HUSI also holds variable interests in various other VIEs which are not consolidated at March 31, 2007 or December 31, 2006. HUSI is not the primary beneficiary of these VIE structures. Information for unconsolidated VIEs is presented in the following table and commentary. Descriptions of these VIE relationships are included in pages 151-152 of HUSI’s 2006 Form 10-K.
In addition to the asset backed commercial paper conduits sponsored by affiliate entities and listed in the table above, HUSI also provides liquidity facilities to asset backed commercial paper conduits sponsored by unrelated third parties. HUSI does not transfer its own receivables into, have ownership interest in, perform administrative duties for, nor service any of the assets of these conduits. HUSI’s involvement in these conduits is limited to providing liquidity facilities. The maximum exposure to loss relating to these liquidity facilities at March 31, 2007 is $1.9 billion.
The following table summarizes the maximum potential amounts of future payments required by financial guarantee arrangements.
Fees are charged for issuing letters of credit commensurate with the customer’s credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of the “stand ready obligation to perform” under these guarantees, amounting to $23 million and $21 million at March 31, 2007 and December 31, 2006, respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $22 million and $25 million at March 31, 2007 and December 31, 2006, respectively.
Credit Derivative Contracts
HUSI enters into credit derivative contracts primarily to satisfy the needs of its customers and, in certain cases, for its own benefit. Credit derivatives are arrangements that provide for one party (the “protection buyer”) to transfer the credit risk of a “reference asset” to another party (the “protection seller”). Under this arrangement the protection seller assumes the credit risk associated with the reference asset without directly purchasing it. The protection buyer agrees to pay a specified fee to the protection seller. In return, the protection seller agrees to pay the protection buyer an agreed upon amount if there is a default during the term of the contract.
In accordance with its policy, HUSI offsets most of the risk it assumes in selling credit protection through a credit derivative contract with another counterparty. Credit derivatives are recorded at fair value. The commitment amount included in the table is the maximum amount that HUSI could be required to pay, without consideration of the approximately equal amount receivable from third parties and any associated collateral.
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Note 17. New Accounting Pronouncements |
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In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 establishes threshold and measurement attributes for financial statement measurement and recognition of tax positions taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The adoption of FIN 48 on January 1, 2007 did not have a material impact on HUSI’s financial position or results of operations. Refer to Note 8 on page 14 of this Form 10-Q.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). SFAS 157 establishes a single authoritative definition of fair value, sets out a framework for measuring fair value, and requires additional disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those years. Early application is permissible only if no annual or interim financial statements have been issued for the earlier periods. HUSI is currently evaluating the impact that adoption of SFAS 157 will have on its financial position and results of operations.
In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, Amendment of FASB Interpretation No. 39 (FSP FIN 39-1). FSP FIN 39-1 allows entities that are party to a master netting arrangement to offset the receivable or payable recognized upon payment or receipt of cash collateral against fair value amounts recognized for derivative instruments that have been offset under the same master netting arrangement in accordance with FASB Interpretation No. 39. The guidance in FSP FIN 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. Entities are required to recognize the effects of applying FSP FIN 39-1 as a change in accounting principle through retrospective application for all financial statements presented unless it is impracticable to do so. HUSI is currently evaluating the impact that adoption of FSP FIN 39-1 will have on its financial position.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159), which creates an alternative measurement method for certain financial assets and liabilities. SFAS 159 permits fair value to be used for both the initial and subsequent measurements on a contract-by-contract election, with changes in fair value to be recognized in earnings as those changes occur. This election is referred to as the “fair value option”. SFAS 159 also requires additional disclosures to compensate for the lack of comparability that will arise from the use of the fair value option. SFAS 159 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted as of the beginning of a company’s fiscal year, provided the company has not yet issued financial statements for that fiscal year. HUSI is currently evaluating the impact the adoption of SFAS 159 will have on its financial position and results of operations.
25
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) |
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FORWARD-LOOKING STATEMENTS |
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The MD&A should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this Form 10-Q and with HUSI’s 2006 Form 10-K. The MD&A may contain certain statements that are forward-looking in nature within the meaning of the Private Securities Litigation Reform Act of 1995. HUSI’s results may differ materially from those noted in the forward-looking statements. Words such as “may”, “should”, “would”, “could”, “intends”, “appears”, “believe”, “expects”, “estimates”, “targeted”, “plans”, “anticipates”, “goal” and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. Statements that are not historical facts, including statements about management’s beliefs and expectations, are forward-looking statements that involve inherent risks and uncertainties and are based on current views and assumptions. A number of factors could cause actual results to differ materially from those contained in any forward-looking statements. For a list of important risk factors that may affect HUSI’s actual results, see Cautionary Statement on Forward-Looking Statements and Risk Factors in Part I of HUSI’s 2006 Form 10-K and Risk Factors in the Form 10-Q for the quarterly period ended March 31, 2007.
Net income decreased $35 million (11%) in the first quarter of 2007, as compared with the same 2006 period. Higher net interest income and fee revenues generated from business expansion initiatives begun in 2005 and 2006, growth of the private label receivable portfolio, and lower income tax expense were more than offset by lower trading results, higher provisions for credit losses, and higher personnel and other expenses associated with expanding core banking and lending operations.
Business expansion initiatives within the PFS, CMB and PB business segments, including rollout of the internet savings product, have led to strong growth in commercial loans, consumer and commercial deposits, and related revenues. Revenue growth from expansion initiatives was partially offset by higher salaries and marketing expenses.
