Interim Report - 10 of 21

Following the market turmoil which began in 2007, there was a modest recovery in the risk appetite of investors in 2009. The first quarter of 2010 saw renewed uncertainty regarding the future growth prospects of the global economy, however, and concerns over sovereign credit risk that began in Greece and extended to other obligors, particularly in Southern Europe. As a result, the second quarter of 2010 saw significant falls in the prices of many assets perceived to be of higher risk, although some stability was regained with the announcement of a package of measures by the EU and the International Monetary Fund.

Widespread downgrading of securitised assets continued in the first half of 2010 as rating agencies changed their rating methodologies in response to the new circumstances. Although these downgrades were largely expected and did not affect management's loss estimates, for those institutions subject to the Basel II framework, which ties capital requirements to external credit ratings, the appetite for securitised assets remained limited regardless of the actual level of expected loss on the securities.

Although the general environment remained difficult, some positive developments were observed in securities supported by US sub-prime and Alt-A mortgages. The prices of the securitised assets had been depressed due to expected further deterioration in the value of the supporting collateral. However, the first half of 2010 saw a stabilisation and in some areas a modest increase in house prices. This, combined with the continued low interest rate environment, contributed to a rise in the price of these securitised assets.

Notwithstanding the renewed uncertainty in the first half of 2010, the levels of write-downs and losses on holdings of structured assets remained modest.

This section contains disclosures about the effect of the market turmoil on HSBC's securitisation exposures and other structured products. HSBC's principal exposures to the US and the UK mortgage markets take the form of credit risk from direct loans and advances to customers which were originated to be held to maturity or refinancing. Details are provided on page 152.

Financial instruments which were most affected by the market turmoil include exposures to direct lending which are held at fair value through profit or

loss, or are classified as available for sale and are also held at fair value. Financial instruments included in these categories comprise asset-backed securities ('ABS's), including mortgage-backed securities ('MBS's) and collateralised debt obligations ('CDO's), exposures to and contingent claims on monoline insurers ('monolines') in respect of structured credit activities and leveraged finance transactions originated for distribution.

HSBC has voluntarily adopted the draft British Bankers' Association Code on Financial Reporting Disclosure ('the draft BBA Code') with effect from its Annual Report and Accounts 2009. The draft code sets out five disclosure principles together with supporting guidance. These principles have been applied, as appropriate, in the context of the Interim Report 2010.

In order to facilitate an understanding of the turmoil in markets for securitised and structured assets and in line with the principles of the draft BBA Code, HSBC has continued to assess good practice recommendations issued from time to time by relevant regulators and standard setters, including the 'Assessment of banks' transparency in their 2009 audited annual reports' recently published by the Committee of European Banking Supervisors.

The particular topics covered in respect of HSBC's securitisation activities and exposure to structured products are as follows:

·; overview of exposure;

·; business model;

·; risk management;

·; accounting policies;

·; nature and extent of HSBC's exposures;

·; fair values of financial instruments; and

·; special purpose entities.

At 30 June 2010, the aggregate carrying amount of HSBC's exposure to ABSs, trading loans held for securitisation and exposure to leveraged finance transactions, including securities mitigated by credit derivatives with monolines and other financial institutions, was US$79.7 billion (30 June 2009: US$77.9 billion; 31 December 2009: US$78.8 billion), as summarised in the table below. The majority of these exposures arose in Global Banking and Markets.

Within the total carrying amount of ABSs on the balance sheet, ABS holdings of US$13.8 billion (30 June 2009: US$12.9 billion; 31 December 2009: US$14.0 billion) are held through vehicles discussed on page 101, where significant first loss protection is provided by external investors on a fully collateralised basis. This includes US$3.3 billion (30 June 2009: US$3.3 billion; 31 December 2009: US$3.3 billion) in respect of sub-prime and Alt‑A residential mortgage exposure.

Overall exposure of HSBC

For footnote, see page 137.

Reconciliation of movement in carrying amount of ABSs

Reclassification of financial assets

The accounting policy for reclassification is set out on page 370 of the Annual Report and Accounts 2009.

During the second half of 2008, HSBC reclassified US$15.3 billion and US$2.6 billion of financial assets from the held-for-trading category to the loans and receivables and available-for-sale classifications, respectively. The effect on HSBC's profit before tax if the reclassifications had not been made, are tabulated below. HSBC has not undertaken any further reclassifications.

Reclassifications of HSBC's financial assets

Reconciliation of effect on profit before tax if reclassifications had not occurred

The following table shows the fair value gains and losses, income and expense recognised in the income statement and shows the impact that would have occurred if no reclassification had taken place.

