15th May 2006 14:31
HSBC Holdings PLC15 May 2006 Part 2 of 2 Corporate, Investment Banking and Markets (CIBM) Overview The CIBM business segment continues to be negatively impacted by steadily risingshort-term interest rates, which limited opportunities to profit from placingfunds generated from operations. While increased short-term rates have apositive impact on interest rate spreads for deposit generating businesses, suchas the PFS and CMB business segments, they have an adverse impact on CIBM whichdoes not generate significant low cost deposit funding. Various treasury and traded markets activities were expanded in 2005. Increasedproducts offered to customers, increased marketing efforts for those products,and an expanded infrastructure to support growth initiatives have resulted inincreased non-funds revenues and operating expenses. Operating Results The following table summarizes results for the CIBM business segment. ---------------------------------------------------------------------------------- 2006 Compared to 2005 Increase/(Decrease) ----------------------Three months ended March 31 2006 2005 Amount %---------------------------------------------------------------------------------- (in millions) Net interest income $ 53 $ 154 $ (101) (66)Other revenues 273 167 106 63 --------- --------- --------- ---------Total revenues 326 321 5 2Operating expenses 183 134 49 37 --------- --------- --------- ---------Working contribution 143 187 (44) (24)Provision for credit losses 2 (18) 20 111 --------- --------- --------- ---------Income before income tax expense $ 141 $ 205 $ (64) (31) ========= ========= ========= ========= Average assets $ 71,321 $ 53,101Average liabilities/equity 79,252 72,243Goodwill at March 31 630 631 Decreased net interest income was primarily due to steadily rising short-terminterest rates during 2005 and 2006, which had an adverse impact on CIBMinterest rate spreads. Net interest income from balance sheet managementactivity decreased approximately $105 million in the first quarter of 2006,compared to the same 2005 period. Increased other revenues was mainly due to: o increased trading revenues; o new service fees generated by a subsidiary transferred to HUSI from HSBC in March 2005, which provides accounting and valuation services for hedge fund clients; and o increased fee-based income, resulting from business expansion initiatives. Partially offsetting these increases were decreased realized gains on sales ofsecurities. Commentary regarding trading revenues and securities gains begins onpage 36 of this Form 10-Q. Additional analysis of growth in trading assets andliabilities is provided on page 26 of this Form 10-Q. Increased operating expenses resulted from: o increased direct expenses associated with foreign exchange, risk management products, and transaction banking businesses; o increased expenses associated with development of an infrastructure to support the growing complexity of the CIBM business; and o increased fees paid to HTSU and other HSBC affiliates for technology services, as CIBM required additional information technology resources to support system conversions and business expansion. 42 The provision for credit losses increased during the first quarter of 2006. Thenet provision credit for 2005 resulted from continuation of relatively lowcharge offs and recoveries of amounts previously charged off. Private Banking (PB) Overview During 2005 and 2006, additional resources have been allocated to expandproducts and services provided to high net worth customers served by thisbusiness segment, resulting in increased revenues and operating expenses. Operating Results The following table summarizes results for the PB business segment. ---------------------------------------------------------------------------------- 2006 Compared to 2005 Increase/(Decrease) ----------------------Three months ended March 31 2006 2005 Amount %---------------------------------------------------------------------------------- (in millions) Net interest income $ 48 $ 40 $ 8 20Other revenues 76 58 18 31 --------- --------- --------- ---------Total revenues 124 98 26 27Operating expenses 75 64 11 17 --------- --------- --------- ---------Working contribution 49 34 15 44Provision for credit losses -- (1) 1 100 --------- --------- --------- ---------Income before income tax expense $ 49 $ 35 $ 14 40 ========= ========= ========= ========= Average assets $ 5,473 $ 4,720Average liabilities/equity 10,520 9,399Goodwill at March 31 428 428 Increased net interest income for the first quarter of 2006 resulted fromincreased average interest earning assets, primarily loans. Increased other revenues for the first quarter of 2006 resulted from: o increased fee income from wealth and tax advisory services provided to high net worth individuals; and o increased equity earnings from a foreign equity investment. Increased operating expenses for the first quarter of 2006 resulted fromadditional resources being allocated to this segment to expand the servicesprovided. 43 CREDIT QUALITY-------------------------------------------------------------------------------- Policies and critical estimates associated with its allowance for credit lossesare summarized on pages 23-24 and 57-60 of HUSI's 2005 Form 10-K. There havebeen no material revisions to policies or methodologies in the first quarter of2006. Credit quality statistics are summarized in Note 3, beginning on page 11 of theconsolidated financial statements. The following table provides an analysis of changes in the allowance for creditlosses and related ratios. --------------------------------------------------------------------------------------------------------------- March 31, December 31, September 30, June 30, March 31,Quarter ended 2006 2005 2005 2005 2005--------------------------------------------------------------------------------------------------------------- (in millions) Balance at beginning of quarter $ 846 $ 852 $ 790 $ 773 $ 788Allowance related to disposition of certain credit card relationships (6) -- -- -- -- Charge offs: Commercial 20 36 16 17 6 Consumer: Residential mortgages 11 8 6 6 4 Credit card receivables 170 186 154 160 159 Other consumer loans 29 34 26 23 30 ------------ ------------ ------------ ------------ ------------ Total consumer loans 210 228 186 189 193 ------------ ------------ ------------ ------------ ------------ Total charge offs 230 264 202 206 199 ------------ ------------ ------------ ------------ ------------ Recoveries on loans charged off: Commercial 15 15 26 7 23 Consumer: Residential mortgages -- -- 1 -- -- Credit card receivables 46 35 30 37 44 Other consumer loans 9 10 8 9 10 ------------ ------------ ------------ ------------ ------------ Total consumer loans 55 45 39 46 54 ------------ ------------ ------------ ------------ ------------ Total recoveries 70 60 65 53 77 ------------ ------------ ------------ ------------ ------------ Total net charge offs 160 204 137 153 122 ------------ ------------ ------------ ------------ ------------ Provision charged to income 157 198 199 170 107 ------------ ------------ ------------ ------------ ------------ Balance at end of quarter $ 837 $ 846 $ 852 $ 790 $ 773 ============ ============ ============ ============ ============ Allowance ratios: Annualized net charge offs to average loans .73% .90% .61% .71% .58% Quarter-end allowance to: Quarter-end total loans .94% .94% .95% .90% .90% Quarter-end total nonaccruing loans 341.63% 351.04% 362.55% 351.11% 318.11% 44 Overview An analysis of changes in the allowance for credit losses for the quarter endedMarch 31, 2006, by general loan categories, is provided in the following table. -------------------------------------------------------------------------------------------------------------Quarter ended Residential Credit Other March 31, 2006 Commercial Mortgage Card Consumer Unallocated Total------------------------------------------------------------------------------------------------------------- (in millions) Balance at beginning of period $ 162 $ 34 $ 600 $ 36 $ 14 $ 846 ----------- ----------- ----------- ----------- ----------- -----------Allowance related to dispositions -- -- (6) -- -- (6)Charge offs 20 11 170 29 -- 230Recoveries 15 -- 46 9 -- 70 ----------- ----------- ----------- ----------- ----------- ----------- Net charge offs 5 11 124 20 -- 160 ----------- ----------- ----------- ----------- ----------- -----------Provision charged to income 14 7 119 16 1 157 ----------- ----------- ----------- ----------- ----------- -----------Balance at end of period $ 171 $ 30 $ 589 $ 32 $ 15 $ 837 =========== =========== =========== =========== =========== =========== The allowance for credit losses decreased $9 million during the first quarter of2006. Total net charge offs of $160 million were mostly offset by the provisionfor credit losses of $157 million and a $6 million reduction of allowance duringthe quarter related to the sale of private label credit card relationships. The allowance for credit losses increased $64 million from March 31, 2005 toMarch 31, 2006, primarily due to the additional reserve requirements associatedwith increased balances within the private label credit card receivableportfolio. Commercial Loan Credit Quality Components of the commercial allowance for credit losses are summarized in thefollowing table. -------------------------------------------------------------------------------- March 31, December 31, March 31, 2006 2005 2005-------------------------------------------------------------------------------- (in millions)On-balance sheet allowance: Specific $ 7 $ 9 $ 21 Collective 160 149 144 Transfer risk 4 4 8 ------------ ------------ ------------ 171 162 173 Unallocated 15 14 14 ------------ ------------ ------------ Total on-balance sheet allowance 186 176 187Off-balance sheet allowance 86 88 77 ------------ ------------ ------------Total commercial allowances $ 272 $ 264 $ 264 ============ ============ ============ The allowance for credit losses associated with commercial loan portfoliosincreased $9 million during the first quarter of 2006. Net charge offs of $5million during the quarter were more than offset by a $14 million provisionexpense associated with commercial loans. Net charge offs of commercial loans continued to run at levels consistent withthose experienced for several recent quarters dating back to 2004, which is wellbelow historical experience for years prior to 2004. Commercial loan creditquality continues to be stable and well managed, reflecting HUSI's generallystrong credit underwriting standards and improving economic conditions. At March31, 2006 HUSI had acceptable on-balance sheet exposure from industriesconsidered to be of higher risk. Overall exposures to these industries werereduced in 2005 and were not materially changed at March 31, 2006. 45 Criticized assets classified as "substandard" increased $137 million during thefirst quarter of 2006, due to: o downgrading of various commercial loans based on recent credit assessments ($70 million); o the downgrading of certain non-investment grade securities ($48 million); and o additional consumer loans being designated as substandard ($19 million). Although overall commercial credit quality is expected to remain stable and wellcontrolled for the remainder of 2006, any sudden and/or unexpected adverseeconomic events or trends could significantly affect credit quality and increaseprovisions for credit losses. Credit Card Receivable Credit Quality The allowance for credit losses associated with credit card receivablesdecreased $11 million during the first quarter of 2006. Net charge offs of $124million and a $6 million reduction of allowance related to the sale of certainprivate label credit card relationships during the quarter were substantiallyoffset by provision expense of $119 million. The net charge off and provisionactivity during the first quarter of 2006, which primarily relates to theprivate label credit card portfolio, is consistent with trends and activity forcalendar year 2005. Receivables included in the private label credit card portfolio are generallymaintained in accruing status until being charged off six months afterdelinquency. The following table provides credit quality data for credit cardreceivables. ------------------------------------------------------------------------------------------------------- March 31, December 31, March 31, 2006 2005 2005------------------------------------------------------------------------------------------------------- (in millions) Accruing balances contractually past due 90 days or more: Balance at end of quarter $ 244 $ 248 $ 210 As a percent of total credit card receivables 1.69% 1.60% 1.75%Allowance for credit losses associated with credit card receivables: Balance at end of quarter $ 589 $ 600 $ 546 As a percent of total credit card receivables 4.07% 3.87% 4.55%Net charge offs of credit card receivables: Total for the quarter ended $ 124 $ 151 $ 115 Annualized net charge offs as a percent of average credit card receivables 3.32% 4.02% 3.83% DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES-------------------------------------------------------------------------------- HUSI is party to various derivative financial instruments as an end user, as aninternational dealer in derivative instruments, and for purely trading purposesin order to realize profits from short-term movements in interest rates,commodity prices, foreign exchange rates and credit spreads. Additionalinformation regarding the use of various derivative instruments is included onpage 26 and pages 95-97 of HUSI's 2005 Form 10-K. Credit and Market Risk Associated with Derivative Contracts Credit (or repayment) risk in derivative instruments is minimized by enteringinto transactions with high quality counterparties, including other HSBC groupentities. Counterparties include financial institutions, government agencies,both foreign and domestic, corporations, funds (mutual funds, hedge funds,etc.), insurance companies and private clients. These counterparties are subjectto regular credit review by the credit risk management department. Mostderivative contracts are governed by an International Swaps and DerivativesAssociation Master Agreement. Depending on the type of counterparty and thelevel of expected activity, bilateral collateral arrangements may be required aswell. 