1st Aug 2005 16:31
HSBC Holdings PLC01 August 2005 Part 2 The following table summarizes the results for each segment. ------------------------------------------------------------------------------------------------------------------- PFS CF CMB CIBM PB Other Total------------------------------------------------------------------------------------------------------------------- (in millions) Three months ended June 30:2005 Net interest income (1) $ 302 $ 166 $ 155 $ 123 $ 42 $ (3) $ 785 Other revenues ......... 86 67 48 98 104 10 413 --------- --------- --------- --------- --------- --------- --------- Total revenues ......... 388 233 203 221 146 7 1,198 Operating expenses (2) . 248 110 90 172 64 -- 684 --------- --------- --------- --------- --------- --------- --------- Working contribution ... 140 123 113 49 82 7 514 Provision for credit losses (3) ........... 22 152 4 (7) (1) -- 170 --------- --------- --------- --------- --------- --------- --------- Income before income tax expense .......... $ 118 $ (29) $ 109 $ 56 $ 83 $ 7 $ 344 ========= ========= ========= ========= ========= ========= ========= Average assets ......... $ 50,088 $ 18,608 $ 15,708 $ 55,430 $ 5,146 $ 315 $ 145,295 Average liabilities/ equity (4) ........... 44,598 644 17,176 73,357 9,508 12 145,295 Goodwill at June 30 (5) 1,167 -- 468 631 428 -- 2,694 2004 Net interest income (1). $ 261 $ 49 $ 147 $ 203 $ 31 $ (2) $ 689 Other revenues ......... 76 -- 48 117 52 5 298 --------- --------- --------- --------- --------- --------- --------- Total revenues ......... 337 49 195 320 83 3 987 Operating expenses (2) . 239 4 93 126 58 -- 520 --------- --------- --------- --------- --------- --------- --------- Working contribution ... 98 45 102 194 25 3 467 Provision for credit losses (3) ........... 26 1 6 (27) -- -- 6 --------- --------- --------- --------- --------- --------- --------- Income before income tax expense .......... $ 72 $ 44 $ 96 $ 221 $ 25 $ 3 $ 461 ========= ========= ========= ========= ========= ========= ========= Average assets ......... $ 38,755 $ 4,203 $ 13,657 $ 45,399 $ 3,814 $ 297 $ 106,125 Average liabilities/ equity (4) ........... 33,484 (3) 15,556 48,097 8,991 -- 106,125 Goodwill at June 30 (5) 1,209 -- 495 631 428 -- 2,763 (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include fully apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. Credit loss reserves are established at a level sufficient to absorb the losses considered to be inherent in the portfolio. (4) Common shareholder's equity and earnings on common shareholder's equity are allocated back to the segments based on the percentage of capital assigned to the business. (5) The reduction in goodwill from June 30, 2004 to June 30, 2005 resulted from the sale or transfer of certain domestic and foreign operations during 2004. 34 ------------------------------------------------------------------------------------------------------------------- PFS CF CMB CIBM PB Other Total------------------------------------------------------------------------------------------------------------------- (in millions) Six months ended June 30:2005 Net interest income (1) $ 602 $ 296 $ 309 $ 277 $ 82 $ (6) $ 1,560 Other revenues ........ 214 147 86 265 162 17 891 --------- --------- --------- --------- --------- --------- --------- Total revenues ........ 816 443 395 542 244 11 2,451 Operating expenses (2) 499 217 188 306 128 -- 1,338 --------- --------- --------- --------- --------- --------- --------- Working contribution .. 317 226 207 236 116 11 1,113 Provision for credit losses (3) .......... 44 261 (1) (25) (2) -- 277 --------- --------- --------- --------- --------- --------- --------- Income before income tax expense ......... $ 273 $ (35) $ 208 $ 261 $ 118 $ 11 $ 836 ========= ========= ========= ========= ========= ========= ========= Average assets ........ $ 50,418 $ 18,446 $ 15,316 $ 54,273 $ 4,934 $ 312 $ 143,699 Average liabilities/ equity (4) .......... 44,168 589 16,679 72,803 9,454 6 143,699 2004 Net interest income (1) $ 529 $ 86 $ 289 $ 382 $ 62 $ (5) $ 1,343 Other revenues ........ 139 -- 85 283 113 12 632 --------- --------- --------- --------- --------- --------- --------- Total revenues ........ 668 86 374 665 175 7 1,975 Operating expenses (2) 469 6 174 239 120 -- 1,008 --------- --------- --------- --------- --------- --------- --------- Working contribution .. 199 80 200 426 55 7 967 Provision for credit losses (3) .......... 43 3 (3) (61) (2) -- (20) --------- --------- --------- --------- --------- --------- --------- Income before income tax expense ......... $ 156 $ 77 $ 203 $ 487 $ 57 $ 7 $ 987 ========= ========= ========= ========= ========= ========= ========= Average assets ........ $ 35,919 $ 3,499 $ 13,363 $ 46,089 $ 3,714 $ 297 $ 102,881 Average liabilities/ equity (4) .......... 