HSBC USA Inc. 10-Q

30th Jul 2007 11:39

HSBC Holdings PLC30 July 2007 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One)|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2007 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number 1-7436 HSBC USA Inc. (Exact name of registrant as specified in its charter) Maryland 13-2764867 (State of Incorporation) (I.R.S. Employer Identification No.) 452 Fifth Avenue, New York, New York 10018(Address of principal executive offices) (Zip Code) (716) 841-2424 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer. See definition of "acceleratedfiler and a 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 (as defined inRule 12b-2 of the Act). Yes |_| No |X| At July 30, 2007, there were 706 shares of the registrant's Common Stockoutstanding, all of which are owned by HSBC North America Inc. DOCUMENTS INCORPORATED BY REFERENCE None ================================================================================ HSBC USA Inc. Form 10-Q TABLE OF CONTENTS Part I FINANCIAL INFORMATION-------------------------------------------------------------------------------- Page ----Item 1. Consolidated Financial Statements Statements of Income .................................... 3 Balance Sheets .......................................... 4 Statements of Changes in Shareholders' Equity ........... 5 Statements of Cash Flows ................................ 6 Notes to Consolidated Financial Statements .............. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) Forward-Looking Statements .............................. 26 Executive Overview ...................................... 26 Basis of Reporting ...................................... 29 Balance Sheet Review .................................... 32 Results of Operations ................................... 35 Segment Results ......................................... 48 Credit Quality .......................................... 54 Off-Balance Sheet Arrangements .......................... 61 Risk Management ......................................... 63 Average Balances and Interest Rates ..................... 69 Item 3. Quantitative and Qualitative Disclosures About Market Risk .. 71 Item 4. Controls and Procedures ..................................... 71 Part II OTHER INFORMATION-------------------------------------------------------------------------------- Item 1A. Risk Factors ................................................ 72 Item 6. Exhibits .................................................... 72 Signature ............................................................... 73 2 HSBC USA Inc.Consolidated Statements of Income ------------------------------------------------------------------------------------------------------------------------ Three months ended June 30, Six months ended June 30, 2007 2006 2007 2006------------------------------------------------------------------------------------------------------------------------ (in millions) Interest income: Loans ............................................... $1,477 $1,382 $2,919 $2,669 Securities .......................................... 274 274 562 537 Trading assets ...................................... 168 102 309 210 Short-term investments .............................. 258 193 477 319 Other ............................................... 44 24 76 37 ------ ------ ------ ------Total interest income .................................. 2,221 1,975 4,343 3,772 ------ ------ ------ ------Interest expense: Deposits ............................................ 959 769 1,848 1,419 Short-term borrowings ............................... 105 74 176 146 Long-term debt ...................................... 350 357 723 697 ------ ------ ------ ------Total interest expense ................................. 1,414 1,200 2,747 2,262 ------ ------ ------ ------Net interest income .................................... 807 775 1,596 1,510Provision for credit losses ............................ 264 222 469 379 ------ ------ ------ ------Net interest income after provision for credit losses .. 543 553 1,127 1,131 ------ ------ ------ ------Other revenues: Trust income ........................................ 24 22 47 44 Service charges ..................................... 52 50 105 97 Credit card fees .................................... 198 139 376 261 Other fees and commissions .......................... 86 91 194 193 HSBC affiliate income ............................... 41 66 88 121 Other income ........................................ 6 3 52 7 Residential mortgage banking revenue ................ 42 27 63 50 Trading revenues .................................... 312 269 449 548 Securities gains, net ............................... 16 6 37 10 ------ ------ ------ ------Total other revenues ................................... 777 673 1,411 1,331 ------ ------ ------ ------Operating expenses: Salaries and employee benefits ...................... 341 321 678 636 Occupancy expense, net .............................. 59 57 118 108 Support services from HSBC affiliates ............... 286 247 565 511 Other expenses ...................................... 192 150 360 305 ------ ------ ------ ------Total operating expenses ............................... 878 775 1,721 1,560 ------ ------ ------ ------Income before income tax expense ....................... 442 451 817 902Income tax expense ..................................... 152 165 253 308 ------ ------ ------ ------Net income ............................................. $ 290 $ 286 $ 564 $ 594 ====== ====== ====== ====== The accompanying notes are an integral part of the consolidated financialstatements. 3 HSBC USA Inc.Consolidated Balance Sheets -------------------------------------------------------------------------------------------------------- June 30, December 31, 2007 2006-------------------------------------------------------------------------------------------------------- (in millions) AssetsCash and due from banks ...................................................... $ 3,592 $ 3,359Interest bearing deposits with banks ......................................... 4,915 1,921Federal funds sold and securities purchased under resale agreements .......... 16,898 13,775Trading assets ............................................................... 27,243 23,630Securities available for sale ................................................ 19,851 19,783Securities held to maturity (fair value $2,910 million and $3,040 million at June 30, 2007 and December 31, 2006, respectively) ............. 2,931 2,972Loans ........................................................................ 87,409 90,237Less - allowance for credit losses ........................................... 902 897 -------- -------- Loans, net ............................................................. 86,507 89,340 -------- --------Properties and equipment, net ................................................ 546 540Intangible assets ............................................................ 595 521Goodwill ..................................................................... 2,716 2,716Other assets ................................................................. 6,381 6,260 -------- --------Total assets ................................................................. $172,175 $164,817 ======== ========LiabilitiesDeposits in domestic offices: Noninterest bearing ....................................................... $ 12,118 $ 12,813 Interest bearing (includes $1,434 million and $1,322 million of deposits recorded at fair value at June 30, 2007 and December 31, 2006, respectively) .......................................................... 63,290 61,538Deposits in foreign offices: Noninterest bearing ....................................................... 1,090 727 Interest bearing .......................................................... 30,355 27,068 -------- -------- Total deposits ......................................................... 106,853 102,146 -------- --------Trading liabilities .......................................................... 15,324 12,314Short-term borrowings ........................................................ 5,430 5,073Interest, taxes and other liabilities ........................................ 3,644 3,771Long-term debt ............................................................... 28,775 29,252 -------- --------Total liabilities ............................................................ 160,026 152,556 -------- --------Shareholders' equity Preferred stock .............................................................. 1,690 1,690Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 706 shares issued and outstanding at June 30, 2007 and December 31, 2006) ................ -- (1) -- (1) Capital surplus ........................................................... 8,123 8,124 Retained earnings ......................................................... 2,705 2,661 Accumulated other comprehensive loss ...................................... (369) (214) -------- -------- Total common shareholder's equity ...................................... 10,459 10,571 -------- --------Total shareholders' equity ................................................... 12,149 12,261 -------- --------Total liabilities and shareholders' equity ................................... $172,175 $164,817 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. (1) Less than $500 thousand 4 HSBC USA Inc.Consolidated Statements of Changes in Shareholders' Equity ------------------------------------------------------------------------------------------------------------------ Six months ended June 30, 2007 2006------------------------------------------------------------------------------------------------------------------ (in millions) Preferred stockBalance, January 1, ............................................................... $ 1,690 $ 1,316Preferred stock issuance .......................................................... -- 374 ------- -------Balance, June 30, ................................................................. 1,690 1,690 ------- ------- Common stockBalance, January 1 and June 30, ................................................... -- (1) -- (1) ------- ------- Capital surplusBalance, January 1, ............................................................... 8,124 8,118Capital contribution from parent .................................................. 2 14Preferred stock issuance costs .................................................... -- (9)Employee benefit plans and other .................................................. (3) 4 ------- -------Balance, June 30, ................................................................. 8,123 8,127 ------- ------- Retained earningsBalance, January 1, ............................................................... 2,661 2,172Net income ........................................................................ 564 594Cash dividends declared on preferred stock ........................................ (50) (37)Cash dividends declared on common stock ........................................... (470) --Cumulative effect of change in accounting for mortgage servicing assets ........... -- (4) ------- -------Balance, June 30, ................................................................. 2,705 2,725 ------- ------- Accumulated other comprehensive incomeBalance, January 1, ............................................................... (214) (12) ------- ------- Net change in net unrealized losses on securities available for sale, net of tax .. (154) (235)Net change in net unrealized (losses) gains on derivatives classified as cash flow hedges, net of tax ........................................................ (12) 30Net change in net unrealized gains on interest only strip receivables, net of tax ......................................................................... -- (4)Unrecognized actuarial gains, transition obligation and prior service costs relating to pension and postretirement benefits, net of tax .............. 9 --Foreign currency translation adjustments, net of tax .............................. 2 (2) ------- -------Other comprehensive loss, net of tax .............................................. (155) (211) ------- -------Balance, June 30, ................................................................. (369) (223) ------- -------Total shareholders' equity, June 30, .............................................. $12,149 $12,319 ======= ======= Comprehensive incomeNet income ........................................................................ $ 564 $ 594Other comprehensive loss .......................................................... (155) (211) ------- -------Comprehensive income .............................................................. $ 409 $ 383 ======= ======= The accompanying notes are an integral part of the consolidated financialstatements. (1) Less than $500 thousand 5 HSBC USA Inc.Consolidated Statements of Cash Flows ------------------------------------------------------------------------------------------------------------ 2007 2006------------------------------------------------------------------------------------------------------------ (in millions) Cash flows from operating activities Net income ....................................................................... $ 564 $ 594 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation, amortization and deferred taxes ................................. 85 236 Provision for credit losses ................................................... 469 379 Net change in other assets and liabilities .................................... (839) 1,316 Net change in loans held for sale to HSBC Markets (USA) Inc. (HMUS): Loans acquired from originators ............................................ (4,607) (9,998) Sales of loans to HMUS ..................................................... 4,688 8,156 Net change in other loans held for sale ....................................... 165 290 Net change in loans attributable to tax refund anticipation loans program: Originations of loans ...................................................... (17,428) (16,100) Sales of loans to HSBC Finance Corporation, including premium .............. 17,640 16,100 Net change in trading assets and liabilities .................................. (232) (3,084) Net change in fair value of derivatives and hedged items ...................... 879 35 -------- -------- Net cash provided by (used in) operating activities ........................ 1,384 (2,076) -------- --------Cash flows from investing activities Net change in interest bearing deposits with banks ............................... (2,994) (3,154) Net change in federal funds sold and securities purchased under resale agreements .................................................................... (3,123) (4,457) Net change in securities available for sale: Purchases of securities available for sale .................................... (5,556) (4,357) Proceeds from sales of securities available for sale .......................... 3,705 1,533 Proceeds from maturities of securities available for sale ..................... 1,729 1,094 Net change in securities held to maturity: Purchases of securities held to maturity ...................................... (130) (752) Proceeds from maturities of securities held to maturity ....................... 171 897 Net change in loans: Originations, net of collections .............................................. 13,351 11,208 Loans purchased from HSBC Finance Corporation ................................. (11,368) (11,054) Net cash used for acquisitions of properties and equipment ....................... (42) (48) Other, net ....................................................................... (21) (61) -------- -------- Net cash used in investing activities ...................................... (4,278) (9,151) -------- --------Cash flows from financing activities Net change in deposits ........................................................... 