46 The total risk in a derivative contract is a function of a number of variables,such as: o whether counterparties exchange notional principal; o volatility of interest rates, currencies, equity or corporate reference entity used as the basis for determining contract payments; o maturity and liquidity of contracts; o credit worthiness of the counterparties in the transaction; and o existence and value of collateral received from counterparties to secure exposures. The following table presents credit risk exposure associated with derivativecontracts. In the table, current credit risk exposure is the recorded fair valueof derivative receivables, which represents revaluation gains from the markingto market of derivative contracts held for trading purposes, for allcounterparties with an International Swaps and Derivatives Association MasterAgreement in place. Future credit risk exposure in the following table is measured using rulescontained in the risk-based capital guidelines published by U.S. bankingregulatory agencies. The risk exposure calculated in accordance with the riskbased capital guidelines potentially overstates actual credit exposure, because: o the risk-based capital guidelines ignore collateral that may have been received from counterparties to secure exposures; and o the risk-based capital guidelines compute exposures over the life of derivative contracts. However, many contracts contain provisions that allow a bank to close out the transaction if the counterparty fails to post required collateral. As a result, these contracts have potential future exposures that are often much smaller than the future exposures derived from the risk-based capital guidelines. The net credit risk exposure amount in the following table does not reflect theimpact of bilateral netting (i.e., netting with a single counterparty when abilateral netting agreement is in place). However, the risk-based capitalguidelines recognize that bilateral netting agreements reduce credit risk andtherefore allow for reductions of exposures when netting requirements have beenmet. In addition, risk-based capital rules require that netted exposures ofvarious counterparties be assigned risk-weightings, which result inrisk-weighted amounts for regulatory capital purposes that are a fraction of theoriginal netted exposures. -------------------------------------------------------------------------------- March 31, December 31, 2006 2005-------------------------------------------------------------------------------- (in millions)Risk associated with derivative contracts: Current credit risk exposure $ 11,572 $ 8,155 Future credit risk exposure 74,075 61,548 ------------ ------------ Total risk exposure 85,647 69,703 Less: collateral held against exposure (2,347) (1,850) ------------ ------------ Net credit risk exposure $ 83,300 $ 67,853 ============ ============ 47 Notional Values of Derivative Contracts The following table summarizes the notional values of derivative contracts. -------------------------------------------------------------------------------- March 31, December 31, 2006 2005-------------------------------------------------------------------------------- (in millions)Interest rate: Futures and forwards $ 112,129 $ 106,826 Swaps 1,759,952 1,674,091 Options written 275,068 199,676 Options purchased 304,679 217,095 ------------ ------------ 2,451,828 2,197,688 ------------ ------------Foreign exchange: Swaps, futures and forwards 339,695 308,264 Options written 36,551 40,213 Options purchased 37,248 40,959 Spot 45,591 21,099 ------------ ------------ 459,085 410,535 ------------ ------------Commodities, equities and precious metals: Swaps, futures and forwards 60,573 48,702 Options written 14,080 14,378 Options purchased 16,525 16,127 ------------ ------------ 91,178 79,207 ------------ ------------ Credit derivatives 494,139 391,814 ------------ ------------ Total $ 3,496,230 $ 3,079,244 ============ ============ 48 OFF-BALANCE SHEET ARRANGEMENTS-------------------------------------------------------------------------------- The following table provides maturity information related to off-balance sheetarrangements and lending and sales commitments. Descriptions of thesearrangements are found on pages 60-62 of HUSI's 2005 Form 10-K. ------------------------------------------------------------------------------------------------------------------ Balance at March 31, 2006 --------------------------------------------------------- One Over One Over Balance at Year Through Five December 31, or Less Five Years Years Total 2005----------------------------------------------------------------------------------------------------------------- (in millions) Standby letters of credit, net of participations $ 4,531 $ 2,123 $ 81 $ 6,735(1) $ 6,114(1)Commercial letters of credit 784 65 1 850 806Loan sales with recourse -- 1 11 12(2) 9(2)Credit derivative contracts 4,484 171,760 95,558 271,802(3) 222,419(3)Commitments to extend credit: Commercial 22,556 29,474 3,853 55,883 51,284 Consumer 8,544 -- -- 8,544 8,305Securities lending indemnifications -- -- -- -- 4,135 ------------ ------------ ------------ ------------ ------------Total $ 40,899 $ 203,423 $ 99,504 $ 343,826 $ 293,072 ============ ============ ============ ============ ============ (1) Includes $558 million and $523 million issued for the benefit of related parties at March 31, 2006 and December 31, 2005 respectively. (2) $11 million and $7 million is indemnified by third parties at March 31, 2006 and December 31, 2005 respectively. (3) Includes $58,239 million and $51,202 million issued for the benefit of related parties at March 31, 2006 and December 31, 2005 respectively. 