32,554 (2) 14,106 47,054 9,169 -- 102,881 (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include fully apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. Credit loss reserves are established at a level sufficient to absorb the losses considered to be inherent in the portfolio. (4) Common shareholder's equity and earnings on common shareholder's equity are allocated back to the segments based on the percentage of capital assigned to the business. (5) The reduction in goodwill from June 30, 2004 to June 30, 2005 resulted from the sale or transfer of certain domestic and foreign operations during 2004. All increases and decreases referred to on the following pages for the secondquarter 2005 and for the first six months of 2005 represent comparisons with thesame 2004 periods. The term "interest rate spread", as used in the following commentary, refers toeither: o the percentage difference between the interest rate earned on earning assets, net of amortized premiums and loan fees, and the cost of funds utilized to fund those assets, as calculated using corporate transfer pricing methodology; or o the percentage difference between the interest rate paid on deposits specifically assigned to a business segment and the associated value of funds as calculated using corporate transfer pricing methodology. 35 Personal Financial Services (PFS) Net interest income increased $41 million (16%) in the second quarter andincreased $73 million (14%) in the first half of 2005, due primarily to: o significant growth in average balances for residential mortgage loans, particularly adjustable rate products, partially offset by the lower average yields on the adjustable rate loans; o more favorable interest rate spreads on personal deposits; and o offset by $16 million of amortization of premium paid during the first half of 2005 for credit card receivables acquired on a daily basis from HSBC Finance Corporation. These receivables are related to various credit card relationships sold to HSBC Finance Corporation in 2004. Other revenues increased $10 million (13%) in the second quarter and increased$75 million (54%) in the first half of 2005, due primarily to the following: o non-interest residential mortgage banking revenue increased $4 million in the second quarter and increased $51 million in the first half of 2005. Commentary regarding residential mortgage banking revenue begins on page 27 of this Form 10-Q; o in May 2005, HUSI sold property to an unaffiliated third party. Approximately $14 million of the gain realized on this sale was recorded in the PFS segment; and o effective in October 2004, HBUS is the originating lender for HSBC Finance Corporation's Taxpayer Financial Services program. Gains recognized for tax refund anticipation loans sold to HSBC Finance Corporation were approximately $19 million in the first half of 2005. Operating expenses increased $9 million (4%) in the second quarter and increased$30 million (6%) for the first half of 2005, due primarily to: o increased personnel, marketing and other direct expenses associated with expanded consumer lending and retail banking operations; and o increased fees paid to HTSU, as HUSI has continued to upgrade its technology environment. Consumer Finance (CF) This segment includes the $12 billion private label receivable portfolio (PLRP)acquired in December 2004 from HSBC Finance Corporation, and other consumerloans acquired from HSBC Finance Corporation and their correspondents beginningin 2003. The following table summarizes the impact of the PLRP on earnings forthis segment for the first half of 2005. ----------------------------------------------------------------Six months ended June 30, 2005 PLRP Other Total---------------------------------------------------------------- (in millions)Net interest income ................... $ 181 $ 115 $ 296Other revenues ........................ 147 -- 147 ----- ----- -----Total revenues ........................ 328 115 443Operating expenses .................... 208 9 217 ----- ----- -----Working contribution .................. 120 106 226Provision for credit losses ........... 248 13 261 ----- ----- -----Income (loss) before income tax expense $(128) $ 93 $ (35) ===== ===== ===== Interest income for the PLRP has been partially offset by approximately $285million of amortization of the initial premium paid for the portfolio. Althoughthe amortization period for the initial premium is two years, amortization isheavily front loaded for 2005 in relation to runoff of the receivable balancespurchased. Other revenues for the PLRP for the first half of 2005 is comprised of thefollowing: o approximately $78 million of credit card and other fees from customers; and o approximately $69 million of securitization revenue from residual interests in securitized credit card receivables acquired as part of the PLRP purchase. 