of the capital stock of our operations in the Czech Republic, Hungary, andSlovakia (the "European Operations") to a wholly owned subsidiary of HSBC Bankplc ("HBEU"), a U.K. based subsidiary of HSBC, for an aggregate purchase priceof approximately $46 million. The sale closed in early November 2006. Becausethe sale of this business is between affiliates under common control, thepremium received in excess of the book value of the stock transferred will berecorded as an increase to additional paid-in capital and will not be reflectedin earnings. At September 30, 2006, we have classified the European Operationsas "Held for Sale" and combined assets of $207 million and liabilities of $178million related to these operations separately in our consolidated balance sheetwithin other assets and other liabilities. Our return on average owned assets ("ROA") was 1.28 percent for the three monthsended September 30, 2006 and 1.60 percent for the nine months ended September30, 2006 compared to .79 percent for the three months ended September 30, 2005and 1.35 percent for the nine months ended September 30, 2005. Return onaveraged managed assets ("ROMA") (a non-GAAP financial measure which assumesthat securitized receivables have not been sold and are still on our balancesheet) was 1.26 percent for the three months ended September 30, 2006 and 1.57percent for the nine months ended September 30, 2006 compared to .75 percent inthe three months ended September 30, 2005 and 1.26 percent for the nine monthsended September 30, 2005. ROA and ROMA increased during both periods as netincome growth, as previously discussed, outpaced the growth in average owned andmanaged assets during the periods. 24 HSBC Finance Corporation -------------------------------------------------------------------------------- The financial information set forth below summarizes selected financialhighlights of HSBC Finance Corporation as of September 30, 2006 and 2005 and forthe three and nine month periods ended September 30, 2006 and 2005. THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------- ------------------- 2006 2005 2006 2005--------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) NET INCOME:.................................... $ 551 $ 281 $2,007 $1,379OWNED BASIS RATIOS: Return on average owned assets............... 1.28% .79% 1.60% 1.35% Return on average common shareholder's equity ("ROE")................................... 10.77 6.03 13.31 10.58 Net interest margin.......................... 6.56 6.81 6.64 6.77 Consumer net charge-off ratio, annualized.... 2.92 2.93 2.80 3.00 Efficiency ratio(1).......................... 41.16 44.33 40.86 44.47MANAGED BASIS RATIOS:(2)Return on average managed assets ("ROMA")...... 1.26% .75% 1.57% 1.26% Net interest margin.......................... 6.59 6.94 6.71 7.01 Risk adjusted revenue........................ 6.88 7.47 7.17 7.45 Consumer net charge-off ratio, annualized.... 2.97 3.21 2.87 3.37 Efficiency ratio(1).......................... 41.16 44.65 40.94 44.20 AS OF SEPTEMBER 30, 2006 2005---------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) RECEIVABLES: Owned basis................................................ $156,929 $128,722 Managed basis(2)........................................... 158,203 135,481TWO-MONTH-AND-OVER CONTRACTUAL DELINQUENCY RATIOS: Owned basis................................................ 4.14% 3.78% Managed basis(2)........................................... 4.16 3.87 -------- (1) Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits. (2) Managed basis reporting is a non-GAAP financial measure. See "Basis of Reporting" for additional discussion on the use of this non-GAAP financial measure and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. Owned receivables were $156.9 billion at September 30, 2006, $154.0 billion atJune 30, 2006 and $128.7 billion at September 30, 2005. With the exception ofprivate label, we experienced growth in all our consumer receivable productscompared to June 30, 2006 and September 30, 2005, with real estate securedreceivables being the primary contributor to the growth. Lower securitizationlevels also contributed to the increase in owned receivables. The acquisition ofMetris in December 2005 also contributed to the increase in owned receivables ascompared to September 30, 2005. Our owned basis two-months-and-over-contractual delinquency ratio increasedcompared to both the prior quarter and the prior year quarter. The increase of46 basis points from the prior quarter was driven largely by higher real estatesecured delinquency levels at our Mortgage Services business due to thedeteriorating performance of certain 2005 and 2006 originations as more fullydiscussed above. Higher personal non-credit card delinquency also contributed tothe increase. Partially offsetting these increases was receivable growth and thebenefit of low unemployment levels in the United States. The increase of 36basis points from the prior year quarter is a result of higher delinquency atour Mortgage Services business and higher MasterCard/Visa delinquency largelydue to the impact of Metris partially offset by lower bankruptcy levels due tothe new bankruptcy legislation enacted in October 2005, receivable growth andthe benefit of low unemployment levels in the United States. Owned net charge-offs as a percentage of average consumer receivables for thequarter was flat compared with the prior year quarter. Decreases in personalbankruptcy filings in our MasterCard/Visa portfolio following the October 2005enactment of bankruptcy legislation in the United States was substantiallyoffset by higher net charge-offs in 25 HSBC Finance Corporation -------------------------------------------------------------------------------- our real estate secured portfolio and in particular at our Mortgage Servicesbusiness due to portfolio seasoning and higher than expected losses on certain2005 real estate secured loan originations as well as higher net charge-offs inour auto finance portfolio due to the seasoning of a growing portfolio. Our owned basis efficiency ratio improved compared to the prior year quarter dueto higher net interest income and higher other revenues due to higher levels ofreceivables, partially offset by an increase in total costs and expenses tosupport receivable growth. During the third quarter of 2006, we supplemented unsecured public debtissuances with proceeds from the continuing sale of newly originated domesticprivate label receivables to HSBC Bank USA, National Association ("HBUS"), debtissued to affiliates and increased levels of secured financings. Because we area subsidiary of HSBC, our credit ratings have improved and our credit spreadsrelative to Treasuries have tightened compared to those we experienced duringthe months leading up to the announcement of our acquisition by HSBC. Primarilyas a result of tightened credit spreads and improved funding availability, werecognized cash funding expense savings of approximately $687 million during thenine months ended September 30, 2006 (approximately $248 million during thethree months ended September 30, 2006) and approximately $407 million during thenine months ended September 30, 2005 (approximately $155 million during thethree months ended September 30, 2005) compared to the funding costs we wouldhave incurred using average spreads and funding mix from the first half of 2002.These tightened credit spreads in combination with the issuance of HSBC