HSBC's fair value gains and losses, income and expense

HSBC's fair value gains and losses, income and expense (continued)

For footnotes, see page 137.

Financial effect of market turmoil

The write-downs incurred by the Group for the last three half-year periods on ABSs, trading loans held for securitisation, leveraged finance transactions and the movement in fair values on available-for-sale ABSs taken to equity, plus impairment losses on specific exposures to banks, are summarised in the following table. Virtually all of these effects were recorded in Global Banking and Markets. Further analyses of the write-downs taken to the income statement by Global Banking and Markets and the net carrying amounts of the positions that generated these write-downs are shown in the succeeding table:

Financial effect of market turmoil on HSBC

Global Banking and Markets write-downs/(write-backs) taken to the income statement and carrying amounts 

For footnote, see page 137.

Asset-backed securities classified as available for sale

HSBC's principal holdings of ABSs in the Global Banking and Markets' business are held through special purpose entities ('SPE's) which were established from the outset with the benefit of external investor first loss protection

support, together with positions held directly and by Solitaire Funding Limited ('Solitaire') where HSBC has first loss risk.

The table below summarises the Group's exposure to ABSs which are classified as available for sale. The methodology used to determine the fair valuation of the securities and hence the available for sale reserve is described on page 114.

Available-for-sale ABSs exposure

For footnotes, see page 137.

Securities investment conduits (special purpose entities)

In the table above, the total carrying amount of ABSs in respect of SPEs represents holdings in which significant first loss protection is provided through capital notes issued by the SICs, excluding Solitaire.

Impairment charges incurred on assets held by these SPEs are offset by a credit to the impairment line for the amount of the loss allocated to capital note holders.

The economic first loss protection remaining at 30 June 2010 amounted to US$2.2 billion (30 June 2009: US$2.2 billion; 31 December 2009: US$2.2 billion).

On an IFRSs accounting basis, the carrying value of the liability for the capital notes at 30 June 2010 amounted to US$0.3 billion (30 June 2009: US$0.6 billion; 31 December 2009: US$0.7 billion). The impairment charge recognised during the first half of 2010 amounted to US$488 million (first half of 2009: US$646 million; second half of 2009: US$20 million).

At 30 June 2010, the available-for-sale reserve in respect of securities held by the SICs was a deficit of US$3.4 billion (30 June 2009: US$7.7 billion; 31 December 2009: US$5.2 billion). Of this, US$3.2 billion related to ABSs (30 June 2009: US$6.6 billion; 31 December 2009: US$4.9 billion).

Impairments recognised during the first half of 2010 from assets held directly or within Solitaire, in recognition of the first loss protection of US$1.2 billion provided by HSBC through credit enhancement and from drawings against the liquidity facility provided by HSBC, were US$277 million (first half of 2009: US$539 million; second half of 2009: US$883 million), based on a notional principal value of securities which were impaired of US$0.4 billion (30 June 2009: US$0.7 billion; 31 December 2009: US$2.6 billion). The reduction in impairment charges compared with the first half of 2009 is due to the stabilising of loss severities and delinquency roll rates which have resulted in lower losses in the underlying collateral pools causing losses in the assets held. The level of impairment recognised in comparison with the deficit in the available-for-sale reserve is a reflection of the credit quality and seniority of the assets held.

Sub-prime and Alt-A residential mortgage-backed securities

Management judges that the assets which are most sensitive to possible future impairment are sub-prime and Alt-A residential MBSs within HSBC's holdings of available-for-sale ABSs.

Excluding those held in the SPEs discussed above, available-for-sale holdings in these higher risk categories amounted to US$4.2 billion at 30 June 2010 (30 June 2009: US$4.6 billion; 31 December 2009: US$4.9 billion). The deficit in the available-for-sale fair value reserve at 30 June 2010 in relation to these securities was US$3.3 billion (30 June 2009: US$5.0 billion; 31 December 2009: US$4.3 billion).

Details of HSBC's methodology for assessing available-for-sale ABSs for objective evidence of impairment at each balance sheet date, are described on page 122.

Available-for-sale ABS impairment and cash loss projections

At 31 December 2009, management undertook an analysis of the portfolio to estimate the further potential impairments and expected cash losses on the available-for-sale ABS portfolio. This exercise comprised a shift of projections of future loss severities, default rates and prepayment rates. The analysis showed that the portfolio is now primarily sensitive to impairments arising on Alt-A securities. The sensitivity of Global Banking and Markets' available-for-sale ABS positions to the loss of protection from monolines reduced during 2009 and is no longer expected to be a significant contributor to future impairment charges. The results of the analysis indicate that further impairment charges of some US$1.1 billion and expected cash losses of some US$450 million could arise over the next two to three years. At 30 June 2010, management re-performed the stress test and the outcome, taking into account the impairment charges in 2010, was consistent with the exercise at 31 December 2009.