Results for the growing private label credit card receivable portfolio, included within the CF business segment, were higher due to higher interest and fees earned and decreased amortization of premiums paid for acquired credit card receivables.
Trading related revenues within the CIBM segment decreased $154 million in the first quarter of 2007. For the first quarter of 2006, higher revenues were attributable to expanded operations and favorable market conditions related to precious metals, foreign exchange and structured products desks. Results for the first quarter of 2007 were negatively impacted by a downturn in certain economic factors in the U.S., such as overall weakness in the housing market which affected residential mortgage related revenues and by reduced volumes of markets activity.
Lower revenues for the first quarter of 2007 also resulted from lower residential mortgage banking related results, which were primarily due to lower loan balances, and from lower equity earnings, as compared with the same 2006 period.
The provision for credit losses increased $48 million for the first quarter of 2007, primarily due to increased average commercial loan and credit card receivable balances and to higher criticized asset balances. In addition, consumer provision expense was unusually low for the first quarter of 2006, due to the impact of bankruptcy legislation enacted in 2005, which resulted in accelerated consumer charge offs during the fourth quarter of 2005.
26
Income tax expense decreased $40 million (28%) for the first quarter of 2007. After a thorough review of its deferred income taxes, HUSI increased the carrying value of its deferred tax assets by $28 million, with a corresponding decrease in income tax expense. The remaining decrease was mainly due to lower income before tax, and to a lower effective tax rate from higher revenues from operations in states with lower tax rates and an increase in low income housing tax credits.
Effective January 1, 2007, operating results for HUSI are now being monitored and reviewed, trends are being evaluated, and decisions are being made about allocating certain resources, such as employees, on an IFRSs basis. As a result, effective with this Form 10-Q, business segment results are reported on an IFRSs basis to align with the revised internal reporting mechanism for monitoring performance. Descriptions of significant differences between U.S. GAAP and IFRSs are provided on pages 29-31 of this Form 10-Q.
On an IFRSs basis, net income was $6 million higher for the first quarter of 2007, as compared with the same 2006 quarter. Improved results for the PFS and CF business segments were offset by lower results for the CIBM, CMB and PB business segments. Commentary regarding results for each business segment on an IFRSs basis is provided on pages 43-47 of this Form 10-Q.
Income Before Income Tax Expense - Significant Trends
Analysis of the components of HUSI’s income before income tax expense begins on page 34 of this Form 10-Q. Income before income tax expense, and various trends and activity affecting operations, are summarized in the following table.
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Income before income tax expense | | $ | 376 | | $ | 451 | | $ | (75 | ) | | (17 | ) |
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Significant trends impacting income before income tax expense: | | | | | | | | | | | | | |
Balance sheet management income (loss) (1) | | $ | (29 | ) | $ | (2 | ) | $ | (27 | ) | | * | |
Trading related revenues (2) | | | 111 | | | 183 | | | (72 | ) | | (39 | ) |
Private label receivable portfolio (3) | | | 58 | | | 10 | | | 48 | | | 480 | |
Loans held for sale to an HSBC affiliate (4) | | | (14 | ) | | 16 | | | (30 | ) | | (188 | ) |
Earnings from equity investments (5) | | | 16 | | | 28 | | | (12 | ) | | (43 | ) |
All other activity (6) | | | 234 | | | 216 | | | 18 | | | 8 | |
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(1) | Comprised primarily of net interest income and, to a lesser extent, gains on sales of investments and trading revenues. Refer to commentary regarding CIBM net interest income, trading revenues, and the CIBM business segment on page 46 of this Form 10-Q, respectively. |
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(2) | Refer to commentary regarding trading revenues beginning on page 39 of this Form 10-Q. Amounts in the table exclude trading related revenues associated with loans held for sale to HMUS of $2 million and $84 million for the first quarter of 2007 and 2006, respectively. |
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(3) | Refer to commentary regarding the CF business segment beginning on page 44 of this Form 10-Q. |
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(4) | Refer to commentary regarding residential mortgage loans held for sale to an HSBC affiliate on page 37 of this Form 10-Q. |
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(5) | Refer to commentary regarding other income beginning on page 38 of this Form 10-Q. |
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(6) | Represents core banking and other activities that have been positively impacted by recent business expansion initiatives. Refer to business segments commentary on pages 43-47 of this Form 10-Q. |
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* | Not meaningful. |
27
Selected Financial Data
The following tables present a summary of selected financial information.