4,707 9,107 Net change in short-term borrowings .............................................. 357 645 Net change in long-term debt: Issuance of long-term debt .................................................... 2,931 2,632 Repayment of long-term debt ................................................... (4,347) (1,300) Preferred stock issuance, net of issuance costs .................................. -- 365 Other (decreases) increases in capital surplus ................................... (1) 18 Dividends paid ................................................................... (520) (37) -------- -------- Net cash provided by financing activities .................................. 3,127 11,430 -------- --------Net change in cash and due from banks ............................................... 233 203Cash and due from banks at beginning of period ...................................... 3,359 4,441 -------- --------Cash and due from banks at end of period ............................................ $ 3,592 $ 4,644 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 6 Notes to Consolidated Financial Statements Note 1. Organization and Basis of Presentation-------------------------------------------------------------------------------- HSBC USA Inc. is an indirect wholly owned subsidiary of HSBC North AmericaHoldings Inc. (HNAH), which is an indirect wholly owned subsidiary of HSBCHoldings plc (HSBC). The accompanying unaudited interim consolidated financialstatements of HSBC USA Inc. and its subsidiaries (collectively, HUSI), includingits principal subsidiary, HSBC Bank USA, National Association (HBUS), have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (U.S. GAAP) for interim financial information, as wellas in accordance with predominant practices within the banking industry.Accordingly, they do not include all of the information and footnotes requiredby U.S. GAAP for complete financial statements. In the opinion of management,all normal and recurring adjustments considered necessary for a fairpresentation of financial position, results of operations and cash flows for theinterim periods have been made. These unaudited interim financial statementsshould be read in conjunction with HUSI's Annual Report on Form 10-K for theyear ended December 31, 2006 (the 2006 Form 10-K). Certain reclassificationshave been made to prior period amounts to conform to the current periodpresentations. The accounting and reporting policies of HUSI are consistent, inall material respects, with those used to prepare the 2006 Form 10-K, except forthe impact of new accounting pronouncements summarized in Note 15 of theseunaudited interim consolidated financial statements. 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. Note 2. Trading Assets and Liabilities-------------------------------------------------------------------------------- Trading assets and liabilities are summarized in the following table. -------------------------------------------------------------------------------- June 30, December 31, 2007 2006-------------------------------------------------------------------------------- (in millions)Trading assets: U.S. Treasury ................................... $ 394 $ 646 U.S. Government agency .......................... 3,451 1,902 Asset backed securities ......................... 3,295 3,053 Corporate bonds ................................. 1,733 1,420 Other securities ................................ 5,642 4,903 Precious metals ................................. 3,449 2,716 Fair value of derivatives ....................... 9,279 8,990 ------- ------- $27,243 $23,630 ======= =======Trading liabilities: Securities sold, not yet purchased .............. $ 3,648 $ 1,914 Payables for precious metals .................... 1,932 1,336 Fair value of derivatives ....................... 9,744 9,064 ------- ------- $15,324 $12,314 ======= ======= During the second quarter of 2007, HUSI adopted the reporting requirements ofFASB Staff Position No. FIN 39-1, Amendment of FASB Interpretation No. 39 (referto Note 15 of these consolidated financial statements). In accordance with thisstandard, HUSI offsets fair value amounts recognized for the obligation toreturn cash collateral or the right to reclaim cash collateral against the fairvalue of derivative instruments executed with the same counterparty under amaster netting agreement. As a result of application of this standard, certainreclassifications have been made to the December 31, 2006 consolidated balancesheet, as noted below. At June 30, 2007 and December 31, 2006, the fair value of derivatives includedin trading assets have been reduced by $3.4 billion and $2.4 billion,respectively, of amounts recognized for the obligation to return cash collateralreceived under master netting agreements with derivative counterparties. AtDecember 31, 2006, these amounts were originally reported as interest bearingdeposits. 7 At June 30, 2007 and December 31, 2006, the fair value of derivatives includedin trading liabilities have been reduced by $2.2 billion and $1.7 billion,respectively, of amounts recognized for the right to reclaim cash collateralpaid under a master netting agreements with derivative counterparties. AtDecember 31, 2006, $.4 billion of these amounts were originally reported asinterest bearing deposits with banks and $1.3 billion were reported as otherassets. Note 3. Securities-------------------------------------------------------------------------------- At June 30, 2007 and December 31, 2006, HUSI held no securities of any singleissuer (excluding the U.S. Treasury, U.S. Government agencies and U.S.Government sponsored enterprises) with a book value that exceeded 10% ofshareholders' equity. The amortized cost and fair value of the securitiesavailable for sale and securities held to maturity portfolios are summarized inthe following tables. ------------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized FairJune 30, 2007 Cost Gains Losses Value------------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury ................................................ $ 606 $-- $ (21) $ 585 U.S. Government sponsored enterprises (1) .................... 10,941 13 (465) 10,489 U.S. Government agency issued or guaranteed .................. 3,591 4 (129) 3,466 Obligations of U.S. states and political subdivisions ........ 648 -- (14) 634 Asset backed securities ...................................... 1,641 1 (6) 1,636 Other domestic debt securities ............................... 2,642 3 (30) 2,615 Foreign debt securities ...................................... 398 -- (4) 394 Equity securities ............................................ 28 5 (1) 32 ------- --- ----- ------- Securities available for sale ................................ $20,495 $26 $(670) $19,851 ======= === ===== =======Securities held to maturity: U.S. Government sponsored enterprises (1) .................... $ 1,851 $15 $ (51) $ 1,815 U.S. Government agency issued or guaranteed .................. 553 17 (7) 563 Obligations of U.S. states and political subdivisions ........ 280 14 -- 294 Other domestic debt securities ............................... 172 -- (9) 163 Foreign debt securities ...................................... 75 -- -- 75 ------- --- ----- ------- Securities held to maturity .................................. $ 2,931 $46 $ (67) $ 2,910 ======= === ===== ======= ------------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized FairDecember 31, 2006 Cost Gains Losses Value------------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury ............................................... $ 1,535 $ 3 $ (8) $ 1,530 U.S. Government sponsored enterprises (1) ................... 10,682 30 (257) 10,455 U.S. Government agency issued or guaranteed ................. 3,793 6 (72) 3,727 Obligations of U.S. states and political subdivisions ....... 515 4 (1) 518 Asset backed securities ..................................... 578 1 (3) 576 Other domestic debt securities .............................. 1,343 3 (19) 1,327 Foreign debt securities ..................................... 860 7 (3) 864 Equity securities ........................................... 775 11 -- 786 ------- --- ----- ------- Securities available for sale ............................... $20,081 $65 $(363) $19,783 ======= === ===== =======Securities held to maturity: U.S. Government sponsored enterprises (1) .................... $ 1,845 $43 $ (17) $ 1,871 U.S. Government agency issued or guaranteed .................. 584 25 (2) 607 Obligations of U.S. states and political subdivisions ........ 325 19 -- 344 Other domestic debt securities ............................... 167 2 (2) 167 Foreign debt securities ...................................... 51 -- -- 51 ------- --- ----- ------- Securities held to maturity .................................. $ 2,972 $89 $ (21) $ 3,040 ======= === ===== ======= (1) Includes primarily mortgage backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). 8 Gross unrealized losses and related fair values, classified as to the length oftime the losses have existed, are summarized in the following tables. ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year --------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair ValueJune 30, 2007 Securities Losses of Investment Securities Losses of Investment------------------------------------------------------------------------------------------------------------------------ ($ in millions)Securities available for sale: U.S. Treasury .................... 1 $ (4) $ 150 3 $ (17) $ 434 U.S. Government sponsored enterprises (1) ................ 334 (92) 2,890 594 (374) 6,636 U.S. Government agency issued or guaranteed ........... 131 (19) 626 827 (109) 2,691 Obligations of U.S. states and political subdivisions .... 94 (13) 611 2 (1) 22 Asset backed securities .......... 12 (3) 853 18 (3) 254 Other domestic debt securities ... 22 (7) 932 58 (22) 925 Foreign debt securities .......... 8 (3) 152 7 (2) 154 Equity securities ................ -- -- -- 1 (1) 23 --- ----- ------ ----- ----- ------- Securities available for sale .... 602 $(141) $6,214 1,510 $(529) $11,139 === ===== ====== ===== ===== =======Securities held to maturity: U.S. Government sponsored enterprises (1) ................ 40 $ (20) $ 881 24 $ (31) $ 374 U.S. Government agency issued or guaranteed ........... 32 (3) 157 166 (4) 38 Obligations of U.S. states and political subdivisions .... 7 * 3 -- -- -- Other domestic debt securities ... 8 (5) 125 5 (4) 38 Foreign debt securities .......... 4 * 75 -- -- -- --- ----- ------ ----- ----- ------- Securities held to maturity ...... 91 $ (28) $1,241 195 $ (39) $ 450 === ===== ====== ===== ===== ======= ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year --------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair ValueDecember 31, 2006 Securities Losses of Investment Securities Losses of Investment------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury .................... 8 $ (1) $ 527 6 $ (7) $ 566 U.S. Government sponsored enterprises (1) ................ 211 (114) 3,158 482 (143) 5,042 U.S. Government agency issued or guaranteed ........... 691 (40) 2,334 268 (32) 1,076 Obligations of U.S. states and political subdivisions .... 12 (1) 85 3 * 27 Asset backed securities .......... 6 * 81 19 (3) 293 Other domestic debt securities ... 10 (1) 153 56 (18) 910 Foreign debt securities .......... 6 (1) 191 11 (2) 227 --- ----- ------ --- ----- ------ Securities available for sale .... 944 $(158) $6,529 845 $(205) $8,141 === ===== ====== === ===== ======Securities held to maturity: U.S. Government sponsored enterprises (1) ................ 23 $ * $ 15 22 $ (17) $ 389 U.S. Government agency issued or guaranteed ........... 49 * 21 169 (2) 35 Obligations of U.S. states and political subdivisions .... 1 * * 9 * 4 Other domestic debt securities ... 2 * 22 4 (2) 33 Foreign debt securities .......... 2 * 51 -- -- -- --- ----- ------ --- ----- ------ Securities held to maturity ...... 77 $ * $ 109 204 $ (21) $ 461 === ===== ====== === ===== ====== (1) Includes primarily mortgaged-backed securities issued by FNMA and FHLMC. * Less than $500 thousand. 9 Gross unrealized losses within the available for sale securities portfolioincreased during the six months ended June 30, 2007 due to the impact of generalincreases in market interest rates on HUSI's portfolios, which are primarilyfixed rate securities. Since substantially all of these securities are highcredit grade (i.e., AAA or AA), and HUSI has the ability and intent to holdthese securities until maturity or a market price recovery, they are notconsidered to be other than temporarily impaired. Note 4. Loans-------------------------------------------------------------------------------- A distribution of the loan portfolio, including loans held for sale, issummarized in the following table. ------------------------------------------------------------------------------------------------- June 30, 2007 December 31, 2006 ----------------------- ----------------------- Held for Sale Held for Sale Total Included in Total Included in Loans Total Loans Loans Total Loans------------------------------------------------------------------------------------------------- (in millions) Commercial loans: Construction and other real estate ....... $ 8,589 $ -- $ 8,918 $ 102 Other commercial ......................... 20,989 -- 20,564 -- ------- ------ ------- ------ 29,578 -- 29,482 102 ------- ------ ------- ------Consumer loans: Residential mortgages .................... 37,779 4,071 39,808 4,227 Credit card receivables .................. 17,635 -- 18,260 -- Other consumer ........................... 2,417 405 2,687 394 ------- ------ ------- ------ 57,831 4,476 60,755 4,621 ------- ------ ------- ------Total loans ................................. $87,409 $4,476 $90,237 $4,723 ======= ====== ======= ====== Loans pledged as collateral are summarized in Note 14 beginning on page 20 ofthis Form 10-Q. Loans Held for Sale Loans held for sale primarily include sub-prime residential mortgage loansacquired from unaffiliated third parties and from HSBC Finance Corporation, withthe intent of selling the loans to an HSBC affiliate, HSBC Markets (USA) Inc.(HMUS). Loans held for sale to HMUS were $3.1 billion at June 30, 2007 andDecember 31, 2006. Also included in loans held for sale are residential mortgageloans held for sale to various governmental agencies and other types of consumerloans. Loans held for sale are recorded at the lower of aggregate cost or market value.Aggregate cost exceeded market value at June 30, 2007 and December 31, 2006.Changes in the valuation allowance utilized to adjust loans held for sale tomarket value are summarized in the following table. ------------------------------------------------------------------------------------------------------------ 2007 2006 -------------------------------------- ------------------------------ Valuation Allowance Related to Valuation Allowance Related to ------------------------------ ------------------------------ Loans Held Other Loans Held Other for Sale Loans Held for Sale Loans Held to HMUS for Sale Total to HMUS for Sale Total--------------------------------------------------------------------------------------------------------- (in millions) Three months ended June 30:Balance at beginning of period ... $(24) $(2) $(26) $ (50) $(20) $ (70)Valuation allowance increase for changes in market value ... (65) (7) (72) (73) -- (73)Releases of valuation allowance for loans sold ....... 