HSBC USA Inc 10-Q Part 2

14th Nov 2007 08:39

HSBC Holdings PLC14 November 2007 PART 2 Item 2. Management's Discussion and Analysis of Financial Condition and Results of 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-------------------------------------------------------------------------------- Challenging market conditions, particularly in the U.S. mortgage and creditmarkets, led to significant declines in trading and other income, which resultedin income before income tax expense of $4 million in the third quarter, and $822million for the nine months ended September 30, 2007, a decrease of 99% and 35%,respectively, from the same periods in 2006. Net income decreased 91% to $21million for the third quarter and 30% to $585 million for the first nine monthsof 2007 from the same periods in 2006. Net interest income was $923 million for the third quarter and $2,520 millionfor the first nine months of 2007, an increase of 19% and 10% from the sameperiods in 2006. These increases primarily resulted from: o higher interest income from growth in the private label credit card portfolio, and reduced amortization of the initial premium paid for the portfolio as the purchased balances pay down; o higher accrued income as a result of a more robust income recognition methodology on private label credit card promotional transactions; and o business expansion initiatives, including continued focus on 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. The 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 third quarter and for thefirst nine months of 2007, primarily due to higher average credit cardreceivable balances and to growing delinquencies within the credit cardportfolio. In addition, consumer provision expense was unusually low for thefirst nine months of 2006, due to the impact of bankruptcy legislation enactedin 2005, which resulted in accelerated consumer charge offs and higher provisionexpense during the fourth quarter of 2005. 27 Other revenues fell as market conditions surrounding sub-prime mortgagesresulted in significantly wider credit spreads and less liquidity in the market.These adverse market conditions resulted in substantial valuation adjustments inseveral asset classes, including available for sale and trading securities,residential mortgage loans held for sale, leveraged acquisition finance loans,and credit derivative products. Other revenues also reflect the decrease invalue of derivative trading instruments used to hedge an investment in Class Bshares issued by MasterCard, Incorporated, the fair value of which has increasedsignificantly but which cannot be recognized until the investment is sold. Theselosses were partially offset by: o increased credit card fees from growing credit card receivable portfolios; o increased trading revenue from structured derivative product transactions and from foreign exchange and precious metals trading desks; and o gains on the sale of HUSI's investment in MasterCard Class B shares. 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. During the first quarter of 2007, after a thorough review of its deferred incometaxes, HUSI increased the carrying value of its deferred tax assets by $28million, with a corresponding decrease in income tax expense. The remainingdecrease in income tax expense and the related decrease in the effective taxrate was mainly due to a concentration of normal tax credits and an adjustmentof the tax provision to reflect the actual tax return liabilities. Income Before Income Tax Expense - Significant Trends Analysis of the components of HUSI's income before income tax expense begins onpage 36 of this Form 10-Q. Income before income tax expense, and various trendsand activity affecting operations, are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Three months Nine months ended ended September 30 September 30----------------------------------------------------------------------------------------------------------------------- (in millions) Income before income tax expense for 2006 .......................................... $ 365 $ 1,267 ---------- ---------- Increase (decrease) in income before income tax expense attributable to: Balance sheet management activities (1) ...................................... (11) (55) Trading related activities (2) ............................................... (29) (33) Private label receivable portfolio (3) ....................................... 35 111 Loans held for sale (4) ...................................................... (218) (299) Residential mortgage banking revenue (5) ..................................... (19) (49) Earnings from equity investments (6) ......................................... (31) (31) All other activity (7) ....................................................... (88) (89) ---------- ---------- (361) (445) ---------- ----------Income before income tax expense for 2007 .......................................... $ 4 $ 822 ========== ========== (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 54 of this Form 10-Q, respectively. (2) Refer to commentary regarding trading revenues beginning on page 41 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 52 of this Form 10-Q. (4) Refer to commentary regarding loans held for sale beginning on page 39 of this Form 10-Q. (5) Refer to commentary regarding residential mortgage banking revenue beginning on page 43 of this Form 10-Q. (6) Refer to commentary regarding other income beginning on page 41 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 50 of this Form 10-Q. 28 Selected Financial Data The following tables present a summary of selected financial information. ------------------------------------------------------------------------------------------------------------------------ Three months ended Nine months ended September 30 September 30 -------------------------- -------------------------- 2007 2006 2007 2006------------------------------------------------------------------------------------------------------------------------ ($ in millions) Income statement:Net interest income ................................. $ 923 $ 777 $ 2,520 $ 2,287Provision for credit losses ......................... (402) (207) (871) (586)Total other revenues ................................ 374 614 1,785 1,946Total operating expenses ............................ (891) (819) (2,612) (2,380)Income tax credit (expense) ......................... 17 (121) (237) (429) --------- --------- --------- ---------Net income .......................................... $ 21 $ 244 $ 585 $ 838 ========= ========= ========= ========= Balances at period end:Loans, net of allowance ............................. $ 91,608 $ 89,134Total assets ........................................ 185,421 167,497Total tangible assets ............................... 182,663 164,754Total deposits ...................................... 110,808 96,827Common shareholder's equity ......................... 10,323 10,411Tangible common shareholder's equity ................ 7,916 7,884Total shareholders' equity .......................... 12,013 12,101 Selected financial ratios:Total shareholders' equity to total assets, at period end ..................................... 6.48% 7.22%Tangible common shareholder's equity to total tangible assets, at period end .................... 4.33% 4.79%Rate of return on average (1): Total assets .................................. 0.05% .59% 0.47% .69% Total common shareholder's equity ............. (0.15) 8.28 6.51 9.89Net interest margin to average (1): Earning assets ................................ 2.53% 2.22% 2.37% 2.26% Total assets .................................. 2.14 1.88 2.02 1.90Average total shareholders' equity to average total assets (1) .................................. 6.99% 7.37% 7.24% 7.39%Efficiency ratio (1) ................................ 68.69 58.88 60.67 56.21 (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 pre-tax net income for thethree month and nine month periods ending September 30, 2007 and 2006 aresummarized on page 28 of this Form 10-Q. 29 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 (IFRS) Effective January 1, 2007, corporate goals of HUSI are based upon resultsreported under IFRS (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 IFRS basis. In addition, HSBCreports its results in accordance with IFRS and IFRS results are used by HSBC inmeasuring and rewarding performance of employees. The following table reconcilesHUSI's net income on a U.S. GAAP basis to net income on an IFRS basis. -------------------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 -------------------------- -------------------------- 2007 2006 2007 2006-------------------------------------------------------------------------------------------------------------------- (in millions) Net income - U.S. GAAP basis .................... $ 21 $ 244 $ 585 $ 838Adjustments, net of tax: Unquoted equity securities ................ (15) -- 29 -- Fair value option ......................... 85 (31) 49 (34) Servicing assets .......................... 9 13 (12) (3) Loan origination .......................... 2 -- 12 -- Loans held for trading purposes ........... (5) 1 (1) 12 Other ..................................... 2 4 6 (2) --------- --------- --------- ---------Net income - IFRS basis ......................... $ 99 $ 231 $ 668 $ 811 ========= ========= ========= ========= Differences between U.S. GAAP and IFRS 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. IFRS 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 IFRS requires 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 IFRS and impact shareholders' equity when the security is classified as available-for-sale under IFRS. 30 Fair value option IFRS 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 IFRS, where derivatives providing an economic hedge for an asset or liability, and so designated under IFRS, 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. 31 Servicing assets IFRS o Under IAS 38, servicing assets are initially recorded on the balance sheet at cost 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 $534 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 IFRS. Therefore, current earnings under U.S. GAAP exceeded earnings under IFRS for the first nine months of 2007. Loan origination IFRS 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 nine months of 2007, the net costs amortized against earningsunder U.S. GAAP exceeded net costs amortized under IFRS. Loans held for trading purposes IFRS o Under IAS 39, loans originated or acquired with the intent to sell them 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. 32 Impact o HUSI holds $6.4 billion of loans held for resale on the balance sheet at September 30, 2007 for various business purposes. These include residential mortgage loans held for resale to HSBC affiliates for securitization purposes, residential mortgage loans held for resale to various governmental agencies, leveraged acquisition finance loans held for sale to third parties, and other types of consumer loans.o Because of differences between fair value and LOCOM accounting, the recorded value of certain pools of loans held for resale under IFRS may exceed the value recorded under U.S. GAAP.o The timing difference between trade date accounting for IFRS and settlement date accounting under U.S. GAAP also results in higher current earnings under IFRS. Other Other includes the net impact of differences relating to various adjustments,none of which were individually material for the third quarter and first ninemonths of 2007 and 2006, respectively. BALANCE SHEET REVIEW-------------------------------------------------------------------------------- HUSI utilizes borrowings from various sources to fund balance sheet growth, tomeet cash and capital needs, and to fund investments in subsidiaries. Balancesheet totals at September 30, 2007, and movements in comparison with priorperiods, are summarized in the following table. --------------------------------------------------------------------------------------------------------------------- Increase (Decrease) from ------------------------------------------------------------- December 31, 2006 September 30,2006 September 30, --------------------------- --------------------------- 2007 Amount % Amount %--------------------------------------------------------------------------------------------------------------------- ($ in millions) Period end assets: Short-term investments ....... $ 21,781 $ 2,726 14 $ 1,135 5 Loans, net ................... 91,608 2,268 3 2,474 3 Trading assets ............... 31,582 7,952 34 6,345 25 Securities ................... 24,555 1,800 8 1,655 7 Other assets ................. 15,895 5,858 58 6,315 66 ---------- ---------- ---------- ---------- ---------- $ 185,421 $ 20,604 13 $ 17,924 11 ========== ========== ========== ========== ==========Funding sources: Total deposits ............... $ 110,808 $ 8,662 8 $ 13,981 14 Trading liabilities .......... 16,819 4,505 37 2,914 21 Short-term borrowings ........ 9,404 4,331 85 2,411 34 All other liabilities ........ 8,246 4,475 119 3.478 73 Long-term debt ............... 28,131 (1,121) (4) (4,772) (15) Shareholders' equity ......... 12,013 (248) (2) (88) (1) ---------- ---------- ---------- ---------- ---------- $ 185,421 $ 20,604 13 $ 17,924 11 ========== ========== ========== ========== ========== 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. 33 Loans, Net Loan balances at September 30, 2007, and movements in comparison with priorperiods, are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Increase (Decrease) from ---------------------------------------------------- December 31, 2006 September 30, 2006 September 30, ----------------------- --------------------- 2007 Amount % Amount %----------------------------------------------------------------------------------------------------------------------- ($ in millions) Total commercial loans ........................ $ 35,446 $ 5,964 20 $ 6,103 21 -------- -------- -------- -------- -------- Consumer loans: Residential mortgages ................... 36,729 (3,079) (8) (4,261) (10) Credit card receivables: Private label ........................ 16,339 (634) (4) 726 5 MasterCard/Visa ...................... 1,705 418 32 531 45 Other consumer .......................... 2,447 (240) (9) (453) (16) -------- -------- -------- -------- -------- Total consumer loans .................... 57,220 (3,535) (6) (3,457) (6) -------- -------- -------- -------- --------Total loans ................................... 92,666 2,429 3 2,646 3Allowance for credit losses ................... 1,058 161 18 172 19 -------- -------- -------- -------- --------Loans, net .................................... $ 91,608 $ 2,268 3 $ 2,474 3 ======== ======== ======== ======== ======== Increased commercial loan balances were partly due to expansion of middle marketactivities, as well as an increase in previously unfunded commitments.Additionally, in the third quarter of 2007, HUSI began originating commercialloans in connection with its participation in a number of leveraged acquisitionfinance syndicates. A majority of these loans were originated with the intent ofselling them to third parties. 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 nine 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 64-65 of this Form 10-Q) haveresulted in higher on-balance sheet credit card receivable balances fromSeptember 30, 2006 to September 30, 2007. Trading Assets and Liabilities Trading assets and liabilities balances at September 30, 2007, and movements incomparison with prior periods, are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Increase (Decrease) from -------------------------------------------------- December 31, 2006 September 30, 2006 September 30, ----------------------- ---------------------- 2007 Amount % Amount %----------------------------------------------------------------------------------------------------------------------- ($ in millions) Trading assets: Securities (1) ............................... $ 13,661 $ 1,737 15 $ (33) -- Precious metals .............................. 4,659 1,943 72 1,184 34 Fair value of derivatives .................... 13,262 4,272 48 5,194 64 --------- --------- --------- --------- --------- $ 31,582 $ 7,952 34 $ 6,345 25 ========= ========= ========= ========= =========Trading liabilities: Securities sold, not yet purchased ........... $ 1,804 $ (110) (6) $ (1,695) (48) Payables for precious metals ................. 1,814 478 36 131 8 Fair value of derivatives .................... 13,201 4,137 46 4,479 51 --------- --------- --------- --------- --------- $ 16,819 $ 4,505 37 $ 2,915 21 ========= ========= ========= ========= ========= (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. 