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Three months ended March 31 | | | 2007 | | | 2006 | | Amount | | % | |
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Income statement: | | | | | | | | | | | | | |
Net interest income | | $ | 790 | | $ | 735 | | $ | 55 | | | 7 | |
Provision for credit losses | | | (205 | ) | | (157 | ) | | (48 | ) | | (31 | ) |
Total other revenues | | | 634 | | | 658 | | | (24 | ) | | (4 | ) |
Total operating expenses | | | (843 | ) | | (785 | ) | | (58 | ) | | (7 | ) |
Income tax expense | | | (103 | ) | | (143 | ) | | 40 | | | 28 | |
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Net income | | $ | 273 | | $ | 308 | | $ | (35 | ) | | (11 | ) |
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Balances at period end: | | | | | | | | | | | | | |
Loans, net of allowance | | $ | 88,031 | | $ | 87,814 | | | 217 | | | — | |
Total assets | | | 172,523 | | | 162,069 | | | 10,454 | | | 6 | |
Total tangible assets | | | 169,763 | | | 159,331 | | | 10,432 | | | 7 | |
Total deposits | | | 107,514 | | | 93,304 | | | 14,210 | | | 15 | |
Common shareholder’s equity | | | 10,506 | | | 10,483 | | | 23 | | | — | |
Tangible common shareholder’s equity | | | 7,977 | | | 7,856 | | | 121 | | | 2 | |
Total shareholders’ equity | | | 12,196 | | | 11,799 | | | 397 | | | 3 | |
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Selected financial ratios: | | | | | | | | | | | | | |
Total shareholders’ equity to total assets, at period end | | | 7.07 | % | | 7.28 | % | | | | | | |
Tangible common shareholder’s equity to total tangible assets, at period end | | | 4.70 | % | | 4.93 | % | | | | | | |
Rate of return on average (1): | | | | | | | | | | | | | |
Total assets | | | .66 | % | | .79 | % | | | | | | |
Total common shareholder’s equity | | | 9.56 | | | 11.34 | | | | | | | |
Net interest margin to average (1): | | | | | | | | | | | | | |
Earning assets | | | 2.32 | % | | 2.28 | % | | | | | | |
Total assets | | | 1.93 | | | 1.90 | | | | | | | |
Average total shareholders’ equity to average total assets (1) | | | 7.32 | % | | 7.39 | % | | | | | | |
Efficiency ratio (1) | | | 59.17 | | | 56.38 | | | | | | | |
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(1) | Selected financial ratios are defined in the Glossary of Terms beginning on page 87 of HUSI’s 2006 Form 10-K. |
Significant trends and transactions that impacted net income for the three months ending March 31, 2007 and 2006 are summarized on page 27 of this Form 10-Q.
28
HUSI’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP).
International Financial Reporting Standards (IFRSs)
Effective January 1, 2007, corporate goals of HUSI are based upon results reported under IFRSs (a non-U.S. GAAP measure). Operating results for HUSI are now monitored and reviewed, trends are being evaluated, and decisions are being made about allocating certain resources, such as employees, on an IFRSs basis. In addition, HSBC reports its results in accordance with IFRSs and IFRSs results are used by HSBC in measuring and rewarding performance of employees. The following table reconciles HUSI’s net income on a U.S. GAAP basis to net income on an IFRSs basis.
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Three months ended March 31 | | 2007 | | 2006 | |
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Net income – U.S. GAAP basis | | $ | 273 | | $ | 308 | |
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Adjustments, net of tax: | | | | | | | |
Fair value option | | | 1 | | | (24 | ) |
Loan origination | | | 8 | | | — | |
Property | | | 6 | | | 3 | |
Unquoted equity securities | | | 5 | | | — | |
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Net income – IFRSs basis | | $ | 293 | | $ | 287 | |
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Differences between U.S. GAAP and IFRSs are as follows:
Fair value option
IFRSs
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• | Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: |
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| - | eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or |
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| - | applies to a group of financial assets, financial liabilities or both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or |
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| - | relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. |
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• | Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it is made. Financial assets and financial liabilities are recognized using trade date accounting. |
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• | Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. |
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U.S. GAAP |
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• | Generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they must meet the definition of trading securities in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities. Financial liabilities are generally reported at amortized cost under U.S. GAAP. |
29
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• | Since January 1, 2006, HUSI has accounted for hybrid financial instruments under the provisions of SFAS 155, Accounting for Certain Hybrid Financial Instruments. Hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation are, where designated through an irrevocable election, initially and subsequently measured at fair value, with changes in fair value recognized through net income. |
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Impact |
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• | HUSI has principally used the fair value designation for certain fixed rate long-term debt issues whose interest rate characteristic has been changed to floating through interest rate swaps as part of a documented interest rate management strategy. Approximately $2 billion of HUSI’s debt issues have been accounted for using the option. The movement in fair value of these debt issues includes the effect of changes in the credit spread and any ineffectiveness in the economic relationship between the related swaps and this debt. Such ineffectiveness arises from the different credit characteristics of the swap and the debt coupled with the sensitivity of the floating leg of the swap to changes in short-term interest rates. In addition, the economic relationship between the swap and the debt can be affected by relative movements in market factors, such as bond and swap rates, and the relative bond and swap rates at inception. The size and direction of the accounting consequences of changes in credit spread and ineffectiveness can be volatile from period to period, but do not alter the cash flows anticipated as part of the documented interest rate management strategy. |
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• | Under U.S. GAAP, debt issues are generally reported at amortized cost. There are circumstances, by virtue of different technical requirements and the transition arrangements to IFRSs, where derivatives providing an economic hedge for an asset or liability, and so designated under IFRSs, are not so treated under U.S. GAAP, thereby creating a reconciliation difference and asymmetrical accounting between the asset and liability and the offsetting derivative. |
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Loan origination |
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IFRSs |
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• | Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. |
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U.S. GAAP |
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• | Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the income statement over the life of the loan as an adjustment to interest income (SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases”). |