36 Operating expenses for the PLRP are primarily fees paid to HSBC FinanceCorporation for loan servicing. Additional direct expenses for management of theportfolio, including technology services and fraud losses, have also beenincurred. The provision for credit losses of $248 million for the PLRP for the first halfof 2005 is consistent with historical experience for this portfolio. Commentaryregarding credit quality begins on page 39 of this Form 10-Q. New domestic private label credit card receivable originations are purchasedfrom HSBC Finance Corporation on a daily basis. In accordance with FederalFinancial Institutions Examination Council (FFIEC) guidance, in the firstquarter of 2006, HSBC Finance Corporation's domestic private label business willchange the required minimum monthly payment amounts for their domestic privatelabel credit card accounts. Preliminary estimates of the potential impact to theCF segment are based on numerous assumptions and take into account a number offactors that are difficult to predict, such as changes in customer behavior,which will not be fully known or understood until the changes are implemented.It is anticipated that the changes, which will reduce the premium associatedwith these daily purchases, reduce fee income, and increase the provision forcredit losses beginning in 2006, will not have a material impact on consolidatedresults. However, this change may have a material impact on the results of theCF segment in 2006. Commercial Banking (CMB) Net interest income increased $8 million (5%) in the second quarter and $20million (7%) in the first half of 2005, resulting from successful rollout ofplanned expansion of various small business, middle-market and real estatecommercial lending programs. CMB also benefited from more favorable interestrate spreads on deposits during 2005. During the third quarter of 2004, HUSI transferred its Panamanian operations toan HSBC affiliate. As a result, commercial loans, deposits and related netinterest income, included in the CMB segment, have decreased in 2005, partiallyoffsetting the increases from business expansions noted above. Operating expenses increased $14 million (8%) for the first half of 2005 as adirect result of business expansion initiatives and increased fees paid to HTSUfor technology services as HUSI has continued to upgrade its technologyenvironment. Corporate, Investment Banking and Markets (CIBM) Net interest income decreased $80 million (39%) in the second quarter anddecreased $105 million (27%) in the first half of 2005. Recent increases inshort-term interest rates, which have favorably impacted interest rate spreadsfor deposit generating businesses such as PFS and CMB, have had an adverseimpact on CIBM funding costs in 2005. Other revenues decreased $19 million (16%) in the second quarter and decreased$18 million (6%) in the first half of 2005. Decreased trading revenues resultingfrom difficult market conditions in the second quarter of 2005 were partiallyoffset by increased fee-based income and increased gains on the sale ofsecurities. Commentary regarding trading revenues and securities gains begins onpage 30 of this Form 10-Q. Operating expenses increased $46 million (37%) in the second quarter andincreased $67 million (28%) in the first half of 2005, due to: o increased direct expenses associated with expanded operations in foreign exchange, risk management products, and transaction banking business; o increased expenses associated with development of an infrastructure to support the growing complexity of the CIBM business; o increased fees paid to HTSU for technology services, as CIBM required additional information technology resources to support system conversions and business expansion; and o partially offsetting the above increases was a decrease in incentive compensation expense resulting from a change in the amortization period utilized for share-based compensation. 37 The provision for credit losses increased $20 million (74%) in the secondquarter and increased $36 million (59%) in the first half of 2005. The netprovision credit of $61 million for the first half of 2004 reflected a period ofunusually low loan charge offs and relatively high recoveries of amountspreviously charged off. The net provision credit of $25 million for the firsthalf of 2005 resulted from continuation of relatively low charge offs, and aspecific $17 million recovery of a loan previously charged off. Private Banking (PB) Net interest income increased $11 million (35%) in the second quarter andincreased $20 million (32%) in the first half of 2005. Average earning assetsassociated with this segment, primarily commercial loans, increasedapproximately 39% for the first half of the year. Operating expenses have alsoincreased as additional resources have been allocated to this segment to expandthe services provided to high net worth domestic and foreign individuals. Other revenues includes the following transactions for 2005 and 2004: o in June 2005, shares in a foreign equity fund were sold to an HSBC affiliate, resulting in a gain of approximately $48 million; o during the first quarter of 2005, HUSI recognized a nominal gain on the sale of a portion of its personal trust business, which was recorded in other revenues; and o during the first quarter of 2004, HUSI realized higher revenue from a foreign equity investment, as compared with the first quarter of 2005. 