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 $21 million and $19 million at March 31, 2006 and December 31, 2005respectively. Also included in other liabilities is an allowance for creditlosses on unfunded standby letters of credit of $18 million and $20 million atMarch 31, 2006 and December 31, 2005 respectively. Credit Derivatives 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 "beneficiary") to transfer thecredit risk of a "reference asset" to another party (the "guarantor"). Underthis arrangement the guarantor assumes the credit risk associated with thereference asset without directly purchasing it. The beneficiary agrees to pay tothe guarantor a specified fee. In return, the guarantor agrees to pay thebeneficiary an agreed upon amount if there is a default during the term of thecontract. In accordance with its policy, HUSI offsets most of the market risk it assumesin selling credit guarantees through a credit derivative contract with anothercounterparty. Credit derivatives, although having characteristics of aguarantee, are accounted for as derivative instruments and are carried at fairvalue. The commitment amount included in the table is the maximum amount thatHUSI could be required to pay, without consideration of the approximately equalamount receivable from third parties and any associated collateral. Securities Lending Indemnifications Through December 31, 2005, HUSI occasionally lent securities of customers, on afully collateralized basis, as an agent to third party borrowers. Customers wereindemnified against the risk of loss, and collateral was obtained from theborrower with a market value exceeding the value of the loaned securities.Securities lending activities were terminated during the first quarter of 2006. 49 RISK MANAGEMENT-------------------------------------------------------------------------------- Overview Some degree of risk is inherent in virtually all of HUSI's activities. For theprincipal activities undertaken by HUSI, the most important types of risks areconsidered to be credit, interest rate, market, liquidity, operational,fiduciary and reputational. Market risk broadly refers to price risk inherent inmark to market positions taken on trading and non-trading instruments.Operational risk technically includes legal and compliance risk. However, sincecompliance risk, including anti-money laundering (AML) risk, has such broadscope within HUSI's businesses, it is addressed as a separate functionaldiscipline. During the first three months of 2006, there have been nosignificant changes in policies or approach for managing various types of risk. Liquidity Management HUSI's approach to address liquidity risk is summarized on pages 67-68 of HUSI's2005 Form 10-K. There have been no changes in HUSI's approach toward liquidityrisk management during 2006. HUSI's ability to regularly attract wholesale funds at a competitive cost isenhanced by strong ratings from the major credit rating agencies. At March 31,2006, HUSI and HBUS maintained the following debt and preferred stock ratings,which are unchanged from December 31, 2005. --------------------------------------------------------------------------------At March 31, 2006 Moody's S&P Fitch--------------------------------------------------------------------------------HUSI: Short-term borrowings P-1 A-1 F1+ Long-term debt Aa3 A+ AA Preferred stock A2 A- AA-HBUS: Short-term borrowings P-1 A-1+ F1+ Long-term debt Aa2 AA- AA HUSI periodically issues capital instruments to fund balance sheet growth, tomeet cash and capital needs, or to fund investments in subsidiaries. In December2005, the United States Securities and Exchange Commission (SEC) amended itsrules regarding registration, communications and offerings under the SecuritiesAct of 1933. The amended rules facilitate access to capital markets bywell-established public companies, provide more flexibility regardingrestrictions on corporate communications during a securities offering andfurther integrate disclosures under the Securities Act of 1933 and theSecurities Exchange Act of 1934. The amended rules provide the most flexibilityto "well-known seasoned issuers", including the option of automaticeffectiveness upon filing of shelf registration statements and relief under theliberalized communications rules. HUSI currently satisfies the eligibilityrequirements for designation as a "well-known seasoned issuer", and has aneffective shelf registration statement with the SEC under which it may issuedebt securities, preferred stock, either separately or represented by depositaryshares, warrants, purchase contracts and units. Interest Rate Risk Management Various techniques are utilized to quantify and monitor risks associated withthe repricing characteristics of HUSI's assets, liabilities, and derivativecontracts. The approach toward managing interest rate risk is summarized onpages 69-71 of HUSI's 2005 Form 10-K. During the first quarter of 2006, therewere no significant changes in policies or approach for managing interest raterisk. 50 Present Value of a Basis Point (PVBP) Analysis PVBP is the change in value of the balance sheet for a one basis point upwardmovement in all interest rates. The following table reflects the PVBP positionat March 31, 2006. -------------------------------------------------------------------------------March 31, 2006 Values------------------------------------------------------------------------------- (in millions)Institutional PVBP movement limit $ 7.5PVBP position at period end 3.4 Economic Value of Equity Economic value of equity is the change in value of the assets and liabilities(excluding capital and goodwill) for either a 200 basis point immediate rateincrease or decrease. The following table reflects the economic value of equityposition at March 31, 2006. ----------------------------------------------------------------------------------------------March 31, 2006 Values---------------------------------------------------------------------------------------------- Institutional economic value of equity limit +/- 20%Projected change in value (reflects projected rate movements on April 1, 2006): Change resulting from a gradual 200 basis point increase in interest rates (9) Change resulting from a gradual 200 basis point decrease in interest rates 1 The projected decrease in value for a 200 basis point increase in rates isprimarily related to the anticipated slowing of prepayments for the heldmortgage and mortgage backed securities portfolios in this higher rateenvironment. This assumes that no management actions are taken to manageexposures to the changing interest rate environment. Dynamic Simulation Modeling Various modeling techniques are utilized to monitor a number of interest ratescenarios for their impact on net interest income. These techniques include bothrate shock scenarios which assume immediate market rate movements of 200 basispoints, as well as scenarios in which rates rise or fall by as much as 200 basispoints over a twelve month period. The following table reflects the impact onnet interest income of the scenarios utilized by these modeling techniques. ------------------------------------------------------------------------------------------------------------ March 31, 2006 Values ---------------------- Amount %------------------------------------------------------------------------------------------------------------ (in millions) Projected change in net interest income (reflects projected rate movements on April 1, 2006): Institutional base earnings movement limit (10) Change resulting from a gradual 200 basis point increase in the yield curve $(179) (6) Change resulting from a gradual 200 basis point decrease in the yield curve 247 8 Change resulting from a gradual 100 basis point increase in the yield curve (88) Change resulting from a gradual 100 basis point decrease in the yield curve 123 Other significant scenarios monitored (reflects projected rate movements on April 1, 2006): Change resulting from an immediate 100 basis point increase in the yield curve (146) Change resulting from an immediate 100 basis point decrease in the yield curve 158 Change resulting from an immediate 200 basis point increase in the yield curve (299) Change resulting from an immediate 200 basis point decrease in the yield curve 224 Change resulting from an immediate 100 basis point increase in short-term rates (267) The projections do not take into consideration possible complicating factorssuch as the effect of changes in interest rates on the credit quality, size andcomposition of the balance sheet. Therefore, although this provides a reasonableestimate of interest rate sensitivity, actual results will vary from theseestimates, possibly by significant amounts. 51 Capital Risk/Sensitivity of Other Comprehensive Income Large movements of interest rates could directly affect some reported capitaland capital ratios. The mark to market valuation of available for salesecurities is credited on a tax effective basis through other comprehensiveincome in the consolidated statement of changes in shareholders' equity.Although this valuation mark is excluded from Tier 1 and Tier 2 capital ratios,it is included in two important accounting based capital ratios: the tangiblecommon equity to tangible assets and the tangible common equity to risk weightedassets. As of March 31, 2006, HUSI had an available for sale securitiesportfolio of approximately $18 billion with a net negative mark to market of$480 million included in tangible common equity of $8 billion. An increase of 25basis points in interest rates of all maturities would lower the mark to marketby approximately $172 million to a net loss of $652 million with the followingresults on the tangible capital ratios. -------------------------------------------------------------------------------- Proforma - Reflecting 25 Basis PointsMarch 31, 2006 Actual Increase in Rates--------------------------------------------------------------------------------Tangible common equity to tangible assets 4.93% 4.87%Tangible common equity to risk weighted assets 6.34 6.26 Value at Risk (VAR) VAR analysis is also used to measure interest rate risk and to calculate theeconomic capital required to cover potential losses due to interest rate risk.The approach toward using VAR to measure interest rate risk is summarized onpages 71-73 of HUSI's 2005 Form 10-K. Trading Activities Trading portfolios reside primarily in the CIBM and residential mortgage bankingareas and include foreign exchange, derivatives, precious metals (gold, silver,platinum), commodities, equities and money market instruments. The tradingportfolios have defined limits pertaining to items such as permissibleinvestments, risk exposures, loss review, balance sheet size and productconcentrations. Loss review refers to the maximum amount of loss that may beincurred before senior management intervention is required. Trading Activities - Treasury Value at Risk The following table summarizes trading VAR, assuming a 99% confidence level fora two year observation period and a 10 day holding period. ----------------------------------------------------------------------------------------- Three Months Ended March 31, 2006 March 31, --------------------------------------- December 31, 2006 Minimum Maximum Average 2005----------------------------------------------------------------------------------------- (in millions) Total trading $ 121 $ 47 $ 121 $ 76 $ 53Commodities 2 -- 10 3 5Credit derivatives 15 15 26 18 18Equities -- -- 1 -- 1Foreign exchange 11 2 21 9 4Interest rate 143 65 143 94 69 52 Trading Volatility The following tables summarize the frequency distribution of daily marketrisk-related revenues for Treasury trading activities during the first quarterof 2006. Market risk-related Treasury trading revenues include realized andunrealized gains (losses) related to Treasury trading activities, but excludethe related net interest income. Analysis of gain (loss) data for the firstthree months of 2006 shows that the largest daily gain was $32 million and thelargest daily loss was $13 million. ----------------------------------------------------------------------------------------------------------------Ranges of daily Treasury trading revenue earned from market risk- Below $(10) $0 to $10 to Over related activities (in millions) $(10) to $0 $10 $20 $20---------------------------------------------------------------------------------------------------------------- Number of trading days market risk-related revenue was within the stated range 2 19 24 12 5 Trading Activities - HSBC Mortgage Corporation (USA) HSBC Mortgage Corporation (USA) is HUSI's mortgage banking subsidiary. Tradingoccurs in mortgage banking operations as a result of an economic hedging programintended to offset changes in value of mortgage servicing rights and the salableloan pipeline. Economic hedging may include, for example, forward contracts tosell residential mortgages and derivative contracts used to protect the value ofMSRs which, while economically viable, may not satisfy the hedge requirements ofSFAS 133. MSRs are assets that represent the present value of net servicing income(servicing fees, ancillary income, escrow and deposit float servicing costs).MSRs are recognized upon the sale of the underlying loans or at the time thatservicing rights are purchased. MSRs are subject to interest rate risk, in thattheir value will fluctuate as a result of a changing interest rate environment. Interest rate risk is mitigated through an active hedging program that usestrading securities and derivative instruments to offset changes in value ofMSRs. Since the hedging program involves trading activity, risk is quantifiedand managed using a number of risk assessment techniques. Rate Shock Analysis Modeling techniques are used to monitor certain interest rate scenarios fortheir impact on the economic value of net hedged MSRs, as reflected in thefollowing table. ------------------------------------------------------------------------------------------------------March 31, 2006 Values------------------------------------------------------------------------------------------------------ (in millions) Projected change in net market value of hedged MSRs portfolio (reflects projected rate movements on April 1, 2006): Value of hedged MSRs portfolio $ 465 Change resulting from an immediate 50 basis point decrease in the yield curve: Change limit (no worse than) (16) Calculated change in net market value (4) Change resulting from an immediate 50 basis point increase in the yield curve: Change limit (no worse than) (8) Calculated change in net market value 6 Change resulting from an immediate 100 basis point increase in the yield curve: Change limit (no worse than) (12) Calculated change in net market value 14 Economic Value of MSRs The economic value of the net, hedged MSRs portfolio is monitored on a dailybasis for interest rate sensitivity. If the economic value declines by more thanestablished limits for one day or one month, various levels of managementreview, intervention and/or corrective actions are required. 