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Impact |
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During the first quarter of 2007, the net costs amortized against earnings under U.S. GAAP exceeded net costs amortized under IFRSs. |
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Property |
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IFRSs |
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• | Under the transition rules of IFRS 1, HSBC has elected to freeze the value of its properties at their January 1, 2004 valuations. These are the “deemed cost” of properties under IFRSs. They will not be revalued in the future. Assets held at historical or deemed cost are depreciated except for freehold land. |
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• | Investment properties are recognized at current market values with gains or losses recognized in net income for the period. Investment properties are not depreciated. |
30
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U.S. GAAP |
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• | U.S. GAAP does not permit revaluations of property, including investment property, although it requires recognition of asset impairment. Any realized surplus or deficit is, therefore, reflected in net income on disposal of the property. Depreciation is charged on all properties based on cost. |
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Impact |
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• | Under IFRSs, the value of property held for own use reflects revaluation surpluses recorded prior to January 1, 2004. Consequently, the values of tangible fixed assets and shareholders’ equity are lower under U.S. GAAP than under IFRSs. |
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• | There is a correspondingly lower depreciation charge and higher net income under U.S. GAAP, partially offset by higher gains (or smaller losses) on the disposal of fixed assets. |
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• | For investment properties, net income under U.S. GAAP does not reflect the unrealized gain or loss recorded under IFRSs for the period. |
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• | Useful lives for certain assets differ between IFRSs and U.S. GAAP. |
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Unquoted equity securities |
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HUSI holds certain equity securities whose market price is not quoted on a recognized exchange, but for which the fair value can be reliably measured either through an active market, comparison to similar equity securities which are quoted, or by using discounted cash flow calculations. |
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IFRSs |
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• | Under IAS 39, equity securities which are not quoted on a recognized exchange, but for which fair value can be reliably measured, are required to be measured at fair value. Accordingly, such securities are measured at fair value and classified as either available-for-sale securities, with changes in fair value recognized in other comprehensive income, or as trading securities, with changes in fair value recognized in income. |
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U.S. GAAP |
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• | Under SFAS 115, equity securities that are not quoted on a recognized exchange are not considered to have a readily determinable fair value and are required to be measured at cost, less any provisions for impairment. Unquoted equity securities are reported within “Other assets”. |
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Impact |
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• | Changes in fair values of equity securities for which IFRSs require recognition of the change and U.S. GAAP requires the securities to be held at cost, impact net income and shareholders’ equity when the security is classified as trading under IFRSs and impact shareholders’ equity when the security is classified as available-for-sale under IFRSs. |
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Other |
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Other includes the net impact of differences relating to various adjustments, none of which were individually material for the quarters ended March 31, 2007 and 2006. |
31
HUSI utilizes borrowings from various sources to fund balance sheet growth, to meet cash and capital needs, and to fund investments in subsidiaries. Balance sheet totals and growth are summarized in the following table.
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Period end assets: | | | | | | | | | | | | | | | | |
Short-term investments | | $ | 23,269 | | $ | 3,815 | | | 20 | | $ | 7,335 | | | 46 | |
Loans, net | | | 88,031 | | | (1,309 | ) | | (1 | ) | | 217 | | | — | |
Trading assets | | | 27,899 | | | 1,861 | | | 7 | | | 1,381 | | | 5 | |
Securities | | | 21,425 | | | (1,330 | ) | | (6 | ) | | (150 | ) | | (1 | ) |
Other assets | | | 11,899 | | | 529 | | | 5 | | | 1,671 | | | 16 | |
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| | $ | 172,523 | | $ | 3,566 | | | 2 | | $ | 10,454 | | | 6 | |
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Funding sources: | | | | | | | | | | | | | | | | |
Total deposits | | $ | 107,514 | | $ | 2,964 | | | 3 | | $ | 14,210 | | | 15 | |
Trading liabilities | | | 14,060 | | | 14 | | | — | | | (123 | ) | | (1 | ) |
Short-term borrowings | | | 5,932 | | | 859 | | | 17 | | | (1,715 | ) | | (22 | ) |
All other liabilities | | | 3,983 | | | 208 | | | 6 | | | (123 | ) | | (3 | ) |
Long-term debt | | | 28,838 | | | (414 | ) | | (1 | ) | | (2,192 | ) | | (7 | ) |
Shareholders’ equity | | | 12,196 | | | (65 | ) | | (1 | ) | | 397 | | | 3 | |
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| | $ | 172,523 | | $ | 3,566 | | | 2 | | $ | 10,454 | | | 6 | |
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Short-Term Investments
Short-term investments include cash and due from banks, interest bearing deposits with banks, Federal funds sold and securities purchased under resale agreements. Increases in these asset balances resulted from an increase in HUSI’s excess liquidity position.
Loans, Net
Loan balances at March 31, 2007 and movements in comparison with prior periods are summarized in the following table.
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Total commercial loans | | $ | 29,532 | | $ | 50 | | | — | | $ | 2,728 | | | 10 | |
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Consumer loans: | | | | | | | | | | | | | | | | |
Residential mortgage | | | 39,496 | | | (312 | ) | | (1 | ) | | (4,847 | ) | | (11 | ) |
Credit card receivables: | | | | | | | | | | | | | | | | |
Private label | | | 15,961 | | | (1,013 | ) | | (6 | ) | | 2,629 | | | 20 | |
MasterCard/Visa | | | 1,352 | | | 66 | | | 5 | | | 223 | | | 20 | |
Other consumer | | | 2,552 | | | (135 | ) | | (5 | ) | | (491 | ) | | (16 | ) |
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Total consumer loans | | | 59,361 | | | (1,394 | ) | | (2 | ) | | (2,486 | ) | | (4 | ) |
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Total loans | | | 88,893 | | | (1,344 | ) | | (1 | ) | | 242 | | | — | |
Allowance for credit losses | | | 862 | | | (35 | ) | | (4 | ) | | 25 | | | 3 | |
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Loans, net | | $ | 88,031 | | $ | (1,309 | ) | | (1 | ) | $ | 217 | | | — | |
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Beginning in 2005, as a result of balance sheet initiatives to reduce prepayment risk and improve HBUS’s structural liquidity, HUSI decided to sell a majority of its residential loan originations through the secondary markets, resulting in reductions in loan balances throughout 2006 and the first quarter of 2007.