34 Growth in securities balances from December 31, 2006 and from September 30, 2006was attributable to purchases of hybrid adjustable rate prime mortgages during2007, due to increased hedging opportunities to capitalize on the current spreadenvironment in these assets. Also contributing to the increase were purchases ofemerging market securities for hedging of credit swap derivative credit riskexposure. Higher derivative balances resulted from increased values on variousderivative products including credit default swaps, foreign currency forwardcontracts and equity swaps as a result of increasing credit spreads during thequarter. Higher precious metals balances were due to higher levels of tradingactivity, and to generally higher market prices for various metals, specificallygold and platinum. Deposits Deposit balances by major depositor categories at September 30, 2007, andmovements in comparison with prior periods, are summarized in the followingtable. ----------------------------------------------------------------------------------------------------------------------- Increase (Decrease) from --------------------------------------------------- December 31, 2006 September 30, 2006 September 30, ----------------------- ----------------------- 2007 Amount % Amount %----------------------------------------------------------------------------------------------------------------------- ($ in millions) Individuals ..................................... $ 48,344 $ 5,078 12 $ 7,351 18Partnerships and corporations ................... 40,867 1,329 3 324 1Domestic and foreign banks ...................... 17,225 982 6 5,360 45U.S. Government, states and political subdivisions .................................. 2,292 365 19 457 25Foreign government and officialinstitutions .................................... 2,080 908 77 489 31 --------- --------- --------- --------- ---------Total deposits .................................. $ 110,808 $ 8,662 8 $ 13,981 14 ========= ========= ========= ========= ========= Total core deposits (1) ......................... $ 63,363 $ 5,787 10 $ 7,545 14 ========= ========= ========= ========= ========= (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 $12.4 billion at September 30, 2007, of which $5.2 billion was raised during the first nine 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 $9 billion in the firstnine months of 2007. 35 RESULTS OF OPERATIONS-------------------------------------------------------------------------------- Net Interest Income An analysis of consolidated average balances and interest rates on a taxableequivalent basis is presented on pages 72-73 of this Form 10-Q. Significantcomponents of HUSI's net interest margin are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 -------------------- --------------------- 2007 2006 2007 2006----------------------------------------------------------------------------------------------------------------------- Yield on total earning assets ..................................... 6.47% 5.91% 6.28% 5.75%Rate paid on interest bearing liabilities ......................... 4.41 4.23 4.40 3.96 ------- ------- ------- -------Interest rate spread .............................................. 2.06 1.68 1.88 1.79Benefit from net non-interest earning or paying funds ............. .47 .54 .49 .47 ------- ------- ------- -------Net interest margin to earning assets (1) ......................... 2.53% 2.22% 2.37% 2.26% ======= ======= ======= ======= (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 72-73 of this Form 10-Q). ---------------------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 ------------------------ ------------------------ Interest Interest Amount Rate Spread Amount Rate Spread---------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income/interest rate spread for 2006 .......... $ 783 1.68% $ 2,306 1.79% ======== ========Increase (decrease) in net interest income associated with: Balance sheet management activities (1) .............. (2) (42) Private label receivable portfolio ................... 88 177 Residential mortgage banking ......................... (19) (61) All other core banking activity ...................... 80 161 -------- --------Net interest income/interest rate spread for 2007 .......... $ 930 2.06% $ 2,541 1.88% ======== ======== ======== ======== (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 third quarter and firstnine months of 2007. A relatively flat yield curve continued to limit availableopportunities to generate additional net funds income within the CIBM businesssegment. The CIBM business segment expanded its operations and products offered toclients, which has resulted in increased trading and lending activity. Theresulting increases in average trading assets and average commercial loanbalances were partially offset by the impact of the relatively flat yield curve. Private Label Receivable Portfolio (PLRP) Higher net interest income for the PLRP for the third quarter and for the firstnine months of 2007 resulted 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; o higher accrued income as a result of a more robust income recognition methodology on private label credit card promotional transactions; and 36 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 $63 million lower for the first nine months of 2007. Residential Mortgage Lower net interest income from residential mortgage activities primarilyresulted from continued narrowing of interest rate spreads and from contractionof the residential mortgage loan portfolio. As a result of a continuing strategyto reduce prepayment risk and improve HBUS's structural liquidity, HUSIcontinues to sell a majority of its residential mortgage loan originations andallow the residential mortgage loan portfolio to runoff. Other Core Banking Activity Higher net interest income from other core banking activity mostly resulted frombusiness expansion initiatives, which have led to increased deposits and loans. Personal deposits continued to grow in 2007 as a result of continued success ofthe Online Savings product and expansion of the branch network. However,customers continued to migrate to higher yielding deposit products such as theOnline Savings product, leading to a change in product mix and narrowing ofdeposit spreads, which partly offset the benefit of higher deposit balances.Refer to page 35 of this Form 10-Q for commentary regarding HUSI's depositstrategy and growth. Significant resources have been dedicated to expansion of various commerciallending businesses and regional offices, which has resulted in increased loanand deposit balances. The average yield earned on commercial loans was alsohigher for the first nine months of 2007. Provision for Credit Losses The provision for credit losses associated with various loan portfolios issummarized in the following table. -------------------------------------------------------------------------------------------------------------- Increase (Decrease) ----------------------- 2007 2006 Amount %-------------------------------------------------------------------------------------------------------------- ($ in millions) Three months ended September 30:Commercial ....................................... $ 57 $ 34 $ 23 68 -------- -------- -------- --------Consumer: Residential mortgages ...................... 24 3 21 * Credit card receivables .................... 301 150 151 101 Other consumer ............................. 20 20 -- -- -------- -------- -------- -------- Total consumer ............................. 345 173 172 99 -------- -------- -------- --------Total provision for credit losses ................ $ 402 $ 207 $ 195 94 ======== ======== ======== ======== Nine months ended September 30:Commercial ....................................... $ 122 $ 110 $ 12 11 -------- -------- -------- --------Consumer: Residential mortgages ...................... 48 18 30 167 Credit card receivables .................... 645 417 228 55 Other consumer ............................. 56 41 15 37 -------- -------- -------- -------- Total consumer ............................. 749 476 273 57 -------- -------- -------- --------Total provision for credit losses ................ $ 871 $ 586 $ 285 49 ======== ======== ======== ======== * Not meaningful. 