53 Hedge Volatility The following table summarizes the frequency distribution of the weekly economicvalue of the MSR asset during the first quarter of 2006. This includes thechange in the market value of the MSR asset net of changes in the market valueof the underlying hedging positions used to hedge the asset. The changes ineconomic value are adjusted for changes in MSR valuation assumptions that weremade during the course of the quarter, if applicable. -------------------------------------------------------------------------------------------------------------------Ranges of mortgage economic value from market risk-related Below $(2) $0 to $2 to Over activities (in millions) $(2) to $0 $2 $4 $4------------------------------------------------------------------------------------------------------------------- Number of trading weeks market risk-related revenue was within the stated range 3 4 4 1 1 Item 3. Quantitative and Qualitative Disclosures About Market Risk-------------------------------------------------------------------------------- Refer to Item 2, Management's Discussion and Analysis of Financial Condition andResults of Operations, under the captions "Interest Rate Risk Management" and"Trading Activities", beginning on page 50 of this Form 10-Q. Item 4. Controls and Procedures-------------------------------------------------------------------------------- HUSI maintains a system of internal and disclosure controls and proceduresdesigned to ensure that information required to be disclosed in reports filed orsubmitted under the Securities Exchange Act of 1934, as amended, (the ExchangeAct), is recorded, processed, summarized and reported on a timely basis. HUSI'sBoard of Directors, operating through its Audit Committee, which is composedentirely of independent outside directors, provides oversight to the financialreporting process. An evaluation was conducted, with the participation of the Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of HUSI's disclosurecontrols and procedures as of the end of the period covered by this report.Based upon that evaluation, the Chief Executive Officer and Chief FinancialOfficer concluded that HUSI's disclosure controls and procedures were effectiveas of the end of the period covered by this report so as to alert them in atimely fashion to material information required to be disclosed in reports filedunder the Exchange Act. There have been no significant changes in HUSI's internal and disclosurecontrols or in other factors that could significantly affect internal anddisclosure controls subsequent to the date that the evaluation was carried out. HUSI continues the process to complete a thorough review of its internalcontrols as part of its preparation for compliance with the requirements ofSection 404 of the Sarbanes-Oxley Act of 2002 (Section 404). Section 404requires management to report on, and external auditors to attest to, theeffectiveness of HUSI's internal control structure and procedures for financialreporting. As a non-accelerated filer under Rule 12b-2 of the Exchange Act,HUSI's first report under Section 404 will be contained in its Form 10-K for theperiod ended December 31, 2007. 54 Part II - OTHER INFORMATION-------------------------------------------------------------------------------- Item 1A. Risk Factors-------------------------------------------------------------------------------- Risk factors were provided in HUSI's Form 10-K for the year ended December 31,2005. However, the following discussion provides a more detailed description ofsome of the important risk factors that could affect HUSI's actual results andcould cause results to vary materially from those expressed in public statementsor documents. Other factors besides those discussed below or elsewhere inreports filed or furnished with the SEC could affect HUSI's business or results.The reader should not consider any description of such factors to be a completeset of all potential risks that may face HUSI. Additional commentary regardingrisks that may affect HUSI and HUSI's approach toward risk management isprovided on pages 63-77 of HUSI's 2005 Annual Report on Form 10-K, and on pages50-54 of this Form 10-Q. General Business, Economic, Political and Market Conditions HUSI's business and earnings are affected by general business, economic, marketand political conditions in the United States and abroad. Given itsconcentration of business activities in the United States, HUSI is particularlyexposed to downturns in the United States economy. For example, in a pooreconomic environment there is greater likelihood that more of HUSI's customersor counterparties could become delinquent or default on their loans or otherobligations. This could result in higher levels of charge offs and provisionsfor credit losses, which would adversely affect HUSI's earnings. Generalbusiness, economic and market conditions that could affect HUSI include, but arenot limited to: o short-term and long-term interest rates; o inflation; o recession; o monetary supply; o fluctuations in both debt and equity capital markets in which HUSI funds its operations; o market value of consumer owned and commercial real estate throughout the United States; o consumer perception as to the availability of credit; and o the ease of filing for bankruptcy. Certain changes to these conditions could diminish demand for HUSI's productsand services, or increase the cost to provide such products or services. Recenttrends in world-wide financial markets related to, among other things, thegrowth of derivatives and hedge funds, could add instability and could changethe way those markets work. Political conditions also may impact HUSI'searnings. The economic health of geographic areas where HUSI has greaterconcentrations of business may decline relative to other geographic regions,with related impacts on HUSI's earnings. Acts or threats of war or terrorism, aswell as actions taken by the United States or other governments in response tosuch acts or threats, could affect business and economic conditions in theUnited States. Competition HUSI operates in a highly competitive environment. Competitive conditions areexpected to continue to intensify as continued merger activity in the financialservices industry produces larger, better-capitalized and more geographicallydiverse companies. New products, customers and channels of distribution areconstantly emerging. In addition, the traditional segregation of the financialservices industry into prime and non-prime segments has eroded and in the futureis expected to continue to do so, further increasing competition in thefinancial services industry. Such competition may impact the terms, rates, costsand/or profits historically included in the loan products HUSI offers orpurchases. The traditional segregation of commercial and investment banks hasall but eroded. There is no assurance that the significant and increasingcompetition within the financial services industry will not materially andadversely affect HUSI's future results of operations. 