Decreased private label credit card receivables during the first quarter of 2007 are due to the seasonality of the portfolio. The addition of new private label relationships to the portfolio and decreased balance requirements of off-balance sheet securitized receivable trusts (refer to page 56 of this Form 10-Q), have resulted in increased on-balance sheet receivable balances from March 31, 2006 to March 31, 2007.
32
Trading Assets and Liabilities
Trading assets and liabilities balances at March 31, 2007, and movements in comparison with prior periods, are summarized in the following table.
| | | | | | | | | | | | | | | | |
|
|
|
|
|
|
| | | | Increase (Decrease) from | |
| | | |
|
|
| | | | December 31, 2006 | | March 31, 2006 | |
| | March 31,
2007 | |
| |
|
|
| | | Amount | | % | | Amount | | % | |
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|
|
|
|
|
|
|
|
|
|
|
| | ($ in millions) | |
Trading assets: | | | | | | | | | | | | | | | | |
Securities (1) | | $ | 13,282 | | $ | 1,358 | | | 11 | | $ | 1,522 | | | 13 | |
Precious metals | | | 4,063 | | | 1,347 | | | 50 | | | 877 | | | 28 | |
Fair value of derivatives | | | 10,554 | | | (844 | ) | | (7 | ) | | (1,018 | ) | | (9 | ) |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
| | $ | 27,899 | | $ | 1,861 | | | 7 | | $ | 1,381 | | | 5 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Trading liabilities: | | | | | | | | | | | | | | | | |
Securities sold, not yet purchased | | $ | 2,781 | | $ | 867 | | | 45 | | $ | 1,017 | | | 58 | |
Payables for precious metals | | | 1,496 | | | 160 | | | 12 | | | 622 | | | 71 | |
Fair value of derivatives | | | 9,783 | | | (1,013 | ) | | (9 | ) | | (1,762 | ) | | (15 | ) |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
| | $ | 14,060 | | $ | 14 | | | * | | $ | (123 | ) | | (1 | ) |
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|
| |
|
| |
|
| |
|
| |
|
| |
| |
(1) | Includes U.S. Treasury securities, securities issued by U.S. Government agencies and U.S. Government sponsored enterprises, other asset backed securities, corporate bonds and debt securities. |
| |
* | Not meaningful. |
Higher trading assets within the CIBM segment were due to changes in market conditions and increased customer demand, particularly related to higher precious metals balances.
Deposits
Deposit balances by major depositor categories at March 31, 2007, and movements in comparison with prior periods, are summarized in the following table.
| | | | | | | | | | | | | | | | |
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|
|
|
|
|
| | | | Increase (Decrease) from | |
| | | |
|
|
| | | | December 31, 2006 | | March 31, 2006 | |
| | March 31,
2007 | |
| |
|
|
| | | Amount | | % | | Amount | | % | |
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|
|
|
|
|
|
|
|
|
|
|
| | ($ in millions) | |
Individuals, partnerships and corporations | | $ | 87,409 | | $ | 4,038 | | | 5 | | $ | 7,321 | | | 9 | |
Domestic and foreign banks | | | 16,919 | | | (1,161 | ) | | (6 | ) | | 6,248 | | | 59 | |
U.S. Government, states and political subdivisions | | | 2,139 | | | 212 | | | 11 | | | 453 | | | 27 | |
Foreign government and official institutions | | | 1,047 | | | (125 | ) | | (11 | ) | | 188 | | | 22 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Total deposits | | $ | 107,514 | | $ | 2,964 | | | 3 | | $ | 14,210 | | | 15 | |
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| |
|
| |
|
| |
|
| |
|
| |
| | | | | | | | | | | | | | | | | |
Total core deposits | | $ | 61,626 | | $ | 4,050 | | | 7 | | $ | 11,830 | | | 24 | |
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| |
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| |
|
| |
|
| |
HUSI monitors “core deposits” as a key measure for assessing results of its core banking network. Core deposits generally include all domestic demand, money market and other savings accounts, as well as time deposits with balances not exceeding $100,000. Beginning in 2004, HUSI implemented a growth strategy for its core banking network, which includes building deposits over a three to five year period, across multiple markets and segments, and utilizing multiple delivery systems. Since inception, the strategy has included various initiatives, such as:
| |
• | full deployment of new personal and business checking and savings products, including relationship based products; |
| |
• | an emphasis on more competitive pricing with the introduction of high yielding products, including internet savings accounts, which have grown significantly beginning in late 2005. Since their introduction in 2005, internet savings balances have grown to $11.5 billion at March 31, 2007, of which $4.3 billion was raised during the first quarter of 2007; |
| |
• | retail branch expansion in existing and new geographic markets; |
| |
• | improving delivery systems, including use of internet capabilities; |
| |
• | refined marketing and customer analytics; and |
| |
• | deepening current customer relationships, thereby driving increased utilization of products and customer retention. |
33
Total deposit growth of $13 billion and $12 billion during calendar years 2006 and 2005, respectively, has been followed by growth of $3 billion in the first three months of 2007.
Net Interest Income
An analysis of consolidated average balances and interest rates on a taxable equivalent basis is presented on page 62 of this Form 10-Q. Significant components of HUSI’s net interest margin are summarized in the following table.