37 Higher provision expense associated with credit card receivables for the thirdquarter and first nine months of 2007 primarily resulted from higherdelinquencies and charge offs within the private label credit card portfolio. Inaddition, provision expense for the first nine months of 2006 was unusually lowdue to the impact of bankruptcy legislation enacted in 2005, which resulted inaccelerated credit card receivable and other consumer loan charge offs duringthe fourth quarter of 2005. During the first quarter of 2007, HUSI refined itsallowance methodology associated with MasterCard/Visa credit card receivables,resulting in a $13 million reduction in the allowance balance and provisionexpense, which partially offset overall increases in credit card allowances.Refer to additional commentary regarding credit card receivables credit qualityon page 61of this Form 10-Q. Commercial loan provision expense increased $23 million for the third quarter of2007, as compared with the same 2006 period. During the second quarter of 2006,provision expense of $29 million was recorded due to a combination of chargeoffs and increased allowances related to a specific commercial real estateinvestment loan for which no specific allowance for credit losses was previouslyrecorded. Excluding this specific 2006 provision, commercial loan provisionexpense increased $41 million for the first nine months of 2007, as comparedwith the same 2006 period. Higher provision expense for the first nine months of2007 was primarily due to higher criticized asset balances. Refer to additionalcommentary regarding commercial loan credit quality beginning on page 60 of thisForm 10-Q. 38 Other Revenues Decreased revenue for the three months and nine months ended September 30, 2007,was mostly driven by reduced liquidity and higher volatility in the credit andsub-prime markets which led to substantial valuation losses being recorded. Thiswas partially offset by increased credit card fees, other fees and commissionsfrom affiliates, and increased security gains. The components of other revenues are summarized in the following tables. ----------------------------------------------------------------------------------------------------------------------- Increase/(Decrease) -------------------Three months ended September 30 2007 2006 Amount %----------------------------------------------------------------------------------------------------------------------- (in millions) Trust income .......................................................... $ 26 $ 22 $ 4 18 ------- ------- ------- ------- Service charges ....................................................... 53 52 1 2 ------- ------- ------- ------- Credit card fees ...................................................... 225 148 77 52 ------- ------- ------- ------- Other fees and commissions: Letter of credit fees ........................................... 19 19 -- -- Wealth and tax advisory services ................................ 28 25 3 12 Other fee-based income, net of referral fees .................... 71 66 5 8 ------- ------- ------- ------- 118 110 8 7 ------- ------- ------- ------- HSBC affiliate income: Service charges ................................................. 1 4 (3) (75) Other fees and commissions ...................................... 28 13 15 115 Gain on sale of residential mortgage loans to HMUS (1) .......... 14 40 (26) (65) Gain on sale of refund anticipation loans to HSBC Finance Corporation ................................................... -- -- -- -- Other affiliate income .......................................... 3 4 (1) (25) ------- ------- ------- ------- 46 61 (15) (25) ------- ------- ------- ------- Other income: Securitization revenue .......................................... -- -- -- -- Insurance ....................................................... 13 11 2 18 Valuation allowance (increase) decrease for changes in market value of loans held for sale .................................. (218) 43 (261) * Gains (loss) on sale of property and other financial assets ..... (16) 34 (50) (147) Earnings from equity investments ................................ 22 53 (31) (58) Miscellaneous income ............................................ 12 16 (4) (25) ------- ------- ------- ------- (187) 157 (344) * ------- ------- ------- ------- Residential mortgage banking revenue .................................. 6 6 -- --Trading revenues ...................................................... 28 52 (24) (46)Securities gains, net ................................................. 59 6 53 * ------- ------- ------- -------Total other revenues .................................................. $ 374 $ 614 $ (240) (39) ======= ======= ======= ======= (1) Refer to tables and commentary regarding "Residential Mortgage Loans Held for Sale to an HSBC Affiliate" on pages 41-42 of this Form 10-Q. * Not meaningful. 39 ----------------------------------------------------------------------------------------------------------------------- Increase/(Decrease) ----------------------Nine months ended September 30 2007 2006 Amount %----------------------------------------------------------------------------------------------------------------------- ($ in millions) Trust income ............................................... $ 73 $ 66 $ 7 11 ------- ------- ------- ------- Service charges ............................................ 158 149 9 6 ------- ------- ------- ------- Credit card fees ........................................... 601 409 192 47 ------- ------- ------- ------- Other fees and commissions: Letter of credit fees ................................ 55 55 -- -- Wealth and tax advisory services ..................... 80 72 8 11 Other fee-based income, net of referral fees ......... 177 175 2 1 ------- ------- ------- ------- 312 302 10 3 ------- ------- ------- ------- HSBC affiliate income: Service charges ...................................... 9 11 (2) (18) Other fees and commissions ........................... 69 36 33 92 Gain on sale of residential mortgage loans to HMUS (1) 24 105 (81) (77) Gain on sale of refund anticipation loans to HSBC Finance Corporation ........................................ 23 21 2 10 Other affiliate income ............................... 9 9 -- -- ------- ------- ------- ------- 134 182 (48) (26) ------- ------- ------- ------- Other income: Securitization revenue ............................... -- 19 (19) (100) Insurance ............................................ 38 35 3 9 Valuation allowance increase for changes in market value of loans held for sale ....................... (299) (114) (185) (162) Gains on sale of property and other financial assets . 6 50 (44) (88) Earnings from equity investments ..................... 63 95 (32) (34) Miscellaneous income ................................. 57 80 (23) (29) ------- ------- ------- ------- (135) 165 (300) (182) ------- ------- ------- ------- Residential mortgage banking revenue ....................... 69 57 12 21Trading revenues ........................................... 477 600 (123) (21)Securities gains, net ...................................... 96 16 80 * ------- ------- ------- -------Total other revenues ....................................... $ 1,785 $ 1,946 $ (161) (8) ======= ======= ======= ======= (1) Refer to tables and commentary regarding "Residential Mortgage Loans Held for Sale to an HSBC Affiliate" on pages 41-42 of this Form 10-Q. * Not meaningful. Credit Card Fees Higher credit card fees in 2007 from private label and co-brand credit cardportfolio activity were primarily due to the following factors: o credit card receivables included in off-balance sheet securitization transactions for the first nine months of 2006 were included in on-balance sheet credit card receivables for the first nine months of 2007. Late fees associated with these receivables, which were recorded in securitization revenue in 2006 (refer to other income commentary), are recorded in credit card fees for 2007; o the number of accounts, volume of customer transaction activity and average receivable balances included within the private label portfolio all were higher for 2007, due to the addition of merchant and customer relationships and to expansion of credit card products offered. Product repricing also resulted in higher fees; and o higher late fees due to increased delinquencies within the private label portfolio. 