HSBC's regular impairment assessment utilises an industry standard valuation model which uses data with reference to the underlying asset pools and models the future projected cash flows of the underlying pools. The key assumptions and inputs to the models are the delinquency status of the underlying loans, the probability of delinquent loans progressing to default, the proportion of assets subsequently recoverable, the prepayment profiles of the underlying assets and the loss severity in the event of default. The projected cash flows of the pools are then used to determine whether payment of principal and interest on the securities held by HSBC will be made. For the purposes of identifying impairment at the reporting date, the future projected cash flows reflect the effect of loss events that have occurred at or prior to the reporting date. For the purposes of performing stress tests to estimate potential future impairment charges, the future projected cash flows reflect additional assumptions about future loss events after the balance sheet date.

This analysis makes assumptions in respect of the future behaviour of loss severities, default rates and prepayment rates. Movements in the parameters are not independent of each other. For example, increased default rates and increased loss severities, which would imply greater impairments, generally arise under economic conditions that give rise to reduced levels of prepayment, reducing the potential for impairment charges. Conversely, economic conditions which increase the rates of prepayment are generally associated with reduced default rates and decreased loss severities. The assumptions used by management in the roll-forward analysis have been set in the context of further increases in loss severities and raised levels of default rates partly offset by stable prepayment rates in the short to medium term.

At 30 June 2010, the incurred and projected impairment charges measured for accounting purposes significantly exceeded the expected cash losses on the securities. Over the lives of the available-for-sale ABSs the cumulative impairment charges will converge towards the level of cash losses.

Asset-backed securities and leveraged finance

HSBC is or has been involved in the following activities in these areas:

·; purchasing US mortgage loans with the intention of structuring and placing securitisations into the market;

·; trading in ABSs, including MBSs, in secondary markets;

·; holding MBSs and other ABSs in balance sheet management activities, with the intention of earning net interest income over the life of the securities;

·; holding MBSs and other ABSs as part of investment portfolios, including the structured investment vehicles ('SIV's), SICs and money market funds described under 'Special purpose entities' below, with the intention of earning net interest income and management fees;

·; holding MBSs or other ABSs in the trading portfolio hedged through credit derivative protection, typically purchased from monolines, with the intention of earning the spread differential over the life of the instruments; and

·; originating leveraged finance loans for the purposes of syndicating or selling them down in order to generate a trading profit and holding them in order to earn interest margin over their lives.

These activities are not a significant part of Global Banking and Markets' business, and Global Banking and Markets is not reliant on them for any material aspect of its business operations or profitability.

Special purpose entities

HSBC enters into certain transactions with customers in the ordinary course of business which involves the establishment of SPEs to facilitate customer transactions. SPEs are used in HSBC's business in order to provide structured investment opportunities for customers, facilitate the raising of funding for customers' business activities, or diversify HSBC's sources of funding and/or improve capital efficiency.

The use of SPEs in this way is not a significant part of HSBC's activities and HSBC is not reliant on the use of SPEs for any material part of its business operations or profitability. Detailed disclosures of HSBC's sponsored SPEs are provided on page 125.

The effect of the market turmoil on HSBC's risk exposures, the way in which HSBC has managed risk exposures in this context, and any changes made in HSBC's risk management policies and procedures in response to the market conditions are set out in the following sections:

·; Credit risk - 'Credit exposure' (see page 141);

·; Liquidity risk - 'The impact of market turmoil on liquidity risk' (see page 175); and

·; Market risk - 'The impact of market turmoil on market risk' (see page 177).

HSBC's accounting policies regarding the classification and valuation of financial instruments are described in the accounting policies on pages 369 to 385 of the Annual Report and Accounts 2009, and the use of assumptions and estimation in respect of the valuation of financial instruments is described on page 63 of the Annual Report and Accounts 2009.

This section contains information on HSBC's exposures to the following:

·; direct lending held at fair value through profit or loss;

·; ABSs including MBSs and CDOs; 

·; monolines;

·; credit derivative product companies ('CDPC's); and

·; leveraged finance transactions.

MBSs are securities that represent interests in a group of mortgages. Investors in these securities have the right to cash received from future mortgage payments (interest and/or principal). Where an MBS references mortgages with different risk profiles, the MBS is classified according to the highest risk class. Consequently, an MBS with both sub-prime and Alt‑A exposures is classified as sub-prime.