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|
|
|
|
|
Three months ended March 31 | | 2007 | | 2006 | |
|
|
|
|
|
|
Yield on total earning assets | | | 6.20 | % | | 5.54 | % |
Rate paid on interest bearing liabilities | | | 4.28 | | | 3.63 | |
| |
|
| |
|
| |
Interest rate spread | | | 1.92 | | | 1.91 | |
Benefit from net non-interest paying funds | | | .40 | | | .37 | |
| |
|
| |
|
| |
Net interest margin on average earning assets (1) | | | 2.32 | % | | 2.28 | % |
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|
| |
|
| |
| |
(1) | Selected financial ratios are defined in the Glossary of Terms beginning on page 87 of HUSI’s 2006 Form 10-K. |
Significant trends affecting the comparability of 2006 and 2007 net interest income and interest rate spread are summarized in the following table. Net interest income in the table is presented on a taxable equivalent basis (refer to page 62 of this Form 10-Q).
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|
|
|
|
|
| | Amount | | Interest Rate
Spread | |
|
|
|
|
|
|
| | ($ in millions) | |
Net interest income/interest rate spread for the three months ended March 31, 2006 | | $ | 742 | | | 1.91 | % |
| | | | |
|
| |
Increase (decrease) in net interest income associated with: | | | | | | | |
Trading related activities (1) | | | (12 | ) | | | |
Balance sheet management activities (2) | | | (28 | ) | | | |
Private label receivable portfolio (3) | | | 66 | | | | |
Other activity (4) | | | 28 | | | | |
| |
|
| | | | |
Net interest income/interest rate spread for the three months ended March 31, 2007 | | $ | 796 | | | 1.92 | % |
| |
|
| |
|
| |
| |
(1) | Refer to page 39 of this Form 10-Q. |
| |
(2) | Represents HUSI’s activities to manage interest rate risk associated with the repricing characteristics of balance sheet assets and liabilities. Interest rate risk, and HUSI’s approach to manage such risk, are described beginning on page 70 of HUSI’s 2006 Form 10-K. |
| |
(3) | Refer to page 44 of this Form 10-Q. |
| |
(4) | Primarily represents core banking activity, principally deposit growth. |
Trading Related and Balance Sheet Management Activities
Lower net interest income from balance sheet management and trading activities continued to impact results for the CIBM business segment during the first quarter of 2007. A persistently flat yield curve continued to limit available opportunities to generate additional net funds income within the CIBM business segment. Although the compression of the interest rate margin has stabilized in recent months, the yield curve is expected to remain flat in the near term.
Beginning in 2005, the CIBM business segment expanded its operations and products offered to clients, which has resulted in increased trading and lending activity in 2006 and 2007. The resulting increases in average trading assets and average commercial loan balances partially offset the negative impact of the flat yield curve.
34
Private Label Receivable Portfolio (PLRP)
Higher net interest income for the PLRP for the first quarter of 2007 resulted from:
| |
• | higher interest income from increased credit card receivable balances, due to the addition of new PLRP merchant relationships during 2006 and 2007, and to decreased balance requirements of off-balance sheet securitized PLRP receivable trusts (refer to page 56 of this Form 10-Q); |
| |
• | lower amortization of premiums paid for purchases of receivables included within the PLRP. Although premiums associated with daily purchases of receivables from HSBC Finance Corporation continue to be recorded and amortized, the amortization associated with the initial portfolio acquisition in 2004 was significantly lower for the first quarter of 2007; and |
| |
• | partially offsetting higher interest income was higher interest expense allocation to the CF business segment associated with funding higher credit card receivables, as well as higher market driven funding costs. |
Other Activity
Higher net interest income from core banking activities within the PFS business segment for the first quarter of 2007 was primarily due to the impact of a growing personal deposit base. Personal deposits are the primary, and relatively low cost, funding source for the PFS segment. These deposits continued to grow in 2007 as a result of continued success of the internet savings product introduced in 2005, and expansion of the branch network. Customers continued to migrate to higher yielding deposit products, such as the internet savings product, leading to a change in product mix and resulting in narrowing of deposit spreads, which partly offset the benefit of higher deposit balances. Refer to page 33 of this Form 10-Q for commentary regarding HUSI’s deposit strategy and growth.
Within the CMB business segment, expansion of various small business and middle-market commercial lending programs have also resulted in higher net interest income for the first quarter of 2007. Significant resources have been dedicated to expansion of various commercial lending businesses and regional offices, which has resulted in increased loans and deposits balances. The average yield earned on commercial loans also increased for the first quarter of 2007, due to increases in general market rates, which resulted in corresponding increases in HBUS’s prime lending rate. Deposits are the primary funding source for the CMB business segment. Although favorable spreads are generally earned on the growing commercial deposit base, net interest income growth has been partially offset by narrowing deposit spreads, as customers continue to migrate to higher yielding deposit products.
The positive impacts of the growing deposit base and business expansion initiatives were partially offset by lower interest earned and lower interest rate spreads on the residential mortgage loan portfolio included within the PFS segment. As a result of a continuing strategy to reduce prepayment risk and improve HBUS’s structural liquidity, HUSI continues to sell a majority of its residential mortgage loan originations and allow the residential mortgage loan portfolio to runoff. Interest rate spreads continued to narrow during the quarter since residential mortgage loans could not be repriced to offset higher funding costs.
Provision for Credit Losses
The provision for credit losses associated with various loan portfolios is summarized in the following table.