FinanceCorporation debt and other funding synergies including asset transfers and debtunderwriting fees paid to HSBC affiliates have enabled HSBC to realize a pre-tax2006 run rate for annual cash funding expense savings in excess of $1 billionper year. In the nine months ended September 30, 2006, the cash funding expensesavings realized by HSBC totaled approximately $881 million. Securitization of consumer receivables has been a source of funding andliquidity for us. In order to align our accounting treatment with that of HSBCinitially under U.K. GAAP and now under International Financial ReportingStandards ("IFRSs"), starting in the third quarter of 2004 we began to structureall new collateralized funding transactions as secured financings. However,because existing public MasterCard and Visa credit card transactions werestructured as sales to revolving trusts that require replenishments ofreceivables to support previously issued securities, receivables will continueto be sold to these trusts until the revolving periods end, the last of which iscurrently projected to occur in the fourth quarter of 2007. We will continue toreplenish at reduced levels certain personal non-credit card securitiesprivately issued to conduits and record the resulting replenishment gains for aperiod of time in order to manage liquidity. Since our securitized receivableshave varying lives, it will take time for all securitized receivables to pay-offand the related interest-only strip receivables to be reduced to zero. While thetermination of sale treatment on new collateralized funding transactions reducedour reported net income under U.S. GAAP, there is no impact on cash received. BASIS OF REPORTING-------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States ("U.S. GAAP"). Unless noted,the discussion of our financial condition and results of operations included inMD&A are presented on an owned basis of reporting. MANAGED BASIS REPORTING We have historically monitored our operations andevaluated trends on a managed basis (a non-GAAP financial measure), whichassumes that securitized receivables have not been sold and remain on ourbalance sheet. This is because the receivables that we securitize are subjectedto underwriting standards comparable to our owned portfolio, are serviced byoperating personnel without regard to ownership and result in a similar creditloss exposure for us. In addition, we fund our operations and make certaindecisions about allocating resources such as capital on a managed basis. When reporting on a managed basis, net interest income, provision for creditlosses and fee income related to receivables securitized are reclassified fromsecuritization related revenue in our owned statement of income into theappropriate caption. Additionally, charge-off and delinquency associated withthese receivables are included in our managed basis credit quality statistics. 26 HSBC Finance Corporation -------------------------------------------------------------------------------- Debt analysts, rating agencies and fixed income investors have also historicallyevaluated our operations on a managed basis for the reasons discussed above andhave historically requested managed basis information from us. We believe thatmanaged basis information enables such investors and other interested parties tobetter understand the performance and quality of our entire loan portfolio andis important to understanding the quality of originations and the related creditrisk inherent in our owned and securitized portfolios. As the level of oursecuritized receivables have fallen over time, managed basis and owned basisresults have now largely converged. As a result, we currently anticipate thatthis Form 10-Q will be the last periodic report that contains managed basisresults. We also now report "Management Basis" results (a non-GAAP financialmeasure) in Reports on Form 8-K on an IFRSs basis with our quarterly results.(See discussion of the use of the IFRSs basis of accounting below.) ManagementBasis reporting, in addition to managed basis adjustments, assumes the privatelabel and real estate secured receivables transferred to HBUS have not been soldand remain on balance sheet. As we continue to manage and service receivablessold to HBUS, we make decisions about allocating certain resources, such asemployees, on a Management Basis. EQUITY RATIOS Tangible shareholders' equity to tangible managed assets("TETMA"), tangible shareholders' equity plus owned loss reserves to tangiblemanaged assets ("TETMA + Owned Reserves") and tangible common equity to tangiblemanaged assets are non-GAAP financial measures that are used by HSBC FinanceCorporation management and certain rating agencies to evaluate capital adequacy.These ratios may differ from similarly named measures presented by othercompanies. The most directly comparable GAAP financial measure is common andpreferred equity to owned assets. We and certain rating agencies also monitor our equity ratios excluding theimpact of the HSBC acquisition purchase accounting adjustments. We do so becausewe believe that the HSBC acquisition purchase accounting adjustments representnon-cash transactions which do not affect our business operations, cash flows orability to meet our debt obligations. We include the impact of acquisitionpurchase accounting adjustments resulting from the Metris acquisition inDecember 2005 in our equity ratios as HSBC Finance Corporation was the acquirerand entered into this acquisition for the purpose of expanding our corebusiness. Preferred securities issued by certain non-consolidated trusts are consideredequity in the TETMA and TETMA + Owned Reserves calculations because of theirlong-term subordinated nature and the ability to defer dividends. TETMA andTETMA + Owned Reserves exclude the Adjustable Conversion-Rate Equity SecurityUnits for all periods subsequent to our acquisition by HSBC as this moreaccurately reflects the impact of these items on our equity post acquisition. 27 HSBC Finance Corporation -------------------------------------------------------------------------------- INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results inaccordance with IFRSs and IFRSs results are used in measuring and rewardingperformance of employees, our management also separately monitors net incomeunder IFRSs (a non-U.S. GAAP financial measure). The following table reconcilesour net income on a U.S. GAAP basis to net income on an IFRSs basis: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------- --------------- 2006 2005 2006 2005 ----- ---- ------ ------ (DOLLARS ARE IN MILLIONS) Net income - U.S. GAAP basis....................... $ 551 $281 $2,007 $1,379Adjustments, net of tax: Securitizations.................................. 2 65 36 233 Derivatives and hedge accounting (including fair value adjustments)............................ (147) 38 (237) 48 Intangible assets................................ 25 47 87 145 Purchase accounting adjustments.................. (25) (20) 5 27 Loan origination................................. (12) (12) (33) (45) Loan impairment.................................. 10 (8) 29 (1) Loans held for resale............................ - - 18 - Interest recognition............................. (12) - 89 - Other............................................ (1) (3) 35 8 ----- ---- ------ ------Net income - IFRSs basis........................... $ 391 $388 $2,036 $1,794 ===== ==== ====== ====== Significant differences between U.S. GAAP and IFRSs are as follows: SECURITIZATIONS IFRSs - The recognition of securitized assets is governed by a three-step process, which may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows arising from securitized assets have been transferred to a third party, and all the risks and rewards of the assets have been transferred, the assets concerned are derecognized. - If the rights to the cash flows are retained by HSBC but there is a contractual obligation to pay them to another party, the securitized assets concerned are derecognized if certain conditions are met such as, for example, when there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If some significant risks and rewards of ownership have been transferred, but some have also been retained, it must be determined whether or not control has been retained. If control has been retained, HSBC continues to recognize the asset to the extent of its continuing involvement; if not, the asset is derecognized. - The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. US GAAP - SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity ("SPE") and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets. - Control is surrendered over transferred assets if, and only if, all of the following conditions are met: - The transferred assets are put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. 28 HSBC Finance Corporation -------------------------------------------------------------------------------- - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. - When HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the special purpose entity, HSBC recognizes this interest at fair value on sale of the assets to the SPE. DERIVATIVES AND HEDGE ACCOUNTING IFRSs - Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter ("OTC") derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models. - In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (that is the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (without modification or repackaging) or will be based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading profit or loss on inception of the derivative. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out. - Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value through profit and loss. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. - Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net basis. - The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. Hedge Accounting: - It is HSBC's policy to document, at the inception of a hedge, the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking the 29 HSBC Finance Corporation -------------------------------------------------------------------------------- hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. Fair value hedge: - Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair values of the assets or liabilities or groups thereof that are attributable to the hedged risks. - If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item is amortized to the income statement based on a recalculated effective interest rate over the residual period to maturity, unless the hedged item has been derecognized whereby it is released to the income statement immediately. Cash flow hedge: - The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement. - Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect the income statement. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability. - When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. Net investment hedge: - Hedges of net investments in foreign operations are accounted for in a similar manner to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation. Hedge effectiveness testing: - IAS 39 requires that at inception and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness) to qualify for hedge accounting. Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis. - The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. - For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For retrospective effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective. Derivatives that do not qualify for hedge accounting: - All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement. US GAAP - The accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39, which HSBC has followed in its IFRSs reporting from January 1, 2005, as described above. However, specific assumptions regarding hedge effectiveness under US GAAP are not permitted by IAS 39. 30 HSBC Finance Corporation -------------------------------------------------------------------------------- - The requirements of SFAS No. 133 have been effective from January 1, 2001. - The US GAAP 'shortcut method' permits an assumption of zero ineffectiveness in hedges of interest rate risk with an interest rate swap provided specific criteria have been met. IAS 39 does not permit such an assumption, requiring a measurement of actual ineffectiveness at each designated effectiveness testing date. - In addition, IFRSs allows greater flexibility in the designation of the hedged item. Under US GAAP, all contractual cash flows must form part of the designated relationship, whereas IAS 39 permits the designation of identifiable benchmark interest cash flows only. - Under US GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. These contracts do not meet the requirements for set off under IAS 32 and hence are presented gross on the balance sheet for IFRSs. DESIGNATION OF FINANCIAL ASSETS AND LIABILITIES AT FAIR VALUE THROUGH PROFIT ANDLOSS IFRSs - Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. - Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it relates. Financial assets and financial liabilities are recognized using trade date accounting. - Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. - Derivative income declined largely due to tightened credit spreads on application of the fair value option to our debt. US GAAP - There are no provisions in US GAAP to make an election similar to that in IAS 39. - Generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they must meet the definition of trading securities in SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities are generally reported at amortized cost under US GAAP. GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES IFRSs - Prior to 1998, goodwill under UK GAAP was written off against equity. HSBC did not elect to reinstate this goodwill on its balance sheet upon transition to IFRSs. From January 1, 1998 to December 31, 2003 goodwill was capitalized and amortized over its useful life. The carrying amount of goodwill existing at December 31, 2003 under UK GAAP was carried forward under the transition rules of IFRS from January 1, 2004, subject to certain adjustments. - IFRS 3 "Business Combinations" requires that goodwill should not be amortized but should be tested for impairment at least annually at the reporting unit level by applying a test based on recoverable amounts. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their market price on the date the transaction is completed. 31 HSBC Finance Corporation -------------------------------------------------------------------------------- US GAAP - Up to June 30, 2001, goodwill acquired was capitalized and amortized over its useful life which could not exceed 25 years. The amortization of previously acquired goodwill ceased with effect from December 31, 2001. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their average market price over a reasonable period before and after the date on which the terms of the acquisition are agreed and announced. - Changes in tax estimates of the basis in assets and liabilities or other tax estimates recorded at the date of acquisition by HSBC are adjusted against goodwill. LOAN ORIGINATION IFRSs - Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. US GAAP - Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the profit and loss account over the life of the loan as an adjustment to interest income (SFAS No. 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) LOAN IMPAIRMENT IFRSs - When statistical models, using historic loss rates adjusted for economic conditions, provide evidence of impairment in portfolios of loans, their values are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate. The calculations include a reasonable estimate of recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. US GAAP - Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery, the loans are written off in full, or to recoverable value where collateral exists. Delinquency depends on the number of days payment is overdue. The delinquency status is applied consistently across similar loan products in accordance with HSBC's credit guidelines. When local regulators mandate the delinquency status at which write-off must occur for different retail loan products and these regulations reasonably reflect estimable recoveries on individual loans, this basis of measuring loan impairment is reflected in US GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. LOANS HELD FOR RESALE IFRSs - Under IAS 39, loans held for resale are treated as trading assets. - As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings. - Any gains realized on sales of such loans are recognized in current period earnings on the trade date. U.S. GAAP - Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet. - Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost. - Subsequent gains on sales of such loans are recognized in current period earnings on the settlement date. 32 HSBC Finance Corporation -------------------------------------------------------------------------------- INTEREST RECOGNITION IFRSs - The calculation and recognition of effective interest rates under IAS 39 requires an estimate of "all fees and points paid or received between parties to the contract" that are an integral part of the effective interest rate be included. US GAAP - FAS 91 also generally requires all fees and costs associated with originating a loan to be recognized as interest, but when the interest rate increases during the term of the loan it prohibits the recognition of interest income to the extent that the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. During the second quarter of 2006, we implemented a methodology for calculatingthe effective interest rate for introductory rate MasterCard/Visa receivablesunder IFRSs over the expected life of the product which resulted in anadjustment being recorded. Of the amount recognized, approximately $58 million(net of tax) would otherwise have been recorded as an IFRS opening balance sheetadjustment as at January 1, 2005 under this methodology. QUANTITATIVE RECONCILIATIONS OF NON-GAAP FINANCIAL MEASURES TO GAAP FINANCIALMEASURES For a reconciliation of managed basis net interest income, fee incomeand provision for credit losses to the comparable owned basis amounts, see Note11, "Business Segments," to the accompanying consolidated financial statements.For a reconciliation of our owned loan portfolio by product to our managed loanportfolio, see Note 4, "Receivables," to the accompanying consolidated financialstatements. For additional quantitative reconciliations of non-GAAP financialmeasures presented herein to the equivalent GAAP basis financial measures, see"Reconciliations to GAAP Financial Measures." 33 HSBC Finance Corporation -------------------------------------------------------------------------------- RECEIVABLES REVIEW-------------------------------------------------------------------------------- The following table summarizes owned receivables at September 30, 2006 andincreases (decreases) over prior periods: Increases (decreases) from ------------------------------- June 30, September 30, 2006 2005 SEPTEMBER 30, ------------- --------------- 2006 $ % $ %--------------------------------------------------------------------------------------------- (dollars are in millions) Real estate secured(1)...................... $ 95,241 $1,348 1.4% $17,111 21.9%Auto finance................................ 12,182 459 3.9 2,045 20.2MasterCard/Visa............................. 25,856 897 3.6 6,882 36.3Private label............................... 2,431 (91) (3.6) (346) (12.5)Personal non-credit card(2)................. 21,034 370 1.8 2,550 13.8Commercial and other........................ 185 (13) (6.6) (35) (15.9) -------- ------ ---- ------- -----Total owned receivables..................... $156,929 $2,970 1.9% $28,207 21.9% ======== ====== ==== ======= ===== -------- (1) Real estate secured receivables are comprised of the following: Increases (decreases) from ----------------------------- June 30, September 30, 2006 2005 SEPTEMBER 30, ------------ -------------- 2006 $ % $ %-------------------------------------------------------------------------------------------- (dollars are in millions) Mortgage Services............................ $49,077 $ (377) (.8)% $11,183 29.5%Consumer Lending and all other............... 46,164 1,725 3.9 5,928 14.7 ------- ------ --- ------- ----Total real estate secured.................... $95,241 $1,348 1.4% $17,111 21.9% ======= ====== === ======= ==== -------- (2) Personal non-credit card receivables are comprised of the following: Increases (decreases) from ----------------------------- June 30, September 30, 2006 2005 SEPTEMBER 30, ------------ -------------- 2006 $ % $ %-------------------------------------------------------------------------------------------- (dollars are in millions) Domestic personal non-credit card............ $13,233 $ 673 5.4% $2,910 28.2%Union Plus personal non-credit card.......... 252 (15) (5.6) (122) (32.6)Personal homeowner loans..................... 4,269 20 .5 273 6.8Foreign personal non-credit card............. 3,280 (308) (8.6) (511) (13.5) ------- ----- ---- ------ -----Total personal non-credit card............... $21,034 $ 370 1.8% $2,550 13.8% ======= ===== ==== ====== ===== At September 30, 2006, approximately 96 percent of real estate securedreceivables at our Consumer Lending business bore fixed rates and 91 percent ofsuch real estate secured receivables were in a first lien position, whileapproximately 42 percent of real estate secured receivables at our MortgageServices business bore fixed rates and 78 percent of real estate securedreceivables were in a first lien position. Also at September 30, 2006, realestate secured loans originated and acquired subsequent to December 30, 2004 byour Mortgage Services business accounted for approximately 62 percent of totalMortgage Services receivables in a first lien position and approximately 89percent of total Mortgage Services receivables in a second lien position.Further at September 30, 2006, we had $6.4 billion of interest-only loans (4percent of total owned receivables), substantially all of which were adjustablerate mortgages. In addition to the adjustable rate interest-only loans discussedabove, at 