38 CREDIT QUALITY-------------------------------------------------------------------------------- HUSI's policies and critical estimates associated with its allowance for creditlosses are summarized on pages 15-16, 37-38 and 77-78 of HUSI's 2004 Form 10-K.There have been no material revisions to policies or methodologies in the firstsix months of 2005. The following table provides an analysis of changes in the allowance for creditlosses and related ratios. ---------------------------------------------------------------------------------------------------------------- June 30, March 31, December 31, September 30, June 30,Quarter ended 2005 2005 2004 2004 2004---------------------------------------------------------------------------------------------------------------- (in millions) Balance at beginning of quarter ............. $ 773 $ 788 $ 340 $ 347 $ 357Allowance related to acquisitions and (dispositions), net ........................ -- -- 505 (11) -- Charge offs: Commercial .......................... 17 6 22 18 11 Consumer: Residential mortgages ........... 6 4 5 2 3 Credit card receivables ......... 160 159 17 17 16 Other consumer loans ............ 23 30 6 6 5 -------- --------- ------------ ------------- --------- Total consumer loans ............ 189 193 28 25 24 -------- --------- ------------ ------------- --------- Total charge offs ................... 206 199 50 43 35 -------- --------- ------------ ------------- --------- Recoveries on loans charged off: Commercial .......................... 7 23 12 16 14 Consumer: Residential mortgages ........... -- -- 1 -- 1 Credit card receivables ......... 37 44 2 2 2 Other consumer loans ............ 9 10 2 2 2 -------- --------- ------------ ------------- --------- Total consumer loans ............ 46 54 5 4 5 -------- --------- ------------ ------------- --------- Total recoveries .................... 53 77 17 20 19 -------- --------- ------------ ------------- --------- Total net charge offs ................... 153 122 33 23 16 -------- --------- ------------ ------------- --------- Provision charged (credited) to income: Commercial .......................... (1) (25) (45) 3 (19) Consumer: Residential mortgages ........... 12 (1) 11 3 4 Credit card receivables ......... 141 108 9 14 18 Other consumer loans ............ 18 25 1 7 3 -------- --------- ------------ ------------- --------- Total consumer loans ........ 171 132 21 24 25 -------- --------- ------------ ------------- --------- Total provision ..................... 170 107 (24) 27 6 -------- --------- ------------ ------------- --------- Balance at end of quarter ............... $ 790 $ 773 $ 788 $ 340 $ 347 ======== ========= ============ ============= ========= Allowance ratios: Annualized net charge offs to average loans .............................. .71% .58% .19% .14% .11% Quarter-end allowance to: Quarter-end total loans ......... .90% .90% .93% .51% .56% Quarter-end total nonaccruing loans .......................... 351.11% 318.11% 298.48% 117.24% 116.05% 39 The following table provides a summary of credit quality statistics. ------------------------------------------------------------------------------------------------------------------------ June 30, March 31, December 31, September 30, June 30, 2005 2005 2004 2004 2004------------------------------------------------------------------------------------------------------------------------ (in millions) Nonaccruing loans Balance at end of period: Commercial: Construction and other real estate ........................... $ 29 $ 28 $ 33 $ 24 $ 33 Other commercial .................. 81 99 117 152 161 --------- --------- ------------ ------------ -------- Total commercial .................. 110 127 150 176 194 --------- --------- ------------ ------------ -------- Consumer: Residential mortgages ............. 115 116 113 94 82 Credit card receivables ........... -- -- -- 19 20 Other consumer loans .............. -- -- 1 1 3 --------- --------- ------------ ------------ -------- Total consumer loans .............. 115 116 114 114 105 --------- --------- ------------ ------------ -------- Total nonaccruing loans ..................... $ 225 $ 243 $ 264 $ 290 $ 299 ========= ========= ============ ============ ======== As a percent of loans: Commercial: Construction and other real estate ........................... .33% .33% .40% .30% .43% Other commercial .................. .53 .66 .80 1.18 1.35 --------- --------- ------------ ------------ -------- Total commercial .................. .46 .54 .65 .84 .99 --------- --------- ------------ ------------ -------- Consumer: Residential mortgages ............. .24 .24 .24 .22 .21 Credit card receivables ........... -- -- -- 1.69 1.75 Other consumer loans .............. -- -- .03 .05 .15 --------- --------- ------------ ------------ -------- Total consumer loans .............. .18 .18 .18 .25 .25 --------- --------- ------------ ------------ -------- Total ....................................... .26% .28% .31% .43% .48% ========= ========= ============ ============ ======== Interest income on nonaccruing loans (quarterly total): Amount which would have been recorded had the associated loans been current in accordance with their original terms ....... $ 7 $ 5 $ 6 $ 5 $ 5 Amount actually recorded .................... 