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|
|
|
| | | | | | | | Increase (Decrease) | |
| |
|
|
Three months ended March 31 | | 2007 | | 2006 | | Amount | | % | |
|
|
|
|
|
|
|
|
|
|
| | ($ in millions) | |
Commercial | | $ | 33 | | $ | 15 | | $ | 18 | | | 120 | |
| |
|
| |
|
| |
|
| |
|
| |
Consumer: | | | | | | | | | | | | | |
Residential mortgages | | | 14 | | | 7 | | | 7 | | | 100 | |
Credit card receivables | | | 140 | | | 119 | | | 21 | | | 18 | |
Other consumer | | | 18 | | | 16 | | | 2 | | | 13 | |
| |
|
| |
|
| |
|
| |
|
| |
Total consumer | | | 172 | | | 142 | | | 30 | | | 21 | |
| |
|
| |
|
| |
|
| |
|
| |
Total provision for credit losses | | $ | 205 | | $ | 157 | | $ | 48 | | | 31 | |
| |
|
| |
|
| |
|
| |
|
| |
The total provision for credit losses for the first quarter of 2007, although higher than the same 2006 period, was lower or comparable to the total provision expense recorded for the last three quarters of 2006.
35
Net commercial charge offs for the first quarter of 2007 reflect a more normalized credit environment when compared with relatively low charge offs and high recoveries recorded for the first quarter of 2006. Average total commercial loan balances increased 8% in the first quarter of 2007, as compared with the same 2006 period, resulting in increased collective allowances for credit losses.
Higher provision expense for credit card receivables resulted from growth in private label credit card receivables. In addition, provision expense for the first quarter of 2006 was unusually low due to the impact of bankruptcy legislation enacted in 2005, which resulted in accelerated consumer charge offs during the fourth quarter of 2005. During the first quarter of 2007, HUSI refined its allowance methodology associated with MasterCard/Visa credit card receivables, resulting in a $13 million reduction in the allowance balance and provision expense.
Refer to commentary regarding credit quality, beginning on page 47 of this Form 10-Q.
Other Revenues
The components of other revenues are summarized in the following table.
| | | | | | | | | | | | | |
|
|
|
|
| | | | | | | | Increase/(Decrease) | |
| |
|
|
Three months ended March 31 | | 2007 | | 2006 | | Amount | | % | |
|
|
|
|
|
|
|
|
|
|
| | ($ in millions) | |
Trust income | | $ | 23 | | $ | 22 | | $ | 1 | | | 5 | |
| |
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| |
|
| |
|
| |
|
| |
| | | | | | | | | | | | | |
Service charges (also see HSBC affiliate income below) | | | 53 | | | 47 | | | 6 | | | 13 | |
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| | | | | | | | | | | | | |
Credit card fees: | | | | | | | | | | | | | |
Private label receivables | | | 144 | | | 100 | | | 44 | | | 44 | |
MasterCard/Visa receivables | | | 34 | | | 22 | | | 12 | | | 55 | |
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|
| |
|
| |
|
| |
|
| |
| | | 178 | | | 122 | | | 56 | | | 46 | |
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|
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|
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| | | | | | | | | | | | | |
Other fees and commissions (also see HSBC affiliate income below): | | | | | | | | | | | | | |
Letter of credit fees | | | 18 | | | 18 | | | — | | | — | |
Wealth and tax advisory services | | | 28 | | | 26 | | | 2 | | | 8 | |
Other fee-based income, net of referral fees | | | 63 | | | 58 | | | 5 | | | 9 | |
| |
|
| |
|
| |
|
| |
|
| |
| | | 109 | | | 102 | | | 7 | | | 7 | |
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| | | | | | | | | | | | | |
HSBC affiliate income: | | | | | | | | | | | | | |
Service charges | | | 4 | | | 4 | | | — | | | — | |
Other fees and commissions | | | 17 | | | 12 | | | 5 | | | 42 | |
Gain on sale of residential mortgage loans to HMUS | | | 1 | | | 17 | | | (16 | ) | | (94 | ) |
Gain on sale of refund anticipation loans to HSBC Finance Corporation | | | 22 | | | 19 | | | 3 | | | 16 | |
Other affiliate income | | | 3 | | | 3 | | | — | | | — | |
| |
|
| |
|
| |
|
| |
|
| |
| | | 47 | | | 55 | | | (8 | ) | | (15 | ) |
| |
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| | | | | | | | | | | | | |
Other income: | | | | | | | | | | | | | |
Securitization revenue | | | — | | | 17 | | | (17 | ) | | (100 | ) |
Insurance | | | 15 | | | 13 | | | 2 | | | 15 | |
Valuation allowance increase for changes in market value of residential mortgage loans held for sale to HMUS | | | (10 | ) | | (79 | ) | | 69 | | | 87 | |
Gains on sale of property and other financial assets | | | 10 | | | 6 | | | 4 | | | 67 | |
Earnings from equity investments | | | 16 | | | 28 | | | (12 | ) | | (43 | ) |
Miscellaneous income | | | 15 | | | 19 | | | (4 | ) | | (21 | ) |
| |
|
| |
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| |
|
| |
|
| |
| | | 46 | | | 4 | | | 42 | | | * | |
| |
|
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|
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|
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|
| |
| | | | | | | | | | | | | |
Residential mortgage banking revenue | | | 20 | | | 23 | | | (3 | ) | | (13 | ) |
Trading revenues | | | 137 | | | 279 | | | (142 | ) | | (51 | ) |
Securities gains, net | | | 21 | | | 4 | | | 17 | | | * | |
| |
|
| |
|
| |
|
| |
|
| |
Total other revenues | | $ | 634 | | $ | 658 | | $ | (24 | ) | | (4 | ) |
| |
|
| |
|
| |
|
| |
|
| |
* Not meaningful
All increases and decreases that follow for the first three months of 2007 represent comparisons with the same 2006 period.