40 -- 40 40 -- 40 ---- --- ---- ----- ---- -----Balance at end of period ......... $(49) $(9) $(58) $ (83) $(20) $(103) ==== === ==== ===== ==== ===== Six months ended June 30:Balance at beginning of period ... $(26) $(3) $(29) $ (11) $(15) $ (26)Valuation allowance increase for changes in market value ... (75) (6) (81) (152) (5) (157)Releases of valuation allowance for loans sold ....... 52 -- 52 80 -- 80 ---- --- ---- ----- ---- -----Balance at end of period ......... $(49) $(9) $(58) $ (83) $(20) $(103) ==== === ==== ===== ==== ===== 10 Loans held for sale to HMUS are subject to interest rate and market risk, inthat their value will fluctuate as a result of changes in the interest rateenvironment. Interest rate risk is mitigated through an active economic hedgingprogram to offset changes in the fair value of the loans held for sale. Tradingrelated revenues related to this economic hedging program, which include netinterest income and trading revenues, were $57 million and $154 million for thefirst six months of 2007 and 2006, respectively. Credit Quality Statistics Nonaccruing loans information is summarized in the following table. ----------------------------------------------------------------------------------------------- June 30, December 31, 2007 2006----------------------------------------------------------------------------------------------- (in millions) Nonaccruing loans Commercial: Construction and other real estate ............................ $ 40 $ 33 Other commercial .............................................. 86 69 ---- ---- Total commercial .............................................. 126 102 ---- ---- Consumer: Residential mortgages ......................................... 198 182 Credit card receivables ....................................... 1 1 ---- ---- Total consumer ................................................ 199 183 ---- ---- Total nonaccruing loans .......................................... $325 $285 ==== ==== Interest income on nonaccruing loans is summarized in the following table. -----------------------------------------------------------------------------------------------Six months ended June 30 2007 2006----------------------------------------------------------------------------------------------- (in millions) Interest income on nonaccruing loans: Amount which would have been recorded had the associated loans been current in accordance with their original terms ........... $12 $11 Amount actually recorded ......................................... 5 4 Additional credit quality statistics are summarized in the following table. ----------------------------------------------------------------------------------------------- June 30, December 31, 2007 2006----------------------------------------------------------------------------------------------- (in millions) Accruing loans contractually past due 90 days or more as to principal or interest: Total commercial loans ........................................... $ 10 $ 22 ---- ---- Consumer: Residential mortgages ......................................... 4 11 Credit card receivables ....................................... 315 339 Other consumer loans .......................................... 15 16 ---- ---- Total consumer loans .......................................... 334 366 ---- ---- Total accruing loans contractually past due 90 days or more ...... $344 $388 ==== ==== Impaired loans: Balance at end of period ......................................... $126 $100 Amount with impairment reserve ................................... 52 35 Impairment reserve ............................................... 22 13 Other real estate and owned assets: Balance at end of period ......................................... $ 65 $ 53 11 Note 5. Allowance for Credit Losses-------------------------------------------------------------------------------- Changes in the allowance for credit losses are summarized in the followingtable. ---------------------------------------------------------------------------------------- Three months ended Six months ended June 30 June 30 ------------------ ---------------- 2007 2006 2007 2006---------------------------------------------------------------------------------------- (in millions) Beginning balance ............................ $862 $837 $897 $846 ---- ---- ---- ----Allowance related to disposition of certain private label credit card relationships ... -- -- -- (6)Net charge offs: Charge offs ............................... 293 239 598 469 Recoveries ................................ 69 49 134 119 ---- ---- ---- ---- 224 190 464 350 ---- ---- ---- ----Provision for credit losses .................. 264 222 469 379 ---- ---- ---- ----Ending balance ............................... $902 $869 $902 $869 ==== ==== ==== ==== Credit quality statistics are provided in Note 4 of these consolidated financialstatements. Note 6. Intangible Assets-------------------------------------------------------------------------------- The composition of intangible assets is summarized in the following table. -------------------------------------------------------------------------------- June 30, December 31, 2007 2006-------------------------------------------------------------------------------- (in millions)Mortgage servicing rights ............................ $552 $474Other ................................................ 43 47 ---- ----Total intangible assets .............................. $595 $521 ==== ==== Mortgage Servicing Rights (MSRs) HUSI has one class of MSRs arising from sales of residential mortgage loans.HUSI recognizes the right to service mortgage loans as a separate and distinctasset at the time the loans are sold. HUSI receives a fee for servicing therelated residential mortgage loans. Servicing fee income of $56 million and $48million for the first six months of 2007 and 2006, respectively, is recorded inresidential mortgage banking revenue in the consolidated statement of income. MSRs are subject to interest rate risk, in that their value will fluctuate as aresult of changes in the interest rate environment. Interest rate risk ismitigated through an active economic hedging program that uses securities andderivatives to offset changes in the fair value of MSRs. Since the hedgingprogram involves trading activity, risk is quantified and managed using a numberof risk assessment techniques, which are addressed in more detail beginning onpage 63 of this Form 10-Q. MSRs are initially measured at fair value at the time that the related loans aresold, and periodically remeasured using the fair value measurement method. Thismethod requires that MSRs be measured at fair value at each reporting date withchanges in fair value of the asset reflected in residential mortgage bankingrevenue in the period that the changes occur. Fair value is determined basedupon the application of valuation models and other inputs. The valuation modelsincorporate assumptions market participants would use in estimating future cashflows. The reasonableness of these valuation models is periodically validated byreference to external independent broker valuations and industry surveys. 12 Fair value of MSRs is calculated using the following critical assumptions. -------------------------------------------------------------------------- June 30, December 31, 2007 2006--------------------------------------------------------------------------Annualized constant prepayment rate (CPR) .... 15.80% 20.80%Constant discount rate ....................... 10.68% 10.34%Weighted average life ........................ 5.7years 4.8years MSRs activity is summarized in the following table. -------------------------------------------------------------------------- 2007 2006-------------------------------------------------------------------------- (in millions)Three months ended June 30:Fair value of MSRs: Beginning balance .............................. $486 $465 Additions related to loan sales ................ 31 22 Changes in fair value due to: Change in valuation inputs or assumptions used in the valuation models .. 57 30 Realization of cash flows ................... (22) (18) ---- ---- Ending balance ................................. $552 $499 ==== ====Six months ended June 30:Fair value of MSRs: Beginning balance .............................. $474 $418 Additions related to loan sales ................ 61 45 Changes in fair value due to: Change in valuation inputs or assumptions used in the valuation models .. 63 75 Realization of cash flows ................... (46) (39) ---- ---- Ending balance ................................. $552 $499 ==== ==== Note 7. Goodwill-------------------------------------------------------------------------------- During the second quarter of 2006, HUSI completed its annual impairment test ofgoodwill. In order to conform its testing date with that of HSBC and other HSBCaffiliates, HUSI changed its accounting policy for the impairment testing dateand completed an additional impairment test of goodwill in the third quarter of2006. At both testing dates, HUSI determined that the fair value of each of thereporting units exceeded its carrying value. As a result, no impairment loss wasrequired to be recognized. In 2007 and subsequent years, the annual impairmenttest of goodwill will continue to be completed in the third quarter. During thesix months ended June 30, 2007, there were no material events or transactionswhich warranted consideration for their impact on recorded book values assignedto goodwill. Note 8. Income Taxes-------------------------------------------------------------------------------- The following table presents HUSI's effective tax rates. ---------------------------------------------------------------------------------------- Three months ended Six months ended June 30 June 30 ------------------ ---------------- 2007 2006 2007 2006---------------------------------------------------------------------------------------- Effective tax rate ........................... 34.4% 36.6% 31.0% 34.1% During the first quarter of 2007, after completing a review of its deferredincome taxes, HUSI increased the carrying value of its net deferred tax assetsand decreased deferred tax expense by $28 million, thereby reducing theeffective tax rate by 3.5% for the first six months of 2007. 13 In the first quarter of 2006, approximately $17 million of income tax liability,related mainly to the completion of ongoing tax audits, was released against taxexpense, thereby reducing the effective tax rate by 1.8% for the first sixmonths of 2006. Excluding the effect of the one-time adjustments in 2006 and 2007, the effectivetax rate for the first six months of 2007 declined 1.5% over the comparable 2006period. This decrease is primarily due to a decline in state and local taxliabilities due to changes in tax laws, higher earnings in low tax jurisdictionsand lower earnings in high tax jurisdictions, and to an overall decreased levelof earnings and to a higher level of low income housing tax credits. HUSI adopted FASB Interpretation No. 48 (FIN 48) effective January 1, 2007(refer to Note 15 of these consolidated financial statements). The adoptionresulted in the recognition of additional current tax liabilities and offsettingdeferred tax assets of $11 million. The total amount of unrecognized taxbenefits as of January 1, 2007 was $86 million. The state tax portion of thisamount is reflected gross and not reduced by federal tax effect. The totalamount of unrecognized tax benefits that, if recognized, would affect theeffective tax rate was $54 million. Major taxing jurisdictions for HUSI and tax years for each that remain subjectto examination are as follows: U.S. Federal 2004 and laterNew York State 1992 and laterNew York City 1995 and later HUSI does not anticipate that any significant tax positions have a reasonablepossibility of being effectively settled within the next 12 months. HUSI recognizes accrued interest related to unrecognized tax benefits in otheroperating expenses. As of January 1, 2007, HUSI had accrued $16 million for thepayment of interest. Note 9. Long-Term Debt-------------------------------------------------------------------------------- Long-term debt is summarized in the following table. -------------------------------------------------------------------------------- June 30, December 31, 2007 2006-------------------------------------------------------------------------------- (in millions)Senior debt ........................................ $23,546 $23,913Subordinated debt .................................. 5,213 5,322All other .......................................... 16 17 ------- -------Total long-term debt ............................... $28,775 $29,252 ======= ======= Senior debt includes $1,546 million and $902 million of debt instrumentsrecorded at fair value at June 30, 2007 and December 31, 2006, respectively. 14 Note 10. Related Party Transactions-------------------------------------------------------------------------------- In the normal course of business, HUSI conducts transactions with HSBC and itssubsidiaries (HSBC affiliates). These transactions occur at prevailing marketrates and terms. All extensions of credit by HUSI to other HSBC affiliates arelegally required to be secured by eligible collateral. Related party balancesand the income and expense generated by related party transactions aresummarized in the following table. -------------------------------------------------------------------------------- June 30, December 31, 2007 2006-------------------------------------------------------------------------------- (in millions)Assets: Cash and due from banks ........................ $ 145 $ 179 Interest bearing deposits with banks ........... 53 59 Federal funds sold and securities purchased under resale agreements ............ 153 141 Trading assets (1) ............................. 11,660 6,895 Loans .......................................... 1,504 813 Other .......................................... 240 242 ------- ------- Total assets ................................... $13,755 $ 8,329 ======= =======Liabilities: Deposits ....................................... $11,200 $12,233 Trading liabilities (1) ........................ 11,419 6,473 Short-term borrowings .......................... 256 464 Other .......................................... 255 254 ------- ------- Total liabilities .............................. $23,130 $19,424 ======= ======= (1) Trading assets and liabilities exclude the impact of netting in accordance with FASB Interpretation No. 39 and FSP FIN 39-1. ---------------------------------------------------------------------------------------- Three months ended Six months ended June 30 June 30 ------------------ ---------------- 2007 2006 2007 2006---------------------------------------------------------------------------------------- (in millions) Interest income .............................. $ 39 $ 12 $ 65 $ 23Interest expense ............................. 106 97 209 197Other revenues: Gains on sales of loans to HMUS ........... 7 52 8 64 Gains on sales of refund anticipation loans to HSBC Finance Corporation ....... 1 1 23 21 Other HSBC affiliates income .............. 33 13 57 36Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation ..... 113 109 232 225 Fees paid to HMUS ......................... 66 52 123 107 Fees paid to HSBC Technology & Services (USA) Inc. (HTSU) for technology services .............................. 62 49 123 106 Fees paid to other HSBC affiliates ........ 