1 3 5 5 4 Accruing loans contractually past due 90 days or more as to principal or interest: Total commercial ............................ $ 7 $ 13 $ 13 $ 15 $ 6 --------- --------- ------------ ------------ -------- Residential mortgages ....................... -- 1 1 2 1 Credit card receivables ..................... 206 210 223 3 2 Other consumer loans ........................ 14 15 22 16 13 --------- --------- ------------ ------------ -------- Total consumer loans ................... 220 226 246 21 16 --------- --------- ------------ ------------ -------- Total accruing loans contractually past due 90 days or more ............................ $ 227 $ 239 $ 259 $ 36 $ 22 ========= ========= ============ ============ ======== Criticized assets (balance at end of period): Special mention ............................. $ 706 $ 728 $ 784 $ 734 $ 673 Substandard ................................. 761 535 590 383 532 Doubtful .................................... 28 34 46 67 66 --------- --------- ------------ ------------ -------- Total ....................................... $ 1,495 $ 1,297 $ 1,420 $ 1,184 $ 1,271 ========= ========= ============ ============ ======== Impaired loans: Balance at end of period .................... $ 102 $ 119 $ 236 $ 252 $ 281 Amount with impairment reserve .............. 79 96 210 233 263 Impairment reserve .......................... 19 21 18 38 38 Other real estate and owned assets: Balance at end of period .................... $ 25 $ 20 $ 15 $ 14 $ 17 Ratio of total nonaccruing loans, other real estate and owned assets to total assets .... .17% .19% .20% .25% .28% 40 Overview The allowance for credit losses increased $17 million (2%) during the secondquarter of 2005 and increased $2 million (less than 1%) during the first sixmonths of 2005. Total provision for credit losses of $277 million for the firstsix months of 2005 was offset by total net charge offs of $275 million. The allowance for credit losses increased $443 million from June 30, 2004 toJune 30, 2005, primarily due to the addition of reserves associated with theacquisition of approximately $12 billion of private label receivables from HSBCFinance Corporation in December of 2004. Commercial Loan Credit Quality The allowance for credit losses associated with commercial loan portfoliosdecreased $11 million during the second quarter and decreased $20 million duringthe first six months of 2005. For the first six months of 2005 net recoveries of$7 million were more than offset by a $27 million credit in the provision forcredit losses associated with commercial loans. General improvement of commercial loan credit quality continued during thesecond quarter, as evidenced by decreased nonaccruing loan balances, anddecreased impaired loans balances. Criticized assets classified as "substandard" increased $226 million during thequarter, primarily due to the addition of non-investment grade securities to thecalculation of these assets. Excluding these securities, criticized assets,primarily commercial loans, have declined in 2005 among all classifications. HUSI expects that a more normalized commercial credit environment for theremainder of 2005 will result in lower recoveries and higher provision expense.Although overall commercial credit quality is expected to remain stable and wellcontrolled, any sudden and/or unexpected adverse economic events or trends couldsignificantly affect credit quality and increase provisions for credit losses. 41 Credit Card Receivable Credit Quality The allowance for credit losses associated with credit card receivablesincreased $18 million in the second quarter and increased $11 million during thefirst six months of 2005. Net charge offs of $238 million in the first sixmonths of 2005 were more than offset by provision for credit losses expense of$249 million. This activity is a direct result of the private label receivableportfolio acquired from HSBC Finance Corporation in December 2004, whichprimarily consisted of credit card receivables. The acquired portfolio isconsidered to be prime credit quality, with historical credit losses rangingfrom 5%-6% over the past few years. The following table provides certain credit quality data for credit cardreceivables. Credit card credit quality was generally stable in the first sixmonths of 2005. The June 30, 2004 data pertains to HUSI's credit card portfolioheld prior to acquisition of the private label receivable portfolio. --------------------------------------------------------------------------------------------------------------- June 30, March 31, December 31, June 30, 2005 2005 2004 2004--------------------------------------------------------------------------------------------------------------- (in millions) Accruing credit card receivables contractually past due 90 days or more: Balance at end of quarter ............................. $ 206 $ 210 $ 223 $ 2 As a percent of total credit card receivables ......... 