55 Federal and State Regulation HUSI operates in a highly regulated environment. Changes in federal, state andlocal laws and regulations affecting banking, consumer credit, bankruptcy,privacy, consumer protection or other matters could materially impact HUSI'sperformance. For example, anti-money laundering requirements under the PatriotAct are frequently revisited by the U.S. Congress and Executive Agencies. Broador targeted legislative or regulatory initiatives may be aimed at lendersoperating in consumer lending markets. These initiatives could affect HUSI insubstantial and unpredictable ways, including limiting the types of consumerloan products it can offer. In addition, there may be amendments to, and newinterpretations of, risk-based capital guidelines and reporting instructions.HUSI cannot determine whether such legislative or regulatory initiatives will beinstituted or predict the impact that such initiatives would have on results. Changes in Accounting Standards HUSI's accounting policies and methods are fundamental to how HUSI records andreports its financial condition and the results of its operations. From time totime the Financial Accounting Standards Board (FASB), the SEC and bankregulators, including the Office of Comptroller of the Currency and the Board ofGovernors of the Federal Reserve System, change the financial accounting andreporting standards that govern the preparation of external financialstatements. These changes are beyond HUSI's control, can be hard to predict andcould materially impact how HUSI reports its financial condition and the resultsof its operations. HUSI could be required to apply new or revised standardsretroactively, resulting in a restatement of prior period financial statementsin material amounts. Management Financial Projections and Judgments Pursuant to U.S. GAAP, HUSI's management is required to use certain estimates inpreparing financial statements, including accounting estimates to determine loanloss reserves, reserves related to future litigation, and the fair market valueof certain assets and liabilities, among other items. In particular, loan lossreserve estimates are judgmental and are influenced by factors outside of HUSI'scontrol. As a result, estimates could change as economic conditions change. Ifvalues determined by HUSI's management for such items turn out to besubstantially inaccurate, unexpected and material losses could result. Lawsuits and Regulatory Investigations and Proceedings HUSI or one of its subsidiaries may be named as a defendant in various legalactions, including class actions and other litigation or disputes with thirdparties, as well as investigations or proceedings brought by regulatoryagencies. These actions may result in judgments, settlements, fines, penaltiesor other results, including additional compliance requirements, adverse to HUSIwhich could have a material adverse effect on HUSI's business, financialcondition or results of operations, or cause serious reputational harm. Operational Risks HUSI's businesses are dependent upon its ability to process a large number ofincreasingly complex transactions. If any of HUSI's financial, accounting, orother data processing systems fail or have other significant shortcomings, HUSIcould be materially and adversely affected. HUSI is similarly dependent on itsemployees. HUSI could be materially and adversely affected if an employee causesa significant operational break-down or failure, either as a result of humanerror or where an individual intentionally sabotages or fraudulently manipulatesHUSI's operations or systems. Third parties with which HUSI does business couldalso be sources of operational risk, including risks associated with break-downsor failures of such parties' own systems or employees. Any of these occurrencescould result in diminished ability of HUSI to operate one or more of itsbusinesses, potential liability to clients, reputational damage and regulatoryintervention, all of which could have a material adverse effect on HUSI. 56 HUSI may also be subject to disruptions of its operating systems and businessesarising from events that are wholly or partially beyond its control. These mayinclude: o computer viruses or electrical or telecommunications outages; o natural disasters, such as hurricanes and earthquakes; o events arising from local or regional politics, including terrorist acts; o unforeseen problems encountered while implementing major new computer systems; or o global pandemics, which could have a significant effect on HUSI's business operations as well as on HSBC affiliates world-wide. Such disruptions may give rise to losses in service to customers, an inabilityto collect receivables in affected areas and other loss or liability to HUSI. In a company as large and complex as HUSI, lapses or deficiencies in internalcontrols over financial reporting may occur from time to time, and there is noassurance that such deficiencies or material weaknesses may not occur in thefuture. In addition there is the risk that HUSI's controls and procedures, businesscontinuity planning, and data security systems could prove to be inadequate. Anysuch failure could affect HUSI's operations and could have a material adverseeffect on HUSI's results of operations by requiring HUSI to expend significantresources to correct the defect, as well as by exposing HUSI to litigation orlosses not covered by insurance. Changes to operational practices from time to time could materially impactHUSI's performance and results. Such changes may include: o raising the minimum payment on credit card accounts; o determinations to acquire or sell private label credit card receivables, residential mortgage loans and other loans; o changes to customer account management, risk management and collection policies and practices; o increasing investment in technology, business infrastructure and specialized personnel; or o outsourcing of various operations. Liquidity