45 37 87 73 15 Transactions Conducted with HSBC Finance Corporation o By agreement, HUSI purchases receivables generated by private label and MasterCard(1)/Visa(2) credit card relationships on a daily basis at a value that approximates fair value, as determined by an independent third party. Premiums paid are amortized to interest income over the estimated life of the receivables purchased. Activity related to these portfolios is summarized in the following table. --------------------------------------------------------------------------------------------------- Private Label MasterCard/Visa ------------------- -------------------Six months ended June 30 2007 2006 2007 2006--------------------------------------------------------------------------------------------------- (in millions) Receivables acquired from HSBC Finance Corporation: Balance at beginning of period ..................... $ 16,973 $ 14,355 $ 1,287 $ 1,159 Receivables acquired ............................... 10,090 9,976 1,278 1,078 Customer payments, net charge offs and other activity .................................. (10,957) (10,172) (1,036) (1,086) -------- -------- ------- ------- Balance at end of period ........................... $ 16,106 $ 14,159 $ 1,529 $ 1,151 ======== ======== ======= =======Unamortized premiums paid to HSBC Finance Corporation: Balance at beginning of period ..................... $ 188 $ 320 $ 15 $ 12 Premiums paid ...................................... 162 167 42 17 Amortization ....................................... (219) (280) (27) (17) -------- -------- ------- ------- Balance at end of period ........................... $ 131 $ 207 $ 30 $ 12 ======== ======== ======= ======= o Support services from HSBC affiliates includes charges by HSBC Finance Corporation under various service level agreements for loan origination and servicing as well as other operational and administrative support. o HUSI's wholly-owned subsidiaries HBUS and HSBC Trust Company (Delaware), N.A. (HTCD) are the originating lenders for a federal income tax refund anticipation loan program for clients of various third party tax preparers, which are managed by HSBC Finance Corporation. By agreement, HBUS and HTCD process applications, fund and subsequently sell these loans to HSBC Finance Corporation. During the six months ended June 30, 2007, approximately $17 billion of loans were originated by HBUS and HTCD and sold to HSBC Finance Corporation, resulting in gains of $23 million. For the same 2006 period, $16 billion of loans were sold to HSBC Finance Corporation, resulting in gains of $21 million. o Certain of HUSI's consolidated subsidiaries have secured lines of credit totaling $2.3 billion with HSBC Finance Corporation. There were no balances outstanding under any of these lines of credit at June 30, 2007 or December 31, 2006. o In 2006, HUSI began acquiring residential mortgage loans at fair value from HSBC Finance Corporation for the purpose of selling these loans to HMUS (see "Transactions Conducted with HMUS" below). During the six months ended June 30, 2007, HUSI acquired $371 million of loans from HSBC Finance Corporation for a total premium of $.4 million. Transactions Conducted with HMUS o HUSI utilizes HMUS for broker dealer, debt and preferred stock underwriting, customer referrals, loan syndication and other treasury and traded markets related services, pursuant to service level agreements. Fees charged by HMUS for broker dealer, loan syndication services, treasury and traded markets related services are included in support services from HSBC affiliates. Debt underwriting fees charged by HMUS are deferred as a reduction of long-term debt and amortized to interest expense over the life of the related debt. Preferred stock issuance costs charged by HMUS are recorded as a reduction of capital surplus. Customer referral fees paid to HMUS are netted against customer fee income, which is included in other fees and commissions. ----------(1) MasterCard is a registered trademark of MasterCard International, Incorporated. (2) Visa is a registered trademark of Visa USA, Inc. 16 o In 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties and from HSBC Finance Corporation and subsequently selling these acquired loans to HMUS (refer to Note 4 of these consolidated financial statements). HUSI maintains no ownership interest in the residential mortgage loans after sale. Under this program, HUSI sold $4.7 billion and $8.2 billion of loans to HMUS during the first six months of 2007 and 2006, respectively. Total gains on sale were $8 million and $64 million during the first six months of 2007 and 2006, respectively. o During the first quarter of 2007, as part of a strategy to consolidate certain investments into a common HSBC entity in North America, HUSI sold certain non-marketable investments to HMUS resulting in total net gains of $6 million. The carrying value of these investments totaled $10 million at the time of the sale. Support Services from HSBC Technology & Services (USA) Inc. HSBC's technology services in North America are centralized within HSBCTechnology & Services (USA) Inc. (HTSU). Technology related assets and softwareacquired for HUSI are generally purchased and owned by HTSU. Pursuant to amaster service level agreement, HTSU charges HUSI for equipment related costsand technology services. HTSU also charges for software development costs, whichgenerally are capitalized by HUSI. Other Transactions with HSBC Affiliates HUSI has a $2 billion line of credit with HSBC which was unused at June 30, 2007and December 31, 2006. HUSI has extended loans and lines of credit to various other HSBC affiliatestotaling $1.4 billion, of which $188 million and $172 million was outstanding atJune 30, 2007 and December 31, 2006, respectively. HUSI utilizes other HSBC affiliates primarily for global outsourcing initiativesand, to a lesser extent, for treasury and traded markets services. HUSI routinely enters into derivative transactions with HSBC Finance Corporationand other HSBC affiliates as part of a global HSBC strategy to offset interestrate or other market risks associated with debt issues and derivative contractswith unaffiliated third parties. The fair value of derivative receivablesrelated to these contracts was approximately $12 billion and $7 billion at June30, 2007 and December 31, 2006, respectively. HUSI, within its Corporate,Investment Banking and Markets business segment, accounts for these transactionson a mark to market basis, with the change in value of contracts with HSBCaffiliates substantially offset by the change in value of related contractsentered into with unaffiliated third parties. Domestic employees of HUSI participate in a defined benefit pension plansponsored by HNAH. Additional information regarding pensions is provided in Note11 of these consolidated financial statements. Employees of HUSI participate in one or more stock compensation plans sponsoredby HSBC. HUSI's share of the expense of these plans on a pre-tax basis for thefirst six months of 2007 and 2006 was approximately $30 million and $36 million,respectively. As of June 30, 2007, HUSI's share of compensation cost related tononvested stock compensation plans was approximately $112 million, which isexpected to be recognized over a weighted-average period of 1.6 years. Adescription of these stock compensation plans begins on page 140 of HUSI's 2006Form 10-K. During the first half of 2007, HUSI declared and paid dividends of $470 millionto its parent company, HSBC North America Inc. There were no dividends declaredor paid during the first half of 2006. 17 Note 11. Pensions and Other Postretirement Benefits of HUSI and HSBC FinanceCorporation-------------------------------------------------------------------------------- Effective January 1, 2005, the separate U.S. defined benefit pension and healthand life insurance plans were merged into a single defined benefit pension plan,under the sponsorship of HNAH, which facilitated the development of a unifiedemployee benefit policy and unified employee benefit plan administration forHSBC affiliates operating in the U.S. The following table presents the components of net periodic benefit cost asallocated to HUSI from HNAH. --------------------------------------------------------------------------------------------------- Other Pension Benefits Postretirement Benefits ---------------- ---------------------- 2007 2006 2007 2006--------------------------------------------------------------------------- ----------------- (in millions) Three months ended June 30:Net periodic benefit cost: Service cost - benefits earned during the period .. $ 8 $ 8 $ 1 $ 1 Interest cost ..................................... 18 16 2 1 Expected return on plan assets .................... (22) (21) -- -- Recognized losses ................................. 1 4 -- -- Transition amount amortization .................... -- -- -- -- ---- ---- ---- --- Net periodic benefit cost ......................... $ 5 $ 7 $ 3 $ 2 ==== ==== ==== === Six months ended June 30:Net periodic benefit cost: Service cost - benefits earned during the period .. $ 16 $ 16 $ 1 $ 1 Interest cost ..................................... 35 33 3 3 Expected return on plan assets .................... (45) (43) -- -- Recognized losses ................................. 3 7 -- -- Transition amount amortization .................... -- -- 1 1 ---- ---- ---- --- Net periodic benefit cost ......................... $ 9 $ 13 $ 5 $ 5 ==== ==== ==== === During 2007, HUSI expects to make no contribution for pension benefits andexpects to contribute approximately $9 million for other postretirementbenefits. Note 12. Regulatory Capital-------------------------------------------------------------------------------- Capital amounts and ratios of HUSI and HBUS, calculated in accordance withbanking regulations, are summarized in the following table. -------------------------------------------------------------------------------------------------------- June 30, 2007 December 31, 2006 ------------------------------------- ------------------------------------ Capital Well-Capitalized Actual Capital Well-Capitalized Actual Amount Minimum Ratio (1) Ratio Amount Minimum Ratio (1) Ratio-------------------------------------------------------------------------------------------------------- ($ in millions) Total capital ratio: HUSI ................. $ 15,214 10.00% 12.27% $15,501 10.00% 12.58% HBUS ................. 15,032 10.00 12.16 14,998 10.00 12.23Tier 1 capital ratio: HUSI ................. 10,424 6.00 8.41 10,577 6.00 8.58 HBUS ................. 10,420 6.00 8.43 10,278 6.00 8.38Tier 1 leverage ratio: HUSI ................. 10,424 3.00(2) 6.30 10,577 3.00(2) 6.36 HBUS ................. 10,420 5.00 6.41 10,278 5.00 6.29Risk weighted assets: HUSI ................. 123,997 123,262 HBUS ................. 123,617 122,652 (1) HUSI and HBUS are categorized as "well-capitalized", as defined by their principal regulators. To be categorized as "well-capitalized" under regulatory guidelines, a banking institution must have the minimum ratios reflected in the above table, and must not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. (2) There is no Tier 1 leverage ratio component in the definition of a well-capitalized bank holding company. The ratio shown is the minimum required ratio. 18 Note 13. Variable Interest Entities (VIEs)-------------------------------------------------------------------------------- HUSI, in the ordinary course of business, makes use of VIE structures in avariety of business activities, primarily to facilitate client needs. VIEstructures are utilized after careful consideration of the most appropriatestructure needed to achieve HUSI's control and risk management objectives and tohelp ensure an efficient and appropriate structure from a regulatory andtaxation perspective. Consolidated VIEs HUSI has entered into a series of transactions with VIEs organized by HSBCaffiliates and unrelated third parties. These VIEs were structured as trusts orcorporations that issue fixed or floating rate instruments backed by the assetsof the issuing entities. HUSI sold trading assets to the VIEs and subsequentlyentered into total return swaps with the VIEs whereby HUSI receives the totalreturn on the transferred assets and, in return, pays a market rate of return toits counterparties. HUSI is the primary beneficiary of these VIEs and,accordingly, consolidated $7.5 billion and $2.6 billion of trading assets atJune 30, 2007 and December 31, 2006, respectively. These assets were pledged ascollateral for obligations of the VIEs, which are included in long-term debt.The holders of the instruments issued by the VIEs have no recourse to thegeneral credit of HUSI beyond the assets sold to the VIEs and pledged ascollateral. Unconsolidated VIEs HUSI also holds variable interests in various other VIEs which were notconsolidated at June 30, 2007 or December 31, 2006, since HUSI is not theprimary beneficiary of these VIE structures. Information for unconsolidated VIEsis presented in the following table and commentary. Descriptions of these VIErelationships are included in pages 151-152 of HUSI's 2006 Form 10-K. ------------------------------------------------------------------------------------- June 30, 2007 December 31, 2006 ------------------ ------------------ Maximum Maximum Total Exposure Total Exposure Assets to Loss Assets to Loss------------------------------------------------------------------------------------- (in millions) Asset backed commercial paper conduits .... $12,546 $6,438 $14,104 $8,048Securitization vehicles ................... 5,531 863 2,242 612Investment funds .......................... 749 -- 717 2Capital funding vehicles .................. 1,093 32 1,093 32Low income housing tax credits ............ 926 170 406 153 ------- ------ ------- ------Total ..................................... $20,845 $7,503 $18,562 $8,847 ======= ====== ======= ====== Other Asset Backed Commercial Paper Conduits In addition to the asset backed commercial paper conduits sponsored by affiliateentities and listed in the table above, HUSI also provides liquidity facilitiesto asset backed commercial paper conduits sponsored by unrelated third parties.HUSI does not transfer its own receivables into, have ownership interest in,perform administrative duties for, nor service any of the assets of theseconduits. HUSI's involvement in these conduits is limited to providing liquidityfacilities. The maximum exposure to loss relating to these liquidity facilitiesat June 30, 2007 is $2.1 billion. 19 Note 14. Financial Guarantee Arrangements, Pledged Assets and ContingentLiabilities-------------------------------------------------------------------------------- Financial Guarantee Arrangements The following table summarizes the maximum potential amounts of future paymentsrequired by financial guarantee arrangements. --------------------------------------------------------------------------------- June 30, December 31, 2007 2006--------------------------------------------------------------------------------- (in millions) Standby letters of credit, net of participations (1) .. $ 7,904 $ 7,259Loan sales with recourse .............................. 7 8Credit derivative contracts (2) ....................... 