40 HSBC Affiliate Income Higher fees and commissions from HSBC affiliates was primarily due to increasedcustomer referral and other fees from HMUS and HSBC associated with currentexpansion of the payments and cash management business and previous expansion ofvarious trading businesses. Fees from HSBC Finance Corporation for loanservicing have also increased in 2007. Other Income In the third quarter of 2006, the last remaining securitization trust agreementrelated to the private label credit card receivable portfolio was amended. As aresult, the trust no longer qualified for sale treatment and all assets andliabilities of the trust were returned to HUSI's consolidated balance sheet. Inaddition, all new collateralized funding transactions have been structured assecured financings since the third quarter of 2004. The loss of securitizationrevenue for 2007 was offset by higher net interest income and higher fee revenue(refer to previous credit card fees commentary) from the receivables andliabilities that were returned to the consolidated balance sheet. HUSI holds an equity investment in a non-consolidated foreign HSBC affiliate.During the third quarter of 2006, this affiliate sold a portion of itsinvestment in a foreign equity fund to another HSBC affiliate. During the secondquarter of 2007, the same affiliate sold its remaining investment in the foreignequity fund. This decrease in equity investment holdings resulted in lowerequity earnings for the first nine months of 2007. Valuation Allowance on Residential Mortgage Loans Held for Sale to an HSBCAffiliate In 2005, HUSI began acquiring residential mortgage loans from unaffiliated thirdparties with the intent of selling these loans to an HSBC affiliate, HSBCMarkets (USA) Inc. (HMUS). HMUS in turn sells these loans to securitizationvehicles. During 2006, HUSI also began acquiring residential mortgage loans fromHSBC Finance Corporation under this program. Loans acquired from unaffiliatedthird parties and HSBC Finance Corporation primarily include sub-primeresidential mortgage loans. In addition, a number of prime adjustable ratemortgage loans originated by HUSI have been identified for this program and arebeing held with the intent of selling these loans to HMUS. HMUS in turn sellsthese loans to securitization vehicles. Loans held for sale are recorded by HUSIat the lower of their aggregate cost or market value, with adjustments to marketvalue being recorded as a valuation allowance. HUSI maintains a portfolio ofderivatives and securities, which are used as economic hedges to offset changesin market values of the loans held for sale to HMUS. Gains on sales associatedwith these loans result from incremental value realized on pools of loans soldto HMUS for securitization. The activity related to this program affects various consolidated financialstatement line items, as summarized in the following table. Lower results andactivity for this program for the third quarter and the first nine months of2007 generally resulted from the overall weakness and illiquidity in the U.S.residential mortgage market, and specifically from significantly reduced fairvalues of sub-prime loans. 41 -----------------------------------------------------------------------------------------------------------------------Three months ended September 30 2007 2006----------------------------------------------------------------------------------------------------------------------- (in millions) Residential mortgage loans held for sale to HMUS: Balance at beginning of period ..................................................... $ 3,059 $ 4,795 Loans acquired from originators .................................................... 1,009 3,088 Loans sold to HMUS ................................................................. (1,061) (4,501) Other, primarily loans resold to originators and other third parties ............... (177) (157) ---------- ---------- Balance at end of period ........................................................... $ 2,830 $ 3,225 ========== ========== Valuation allowance for changes in market value of loans held for sale to HMUS: Balance at beginning of period ..................................................... $ (49) $ (83) Valuation allowance (increase) decrease for changes in market value ................ (146) 29 Releases of valuation allowance for loans sold to HMUS ............................. 3 53 ---------- ---------- Balance at end of period ........................................................... $ (192) $ (1) ========== ========== Impact on income before income taxes: Net interest income associated with loans held for sale to HMUS (1) ................ $ 6 $ 13 Gains on sale of residential mortgage loans sold to HMUS, recorded in HSBC affiliate income ........................................................................... 14 40 Valuation allowance (increase) decrease for changes in market value of loans held for sale to HMUS, recorded in other income ................................................... (146) 29 Trading revenues recognized from economic hedges held to offset changes in market values of loans held for sale to HMUS (1) ............................................... (30) (57) Net program costs included in other expenses ....................................... (3) (6) ---------- ---------- Net impact on income before income taxes ........................................... $ (159) $ 19 ========== ========== -----------------------------------------------------------------------------------------------------------------------Nine months ended September 30 2007 2006----------------------------------------------------------------------------------------------------------------------- (in millions) Residential mortgage loans held for sale to HMUS: Balance at beginning of period ..................................................... $ 3,126 $ 2,882 Loans acquired from originators .................................................... 6,028 13,218 Loans sold to HMUS ................................................................. (5,749) (12,657) Other, primarily loans resold to originators and other third parties ............... (575) (218) ---------- ---------- Balance at end of period ........................................................... $ 2,830 $ 3,225 ========== ========== Valuation allowance for changes in market value of loans held for sale to HMUS: Balance at beginning of period ..................................................... $ (26) $ (11) Valuation allowance increase for changes in market value ........................... (221) (123) Releases of valuation allowance for loans sold to HMUS ............................. 55 133 ---------- ---------- Balance at end of period ........................................................... $ (192) $ (1) ========== ========== Impact on income before income taxes: Net interest income associated with loans held for sale to HMUS (1) ................ $ 39 $ 51 Gains on sale of residential mortgage loans sold to HMUS, recorded in HSBC affiliate income ........................................................................... 24 105 Valuation allowance increase for changes in market value of loans held for sale to HMUS, recorded in other income ................................................... (221) (123) Trading revenues recognized from economic hedges held to offset changes in market values of loans held for sale to HMUS (1) ............................................... (7) 59 Net program costs included in other expenses ....................................... (15) (9) ---------- ---------- Net impact on income before income taxes ........................................... $ (180) $ 83 ========== ========== (1) Refer to trading revenues commentary beginning on page 45 of this Form 10-Q. Valuation Allowance for Leveraged Acquisition Finance Loans Held for Sale HUSI originates commercial loans in connection with its participation in anumber of leveraged acquisition finance syndicates. A substantial majority ofthese loans were originated with the intent of selling them to unaffiliatedthird parties and are classified as held for sale at September 30, 2007.Commercial loans held for sale, including those related to the leveraged lendingprogram, are recorded at the lower of cost or market value with valuationadjustments recorded to a valuation allowance and reflected in Other Income.Adverse conditions in the corporate credit markets resulted in a substantialincrease in the valuation allowance for commercial loans held for sale. 42 Residential Mortgage Banking Revenue The following tables present the components of residential mortgage bankingrevenue. Net interest income includes interest earned/paid on assets andliabilities of the residential mortgage banking business, as well as the fundingcost or benefit associated with these balances. The net interest incomecomponent in the table is included in net interest income in the consolidatedstatement of income and reflects actual interest earned, net of cost of funds,and adjusted for corporate transfer pricing. ----------------------------------------------------------------------------------------------------------------------- Increase (Decrease) ---------------------Three months ended September 30 2007 2006 Amount %----------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income ............................................... $ 59 $ 78 $ (19) (24) ======= ======= ======= =======Servicing related income: Servicing fee income ........................................ 