1.60% 1.75% 1.85% .17% Allowance for credit losses associated with credit card receivables: Balance at end of quarter ............................. $ 559 $ 541 $ 548 $ 50 As a percent of total credit card receivables ......... 4.34% 4.51% 4.54% 4.37% Net charge offs of credit card receivables: Total for the quarter ended ........................... $ 123 $ 115 $ 15 $ 14 Annualized net charge offs as a percent of average credit card receivables for the quarter ..... 3.89% 3.83% 4.05% 4.98% Receivables included in the private label receivable portfolio are generallymaintained in accruing status until being charged off six months afterdelinquency. Other Consumer Loan Credit Quality The allowance for credit losses associated with residential mortgage and otherconsumer loans increased $10 million in the second quarter and in the first sixmonths of 2005. Provision for credit losses expense of $54 million for the firstsix months of 2005, primarily associated with various installment lendingportfolios, was partially offset by net charge offs of $44 million, alsoprimarily from installment lending portfolios. 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 onpages 79-80 and pages 107-109 of HUSI's 2004 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. 42 The following table presents credit risk exposure and net fair value associatedwith derivative contracts. Total fair value of derivative receivables reflectsrevaluation gains from the marking to market of derivative contracts held fortrading purposes, for all counterparties with an International Swaps andDerivatives Association Master Agreement in place. The net fair value of allderivative contracts represents the total fair value previously described, lessthe net liability balance representing revaluation losses from the marking tomarket of derivative contracts held for trading purposes. ------------------------------------------------------------------------------------------------ June 30, December 31, 2005 2004------------------------------------------------------------------------------------------------ (in millions) Credit risk exposure associated with derivative contracts: Total fair value of derivative receivables ................. $ 7,523 $ 9,607 Collateral held against exposure ........................... (2,234) (4,091) ----------- ------------Net credit risk exposure ......................................... $ 5,289 $ 5,516 =========== ============ Net fair value of all derivative contracts ....................... $ (18) $ (249) =========== ============ Notional Values of Derivative Contracts The notional value of derivative contracts only provides an indicator of thetransaction volume in these types of instruments. It does not represent exposureto market or credit risks under these contracts. The following table summarizes the notional values of derivative contracts. ------------------------------------------------------------------------------------------------ June 30, December 31, 2005 2004------------------------------------------------------------------------------------------------ (in millions) Interest rate: Futures and forwards ....................................... $ 75,679 $ 79,830 Swaps ...................................................... 1,527,997 1,219,657 Options written ............................................ 133,899 105,582 Options purchased .......................................... 124,805 90,635 ----------- ------------ 1,862,380 1,495,704 ----------- ------------Foreign exchange: Swaps, futures and forwards ................................ 272,722 234,424 Options written ............................................ 37,232 42,719 Options purchased .......................................... 38,344 43,200 Spot ....................................................... 50,691 21,927 ----------- ------------ 398,989 342,270 ----------- ------------Commodities, equities and precious metals: Swaps, futures and forwards ................................ 55,538 40,876 Options written ............................................ 12,200 10,648 Options purchased .......................................... 13,790 11,729 ----------- ------------ 81,528 63,253 ----------- ------------ Credit derivatives ............................................... 286,161 135,937 ----------- ------------ Total ............................................................ $ 2,629,058 $ 2,037,164 =========== ============ 43 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 43-44 of HUSI's 2004 Form 10-K. -------------------------------------------------------------------------------------------------------- One Over One Over Year Through FiveJune 30, 2005 or Less Five Years Years Total-------------------------------------------------------------------------------------------------------- (in millions) Standby letters of credit, net of participations .. $ 3,796 $ 1,854 $ 129 $ 5,779 (1)Commercial letters of credit ...................... 