34 HSBC Finance Corporation -------------------------------------------------------------------------------- September 30, 2006 we had approximately $22.5 billion of adjustable ratemortgages (14 percent of total owned receivables) at our Consumer Lending andMortgage Services businesses. RECEIVABLE INCREASES (DECREASES) SINCE JUNE 30, 2006 Growth in our branch realestate secured business as discussed above was partially offset by the plannedreduction in correspondent purchases, including second lien and selected higherrisk products. These actions, combined with normal portfolio attrition, resultedin a decline in the overall portfolio balance at our Mortgage Services business.Growth in our auto finance portfolio reflects lower levels of securitizations,organic growth and increased volume in both the dealer network and the consumerdirect loan program. The increase in our MasterCard/Visa portfolio reflectslower securitization levels and strong domestic organic growth especially in ourUnion Privilege, as well as other non-prime portfolios including Metris.Decreases in our private label portfolio reflect lower retail sales volumes inthe U.K. Personal non-credit card receivables increased as a result of increasedmarketing and lower securitization levels. RECEIVABLE INCREASES (DECREASES) SINCE SEPTEMBER 30, 2005 Driven by growth inour correspondent and branch businesses, real estate secured receivablesincreased over the year-ago period. Real estate secured receivable levels in ourbranch-based consumer lending business improved because of higher sales volumes.Also contributing to the increase were purchases of $.6 billion from portfolioacquisition programs since the prior year quarter. We continued to enter intoagreements with additional correspondents to purchase their newly originatedloans on a flow basis. Auto finance receivables increased over the year-agoperiod due to organic growth principally in the near-prime portfolio. This camefrom newly originated loans acquired from our dealer network, growth in theconsumer direct loan program and lower securitization levels. Additionally, wehave experienced continued growth from the expansion of our auto finance programin Canada. MasterCard and Visa receivables growth reflects the $5.3 billion ofreceivables acquired as part of our acquisition of Metris in December 2005,strong domestic organic growth especially in our Union Privilege and non-primeportfolios, lower securitization levels and the successful launch of aMasterCard program in Canada in 2005. These increases were partially offset bythe sale of our U.K. credit card business in December 2005 which included $2.2billion of MasterCard/Visa receivables. Private label receivables decreased fromthe year ago period as a result of lower retail sales volumes in the U.K. andthe sale of our U.K. credit card business in December 2005, which included $300million of private label receivables. Personal non-credit card receivablesincreased from the year-ago period as a result of increased marketing, includingseveral large direct mail campaigns, and lower securitization levels. RESULTS OF OPERATIONS-------------------------------------------------------------------------------- Unless noted otherwise, the following discusses amounts reported in our ownedbasis statement of income. NET INTEREST INCOME The following table summarizes net interest income: Increase (decrease) ----------------THREE MONTHS ENDED SEPTEMBER 30, 2006 (1) 2005 (1) AMOUNT %--------------------------------------------------------------------------------------------- Finance and other interest income...... $4,535 11.43% $3,402 10.71% $1,133 33.3%Interest expense....................... 1,933 4.87 1,239 3.90 694 56.0 ------ ----- ------ ----- ------ ----Net interest income.................... $2,602 6.56% $2,163 6.81% $ 439 20.3% ====== ===== ====== ===== ====== ==== Increase (decrease) ----------------NINE MONTHS ENDED SEPTEMBER 30, 2006 (1) 2005 (1) AMOUNT %---------------------------------------------------------------------------------------------- Finance and other interest income...... $12,933 11.27% $9,491 10.56% $3,442 36.3%Interest expense....................... 5,318 4.63 3,405 3.79 1,913 56.2 ------- ----- ------ ----- ------ ----Net interest income.................... $ 7,615 6.64% $6,086 6.77% $1,529 25.1% ======= ===== ====== ===== ====== ==== -------- (1) % Columns: comparison to average owned interest-earning assets. 35 HSBC Finance Corporation -------------------------------------------------------------------------------- The increases in net interest income during the quarter and year-to-date periodswere due to higher average receivables and a higher overall yield, partiallyoffset by higher interest expense. Overall yields increased due to increases inour rates on variable rate products which reflected market movements and variousother repricing initiatives, such as reduced levels of promotional rate balancesin 2006. Changes in receivable mix also contributed to the increase in yield dueto the impact of increased levels of higher yielding MasterCard/Visa receivablesdue to lower securitization levels and our acquisition of Metris in December2005. The higher interest expense was due to a larger balance sheet and asignificantly higher cost of funds due to a rising interest rate environment. 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 $102 million and $331 million for the three andnine month periods ended September 30, 2006, which included $15 million and $54million, respectively, relating to Metris. Amortization of purchase accountingfair value adjustments increased net interest income by $132 million for thethree months ended September 30, 2005 and $392 million for the nine months endedSeptember 30, 2005. Net interest margin, annualized, decreased during the three and nine monthsended September 30, 2006 as compared to the year-ago periods as the improvementin the overall yield on our receivable portfolio, as discussed above, was morethan offset by the higher funding costs. The following table shows the impact ofthese items on net interest margin at September 30, 2006: NINE MONTHS THREE MONTHS ENDED ENDED ------------------------------------------------------------------------------------------------- Net interest margin - September 30, 2005.................. 6.81% 6.77%Impact to net interest margin resulting from: Sale of U.K. credit card business in December 2005...... .02 .04 Metris acquisition in December 2005..................... .33 .35 Receivable pricing...................................... .38 .30 Receivable mix.......................................... .06 .04 Cost of funds........................................... (.99) (.88) Other................................................... (.05) .02 ---- ----Net interest margin - September 30, 2006.................. 