533,474 431,631 -------- --------Total ................................................. $541,385 $438,898 ======== ======== (1) Includes $570 million and $542 million issued for the benefit of HSBC affiliates at June 30, 2007 and December 31, 2006, respectively. (2) Includes $84,952 million and $71,908 million issued for the benefit of HSBC affiliates at June 30, 2007 and December 31, 2006, respectively. Standby Letters of Credit Fees are charged for issuing letters of credit commensurate with the customer'scredit evaluation and the nature of any collateral. Included in otherliabilities are deferred fees on standby letters of credit, representing thefair value of the "stand ready obligation to perform" under these guarantees,amounting to $24 million and $21 million at June 30, 2007 and December 31, 2006,respectively. Also included in other liabilities is an allowance for creditlosses on unfunded standby letters of credit of $25 million at June 30, 2007 andDecember 31, 2006. Credit Derivative Contracts HUSI enters into credit derivative contracts primarily to satisfy the needs ofits customers and, in certain cases, for its own benefit. Credit derivatives arearrangements that provide for one party (the "protection buyer") to transfer thecredit risk of a "reference asset" to another party (the "protection seller").Under this arrangement, the protection seller assumes the credit risk associatedwith the reference asset without directly purchasing it. The protection buyeragrees to pay a specified fee to the protection seller. In return, theprotection seller agrees to pay the protection buyer an agreed upon amount ifthere is a default during the term of the contract. In accordance with its policy, HUSI offsets most of the risk it assumes inselling credit protection through a credit derivative contract with anothercounterparty. Credit derivatives are recorded at fair value. The commitmentamount included in the table is the maximum amount that HUSI could be requiredto pay, without consideration of the approximately equal amount receivable fromthird parties and any associated collateral. 20 Pledged Assets The following table summarizes pledged assets included in the consolidatedbalance sheet. -------------------------------------------------------------------------------- June 30, December 31, 2007 2006-------------------------------------------------------------------------------- (in millions)Interest bearing deposits with banks ................ $ 700 $ 764Trading assets (1) .................................. 3,276 2,961Securities available for sale (2) ................... 6,820 6,775Securities held to maturity ......................... 238 273Loans (3) ........................................... 7,093 8,426Other assets (4) .................................... 1,195 849 ------- -------Total ............................................... $19,322 $20,048 ======= ======= (1) Trading assets are primarily pledged against liabilities associated with consolidated variable interest entities (refer to Note 13 of the consolidated financial statements, beginning on page 19 of this Form 10-Q). (2) Securities available for sale are primarily pledged against various short-term borrowings. (3) Loans are primarily private label credit card receivables pledged against long-term secured borrowings and residential mortgage loans pledged against long-term borrowings from the Federal Home Loan Bank. (4) Other assets represent cash on deposit with non-banks related to derivative collateral support agreements. Litigation HUSI is named in and is defending legal actions in various jurisdictions arisingfrom its normal business. None of these proceedings is regarded as materiallitigation. In addition, there are certain proceedings related to the "PrincetonNote Matter" that are described below. In relation to the Princeton Note Matter, as disclosed in HUSI's 2002 AnnualReport on Form 10-K, two of the noteholders were not included in the settlementand their civil suits are continuing. The U.S. Government initially excluded oneof the noteholders from the restitution order (Yakult Honsha Co., Ltd.) becausea senior officer of the noteholder was being criminally prosecuted in Japan forhis conduct relating to its Princeton Notes. The senior officer in question wasconvicted during September 2002 of various criminal charges related to the saleof the Princeton Notes. The U.S. Government excluded the other noteholder(Maruzen Company, Limited) because the sum it is likely to recover from thePrinceton Receiver exceeds its losses attributable to its funds transfers withRepublic New York Securities Corporation, as calculated by the U.S. Government.Both of these civil suits seek compensatory, punitive, and treble damagespursuant to RICO and assorted fraud and breach of duty claims arising fromunpaid Princeton Notes with face amounts totaling approximately $125 million. Noamount of compensatory damages is specified in either complaint. These twocomplaints name HUSI, HBUS, and Republic New York Securities Corporation asdefendants. HUSI and HBUS moved to dismiss both complaints in 2003. These motions remainedsub judice until 2007, when the Maruzen and Yakult cases were transferred to anew judge, who ordered the plaintiffs to file amended complaints and establisheda schedule for motions to dismiss to be addressed to those amended pleadings.The parties to the Maruzen and Yakult cases recently engaged in separatesettlement discussions, resulting in the conclusion of the Maruzen case, and asettlement in principle on the Yakult case. In neither case will the settlementamount have a material impact on HUSI's consolidated results. Note 15. New Accounting Pronouncements-------------------------------------------------------------------------------- In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertaintyin Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48). FIN 48establishes threshold and measurement attributes for financial statementmeasurement and recognition of tax positions taken or expected to be taken in atax return. FIN 48 also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure andtransition. FIN 48 is effective for fiscal years beginning after December 15,2006. The adoption of FIN 48 on January 1, 2007 did not have a material impacton HUSI's financial position or results of operations. Refer to Note 8 beginningon page 13 of this Form 10-Q. 21 In September 2006, the FASB issued Statement of Financial Accounting StandardsNo. 157, Fair Value Measurements (SFAS 157). SFAS 157 establishes a singleauthoritative definition of fair value, sets out a framework for measuring fairvalue, and requires additional disclosures about fair value measurements. SFAS157 is effective for fiscal years beginning after November 15, 2007 and interimperiods within those years. Early application is permissible only if no annualor interim financial statements have been issued for the earlier periods. HUSIis currently evaluating the impact that adoption of SFAS 157 will have on itsfinancial position and results of operations. In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, Amendment ofFASB Interpretation No. 39 (FSP FIN 39-1). FSP FIN 39-1 allows entities that areparty to a master netting arrangement to offset the receivable or payablerecognized upon payment or receipt of cash collateral against fair value amountsrecognized for derivative instruments that have been offset under the samemaster netting arrangement in accordance with FASB Interpretation No. 39. Theguidance in FSP FIN 39-1 is effective for fiscal years beginning after November15, 2007, with early adoption permitted. Entities are required to recognize theeffects of applying FSP FIN 39-1 as a change in accounting principle throughretrospective application for all financial statements presented unless it isimpracticable to do so. HUSI adopted FSP FIN 39-1 during the second quarter of2007, the impact of which is described in Note 2 of these consolidated financialstatements. In February 2007, the FASB issued Statement of Financial Accounting StandardsNo. 159, The Fair Value Option for Financial Assets and Financial Liabilities(SFAS 159), which creates an alternative measurement method for certainfinancial assets and liabilities. SFAS 159 permits fair value to be used forboth the initial and subsequent measurements on a contract-by-contract election,with changes in fair value to be recognized in earnings as those changes occur.This election is referred to as the "fair value option". SFAS 159 also requiresadditional disclosures to compensate for the lack of comparability that willarise from the use of the fair value option. SFAS 159 is effective for fiscalyears beginning after November 15, 2007, with early adoption permitted as of thebeginning of a company's fiscal year, provided the company has not yet issuedfinancial statements for that fiscal year. HUSI is currently evaluating theimpact the adoption of SFAS 159 will have on its financial position and resultsof operations. Note 16. Business Segments-------------------------------------------------------------------------------- HUSI has five distinct segments that it utilizes for management reporting andanalysis purposes, which are generally based upon customer groupings, as well asproducts and services offered. The segments are described on pages 19-20 ofHUSI's Form 10-Q for the quarterly period ended March 31, 2007. Effective January 1, 2007, corporate goals of HUSI are based upon resultsreported under International Financial Reporting Standards (IFRSs), which areutilized by HSBC to prepare its consolidated financial statements. Operatingresults for HUSI are now being monitored and reviewed, trends are beingevaluated, and decisions are being made about allocating certain resources on anIFRSs basis. As a result, business segment results are reported on an IFRSsbasis to align with the revised internal reporting mechanism for monitoringperformance. Results for the second quarter and first six months of 2006 havebeen restated on an IFRSs basis. Net interest income of each segment represents the difference between actualinterest earned on assets and interest paid on liabilities of the segment,adjusted for a funding charge or credit. Segments are charged a cost to fundassets (e.g. customer loans) and receive a funding credit for funds provided(e.g. customer deposits) based on equivalent market rates. The objective ofthese charges/credits is to transfer interest rate risk from the segments to onecentralized unit in Treasury and more appropriately reflect the profitability ofsegments. Certain other revenue and operating expense amounts are also apportioned amongthe business segments based upon the benefits derived from this activity or therelationship of this activity to other segment activity. For segment reportingpurposes, these inter-segment transactions are accounted for as if they werewith third parties and have not been eliminated. Results for each segment on an IFRSs basis, as well as a reconciliation of totalresults under IFRSs to U.S. GAAP consolidated totals, are provided in thefollowing tables. Descriptions of the significant differences between IFRSs andU.S. GAAP that impact HUSI's results follow the tables. 22 The following table summarizes the results for each segment. Analysis ofoperating results for each segment begins on page 48 of this Form 10-Q. ------------------------------------------------------------------------------------------------------------------------ IFRSs Consolidated Amounts (1) (2) U.S. GAAP ----------------------------------------------------------- IFRSs IFRSs Consolidated PFS CF CMB CIBM PB Other Total Adjustments Reclassifications Totals------------------------------------------------------------------------------------------------------------------------ (in millions) Three months ended June 30, 2007Net interest income (expense) $ 274 $ 210 $ 202 $ 141 $ 50 $ (3) $ 874 $ -- $ (67) $ 807Other revenues 113 59 66 321 71 (66) 564 19 194 777 ------- ------- ------- -------- ------- ------ -------- -------- ------- --------Total revenues 387 269 268 462 121 (69) 1,438 19 127 1,584Provision for credit losses ..... 25 214 19 (5) 5 -- 258 1 5 264 ------- ------- ------- -------- ------- ------ -------- -------- ------- -------- 362 55 249 467 116 (69) 1,180 18 122 1,320Operating expenses .. 319 9 142 198 86 1 755 1 122 878 ------- ------- ------- -------- ------- ------ -------- -------- ------- --------Income before income tax expense $ 43 $ 46 $ 107 $ 269 $ 30 $ (70) $ 425 $ 17 $ -- $ 442 ======= ======= ======= ======== ======= ====== ======== ======== ======= ======== Balances at end of period:Total assets $36,742 $21,344 $19,126 $132,212 $ 5,449 $ 411 $215,284 $(43,109) $ -- $172,175Total loans . 32,044 20,344 17,207 22,042 4,624 -- 96,261 347 (9,199) 87,409Goodwill .... 917 -- 366 494 335 -- 2,112 604 -- 2,716Total deposits 41,473 42 17,133 34,198 10,241 -- 103,087 3,379 387 106,853 Three months ended June 30, 2006Net interest income (expense) $ 290 $ 176 $ 171 $ 112 $ 48 $ (7) $ 790 $ 19 $ (34) $ 775Other revenues 106 29 62 270 60 22 549 (32) 156 673 ------- ------- ------- -------- ------- ------ -------- -------- ------- --------Total revenues 396 205 233 382 108 15 1,339 (13) 122 1,448Provision for credit losses .... 8 154 27 (14) 30 -- 205 2 15 222 ------- ------- ------- -------- ------- ------ -------- -------- ------- -------- 388 51 206 396 78 15 1,134 (15) 107 1,226Operating expenses .. 291 7 114 184 72 4 672 (4) 107 775 ------- ------- ------- -------- ------- ------ -------- -------- ------- --------Income before income tax expense $ 97 $ 44 $ 92 $ 212 $ 6 $ 11 $ 462 $ (11) $ -- $ 451 ======= ======= ======= ======== ======= ====== ======== ======== ======= ======== Balances at end of period:Total assets $41,523 $20,648 $17,631 $123,654 $ 5,530 $ 341 $209,327 $(40,938) $ -- $168,389Total loans . 37,287 19,418 14,968 12,094 4,896 2 88,665 -- 2,540 91,205Goodwill .... 917 -- 366 494 335 -- 2,112 582 -- 2,694Total deposits 33,629 58 13,207 41,375 10,411 392 99,072 -- 326 99,398 (1) Represents adjustments associated with differences between IFRSs and U.S. GAAP bases of accounting. These adjustments, which are more fully described beginning on page 24 of this Form 10-Q, consist of the following: -------------------------------------------------------------------------------------------------------------- Net Provision Income Interest Other for Credit Operating Before Income Total Income Revenues Losses Expenses Tax Expense Assets-------------------------------------------------------------------------------------------------------------- (in millions)Three months ended June 30, 2007Unquoted equity securities ........ $ -- $(67) $-- $-- $(67) $ --Fair value option ................. (2) 66 -- -- 64 --Servicing assets .................. -- 31 -- -- 31 --Loan origination .................. (5) (2) -- (4) (3) --Loans held for trading purposes ... -- (9) -- -- (9) --Recording derivative assets andliabilities gross ................. -- -- -- -- -- (43,109)Other ............................. 7 -- 1 5 1 -- ---- ----- --- --- ---- --------Total ............................. $ -- $ 19 $ 1 $ 1 $ 17 $(43,109) ==== ===== === === ==== ======== Three months ended June 30, 2006Unquoted equity securities ........ $ -- $ -- $-- $-- $ -- $ --Fair value option ................. -- (34) -- -- (34) --Servicing assets .................. -- 23 -- -- 23 --Loan origination .................. 9 (5) -- (5) 9 --Loans held for trading purposes ... -- (8) -- 1 (9) --Recording derivative assets and liabilities gross .............. -- -- -- -- -- (40,938)Other ............................. 10 (8) 2 -- -- -- ---- ----- --- --- ---- --------Total ............................. $ 19 $(32) $ 2 $(4) $(11) $(40,938) ==== ===== === === ==== ======== (2) Represents differences in financial statement presentation between IFRSs and U.S. GAAP. 23 The following table summarizes the results for each segment. Analysis ofoperating results for each segment begins on page 48 of this Form 10-Q. ----------------------------------------------------------------------------------------------------------------------- IFRSs Consolidated Amounts (1) (2) U.S. GAAP ------------------------------------------------- IFRSs IFRSs Consolidated PFS CF CMB CIBM PB Other Total Adjustments Reclassifications Totals----------------------------------------------------------------------------------------------------------------------- (in millions) Six months ended June 30, 2007Net interest income (expense) ..... $560 $409 $398 $138 $100 $ (4) $1,601 $(3) $ (2) $1,596Other revenues ... 263 107 128 575 144 (61) 1,156 5 250 1,411 ---- ---- ---- ---- ---- ---- ------ --- ---- ------Total revenues ... 823 516 526 713 244 (65) 2,757 2 248 3,007Provision for credit losses ........ 