911 38 -- 949Loan sales with recourse .......................... -- 1 8 9 (2)Credit derivative contracts ....................... 2,263 137,007 13,478 152,748 (3)Commitments to extend credit: Commercial .................................. 18,673 22,694 3,572 44,939 Consumer .................................... 6,346 -- -- 6,346Commitments to deliver mortgage backed securities . 2,827 -- -- 2,827Securities lending indemnifications ............... 4,547 -- -- 4,547 --------- ---------- --------- ----------Total ............................................. $ 39,363 $ 161,594 $ 17,187 $ 218,144 ========= ========== ========= ========== (1) Includes $460 million issued for the benefit of related parties. (2) $7 million of this amount is indemnified by third parties. (3) Includes $19,211 million issued for the benefit of related parties. 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 $18 million and $15 million at June 30, 2005 and December 31, 2004respectively. Also included in other liabilities is an allowance for creditlosses on unfunded standby letters of credit of $26 million and $28 million atJune 30, 2005 and December 31, 2004 respectively. Securities Lending Indemnifications HUSI may lend securities of customers, on a fully collateralized basis, as anagent to third party borrowers. Customers are indemnified against the risk ofloss, and collateral is obtained from the borrower with a market value exceedingthe value of the loaned securities. At June 30, 2005, the fair value of thatcollateral was approximately $4,636 million. VARIABLE INTEREST ENTITIES (VIEs)-------------------------------------------------------------------------------- The following table provides information for unconsolidated VIEs. Descriptionsof these VIE relationships are included in pages 111-112 of HUSI's 2004 Form10-K. -------------------------------------------------------------------------------------------------------- June 30, 2005 December 31, 2004 ----------------------- ----------------------- Maximum Maximum Total Exposure Total Exposure Assets to Loss Assets to Loss-------------------------------------------------------------------------------------------------------- (in millions) Asset backed commercial paper conduits ............ $ 8,640 $ 5,969 $ 5,657 $ 5,867Securitization vehicles ........................... 1,080 546 1,062 552Investment funds .................................. 2,257 -- 2,832 36Capital funding vehicles .......................... 1,093 32 1,093 32Low income housing tax credits .................... 1,112 110 994 88 --------- ---------- --------- ----------Total ............................................. $ 14,182 $ 6,657 $ 11,638 $ 6,575 ========= ========== ========= ========== 44 Asset Backed Commercial Paper Conduits In the normal course of business, HUSI provides liquidity facilities to assetbacked commercial paper conduits sponsored by unrelated third parties. HUSI doesnot transfer its own receivables into the financing entity, has no ownershipinterest, no administrative duties, and does not service any assets of theseconduits. The only interest HUSI has in these entities are liquidity facilitiesin the amount of approximately $1.3 billion at June 30, 2005. These facilitiesare excluded from the table summarizing HUSI's involvement in VIEs. CAPITAL-------------------------------------------------------------------------------- The following table presents the capital ratios of HUSI and HBUS calculated inaccordance with banking regulations. To be categorized as "well-capitalized"under the Federal Reserve Board and Federal Deposit Insurance Corporationguidelines, a banking institution must have the minimum ratios reflected in thetable, and must not be subject to a directive, order, or written agreement tomeet and maintain specific capital levels. ------------------------------------------------------------------------------------------------------------- "Well-Capitalized" June 30, December 31, Minimum 2005 2004------------------------------------------------------------------------------------------------------------- Total capital (to risk weighted assets) HUSI .................................................... 10.00% 12.67% 12.53% HBUS .................................................... 10.00 12.65 12.46Tier 1 capital (to risk weighted assets) HUSI .................................................... 6.00 8.74 8.34 HBUS .................................................... 6.00 8.99 8.66Tier 1 capital (to average assets) HUSI .................................................... 3.00 6.84 7.20 HBUS .................................................... 5.00 7.10 7.51Tangible common equity (to risk weighted assets) HUSI .................................................... 7.03 7.07 HBUS .................................................... 