6.56% 6.64% ==== ==== 36 HSBC Finance Corporation -------------------------------------------------------------------------------- Our net interest income on a managed basis includes finance income earned on ourowned receivables as well as on our securitized receivables. This finance incomeis offset by interest expense on the debt recorded on our balance sheet as wellas the contractual rate of return on the instruments issued to investors whenthe receivables were securitized. Managed basis net interest income was $2.6billion in the three months ended September 30, 2006, an increase of 13.0percent from $2.3 billion in the three months ended September 30, 2005. For thenine months ended September 30, 2006, managed basis net interest income was $7.8billion, up 14.7 percent from $6.8 billion in the nine months ended September30, 2005. Managed basis net interest margin, annualized, was 6.59 percent in thecurrent quarter and 6.71 percent in the year-to-date period, compared to 6.94percent and 7.01 percent in the year-ago periods. The decreases were due tohigher funding costs due to a larger managed basis balance sheet and a risinginterest rate environment, partially offset by the higher overall yields on ourreceivables as discussed above. The following table shows the impact of theseitems on our net interest margin on a managed basis at September 30, 2006: NINE MONTHS THREE MONTHS ENDED ENDED ------------------------------------------------------------------------------------------------- Net interest margin - September 30, 2005.................. 6.94% 7.01%Impact to net interest margin resulting from: Sale of U.K. credit card business in December 2005...... - .03 Metris acquisition in December 2005..................... .32 .32 Receivable pricing...................................... .47 .37 Receivable mix.......................................... (.13) (.21) Cost of funds........................................... (.97) (.89) Other................................................... (.04) .08 ---- ----Net interest margin - September 30, 2006.................. 6.59% 6.71% ==== ==== Net interest margin on a managed basis is greater than on an owned basis becausethe managed basis portfolio includes relatively more unsecured loans, which havehigher yields. The effect on net interest margin of receivable mix is greater ona managed basis than on an owned basis because in the owned portfolio the impactof higher levels of higher yielding MasterCard/Visa receivables due to lowersecuritization levels partially offset the impact of higher levels of loweryielding correspondent real estate secured receivables. Managed basis risk adjusted revenue (a non-GAAP financial measure whichrepresents net interest income, plus other revenues, excluding securitizationrelated revenue and the mark-to-market on derivatives which do not qualify aseffective hedges and ineffectiveness associated with qualifying hedges underSFAS No. 133, less net charge-offs as a percentage of average interest earningassets) decreased to 6.88 percent in the current quarter from 7.47 percent inthe year-ago quarter. Managed basis risk adjusted revenue decreased to 7.17percent in the year-to-date period from 7.45 percent in the year-ago period.Managed basis risk adjusted revenue decreased due to lower net interest marginpartially offset by slightly lower net charge-offs. See "Basis of Reporting" foradditional discussion on the use of non-GAAP financial measures. PROVISION FOR CREDIT LOSSES The following table summarizes provision for creditlosses: INCREASE (DECREASE) --------------- 2006 2005 AMOUNT %------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Three months ended September 30,................. $1,384 $1,361 $ 23 1.7%Nine months ended September 30,.................. 3,498 3,233 265 8.2% Our provision for credit losses increased during both periods. The provision forcredit losses in the third quarter of 2005 included an increase of $280 millionrelated to credit loss exposure as a result of Katrina and higher bankruptcyfilings in the period leading up to the October 17, 2005 effective date of newbankruptcy legislation in the United States. Excluding these adjustments and thesubsequent releases of Katrina reserves in 2006, our provision for credit lossesincreased significantly in 2006 (31 percent over the year-ago quarter and 22percent over the year-to-date period). This increase in the provision for creditlosses was largely driven by higher delinquency 37 HSBC Finance Corporation -------------------------------------------------------------------------------- and loss estimates at our Mortgage Services business as loans originated andacquired in 2005 and 2006 in the second lien and portions of the first lien realestate secured portfolios are experiencing higher delinquency and for such loansoriginated and acquired in 2005, higher charge-offs. Also contributing to thisincrease was the impact of higher receivable levels and portfolio seasoning.These increases were partially offset by lower bankruptcy levels as a result ofreduced filings, and the benefit of low unemployment levels in the UnitedStates. The provision as a percent of average owned receivables, annualized, was3.55 percent in the current quarter and 3.11 percent year-to-date, compared to4.41 percent and 3.71 percent in the year-ago periods. In 2006, credit lossreserves increased as the provision for owned credit losses was $246 milliongreater than net charge-offs in the third quarter of 2006 and $352 milliongreater than net charge-offs in the year-to-date period. In 2005, credit lossreserves increased as the provision for owned credit losses was $459 milliongreater than net charge-offs in the third quarter of 2005 and $624 milliongreater than net charge-offs in the year-to-date period. The provision forcredit losses may vary from quarter to quarter depending on the product mix andcredit quality of loans in our portfolio. See "Credit Quality" included in thisMD&A for further discussion of factors affecting the provision for creditlosses. OTHER REVENUES The following table summarizes other revenues: INCREASE (DECREASE) --------------THREE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT %-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Securitization related revenue...................... $ 24 $ 41 $(17) (41.5)%Insurance revenue................................... 280 274 6 2.2Investment income................................... 31 33 (2) (6.1)Derivative income (expense)......................... 68 (53) 121 100+Fee income.......................................... 559 439 120 27.3Enhancement services revenue........................ 129 71 58 81.7Taxpayer financial services revenue................. 4 (1) 5 100+Gain on receivable sales to HSBC affiliates......... 101 99 2 2.0Servicing and other fees from HSBC affiliates....... 121 109 12 11.0Other income........................................ 48 135 (87) (64.4) ------ ------ ---- -----Total other revenues................................ $1,365 $1,147 $218 19.0% ====== ====== ==== ===== INCREASE (DECREASE) -----------------NINE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT %------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Securitization related revenue.................. $ 146 $ 180 $ (34) (18.9)%Insurance revenue............................... 779 809 (30) (3.7)Investment income............................... 99 99 - -Derivative income............................... 118 283 (165) (58.3)Fee income...................................... 1,393 1,099 294 26.8Enhancement services revenue.................... 363 201 162 80.6Taxpayer financial services revenue............. 258 260 (2) (.8)Gain on receivable sales to HSBC affiliates..... 283 308 (25) (8.1)Servicing and other fees from HSBC affiliates... 355 329 26 7.9Other income.................................... 221 250 (29) (11.6) ------ ------ ----- -----Total other revenues............................ $4,015 $3,818 $ 197 5.2% ====== ====== ===== ===== 38 HSBC Finance Corporation -------------------------------------------------------------------------------- SECURITIZATION RELATED REVENUE is the result of the securitization of ourreceivables and includes the following: INCREASE (DECREASE) -----------------THREE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT %----------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net initial gains................................. $ - $ - $ - -Net replenishment gains(1)........................ 4 38 (34) (89.5)%Servicing revenue and excess spread............... 20 3 17 100+ ---- ---- ----- -----Total............................................. $ 24 $ 41 $ (17) (41.5)% ==== ==== ===== ===== INCREASE (DECREASE) -----------------NINE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT %----------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net initial gains................................. $ - $ - $ - -Net replenishment gains(1)........................ 23 135 (112) (83.0)%Servicing revenue and excess spread............... 123 45 78 100+ ---- ---- ----- -----Total............................................. $146 $180 $ (34) (18.9)% ==== ==== ===== ===== -------- (1) Net replenishment gains reflect inherent recourse provisions of $7 million in the three months ended September 30, 2006 and $37 million in the nine months ended September 30, 2006. Net replenishment gains reflect inherent recourse provisions of $48 million in the three months ended September 30, 2005 and $201 million in the nine months ended September 30, 2005. The decline in securitization related revenue in both periods of 2006 was due todecreases in the level of securitized receivables as a result of our decision inthe third quarter of 2004 to structure all new collateralized fundingtransactions as secured financings. Because existing public MasterCard and Visacredit card transactions were structured as sales to revolving trusts thatrequire replenishments of receivables to support previously issued securities,receivables will continue to be sold to these trusts until the revolving periodsend, the last of which is currently projected to occur in the fourth quarter of2007. We will continue to replenish at reduced levels, certain personal non-credit card securities privately issued to conduits and record the resultingreplenishment gains for a period of time in order to manage liquidity. Since oursecuritized receivables have varying lives, it will take time for allsecuritized receivables to pay-off and the related interest-only stripreceivables to be reduced to zero. While the termination of sale treatment onnew collateralized funding transactions reduced our reported net income underU.S. GAAP, there is no impact on cash received. Insurance revenue increased over the prior-year quarter as a result of a newreinsurance contract signed in the third quarter in our domestic operations andhigher revenues in our U.K. operations, primarily due to a favorable foreignexchange impact, partially offset by lower revenue in our domestic operations.Insurance revenue decreased during the year-to-date period as a result of lowerinsurance sales volumes in our U.K. operations and lower revenue in our domesticoperations primarily due to the restructuring of an insurance product effectiveApril 1, 2006, partially offset by the new reinsurance activity previouslydiscussed. Investment income, which includes income on securities available for sale in ourinsurance business and realized gains and losses from the sale of securities,was essentially flat in both periods as lower average insurance investmentbalances were offset by increases in interest rates. 39 HSBC Finance Corporation -------------------------------------------------------------------------------- Derivative income (expense), which includes realized and unrealized gains andlosses on derivatives which do not qualify as effective hedges under SFAS No.133 as well as the ineffectiveness on derivatives associated with our qualifyinghedges, is summarized in the table below: THREE MONTHS ENDED SEPTEMBER 30, 2006 2005-------------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)....................................... $(4) $ 13Mark-to-market on derivatives which do not qualify as effective hedges.......................................................... 65 (114)Ineffectiveness................................................... 7 48 --- -----Total............................................................. $68 $ (53) === ===== NINE MONTHS ENDED SEPTEMBER 30, 2006 2005------------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)....................................... $ 2 $ 46Mark-to-market on derivatives which do not qualify as effective hedges.......................................................... 14 211Ineffectiveness................................................... 102 26 ---- ----Total............................................................. $118 $283 ==== ==== Derivative income for the three month period ending September 30, 2006, wasprimarily driven by the impact of changes in interest rates on the value ofreceive fixed, pay variable swaps that do not qualify for hedge accounting underSFAS No. 133. During this period interest rates fell causing an increase invalue in these swaps. Conversely, during the comparable period in 2005, interestrates rose causing a decrease in value. For the year-to-date period, derivativeincome decreased primarily due to a significant reduction during 2005 in thepopulation of interest rate swaps which do not qualify for hedge accountingunder SFAS No. 133. In addition during 2006, we have experienced a risinginterest rate environment compared to a yield curve that generally flattened inthe comparable period of 2005. The income from ineffectiveness in both periodsresulted from the designation during 2005 of a significant number of ourderivatives as effective hedges under the long-haul method of accounting. Thesederivatives had not previously qualified for hedge accounting under SFAS No.133. In addition, all of the hedge relationships which qualified under theshortcut method provisions of SFAS No. 133 have now been redesignated,substantially all of which are hedges under the long-haul method of hedgeaccounting. Redesignation of swaps as effective hedges reduces the overallvolatility of reported mark-to-market income, although establishing such swapsas long-haul hedges creates volatility as a result of hedge ineffectiveness. Allderivatives are economic hedges of the underlying debt instruments regardless ofthe accounting treatment. Net income volatility, whether based on changes in interest rates for swapswhich do not qualify for hedge accounting or ineffectiveness recorded on ourqualifying hedges under the long-haul method of accounting, impacts thecomparability of our reported results between periods. Accordingly, derivativeincome for the three and nine months ended September 30, 2006 should not beconsidered indicative of the results for any future periods. 