29 388 37 (10) 12 -- 456 5 8 469 ---- ---- ---- ---- ---- ---- ------ --- ---- ------ 794 128 489 723 232 (65) 2,301 (3) 240 2,538Operating expenses 611 17 282 387 168 2 1,467 14 240 1,721 ---- ---- ---- ---- ---- ---- ------ --- ---- ------Income before income tax expense $183 $111 $207 $336 $ 64 $(67) $ 834 (17) $ -- $ 817 ==== ==== ==== ==== ==== ==== ====== === ==== ======Six months ended June 30, 2006Net interest income (expense) ....... $577 $338 $350 $137 $ 96 $(10) $1,488 $ 7 $ 15 $1,510Other revenues .... 242 40 123 559 137 (3) 1,098 2 231 1,331 ---- ---- ---- ---- ---- ---- ------ --- ---- ------Total revenues ... 819 378 473 696 233 (13) 2,586 9 246 2,841Provision for credit losses ........ 24 299 31 (12) 30 -- 372 (9) 16 379 ---- ---- ---- ---- ---- ---- ------ --- ---- ------ 795 79 442 708 203 (13) 2,214 18 230 2,462Operating expenses 580 14 233 355 149 4 1,335 (5) 230 1,560 ---- ---- ---- ---- ---- ---- ------ --- ---- ------Income before income tax expense .... $215 $ 65 $209 $353 $ 54 $(17) $ 879 $23 $ -- $ 902 ==== ==== ==== ==== ==== ==== ====== === ==== ====== (1) Represents adjustments associated with differences between IFRSs and U.S. GAAP bases of accounting. These adjustments, which are more fully described below, consist of the following: ------------------------------------------------------------------------------------------------------------------- Net Provision Income Interest Other for Credit Operating Before Income Income Revenues Losses Expenses Tax Expense------------------------------------------------------------------------------------------------------------------- (in millions)Six months ended June 30, 2007Unquoted equity securities ......................... $-- $(76) $-- $ -- $(76)Fair value option .................................. (2) 64 -- -- 62Servicing assets ................................... -- 36 -- -- 36Loan origination ................................... (7) (5) -- 5 (17)Loans held for trading purposes .................... -- (7) -- -- (7)Other .............................................. 6 (7) 5 9 (15) --- ---- --- ---- ----Total .............................................. $(3) $ 5 $ 5 $ 14 $(17) === ==== === ==== ====Six months ended June 30, 2006Unquoted equity securities ......................... $-- $ -- $-- $ -- $ --Fair value option .................................. -- 7 -- -- 7Servicing assets ................................... -- 28 -- -- 28Loan origination ................................... 7 (7) -- (10) 10Loans held for trading purposes .................... -- (20) -- -- (20)Other .............................................. -- (6) (9) 5 (2) --- ---- --- ---- ----Total .............................................. $ 7 $ 2 $(9) $ (5) $ 23 === ==== === ==== ==== (2) Represents differences in financial statement presentation between IFRSs and U.S. GAAP. Differences between IFRSs and U.S. GAAP Unquoted equity securities - Under IFRSs, certain equity securities which arenot quoted on a recognized exchange, but for which fair value can be reliablymeasured, are required to be measured at fair value. Securities measured at fairvalue under IFRSs are classified as either available for sale securities, withchanges in fair value recognized in shareholders' equity, or as tradingsecurities, with changes in fair value recognized in income. Under U.S. GAAP,equity securities that are not quoted on a recognized exchange, are notconsidered to have a readily determinable fair value and are required to bemeasured at cost, less any provisions for known impairment, in other assets. Fair value option - Reflects the impact of applying the fair value option underIFRSs for certain debt issued, which is accounted for either at amortized costor is only adjusted for market interest rate risk movements under U.S. GAAP.This impact is primarily recorded as other revenues within the Other businesssegment. 24 Servicing assets - Servicing assets are initially recorded at fair value forboth U.S. GAAP and IFRSs. Under U.S. GAAP, all subsequent adjustments to fairvalue are reflected in current earnings. Under IFRSs: (1) servicing assets areperiodically tested for impairment with impairment adjustments charged againstcurrent earnings; and (2) recoveries of impairment are credited to currentearnings only to the extent of previous write-downs. Loan origination - Certain loan fees and incremental direct loan originationcosts, including direct salaries but excluding overhead costs, are deferred andamortized to earnings over the life of the loan under IFRSs. Certain loan feesand direct, but not necessarily incremental loan origination costs, including anapportionment of overhead in addition to direct salaries, are deferred andamortized to earnings under U.S. GAAP. For the first half of 2007, the netcosts amortized under U.S. GAAP exceed net costs amortized under IFRSs. Loans held for trading purposes - Under IFRSs, loans held for resale are treatedas trading assets and are initially recorded at fair value, with changes in fairvalue being recognized in current period earnings, and any gains on salerecognized on the trade date. Under U.S. GAAP, loans held for resale arerecorded at the lower of amortized cost or market value (LOCOM), with gains onsale being recognized on the settlement date. Because of the differences betweenfair value and LOCOM accounting, the recorded value of certain pools of loansheld for resale under IFRSs exceeds the recorded value under U.S. GAAP,resulting in higher IFRSs earnings. The timing difference between trade dateaccounting under IFRSs and settlement date accounting under U.S. GAAP alsoresults in higher current earnings under IFRSs. Recording derivative assets and liabilities gross - Under U.S. GAAP, derivativereceivables and payables with the same counterparty may be reported net in thebalance sheet when there is an executed International Swaps and DerivativesAssociation, Inc. (ISDA) Master Netting Arrangement. In addition, under U.S.GAAP, fair value amounts recognized for the obligation to return cash collateralreceived or the right to reclaim cash collateral paid are offset against thefair value of derivative instruments. Under IFRSs, these agreements do not meetthe requirements for offset, and therefore such derivative receivables andpayables are presented gross on the balance sheet. Other - Includes the net impact of differences relating to various adjustments,none of which were individually material for the second quarter and first sixmonths of 2007 and 2006. 25 Item 2. Management's Discussion and Analysis of Financial Condition and Resultsof Operations (MD&A)-------------------------------------------------------------------------------- FORWARD-LOOKING STATEMENTS-------------------------------------------------------------------------------- The MD&A should be read in conjunction with the consolidated financialstatements, notes and tables included elsewhere in this Form 10-Q and withHUSI's 2006 Form 10-K. The MD&A may contain certain statements that areforward-looking in nature within the meaning of the Private SecuritiesLitigation Reform Act of 1995. HUSI's results may differ materially from thosenoted in the forward-looking statements. Words such as "may", "should", "would","could", "intends", "appears", "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. Statements that are not historicalfacts, including statements about management's beliefs and expectations, areforward-looking statements that involve inherent risks and uncertainties and arebased on current views and assumptions. A number of factors could cause actualresults to differ materially from those contained in any forward-lookingstatements. For a list of important risk factors that may affect HUSI's actualresults, see Cautionary Statement on Forward-Looking Statements and Risk Factorsin Part I of HUSI's 2006 Form 10-K. EXECUTIVE OVERVIEW-------------------------------------------------------------------------------- Income before income tax expense decreased $9 million (2%) and decreased $85million (9%) for the second quarter and the first six months of 2007,respectively, in comparison with the same 2006 periods. Net income increased $4million (1%) for the second quarter, but decreased $30 million for the first sixmonths of 2007. Higher net interest income in 2007 primarily resulted from: o higher interest income from growth in the private label credit card portfolio, and from reduced amortization of initial purchase premiums paid for these receivables; and o business expansion initiatives, including rollout of the Online Savings product, new branches and expansion of services and products to small business customers, which led to growth in consumer and commercial deposits and in commercial loans. These increases in net interest income were partially offset by: o continued narrowing of interest spreads primarily due to competitive pressures as customers migrated to higher yielding deposit products; and o lower interest income from residential mortgage loans due to the impact of balance sheet initiatives to reduce prepayment risk and improve liquidity by selling the majority of residential mortgage loan originations through the secondary markets and by allowing the existing residential mortgage loan portfolio to run off. The provision for credit losses increased for the second quarter and for thefirst half of 2007, primarily due to higher average credit card receivablebalances and to growing delinquencies within the credit card portfolio. Inaddition, consumer provision expense was unusually low for the first quarter of2006, due to the impact of bankruptcy legislation enacted in 2005, whichresulted in accelerated consumer charge offs during the fourth quarter of 2005. Higher other revenues primarily resulted from the following: o increased credit card fees from growing credit card receivable portfolios; and o increased trading revenue from structured derivative product transactions and from foreign exchange trading desks, which were partially offset by fewer market opportunities in precious metals and other global markets trading desks, which were particularly strong in the first quarter of 2006. 26 These increases in other revenues were partially offset by: o lower results of a program under which HUSI acquires residential mortgage loans and subsequently sells these loans to an HSBC affiliate for securitization, which has been negatively impacted by the overall weakness in the U.S. housing market; and o the decrease in value of a derivative trading instrument used to offset the change in value of an investment in Class B shares issued by MasterCard International, Inc., the fair value of which has increased significantly but which cannot be recognized until the investment is sold. Increased operating expenses for 2007 resulted mainly from higher salaries,marketing and other direct expenses related to business expansion initiatives,and to higher technology and other costs to support the build out of enhancedproduct and service platforms. Income tax expense decreased $13 million (8%) for the second quarter of 2007 anddecreased $55 million (18%) for the first half of 2007. During the first quarterof 2007, after a thorough review of its deferred income taxes, HUSI increasedthe carrying value of its deferred tax assets by $28 million, with acorresponding decrease in income tax expense. The remaining decrease inprovision was mainly due to lower income before tax, to a lower effective taxrate from higher revenues from operations in states with lower tax rates and tohigher low income housing tax credits. Income Before Income Tax Expense - Significant Trends Analysis of the components of HUSI's income before income tax expense begins onpage 35 of this Form 10-Q. Income before income tax expense, and various trendsand activity affecting operations, are summarized in the following table. ---------------------------------------------------------------------------------------------------------- Three months Six months ended June 30 ended June 30---------------------------------------------------------------------------------------------------------- (in millions) Income before income tax expense for 2006 ............................... $451 $902 ---- ---- Increase (decrease) in income before income tax expense attributable to: Balance sheet management activities (1) .............................. (17) (44) Trading related activities (2) ....................................... 70 -- Private label receivable portfolio (3) ............................... 22 70 Loans held for sale to an HSBC affiliate (4) ......................... (54) (85) Residential mortgage banking revenue (5) ............................. (5) (30) Earnings from equity investments (6) ................................. 10 -- All other activity (7) ............................................... (35) 4 ---- ---- (9) (85) ---- ----Income before income tax expense for 2007 ............................... $442 $817 ==== ==== (1) Balance sheet management activities are comprised primarily of net interest income and, to a lesser extent, gains on sales of investments and trading revenues, resulting from management of interest rate risk associated with the repricing characteristics of balance sheet assets and liabilities. Refer to commentary regarding CIBM net interest income, trading revenues, and the CIBM business segment beginning on page 51 of this Form 10-Q, respectively. (2) Refer to commentary regarding trading revenues beginning on page 43 of this Form 10-Q. Amounts in the table exclude trading related revenues from hedging activities associated with loans held for sale to an HSBC affiliate, which are reported in a separate line of the table. (3) Refer to commentary regarding the CF business segment beginning on page 49 of this Form 10-Q. (4) Refer to commentary regarding residential mortgage loans held for sale to an HSBC affiliate beginning on page 39 of this Form 10-Q. (5) Refer to commentary regarding residential mortgage banking revenue beginning on page 41 of this Form 10-Q. (6) Refer to commentary regarding other income beginning on page 40 of this Form 10-Q. (7) Represents core banking and other activities that have been impacted by recent business expansion initiatives. Refer to business segments commentary beginning on page 48 of this Form 10-Q. 27 Selected Financial Data The following tables present a summary of selected financial information. ------------------------------------------------------------------------------------------------------ Three months ended Six months ended June 30 June 30 ---------------------- ------------------- 2007 2006 2007 2006------------------------------------------------------------------------------------------------------ ($ in millions) Income statement:Net interest income .............................. $ 807 $ 775 $ 1,596 $ 1,510Provision for credit losses ...................... (264) (222) (469) (379)Total other revenues ............................. 777 673 1,411 1,331Total operating expenses ......................... (878) (775) (1,721) (1,560)Income tax expense ............................... (152) (165) (253) (308) -------- -------- ------- --------Net income ....................................... $ 290 $ 286 $ 564 $ 594 ======== ======== ======= ======== Balances at period end:Loans, net of allowance .......................... $ 86,507 $ 90,336Total assets ..................................... 172,175 168,389Total tangible assets ............................ 169,416 165,644Total deposits ................................... 106,853 99,398Common shareholder's equity ...................... 10,459 10,629Tangible common shareholder's equity ............. 8,081 8,117Total shareholders' equity ....................... 12,149 12,319 Selected financial ratios:Total shareholders' equity to total assets, at period end ................................. 