Adequate liquidity is critical to HUSI's ability to operate its businesses, growand be profitable. A compromise to liquidity could therefore have a negativeeffect on HUSI. Potential conditions that could negatively affect HUSI'sliquidity include: o diminished access to capital markets; o unforeseen cash or capital requirements; o an inability to sell assets; and o an inability to obtain expected funding from HSBC affiliates and clients. HUSI's credit ratings are an important part of maintaining liquidity. Anydowngrade in credit ratings could potentially increase borrowing costs, limitaccess to capital markets, require cash payments or collateral posting, andpermit termination of certain contracts material to HUSI. 57 Acquisition Integration HUSI has in the past, and may again in the future, seek to grow its business byacquiring other businesses or loan portfolios. There can be no assurance thatacquisitions will have the anticipated positive results, including resultsrelating to: o the total cost of integration; o the time required to complete the integration; o the amount of longer-term cost savings; or o the overall performance of the combined entity. Integration of an acquired business can be complex and costly, and may sometimesinclude combining relevant accounting and data processing systems and managementcontrols, as well as managing relevant relationships with clients, suppliers andother business partners, as well as with employees. There is no assurance that any businesses or portfolios acquired in the future,will be successfully integrated and will result in all of the positive benefitsanticipated. If HUSI is not able to successfully integrate past and futureacquisitions, there is the risk that its results of operations could bematerially and adversely affected. Risk Management HUSI seeks to monitor and manage its risk exposure through a variety of separatebut complementary financial, credit, operational, compliance and legal reportingsystems, including models and programs that predict loan delinquency and loss.While HUSI employs a broad and diversified set of risk monitoring and riskmitigation techniques, those techniques and the judgments that accompany theirapplication cannot anticipate every unfavorable event or the specifics andtiming of every outcome. Accordingly, HUSI's ability to successfully identifyand balance risks and rewards, and to manage all significant risks, is animportant factor that can significantly impact results of operations. Employee Retention HUSI's employees are its most important resource and, in many areas of thefinancial services industry, competition for qualified personnel is intense. IfHUSI were unable to continue to retain and attract qualified employees tosupport the various functions of its business, HUSI's performance, including itscompetitive position, could be materially and adversely affected. Reputational Risk HUSI's ability to attract and retain customers and conduct business transactionswith its counterparties could be adversely affected to the extent that itsreputation is damaged. Failure to address, or appearing to fail to address,various issues that could give rise to reputational risk could cause harm toHUSI and its business prospects. Reputational issues include, but are notlimited to: o appropriately addressing potential conflicts of interest, legal and regulatory requirements; o ethical issues; o adequacy of anti-money laundering processes; o privacy issues; o record-keeping; o sales and trading practices; o proper identification of the legal, reputational, credit, liquidity and market risks inherent in HUSI's products; and o general company performance. The failure to address these issues appropriately could make customers unwillingto do business with HUSI, which could adversely affect its results ofoperations. 58 Item 6. Exhibits-------------------------------------------------------------------------------- 4.1 Senior Indenture, dated as of March 31, 2006, by and between HUSI and Deutsche Bank Trust Company Americas (incorporated by reference to Exhibit 4.1 to HUSI's registration statement on Form S-3, Registration No. 333-133007, as filed with the Commission on April 5, 2006). 4.2 Senior Indenture, dated as of October 24, 1996, by and between HUSI and Bankers Trust Company, as trustee (incorporated by reference to Exhibit 4.1 to post-effective amendment No. 1 to HUSI's registration statement on Form S-3, Registration No. 333-42421, as filed with the Commission on April 3, 2002). 4.3 First Supplemental Indenture to Senior Indenture, dated as of February 25, 2000 (incorporated by reference to Exhibit 4.2 to post-effective amendment No. 1 to HUSI's registration statement on Form S-3, Registration No. 333-42421, as filed with the Commission on April 3, 2002). 4.4 Second Supplemental Indenture to Senior Indenture, dated November 28, 2005, among HUSI, Deutsche Bank Trust Company Americas, as original trustee, and Wells Fargo Bank, N.A., as series trustee (incorporated by reference to Exhibit 4.1 to HUSI's Current Report on Form 8-K, dated November 21, 2005, as filed with the Commission on November 28, 2005). 4.5 Subordinated Indenture, dated as of October 24, 1996, by and between HUSI and Bankers Trust Company, as trustee (incorporated by reference to Exhibit 4.3 to post-effective amendment No. 1 to HUSI's registration statement on Form S-3, Registration No. 333-42421, as filed with the Commission on April 3, 2002). 4.6 First Supplemental Indenture to Subordinated Indenture, dated as of December 12, 1996 (incorporated by reference to Exhibit 4.4 to post-effective amendment No. 1 to HUSI's registration statement on Form S-3, Registration No. 333-42421, as filed with the Commission on April 3, 2002). 4.7 Second Supplemental Indenture to Subordinated Indenture, dated as of March 1, 1999 (incorporated by reference to Exhibit 4.5 to post-effective amendment No. 1 to HUSI's registration statement on Form S-3, Registration No. 333-42421, as filed with the Commission on April 3, 2002). 4.8 Third Supplemental Indenture to Subordinated Indenture, dated as of February 25, 2000 (incorporated by reference to Exhibit 4.6 to post-effective amendment No. 1 to HUSI's registration statement on Form S-3, Registration No. 333-42421, as filed with the Commission on April 3, 2002). 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.0 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 59 SIGNATURE-------------------------------------------------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized. HSBC USA Inc. ----------------------- (Registrant) Date: May 12, 2006 /s/ Clive R. Bucknall -------------------------------- Clive R. Bucknall Controller (On behalf of Registrant) 60 This information is provided by RNS The company news service from the London Stock ExchangeRelated Shares:
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