29 25 4 16 Changes in fair value of MSRs due to: Changes in valuation inputs or assumptions used in valuation model ................................ (28) (43) 15 35 Realization of cash flows ................................ (14) (21) 7 33 Trading - Derivative instruments used to offset changes in value of MSRs .................................. 19 38 (19) (50) ------- ------- ------- ------- 6 (1) 7 * ------- ------- ------- -------Originations and sales related income: (Losses) gains on sales of residential mortgages ............ (5) 3 (8) * Trading and fair value hedge activity ....................... (1) (1) -- -- ------- ------- ------- ------- (6) 2 (8) * ------- ------- ------- -------Other mortgage income ............................................. 6 5 1 20 ------- ------- ------- -------Total residential mortgage banking revenue included in other revenues ............................................... 6 6 -- -- ------- ------- ------- -------Total residential mortgage banking related revenue ................ $ 65 $ 84 $ (19) (23) ======= ======= ======= ======= ----------------------------------------------------------------------------------------------------------------------- Increase (Decrease) ---------------------Nine months ended September 30 2007 2006 Amount %----------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income ............................................... $ 199 $ 260 $ (61) (23) ======= ======= ======= =======Servicing related income: Servicing fee income ........................................ 85 74 11 15 Changes in fair value of MSRs due to: Changes in valuation inputs or assumptions used in valuation model ................................ 35 31 4 13 Realization of cash flows ................................ (60) (60) -- -- Trading - Derivative instruments used to offset changes in value of MSRs .................................. (34) (19) (15) (79) ------- ------- ------- ------- 26 26 -- -- ------- ------- ------- -------Originations and sales related income: Gains on sales of residential mortgages ..................... 23 14 9 64 Trading and fair value hedge activity ....................... -- 1 (1) * ------- ------- ------- ------- 23 15 8 53 ------- ------- ------- -------Other mortgage income ............................................. 20 16 4 25 ------- ------- ------- -------Total residential mortgage banking revenue included in other revenues ............................................... 69 57 12 21 ------- ------- ------- -------Total residential mortgage banking related revenue ................ $ 268 $ 317 $ (49) (15) ======= ======= ======= ======= * Not meaningful. 43 Net Interest Income Decreased net interest income for the third quarter and first nine months of2007 resulted from lower average residential mortgage loans outstanding as wellas a slight narrowing of interest rate spreads. During 2007, HUSI continued tosell the majority of new loan originations to government sponsored enterprisesand private investors and allow existing loans to runoff. The held loansportfolio is expected to continue to decline for the remainder of 2007 as aresult of this initiative. Servicing Related Income Higher servicing fee income for the third quarter and first nine months of 2007resulted from a higher volume of loans included within the average servicedloans portfolio. The average serviced loans portfolio increased approximately13% in the third quarter and first nine months of 2007 due to the followingfactors: o the volume of loans sold in the third quarter and first nine months of 2007 was consistent with the same timeframes in 2006; and o in 2007, HUSI commenced servicing a portfolio of loans previously serviced by a third party. The increased serviced loans portfolio, and its positive impact on service feeincome, was partially offset by a decrease in value of the hedged MSRs portfolioincluding an increase in realization of cash flows on the growing portfolio ofloans serviced for others for the first nine months of 2007. 44 Trading Revenues Trading revenues are generated by HUSI's participation in the foreign exchange,credit derivative and precious metal markets; from trading derivative contracts,including interest rate swaps and options; from trading securities; and as aresult of certain residential mortgage banking activities. The following table summarizes trading related revenues by business. The data inthe table includes net interest income earned on trading instruments, as well asfunds transfer charges and credits associated with these trading positions. Thetrading related net interest income component is included in net interest incomeon the consolidated income statement. Trading revenues related to the mortgagebanking business are included in residential mortgage banking revenue. ---------------------------------------------------------------------------------------------------------------------- Increase (Decrease) ---------------------- 2007 2006 Amount %---------------------------------------------------------------------------------------------------------------------- ($ in millions) Three months ended September 30:Trading revenues .............................................. $ 28 $ 52 $ (24) (46)Net interest expense .......................................... (1) (16) 15 94 -------- -------- -------- --------Trading related revenues ...................................... $ 27 $ 36 $ (9) (25) ======== ======== ======== ======== Business: Derivatives instruments ................................. $ (33) $ 48 $ (81) (169) Economic hedges of loans held for sale to HMUS .......... (24) (44) 20 45 Treasury (primarily securities) ......................... (28) (7) (21) * Foreign exchange and banknotes .......................... 77 37 40 108 Precious metals ......................................... 24 3 21 * Other trading ........................................... 11 (1) 12 * -------- -------- -------- --------Trading related revenues ...................................... $ 27 $ 36 $ (9) (25) ======== ======== ======== ======== Nine months ended September 30:Trading revenues .............................................. $ 477 $ 600 $ (123) (21)Net interest expense .......................................... (30) (42) 12 29 -------- -------- -------- --------Trading related revenues ...................................... $ 447 $ 558 $ (111) (20) ======== ======== ======== ======== Business: Derivatives instruments ................................. $ 201 $ 221 $ (20) (9) Economic hedges of loans held for sale to HMUS .......... 32 110 (78) (71) Treasury (primarily securities) ......................... (33) 7 (40) * Foreign exchange and banknotes .......................... 191 132 59 45 Precious metals ......................................... 47 74 (27) (36) Other trading ........................................... 