9.01 8.69 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 six months of 2005, there have been no significantchanges in policies or approach for managing various types of risk. Liquidity Management HUSI's approach to address liquidity risk is summarized on pages 49-50 of HUSI's2004 Form 10-K. HUSI's ability to regularly attract wholesale funds at a competitive cost isenhanced by strong ratings from the major credit rating agencies. At June 30,2005, HUSI and HBUS maintained the following long and short-term debt ratings: -------------------------------------------------------------------------------------------------------- Short-Term Debt Long-Term Debt ----------------------------------- ----------------------------------- Moody's S&P Fitch Moody's S&P Fitch ------- ---- ----- ------- --- ----- HSBC USA Inc. P-1 A-1 F1+ Aa3 A+ AAHSBC Bank USA, N.A. P-1 A-1+ F1+ Aa2 AA- AA 45 HUSI periodically issues capital instruments to fund balance sheet growth, tomeet cash and capital needs, or to fund investments in subsidiaries. In April2005, HUSI issued 20,700,000 floating rate non-cumulative preferred shares.Total proceeds of this issuance, net of transaction fees, were approximately$500 million. Commentary regarding growth and composition of the consolidated balance sheet isprovided on pages 19-20 of this Form 10-Q. 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 51-56 of HUSI's 2004 Form 10-K. During the first six months of 2005, therewere no significant changes in policies or approach for managing interest raterisk. 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. In June 2005, HUSI's institutional PVBP movementlimit was increased from $6.5 million to $7.5 million. The following tablereflects the PVBP position at June 30, 2005. -------------------------------------------------------------------------------- June 30, 2005-------------------------------------------------------------------------------- (in millions)Institutional PVBP movement limit ............................. $ 7.5PVBP position at period end ................................... 1.0 Capital at Risk Capital at risk is the change in base case valuation of the balance sheet foreither a 200 basis point gradual rate increase or a 100 basis point gradual ratedecrease. The projected changes in valuation are reflected on an after taxbasis. The following table reflects the capital at risk position at June 30,2005. ----------------------------------------------------------------------------------------------------------------- June 30, 2005----------------------------------------------------------------------------------------------------------------- Institutional capital at risk movement limit ................................................... +/- 10%Projected change in value resulting from a gradual 200 basis point increase in interest rates .. 2Projected change in value resulting from a gradual 100 basis point decrease in interest rates .. (4) The projected drop in value for a 100 basis point gradual decrease in rates isprimarily related to the anticipated acceleration of prepayments for the heldmortgage and mortgage backed securities portfolios in this lower rateenvironment. This assumes that no management actions are taken to manageexposures to the changing interest rate environment. Capital at risk valuations are currently calculated using discounted cash flowsanticipated for specific rate environments. A market based calculation, whichrelies less on discounted cash flows in favor of actual market valuations, iscurrently under development. 46 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. --------------------------------------------------------------------------------------------------------------------- June 30, 2005 ---------------------- Amount %--------------------------------------------------------------------------------------------------------------------- (in millions) Projected change in net interest income (reflects projected rate movements on July 1, 2005): Institutional base earnings movement limit ........................................... (10) Change resulting from a gradual 200 basis point increase in the yield curve .......... $ (144) (4) Change resulting from a gradual 200 basis point decrease in the yield curve .......... 328 9 Change resulting from a gradual 100 basis point increase in the yield curve .......... (27) Change resulting from a gradual 100 basis point decrease in the yield curve .......... 243 Other significant scenarios monitored (reflects projected rate movements on July 1, 2005): Change resulting from an immediate 100 basis point increase in the yield curve ....... (96) Change resulting from an immediate 100 basis point decrease in the yield curve ....... 76 Change resulting from an immediate 200 basis point increase in the yield curve ....... (282) Change resulting from an immediate 200 basis point decrease in the yield curve ....... 55Related Shares:
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