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 portfolio, due to higher levels ofMasterCard/Visa credit card receivables, primarily as a result of ouracquisition of Metris in December 2005, partially offset by the impact of FFIECguidance which limits certain fee billings for non-prime credit card accounts.See "Segment Results - Managed Basis" for additional information on fee incomeon a managed basis. Enhancement services revenue, which consists of ancillary credit card revenuefrom products such as our Account Secure Plus (debt waiver) and our IdentityProtection Plan, was higher in both periods primarily as a result of higherlevels of MasterCard/Visa receivables, higher penetration levels and theacquisition of Metris in December 2005. Taxpayer financial services ("TFS") revenue decreased during the nine monthsended September 30, 2006 as TFS revenue during the nine months ended September30, 2005 reflects a gain of $24 million on the sale of certain bad debt recoveryrights to a third party. Excluding the impact of this gain in the prior year,TFS revenue in the nine 40 HSBC Finance Corporation -------------------------------------------------------------------------------- months ended September 30, 2006 increased compared to the prior year period dueto increased loan volume in the 2006 tax season. Gain on receivable sales to HSBC affiliates includes the daily sales of domesticprivate label receivable originations (excluding retail sales contracts) andcertain MasterCard/Visa account originations to HBUS. The increase over theprior-year quarter was due to increased pricing on our private label receivablespartially offset by lower volumes and higher MasterCard/Visa volume. Thedecrease in the gain on receivable sales to HSBC affiliates during the ninemonths of 2006 primarily reflects lower overall pricing on the daily sales ofdomestic private label receivable originations during 2006 partially offset byhigher volumes. Servicing and other fees from HSBC affiliates primarily represents revenuereceived under service level agreements under which we service MasterCard/Visacredit card and domestic private label receivables as well as real estatesecured and auto finance receivables for HSBC affiliates. The increases relateto higher levels of receivables being serviced during the first nine months of2006. Other income decreased in both periods. Other income for the nine months endedSeptember 30, 2005 was favorably impacted by the gains on partial sales of areal estate investment. Also contributing to the decrease in other income inboth periods was lower asset sales in our Decision One business. COSTS AND EXPENSES Effective December 20, 2005, our U.K. based technologyservices employees were transferred to HSBC Bank plc ("HBEU"). As a result,operating expenses relating to information technology, which have previouslybeen reported as salaries and fringe benefits, are now billed to us by HBEU andreported as support services from HSBC affiliates. The following table summarizes total costs and expenses: INCREASE (DECREASE) --------------THREE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT %-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Salaries and employee benefits...................... $ 571 $ 513 $ 58 11.3%Sales incentives.................................... 94 117 (23) (19.7)Occupancy and equipment expenses.................... 78 83 (5) (6.0)Other marketing expenses............................ 197 196 1 .5Other servicing and administrative expenses......... 318 194 124 63.9Support services from HSBC affiliates............... 261 226 35 15.5Amortization of intangibles......................... 63 90 (27) (30.0)Policyholders' benefits............................. 123 109 14 12.8 ------ ------ ---- -----Total costs and expenses............................ $1,705 $1,528 $177 11.6% ====== ====== ==== ===== 41 HSBC Finance Corporation -------------------------------------------------------------------------------- INCREASE (DECREASE) --------------NINE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT %-------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Salaries and employee benefits...................... $1,716 $1,536 $180 11.7%Sales incentives.................................... 272 289 (17) (5.9)Occupancy and equipment expenses.................... 240 252 (12) (4.8)Other marketing expenses............................ 546 561 (15) (2.7)Other servicing and administrative expenses......... 847 680 167 24.6Support services from HSBC affiliates............... 783 652 131 20.1Amortization of intangibles......................... 206 280 (74) (26.4)Policyholders' benefits............................. 348 347 1 .3 ------ ------ ---- -----Total costs and expenses............................ $4,958 $4,597 $361 7.9% ====== ====== ==== ===== Salaries and employee benefits increased in both periods as a result ofadditional staffing in our Consumer Lending, Mortgage Services, Retail Servicesand Canadian operations to support growth as well as additional staffing in ourCredit Card Services operations as a result of the acquisition of Metris inDecember 2005. These increases were offset by lower salaries and employeebenefits expense in our U.K. operations as a result of the sale of our U.K.credit card business and the transfer of our U.K. based technology servicesemployees to HBEU in December 2005. Sales incentives decreased in both periods primarily due to lower originationvolumes in our Mortgage Services business and our U.K. operations. Occupancy and equipment expenses decreased in both periods as a result of thesale of our U.K. credit card business in December 2005 which included the leaseassociated with the credit card call center as well as lower repairs andmaintenance costs. These decreases were partially offset by higher occupancy andequipment expenses resulting from our acquisition of Metris in December 2005. Other marketing expenses includes payments for advertising, direct mail programsand other marketing expenditures. Other marketing expenses in the quarter wereflat with the prior year period as reduced marketing in the U.K. was offset byan increase in marketing related to the launch of a co-brand credit card in ourdomestic business. The decrease in the nine month period was primarily due todecreased marketing expenses in our U.K. operations as a result of the sale ofour U.K. credit card business in December 2005, partially offset by highermarketing related to the co-brand credit card. Other servicing and administrative expenses increased during both periods as aresult of higher systems costs, higher REO expenses and higher insuranceoperating expense in our U.K. operations. Lower deferred origination costs atour Mortgage Services business due to lower volumes also contributed to theincrease in the quarter. Additionally, other servicing and administrativeexpenses for the year-to-date period in 2005 included a lower estimate ofexposure relating to accrued finance charges associated with certain loanrestructures. Support services from HSBC affiliates, which includes technology and otherservices charged to us by HSBC Technology and Services (USA) Inc. ("HTSU"),increased in both periods primarily due to receivable growth. Additionally, in2006, support services from HSBC affiliates also includes certain informationtechnology operating expenses for our U.K. operations charged to us by HBEU. Amortization of intangibles decreased in both periods as a result of lowerintangible amortization for our purchased credit card relationships due to acontract renegotiation with one of our co-branded credit card partners, loweramortization related to an individual contractual relationship and loweramortization associated with our U.K. operations as a result of the sale of ourU.K. credit card business in December 2005. These decreases were partiallyoffset by increased amortization associated with the Metris cardholderrelationships. 42 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock ExchangeRelated Shares:
HSBC Holdings