9 14 (5) (36) -------- -------- -------- --------Trading related revenues ...................................... $ 447 $ 558 $ (111) (20) ======== ======== ======== ======== * Not meaningful. During the first nine months of 2006, a wider range of product offerings andenhanced sales capabilities within the CIBM business segment, along withfavorable market conditions in certain sectors, drove significant trading gainsacross all major client-related activities. Successful launches of new productsand increased sales of structured products that are tailored to specificcustomer needs led to strong derivatives trading revenues. Gains in the preciousmetals business reflected volume growth driven by a surge in demand arising fromstrong commodities markets. Income streams in the foreign exchange businessremained robust against the backdrop of a weakening U.S. dollar. During the third quarter of 2007, trading revenue was affected by reducedliquidity, widening spreads and higher volatility in the credit and sub-primelending markets which impacted trading in mortgage backed securities and creditderivatives. The market turmoil has caused a significant fall in revenues inboth the third quarter and the first nine months of 2007 as compared with thesame 2006 periods. Precious metals revenue also experienced a decline in thefirst nine months of 2007, as compared to prior year, as a result of lower pricevolatility. Partially offsetting this, the foreign exchange business hascontinued to contribute solid revenues as a result of ongoing market volatilityand the performance for the first nine months benefited from structured creditand emerging markets derivatives activity in the first half of the year. 45 Effective during the third quarter of 2006, HUSI maintains a portfolio ofMasterCard, Incorporated Class B shares as part of structured producttransactions for customers. In addition, HUSI uses derivative instruments tooffset changes in the fair value of the MasterCard Class B shares. The increasein value of the derivative instruments, which totaled $22 million for the thirdquarter and the decrease in value of the derivative instruments, which totaled$56 million for the first nine months of 2007, are reflected in trading revenuefrom derivative instruments. Under U.S. GAAP, the increased value of theMasterCard Class B shares is not recognized until they are sold. HUSI also maintains a portfolio of derivative instruments that are utilized aseconomic hedges to offset changes in market values of loans held for sale toHMUS. Lower revenues from economic hedges of loans held for sale to HMUSresulted from the overall weakness of the U.S. housing market. Lower tradingresults related to this program are generally offset by the changes in thevaluation allowance related to loans held for sale to HMUS, which is recorded inother revenues. Further analysis and commentary regarding these loans and theassociated hedges is provided beginning on page 41 of this Form 10-Q. HUSI recognizes gains or losses at the inception of derivative transactions onlywhen the fair value of the transaction can be verified to market transactions orif all significant pricing model assumptions can be verified to observablemarket data. Gain or loss not recognized at inception is recorded in tradingassets and recognized over the term of the derivative contract, or when marketdata becomes observable. The availability of observable market data resulted inrecognition of $7 million and $40 million in trading revenues for the first ninemonths of 2007 and 2006, respectively. Securities Gains, Net HUSI maintains various securities portfolios as part of its overall balancesheet diversification and risk management strategies. The following tablesummarizes net securities gains resulting from various strategies. ------------------------------------------------------------------------------------------------ 2007 2006------------------------------------------------------------------------------------------------ (in millions) Three months ended September 30:Sales of MasterCard Class B Shares ........................... $ 55 $ --Balance sheet diversity and reduction of risk ................ -- (5)Management of Latin American investment exposure ............. 3 3Sales of securities to an HSBC affiliate (1) ................ -- --Other ........................................................ 1 8 --------- ---------Securities gains, net ........................................ $ 59 $ 6 ========= ========= Nine months ended September 30:Sales of MasterCard Class B Shares ........................... $ 55 $ --Balance sheet diversity and reduction of risk ................ 9 (2)Management of Latin American investment exposure ............. 23 3Sales of securities to an HSBC affiliate (1) ................. 9 --Other ........................................................ -- 15 --------- ---------Securities gains, net ........................................ $ 96 $ 16 ========= ========= (1) Represents net gains realized from transfers of various available for sale securities, other non-marketable securities and equity investments as part of a strategy to consolidate certain investments into common HSBC entities. 46 Operating Expenses The components of operating expenses are summarized in the following tables. ---------------------------------------------------------------------------------------------------------------------- Increase (Decrease) -----------------------Three months ended September 30 2007 2006 Amount %---------------------------------------------------------------------------------------------------------------------- ($ in millions) Salaries and employee benefits: Salaries .................................................. $ 241 $ 234 $ 7 3 Employee benefits ......................................... 96 83 13 16 --------- --------- --------- --------- Total salaries and employee benefits ...................... 337 317 20 6 --------- --------- --------- --------- Occupancy expense, net .......................................... 63 54 9 17 --------- --------- --------- --------- Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation for loan servicing and other administrative support .............. 115 111 4 4 Fees paid to HMUS ......................................... 58 58 -- -- Fees paid to HTSU for technology services ................. 63 64 (1) (2) Fees paid to other HSBC affiliates ........................ 44 40 4 10 --------- --------- --------- --------- Total support services from HSBC affiliates ............... 280 273 7 3 --------- --------- --------- --------- Other expenses: Equipment and software .................................... 13 17 (4) (24) Marketing ................................................. 34 28 6 21 Outside services .......................................... 44 29 15 52 Professional fees ......................................... 19 17 2 12 Telecommunications ........................................ 5 6 (1) (17) Postage, printing and office supplies ..................... 9 9 -- -- Insurance business ........................................ 15 5 10 200 Miscellaneous ............................................. 72 64 8 13 --------- --------- --------- --------- Total other expenses ...................................... 211 175 36 21 --------- --------- --------- ---------Total operating expenses ........................................ $ 891 $ 819 $ 72 9 ========= ========= ========= =========Personnel - average number ...................................... 12,329 12,216 113 1 ----------------------------------------------------------------------------------------------------------------------- Increase (Decrease) -----------------------Nine months ended September 30 2007 2006 Amount %----------------------------------------------------------------------------------------------------------------------- ($ in millions) Salaries and employee benefits: Salaries ................................................... $ 731 $ 671 $ 60 9 Employee benefits .......................................... 285 282 3 1 --------- --------- --------- --------- Total salaries and employee benefits ....................... 1,016 953 63 7 --------- --------- --------- --------- Occupancy expense, net ........................................... 181 163 18 11 --------- --------- --------- --------- Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation for loan servicing and other administrative support ............... 347 336 11 3 Fees paid to HMUS .......................................... 181 165 16 10 Fees paid to HTSU for technology services .................. 185 170 15 9 Fees paid to other HSBC affiliates ......................... 131 114 17 15 --------- --------- --------- --------- Total support services from HSBC affiliates ................ 844 785 59 8 --------- --------- --------- --------- Other expenses: Equipment and software ..................................... 42 56 (14) (25) Marketing .................................................. 97 74 23 31 Outside services ........................................... 115 89 26 29 Professional fees .......................................... 