7.06% 7.32%Tangible common shareholder's equity to total tangible assets, at period end ................ 4.77% 4.90%Rate of return on average (1): Total assets .................................. .69% .70% .69% .75% Total common shareholder's equity ............. 10.14 10.09 9.85 10.71Net interest margin to average (1): Earning assets ................................ 2.26% 2.27% 2.28% 2.28% Total assets .................................. 1.94 1.90 1.96 1.92Average total shareholders' equity to average total assets (1) .............................. 7.26% 7.30% 7.37% 7.41%Efficiency ratio (1) ............................. 55.45 53.49 57.21 54.91 (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 87 of HUSI's 2006 Form 10-K. Significant trends and transactions that impacted net income for the three monthand six month periods ending June 30, 2007 and 2006 are summarized on page 27 ofthis Form 10-Q. 28 BASIS OF REPORTING-------------------------------------------------------------------------------- HUSI's consolidated financial statements are prepared in accordance withaccounting principles generally accepted in the United States of America (U.S.GAAP). International Financial Reporting Standards (IFRSs) Effective January 1, 2007, corporate goals of HUSI are based upon resultsreported under IFRSs (a non-U.S. GAAP measure). Operating results for HUSI arenow monitored and reviewed, trends are being evaluated, and decisions are beingmade about allocating certain resources on an IFRSs basis. In addition, HSBCreports its results in accordance with IFRSs and IFRSs results are used by HSBCin measuring and rewarding performance of employees. The following tablereconciles HUSI's net income on a U.S. GAAP basis to net income on an IFRSsbasis. ------------------------------------------------------------------------------------- Three months ended Six months ended June 30 June 30 ------------------ ---------------- 2007 2006 2007 2006------------------------------------------------------------------------------------- (in millions) Net income - U.S. GAAP basis ............. $290 $286 $564 $594Adjustments, net of tax: Unquoted equity securities ............ 39 -- 44 -- Fair value option ..................... (37) 20 (36) (3) Servicing assets ...................... (17) (13) (21) (16) Loan origination ...................... 2 (6) 10 -- Loans held for trading purposes ....... 4 5 4 12 Other ................................. (4) 2 4 (7) ---- ---- ---- ----Net income - IFRSs basis ................. $277 $294 $569 $580 ==== ==== ==== ==== Differences between U.S. GAAP and IFRSs are as follows: Unquoted equity securities HUSI holds certain equity securities whose market price is not quoted on arecognized exchange, but for which the fair value can be reliably measuredeither through an active market, comparison to similar equity securities whichare quoted, or by using discounted cash flow calculations. IFRSs o Under IAS 39, equity securities which are not quoted on a recognized exchange, but for which fair value can be reliably measured, are required to be measured at fair value. Accordingly, such securities are measured at fair value and classified as either available-for-sale securities, with changes in fair value recognized in other comprehensive income, or as trading securities, with changes in fair value recognized in income. U.S. GAAP o Under SFAS 115, equity securities that are not quoted on a recognized exchange are not considered to have a readily determinable fair value and are required to be measured at cost, less any provisions for impairment. Unquoted equity securities are reported within "Other assets". Impact o Changes in fair values of equity securities for which IFRSs require recognition of the change and U.S. GAAP requires the securities to be held at cost, impact net income and shareholders' equity when the security is classified as trading under IFRSs and impact shareholders' equity when the security is classified as available-for-sale under IFRSs. 29 Fair value option IFRSs o 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. o 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 is made. Financial assets and financial liabilities are recognized using trade date accounting. o Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. U.S. GAAP o 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 U.S. GAAP. o Since January 1, 2006, HUSI has accounted for hybrid financial instruments under the provisions of SFAS 155, Accounting for Certain Hybrid Financial Instruments. Hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation are, where designated through an irrevocable election, initially and subsequently measured at fair value, with changes in fair value recognized through net income. Impact o HUSI has principally used the fair value designation for certain fixed rate long-term debt issues whose interest rate characteristic has been changed to floating through interest rate swaps as part of a documented interest rate management strategy. Approximately $2 billion of HUSI's debt issues have been accounted for using the option. The movement in fair value of these debt issues includes the effect of changes in the credit spread and any ineffectiveness in the economic relationship between the related swaps and this debt. Such ineffectiveness arises from the different credit characteristics of the swap and the debt coupled with the sensitivity of the floating leg of the swap to changes in short-term interest rates. In addition, the economic relationship between the swap and the debt can be affected by relative movements in market factors, such as bond and swap rates, and the relative bond and swap rates at inception. The size and direction of the accounting consequences of changes in credit spread and ineffectiveness can be volatile from period to period, but do not alter the cash flows anticipated as part of the documented interest rate management strategy. o Under U.S. GAAP, debt issues are generally reported at amortized cost. There are circumstances, by virtue of different technical requirements and the transition arrangements to IFRSs, where derivatives providing an economic hedge for an asset or liability, and so designated under IFRSs, are not so treated under U.S. GAAP, thereby creating a reconciliation difference and asymmetrical accounting between the asset and liability and the offsetting derivative. 30 Servicing assets IFRSs o Under IAS 38, servicing assets are initially recorded on the balance sheet at fair value and amortized over the projected life of the assets. o Servicing assets are periodically tested for impairment with impairment adjustments charged against current earnings. o Subsequent recoveries of impairment, if any, are credited to current earnings only to the extent of previous write-downs. U.S. GAAP o Under U.S. GAAP, servicing assets are initially recorded on the balance sheet at fair value. o All subsequent adjustments to fair value are reflected in current period earnings. Impact o HUSI's mortgage subsidiary currently holds $550 million of residential mortgage servicing rights (MSRs), primarily related to loans sold to governmental agencies. o For certain pools of MSRs, fair value recorded under U.S. GAAP exceeds amortized cost recorded under IFRSs. Therefore, current earnings under U.S. GAAP exceeded earnings under IFRSs for the first six months of 2007. Loan origination IFRSs o Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. U.S. GAAP o Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the income statement 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"). Impact During the first six months of 2007, the net costs amortized against earningsunder U.S. GAAP exceeded net costs amortized under IFRSs. Loans held for trading purposes IFRSs o Under IAS 39, loans held for resale are treated as trading assets. o As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings. o Any gains realized on sales of such loans are recognized in current period earnings on the trade date. U.S. GAAP o Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet. o Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost. o Subsequent gains on sale of such loans are recognized in current period earnings on the settlement date. 31 Impact o HUSI holds $4.5 billion of loans held for resale on the balance sheet at June 30, 2007 for various business purposes. These include residential mortgage loans held for resale to HSBC affiliates for securitization purposes, residential mortgage loans held for resale to various governmental agencies and other types of consumer loans. o Because of differences between fair value and LOCOM accounting, the recorded value of certain pools of loans held for resale under IFRSs exceeds the value recorded under U.S. GAAP at June 30, 2007, resulting in higher IFRSs earnings. o The timing difference between trade date accounting for IFRSs and settlement date accounting under U.S. GAAP also results in higher current earnings under IFRSs. Other Other includes the net impact of differences relating to various adjustments,none of which were individually material for the second quarter and first sixmonths of 2007 and 2006, respectively. BALANCE SHEET REVIEW-------------------------------------------------------------------------------- HUSI utilizes borrowings from various sources to fund balance sheet growth, tomeet cash and capital needs, and to fund investments in subsidiaries. Balancesheet totals at June 30, 2007, and movements in comparison with prior periods,are summarized in the following table. ------------------------------------------------------------------------------------------- Increase (Decrease) from --------------------------------------- December 31, 2006 June 30, 2006 June 30, ------------------ ----------------- 2007 Amount % Amount %------------------------------------------------------------------------------------------- ($ in millions) Period end assets: Short-term investments .......... $ 25,405 $ 6,350 33 $ 6,331 33 Loans, net ...................... 86,507 (2,833) (3) (3,829) (4) Trading assets .................. 27,243 3,613 15 912 3 Securities ...................... 22,782 27 -- 234 1 Other assets .................... 10,238 201 2 138 1 -------- ------- --- ------- --- $172,175 $ 7,358 4 $ 3,786 2 ======== ======= === ======= ===Funding sources: Total deposits .................. $106,853 $ 4,707 5 $ 7,455 8 Trading liabilities ............. 15,324 3,010 24 1,450 10 Short-term borrowings ........... 5,430 357 7 (1,479) (21) All other liabilities ........... 3,644 (127) (3) (1,265) (26) Long-term debt .................. 28,775 (477) (2) (2,205) (7) Shareholders' equity ............ 12,149 (112) (1) (170) (1) -------- ------- --- ------- --- $172,175 $ 7,358 4 $ 3,786 2 ======== ======= === ======= === Short-Term Investments Short-term investments include cash and due from banks, interest bearingdeposits with banks, Federal funds sold and securities purchased under resaleagreements. Increases in these asset balances resulted from an increase inHUSI's excess liquidity position, which was primarily due to deposit growth in2006 and 2007. 32 Loans, Net Loan balances at June 30, 2007, and movements in comparison with prior periods,are summarized in the following table. ------------------------------------------------------------------------------------------------- Increase (Decrease) from -------------------------------------- December 31, 2006 June 30, 2006 June 30, ----------------- ------------------ 2007 Amount % Amount %------------------------------------------------------------------------------------------------- ($ in millions) Total commercial loans ...................... $29,578 $ 96 -- $ (68) -- -------- ------- --- ------- --- Consumer loans: Residential mortgages .................... 37,779 (2,029) (5) (5,545) (13) Credit card receivables: Private label ......................... 16,106 (867) (5) 1,948 14 MasterCard/Visa ....................... 1,529 242 19 377 33 Other consumer ........................... 2,417 (270) (10) (508) (17) ------- ------- --- ------- --- Total consumer loans ..................... 57,831 (2,924) (5) (3,728) (6) ------- ------- --- ------- ---Total loans ................................. 87,409 (2,828) (3) (3,796) (4)Allowance for credit losses ................. 902 5 1 33 4 ------- ------- --- ------- ---Loans, net .................................. $86,507 $(2,833) (3) $(3,829) (4) ======= ======= === ======= === Beginning in 2005, as a result of balance sheet initiatives to reduce prepaymentrisk and improve HBUS's structural liquidity, HUSI decided to sell a majority ofits residential loan originations through the secondary markets and allow theexisting loan portfolio to run off, resulting in reductions in loan balancesthroughout 2006 and the first six months of 2007. The addition of new merchant and customer relationships to the private labelcredit card portfolio and decreased balance requirements of off-balance sheetsecuritized receivable trusts (refer to pages 61-62 of this Form 10-Q) haveresulted in higher on-balance sheet credit card receivable balances from June30, 2006 to June 30, 2007. Trading Assets and Liabilities Trading assets and liabilities balances at June 30, 2007, and movements incomparison with prior periods, are summarized in the following table. ------------------------------------------------------------------------------------------------- Increase (Decrease) from -------------------------------------- December 31, 2006 June 30, 2006 June 30, ----------------- ---------------- 2007 Amount % Amount %------------------------------------------------------------------------------------------------- ($ in millions) Trading assets: Securities (1) ........................... $14,515 $2,591 22 $ 408 3 Precious metals .......................... 3,449 733 27 892 35 Fair value of derivatives ................ 9,279 289 3 (387) (4) ------- ------ --- ------ --- $27,243 $3,613 15 $ 913 3 ======= ====== === ====== === Trading liabilities: Securities sold, not yet purchased ...... $ 3,648 $1,734 91 $ 866 31 Payables for precious metals ............. 1,932 596 45 619 47 Fair value of derivatives ................ 9,744 680 8 (35) -- ------- ------ --- ------ --- $15,324 $3,010 24 $1,450 10 ======= ====== === ====== === (1) Includes U.S. Treasury securities, securities issued by U.S. Government agencies and U.S. Government sponsored enterprises, other asset backed securities, corporate bonds and debt securities. Growth in securities balances from December 31, 2006 and from June 30, 2006 wasattributable to increased hedging opportunities to capitalize on the currentspread environment. Higher derivatives balances resulted from increased volumeof structured derivative product transactions during 2007. Higher preciousmetals balances were due to higher levels of trading activity, and to generallyhigher market prices for various metals. 33 Deposits Deposit balances by major depositor categories at June 30, 2007, and movementsin comparison with prior periods, are summarized in the following table. ------------------------------------------------------------------------------------------------ Increase (Decrease) from ------------------------------------ December 31, 2006 June 30, 2006 June 30, ----------------- ---------------- 2007 Amount % Amount %------------------------------------------------------------------------------------------------ ($ in millions) Individuals, partnerships and corporations .. $ 85,456 $2,652 3 $ 947 1Domestic and foreign banks ................... 17,696 1,453 9 5,310 43U.S. Government, states and political subdivisions ............................... 2,023 96 5 426 27Foreign government and official institutions ............................... 