CDOs are securities in which ABSs and/or other related assets have been purchased and securitised by a third party, or securities which pay a return which is referenced to those assets. CDOs may include exposure to sub-prime mortgage assets where these are part of the underlying assets or reference assets. As there can be uncertainty surrounding the precise nature of the underlying collateral supporting CDOs, all CDOs supported by residential mortgage-related assets, irrespective of the level of sub-prime assets referenced or contained therein, are classified as sub-prime.

HSBC's holdings of ABSs and CDOs, and its direct lending positions, include the following categories of collateral and lending activity:

·; sub-prime: loans to customers who have limited credit histories, modest incomes or high debt-to-income ratios or have experienced credit problems caused by occasional delinquencies,

prior charge-offs, bankruptcy or other credit-related actions. For US mortgages, standard US credit scores are primarily used to determine whether a loan is sub-prime. US Home Equity Lines of Credit ('HELoC's) are classified as sub-prime. For non-US mortgages, management judgement is used to identify loans with similar risk characteristics to sub-prime, for example, UK non-conforming mortgages (see below);

·; US Home Equity Lines of Credit: a form of revolving credit facility provided to customers, which is supported by a first or second lien charge over residential property. Global Banking and Markets' holdings of HELoCs are classified as US sub-prime residential mortgage assets;

·; US Alt-A: loans classified as Alt-A are regarded as lower risk than sub-prime, but they share higher risk characteristics than lending under fully conforming standard criteria. US credit scores, as well as the level and completeness of mortgage documentation held (such as whether there is proof of income), are considered when determining whether an Alt-A classification is appropriate. Mortgages in the US which are not eligible to be sold to the major government sponsored mortgage agencies, Ginnie Mae (Government National Mortgage Association), Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation), are classified as Alt-A if they do not meet the criteria for classification as sub-prime;

·; US Government agency and US Government sponsored enterprises mortgage-related assets: securities that are guaranteed by US Government agencies, such as Ginnie Mae, or are guaranteed by US Government sponsored entities, including Fannie Mae and Freddie Mac;

·; UK non-conforming mortgage-related assets: UK mortgages that do not meet normal lending criteria. This includes instances where the normal level of documentation has not been provided (for example, in the case of self-certification of income), or where increased risk factors, such as poor credit history, result in lending at a rate that is higher than the normal lending rate. UK non-conforming mortgages are treated as sub-prime exposures; and

·; other mortgage-related assets: residential mortgage-related assets that do not meet any of the classifications described above. Prime residential mortgage-related assets are included in this category.

HSBC's exposure to non-residential mortgage-related ABSs and direct lending includes:

·; commercial property mortgage-related assets: MBSs with collateral other than residential mortgage-related assets;

·; leveraged finance-related assets: securities with collateral relating to leveraged finance loans;

·; student loan-related assets: securities with collateral relating to student loans; and

·; other assets: securities with other receivable-related collateral.

Included in the tables on pages 105 to 109 are ABSs which are held through SPEs that are consolidated by HSBC. Although HSBC consolidates these assets in full, the risks arising from the assets are mitigated to the extent of third-party investment in notes issued by those SPEs. For a description of HSBC's holdings of and arrangements with SPEs, see page 125.

The exposures detailed in the table on page 105 include long positions where risk is mitigated by specific credit derivatives with monolines and other financial institutions. These positions comprise:

·; residential MBSs with a carrying amount of US$0.6 billion (30 June 2009: US$0.9 billion; 31 December 2009: US$1.0 billion);

·; residential MBS CDOs with a carrying amount of US$13 million (30 June 2009: US$16 million; 31 December 2009: US$15 million); and

·; ABSs other than residential MBSs and MBS CDOs with a carrying amount of US$8.0 billion (30 June 2009: US$8.3 billion; 31 December 2009: US$9.2 billion).

In the tables on pages 107 to 109, carrying amounts and gains and losses are given for securities except those where risk is mitigated through specific credit derivatives with monolines, as detailed above, with a total carrying amount of US$8.6 billion (30 June 2009: US$9.2 billion; 31 December 2009: US$10.2 billion). The counterparty credit risk arising from the derivative transactions undertaken with monolines is covered in the monoline exposure analysis on page 111.

Carrying amount of HSBC's consolidated holdings of ABSs, and direct lending held at fair value through profit or loss

Carrying amount of HSBC's consolidated holdings of ABSs, and direct lending held at fair value through profit or loss

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