52 48 4 8 Telecommunications ......................................... 15 15 -- -- Postage, printing and office supplies ...................... 27 25 2 8 Insurance business ......................................... 27 15 12 80 Miscellaneous .............................................. 196 157 39 25 --------- --------- --------- --------- Total other expenses ....................................... 571 479 92 19 --------- --------- --------- ---------Total operating expenses ......................................... $ 2,612 $ 2,380 $ 232 10 ========= ========= ========= =========Personnel - average number ....................................... 12,324 12,094 230 2 47 Overview Increased expenses for the third quarter and for the first nine months of 2007were largely driven by higher personnel, marketing, technology and other expensegrowth associated with continued rollout of various business growth initiativesaffecting all business segments. Salaries and Employee Benefits Higher salaries expenses for the first nine months of 2007 are mainly due to: o higher staff counts and a changing mix of staffing to support various business growth initiatives, primarily within the PFS, CIBM and PB business segments; o higher average salaries and pay rates, due to normal annual pay increases; and o higher personnel costs within the CIBM segment associated with the expansion of various businesses that are better positioned to leverage HSBC's global markets capabilities, and with repositioning certain other businesses in order to focus on building a financing and emerging markets led wholesale banking business. During the second quarter of 2006, the HSBC Remuneration Committee exercised itsdiscretion to waive the Total Shareholder Return performance condition relatedto 2003 share option awards under the HSBC Group Share Option Plan (refer topage 141 of HUSI's 2006 Form 10-K for a description of this plan). Thismodification resulted in an additional charge to employee benefits expense of $9million for the second quarter of 2006. No similar charge was recorded during2007. Excluding this 2006 charge, higher employee benefit costs directlyassociated with increased salaries expenses were offset by lower pension costs. Occupancy Expense, Net Expansion of the core banking and commercial lending networks within the PFS andCMB business segments has been a key component of recent business expansioninitiatives. New branches have been opened and lending operations have beenexpanded, which have resulted in higher rental expenses, depreciation ofleasehold improvements, utilities and other occupancy expenses during the firstnine months of 2007. Support Services from HSBC Affiliates HUSI has routinely purchased private label credit card receivables from HSBCFinance Corporation since December 2004. In addition, higher qualitynonconforming residential mortgage loans were acquired from HSBC FinanceCorporation's correspondent network from December 2003 until September 2005. Inmost cases, HSBC Finance Corporation retained the right to service theseportfolios. Fees charged by HSBC Finance Corporation for loan origination andservicing expenses, which are primarily recorded in the CF segment, haveincreased moderately for 2007 due to an increased number of private label creditcard receivables serviced. Fees charged by HMUS pursuant to service level agreements for broker dealer,loan syndication, treasury and traded markets related services are included insupport services from HSBC affiliates. Higher fees charged by HMUS for the firstnine months of 2007 primarily relate to increased loan syndication services. 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. Fees charged by HTSU to HUSI for technology servicesare higher in 2007, as HUSI continues to upgrade its technology environmentwithin all business segments. HUSI also utilizes other HSBC affiliates in support of global outsourcinginitiatives and, to a lesser extent, for treasury and traded markets services.Higher expense for 2007 primarily resulted from expanded data processing andother global outsourcing services. 48 Other Expenses Higher marketing and promotional expenses resulted from continuing investment inHSBC brand activities, promotion of the internet savings account and marketingsupport for branch expansion initiatives, primarily within the PFS businesssegment. As a result of a decision to discontinue operations of HBUS's real estatesettlement services company, certain deferred start-up costs and othercontractual costs totaling $6 million were included in outside services for thesecond quarter of 2007. Employment agency and staff recruitment fees, alsoincluded in outside services, have increased in 2007, primarily to supportbusiness expansion and ongoing technology enhancement projects. The increase in Insurance business expense in the third quarter of 2007primarily relates to the costs incurred to terminate a portion of the annuityreinsurance business. Additionally, there was a nominal increase in claims forthe quarter. Miscellaneous expenses for the first nine months of 2006 were unusually low,mainly due to reversal of a charge for the accrued interest related tosettlement of certain income tax liabilities during the second quarter of 2006.Excluding this 2006 adjustment, higher miscellaneous expenses for 2007 wereprimarily due to increased insurance costs and higher expenses associated withbusiness expansion. Efficiency Ratio -------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 ----------------------- ---------------------- 2007 2006 2007 2006-------------------------------------------------------------------------------------------------------- Efficiency ratio (1) ................................ 68.69% 58.88% 60.67% 56.21% (1) Ratio of total operating expenses, reduced by minority interests, to the sum of net interest income and other revenues. Higher net interest income was more than offset by a decrease in other revenuesand increased operating expenses for the third quarter and the first nine monthsof 2007, resulting in an increase in the efficiency ratio for both periods. 49 SEGMENT RESULTS-------------------------------------------------------------------------------- HUSI has five distinct segments that are utilized for management reporting andanalysis purposes. The segments, which are based upon customer groupings as wellas products and services offered, are described on pages 19-20 of HUSI's Form10-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 (IFRS), 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 anIFRS basis. As a result, business segment results are reported on an IFRS basisto align with the revised internal reporting mechanism for monitoringperformance. Results for 2007 and 2006 in the tables that follow are reflectedon an IFRS basis. Results for each business segment on an IFRS basis are summarized in thefollowing tables. Personal Financial Services (PFS) Overview Resources continue to be directed towards expansion of the core retail bankingbusiness, including investment in the HSBC brand, expansion of the branchnetwork in existing and new geographic areas, and continued rollout of HSBCDirect, the internet banking channel. Significant expense growth from theseinitiatives for the third quarter and the first nine months of 2007 has beenpartially offset by growth in revenues from key investments. Net interest incomefrom core banking activities has decreased in 2007 due to continued narrowing ofinterest rate spreads, as well as customer migration to higher yielding depositproducts such as Online Savings and CDs and was partially offset by the positiveimpact of new customers and product sales. Balance sheet growth for core retail banking for the first nine months of 2007was highlighted by a 24.5% increase in average deposits, as compared with thesame 2006 period. This was driven by a successful strategy to build depositsacross multiple markets and business segments and utilizing various deliverychannels. PFS business segment results for 2007 also have been impacted by lowerresidential mortgage banking revenue, primarily due to loan portfolio runoff.During 2007, as part of a continuing effort to manage prepayment risk andliquidity, HUSI made the decision to sell a majority of its residential mortgageloan originations and allow the residential mortgage loan portfolio to run off. 50 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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