1,678 506 43 772 85 -------- ------ --- ------- ---Total deposits ............................... $106,853 $4,707 5 $7,455 8 ======== ====== === ======= === Total core deposits (1) ...................... $ 62,166 $4,590 8 $5,927 11 ======== ====== === ======= === (1) HUSI monitors "core deposits" as a key measure for assessing results of its core banking network. Core deposits generally include all domestic demand, money market and other savings accounts, as well as time deposits with balances not exceeding $100,000. Beginning in 2004, HUSI implemented a growth strategy for its retail bankingnetwork, which includes building deposits over a three to five year periodacross multiple geographic markets, channels and customer segments and utilizingmultiple delivery systems. Since inception, the following initiatives have beenlaunched: o deployment of new personal and business checking and savings products, with an emphasis on relationship based products that offer more competitive pricing; o new internet based products offered through the HSBC Direct website, particularly Online Savings accounts, which have grown significantly since 2005. Since their introduction, Online Savings balances have grown to $11.9 billion at June 30, 2007, of which $4.8 billion was raised during the first six months of 2007; o a retail branch expansion strategy within our existing footprint as well as in new geographic markets; o improved delivery systems, including internet, call center and ATM capabilities; and o refined marketing and customer analytics to drive increased utilization of products and improve customer retention. Total deposit growth of $13 billion and $12 billion during calendar years 2006and 2005, respectively, has been followed by growth of $5 billion in the firstsix months of 2007. 34 RESULTS OF OPERATIONS-------------------------------------------------------------------------------- Net Interest Income An analysis of consolidated average balances and interest rates on a taxableequivalent basis is presented on pages 69-70 of this Form 10-Q. Significantcomponents of HUSI's net interest margin are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Three months ended June 30 Six months ended June 30 -------------------------- ------------------------ 2007 2006 2007 2006----------------------------------------------------------------------------------------------------------------------- Yield on total earning assets ................................. 6.18% 5.76% 6.18% 5.67%Rate paid on interest bearing liabilities ..................... 4.43 3.95 4.40 3.82 ---- ---- ---- ----Interest rate spread .......................................... 1.75 1.81 1.78 1.85Benefit from net non-interest earning or paying funds ......... .51 .46 .50 .43 ---- ---- ---- ----Net interest margin to earning assets (1) ..................... 2.26% 2.27% 2.28% 2.28% ==== ==== ==== ==== (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 87 of HUSI's 2006 Form 10-K. Significant trends affecting the comparability of 2007 and 2006 net interestincome and interest rate spread are summarized in the following table. Netinterest income in the table is presented on a taxable equivalent basis (referto pages 69-70 of this Form 10-Q). ------------------------------------------------------------------------------------------------------------------------ Three months ended June 30 Six months ended June 30 -------------------------- ------------------------- Interest Interest Amount Rate Spread Amount Rate Spread------------------------------------------------------------------------------------------------------------------------ ($ in millions) Net interest income/interest rate spread for 2006 ............. $782 1.81% $1,524 1.85% ==== ====Increase (decrease) in net interest income associated with: Balance sheet management activities (1) .................... (13) (40) Private label receivable portfolio ........................ 28 94 Residential mortgage banking ............................... (20) (43) All other core banking activity ............................ 38 75 ---- ------Net interest income/interest rate spread for 2007 ............. $815 1.75% $1,610 1.78% ==== ==== ====== ==== (1) Represents HUSI's activities to manage interest rate risk associated with the repricing characteristics of balance sheet assets and liabilities. Interest rate risk, and HUSI's approach to manage such risk, are described beginning on page 70 of HUSI's 2006 Form 10-K. Balance Sheet Management Activities Lower net interest income from balance sheet management activities continued toimpact results for the CIBM business segment during the second quarter and firstsix months of 2007. A relatively flat yield curve continued to limit availableopportunities to generate additional net funds income within the CIBM businesssegment. Beginning in 2005, the CIBM business segment expanded its operations andproducts offered to clients, which has resulted in increased trading and lendingactivity in 2006 and 2007. The resulting increases in average trading assets andaverage commercial loan balances partially offset the negative impact of theflat yield curve. Private Label Receivable Portfolio (PLRP) Higher net interest income for the PLRP for the first six months of 2007resulted from: o increased credit card receivable balances, due to the addition of new PLRP merchant relationships during 2006 and 2007, and to decreased balance requirements of off-balance sheet securitized PLRP receivable trusts; and o lower amortization of premiums paid for purchases of receivables included within the PLRP. Although premiums associated with daily purchases of receivables from HSBC Finance Corporation continue to be recorded and amortized, premium amortization associated with the initial portfolio acquisition in 2004 was $51 million lower for the first six months of 2007. 35 Other Core Banking Activity Lower net interest income from core banking activities primarily resulted fromcontinued narrowing of interest rate spreads and from contraction of theresidential mortgage loan portfolio, which was partially offset by increasedinterest income from growing credit card receivable portfolios and from growthin various small business commercial lending portfolios. Personal deposits continued to grow in 2007 as a result of continued success ofthe Online Savings product and expansion of the branch network. However,customers continued to migrate to higher yielding deposit products such as theOnline Savings product, leading to a change in product mix and resulting innarrowing of deposit spreads, which partly offset the benefit of higher depositbalances. Refer to page 34 of this Form 10-Q for commentary regarding HUSI'sdeposit strategy and growth. Significant resources have been dedicated to expansion of various commerciallending businesses and regional offices, which has resulted in increased loanand deposit balances. The average yield earned on commercial loans was alsohigher for the first six months of 2007. Net interest income growth has beenpartially offset by narrowing deposit spreads, as customers continue to migrateto higher yielding deposit products. In addition to narrowing interest spreads, the positive impacts of the growingdeposit base and business expansion initiatives were further offset by lowerinterest earned and lower interest rate spreads on the residential mortgage loanportfolio. As a result of a continuing strategy to reduce prepayment risk andimprove HBUS's structural liquidity, HUSI continues to sell a majority of itsresidential mortgage loan originations and allow the residential mortgage loanportfolio to runoff. Provision for Credit Losses The provision for credit losses associated with various loan portfolios issummarized in the following table. ---------------------------------------------------------------------------------- Increase (Decrease) ------------------- 2007 2006 Amount %------------------------------------------------------------------------------- ($ in millions) Three months ended June 30:Commercial ................................. $ 32 $ 61 $(29) (48) ---- ---- ---- ---Consumer: Residential mortgages ................... 10 8 2 25 Credit card receivables ................. 204 148 56 38 Other consumer .......................... 18 5 13 260 ---- ---- ---- --- Total consumer .......................... 232 161 71 44 ---- ---- ---- ---Total provision for credit losses .......... $264 $222 $ 42 19 ==== ==== ==== === Six months ended June 30:Commercial ................................. $ 65 $ 76 $(11) (14) ---- ---- ---- ---Consumer: Residential mortgages ................... 24 15 9 60 Credit card receivables ................. 344 267 77 29 Other consumer .......................... 36 21 15 71 ---- ---- ---- --- Total consumer .......................... 404 303 101 33 ---- ---- ---- ---Total provision for credit losses .......... $469 $379 $ 90 24 ==== ==== ==== === Increased total provision expense for the second quarter and first half of 2007was primarily due to higher provisions associated with the growing private labelcredit card receivable portfolio and to a lesser extent, to higher provisionsassociated with other consumer loan portfolios, which were partially offset bylower provisions associated with commercial loan portfolios. 36 Higher provision expense and net charge offs associated with credit cardreceivables are consistent with portfolio growth, particularly within theprivate label credit card portfolio. In addition, provision expense for thefirst six months of 2006 was unusually low due to the impact of bankruptcylegislation enacted in 2005, which resulted in accelerated credit cardreceivable and other consumer loan charge offs during the fourth quarter of2005. During the first quarter of 2007, HUSI refined its allowance methodologyassociated with MasterCard/Visa credit card receivables, resulting in a $13million reduction in the allowance balance and provision expense, whichpartially offset overall increases in credit card allowances. Refer toadditional commentary regarding credit card receivables credit quality on page58 of this Form 10-Q. During the second quarter of 2006, provision expense of $29 million was recordeddue to a combination of charge offs and increased allowances related to aspecific commercial real estate investment loan for which no allowance forcredit losses was previously recorded. Excluding this specific 2006 provision,commercial loan provision expense was unchanged for the second quarter andincreased $18 million for the first half of 2007, as compared with the same 2006periods. Higher provision expense for the first half of 2007 was primarily dueto higher criticized asset balances. Refer to additional commentary regardingcommercial loan credit quality beginning on page 57 of this Form 10-Q. Other Revenues The components of other revenues are summarized in the following tables. ------------------------------------------------------------------------------------------------------------- Increase/(Decrease) -------------------Three months ended June 30 2007 2006 Amount %----------------------------------------------------------------------------------------------------------- ($in millions) Trust income ..................................................... $ 24 $ 22 $ 2 9 ---- ---- ---- --- Service charges .................................................. 52 50 2 4 ---- ---- ---- --- Credit card fees ................................................. 198 139 59 42 ---- ---- ---- --- Other fees and commissions: Letter of credit fees ......................................... 17 18 (1) (6) Wealth and tax advisory services .............................. 24 22 2 9 Other fee-based income, net of referral fees .................. 45 51 (6) (12) ---- ---- ---- --- 86 91 (5) (5) ---- ---- ---- --- HSBC affiliate income: Service charges ............................................... 4 4 -- -- Other fees and commissions .................................... 25 7 18 257 Gain on sale of residential mortgage loans to HMUS (1) ........ 7 52 (45) (87) Gain on sale of refund anticipation loans to HSBC Finance ..... Corporation 1 1 -- -- Other affiliate income ........................................ 4 2 2 100 ---- ---- ---- --- 41 66 (25) (38) ---- ---- ---- --- Other income: Securitization revenue ........................................ -- 2 (2) (100) Insurance ..................................................... 12 11 1 9 Valuation allowance increase for changes in market value of loans held for sale to HMUS (1) ............................. (65) (73) 8 11 Gains on sale of property and other financial assets .......... 13 10 3 30 Earnings from equity investments .............................. 24 14 10 71 Miscellaneous income .......................................... 22 39 (17) (44) ---- ---- ---- --- 6 3 3 100 ---- ---- ---- --- Residential mortgage banking revenue ............................. 42 27 15 56Trading revenues ................................................. 312 269 43 16Securities gains, net ............................................ 16 6 10 167 ---- ---- ---- ---Total other revenues ............................................. $777 $673 $104 15 ==== ==== ==== === (1) Refer to tables and commentary regarding "Residential Mortgage Loans Held for Sale to an HSBC Affiliate" on pages 39-40 of this Form 10-Q. 37 ----------------------------------------------------------------------------------------------------------- Increase/(Decrease) ---------------------Six months ended June 30 2007 2006 Amount %--------------------------------------------------------------------------------------------------------------- ($ in millions) Trust income ................................................ $ 47 $ 44 $ 3 7 ------ ------ ---- ---- Service charges ............................................. 105 97 8 8 ------ ------ ---- ---- Credit card fees ............................................ 376 261 115 44 ------ ------ ---- ---- Other fees and commissions: Letter of credit fees .................................... 36 36 -- -- Wealth and tax advisory services ......................... 52 48 4 8 Other fee-based income, net of referral fees ............. 106 109 (3) 3 ------ ------ ---- ---- 194 193 1 1 ------ ------ ---- ---- HSBC affiliate income: Service charges .......................................... 8 7 1 14 Other fees and commissions ............................... 42 24 18 75 Gain on sale of residential mortgage loans to HMUS (1) ... 8 64 (56) (88) Gain on sale of refund anticipation loans to HSBC Finance Corporation ........................................... 23 21 2 10 Other affiliate income ................................... 7 5 2 40 ------ ------ ---- ---- 88 121 (33) (27) ------ ------ ---- ---- Other income: Securitization revenue ................................... -- 19 (19) (100) Insurance ................................................ 26 24 2 8 Valuation allowance increase for changes in market value of loans held for sale to HMUS (1) ..................... (75) (152) 77 51 Gains on sale of property and other financial assets ..... 23 16 7 44 Earnings from equity investments ......................... 41 41 -- -- Miscellaneous income ..................................... 37 59 (22) (37) ------ ------ ---- ---- 52 7 45 643 ------ ------ ---- ---- Residential mortgage banking revenue ........................ 63 50 13 26Trading revenues ............................................ 449 548 (99) (18)Securities gains, net ....................................... 37 10 27 270 ------ ------ ---- ----Total other revenues ........................................ $1,411 $1,331 $ 80 6 ====== ====== ==== ==== (1) Refer to tables and commentary regarding "Residential Mortgage Loans Held for Sale to an HSBC Affiliate" on pages 39-40 of this Form 10-Q. 38 This information is provided by RNS The company news service from the London Stock Exchange

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