36
Residential Mortgage Loans Held for Sale to an HSBC Affiliate
In 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties with the intent of selling these loans to an HSBC affiliate, HSBC Markets (USA) Inc. (HMUS). HMUS in turn is selling these loans to securitization vehicles. During 2006, HUSI also began acquiring residential mortgage loans from HSBC Finance Corporation under this program. These loans, which primarily include sub-prime residential mortgage loans, are recorded by HUSI at the lower of their aggregate cost or market value, with adjustments to market value being recorded as a valuation allowance. The loans are generally held on HUSI’s balance sheet for 30-90 days, resulting in activity that affects various balance sheet and income statement line items, as summarized in the table below. HUSI maintains a portfolio of derivatives and securities, which are used as economic hedges to offset changes in market values of the loans held for sale to HMUS. Gains on sales associated with these loans result from incremental value realized on pools of loans sold to HMUS for securitization. The following table summarizes activity recorded as a result of acquiring, holding and selling these loans.
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|
Three months ended March 31 | | 2007 | | 2006 | |
|
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|
|
|
| | (in millions) | |
Residential mortgage loans held for sale to HMUS: | | | | | | | |
Balance at beginning of period | | $ | 3,116 | | $ | 2,882 | |
Loans acquired from originators | | | 3,464 | | | 5,274 | |
Loans sold to HMUS | | | (2,592 | ) | | (3,675 | ) |
Other, primarily loans resold to originators and other third parties | | | (244 | ) | | — | |
| |
|
| |
|
| |
Balance at end of period | | $ | 3,744 | | $ | 4,481 | |
| |
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| |
|
| |
| | | | | | | |
Valuation allowance for adjustments to market value: | | | | | | | |
Balance at beginning of period | | $ | (26 | ) | $ | (11 | ) |
Increase in valuation allowance for net reductions in market value | | | (10 | ) | | (79 | ) |
Releases of valuation allowance for loans sold to HMUS | | | 12 | | | 40 | |
| |
|
| |
|
| |
Balance at end of period | | $ | (24 | ) | $ | (50 | ) |
| |
|
| |
|
| |
| | | | | | | |
Impact on income before income taxes: | | | | | | | |
Net interest income associated with loans held for sale to HMUS (1) | | $ | 17 | | $ | 20 | |
Gains on sale of residential mortgage loans sold to HMUS, recorded in HSBC affiliate income | | | 1 | | | 17 | |
Increase in valuation allowance for reductions in market value of loans held for sale to HMUS, recorded in other income | | | (10 | ) | | (79 | ) |
Trading revenues (expense) recognized from economic hedges held to offset changes in market values of loans held for sale to HMUS (1) | | | (15 | ) | | 64 | |
Net program costs included in other expenses | | | (7 | ) | | (6 | ) |
| |
|
| |
|
| |
Net impact on income before income taxes | | $ | (14 | ) | $ | 16 | |
| |
|
| |
|
| |
| |
(1) | Refer to trading revenues commentary on page 39 of this Form 10-Q. |
Lower results and activity for this program for the first quarter of 2007 primarily resulted from the overall weakness in the U.S. residential mortgage market.
37
Credit Card Fees
Higher credit card fees in the first quarter of 2007 primarily resulted from private label credit card portfolio activity included within the CF business segment. Increased fees for this portfolio were primarily due to the following factors.
| |
• | Credit card receivables included in off-balance sheet securitization transactions for the first quarter of 2006 were included in on-balance sheet credit card receivables for the first quarter of 2007. Late fees associated with these receivables, which were recorded in securitization revenue in 2006, were recorded in credit card fees for 2007. Refer to other income commentary. |
| |
• | The number of accounts, volume of customer transaction activity and average receivable balances included within the private label portfolio all were higher for the first quarter of 2007, due to the addition of merchant relationships and to expansion of credit card products offered. |
Other Income
HUSI recorded no securitization revenue in the first quarter of 2007. In the third quarter of 2006, the last remaining securitization trust agreement related to the private label credit card receivable portfolio was amended. As a result, the trust no longer qualified for sale treatment and all assets and liabilities of the trust were returned to HUSI’s consolidated balance sheet. In addition, all new collateralized funding transactions have been structured as secured financings since the third quarter of 2004. Lower securitization revenue for the first quarter of 2007 was offset by higher net interest income and higher fee revenue (refer to previous credit card fees commentary) from the receivables and liabilities that were returned to the consolidated balance sheet.
The PB business segment includes an equity investment in a non-consolidated foreign HSBC affiliate (the foreign equity investment). During the third quarter of 2006, the foreign equity investment sold its investment in a foreign equity fund to another HSBC affiliate. The resulting decrease in equity investment holdings resulted in lower equity earnings for the first quarter of 2007.
Residential Mortgage Banking Revenue
The following table presents the components of residential mortgage banking revenue. Net interest income includes interest earned/paid on assets and liabilities of the residential mortgage banking business, as well as the funding cost or benefit associated with these balances. The net interest income component in the table is included in net interest income in the consolidated statement of income and reflects actual interest earned, net of cost of funds, and adjusted for corporate transfer pricing.
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|
| | | | | | | | Increase (Decrease) |
| | | | | | | |
|
|
Three months ended March 31 | | 2007 | | 2006 | | Amount | | % | |
|
|
|
|
|
|
|
|
|
|
| | ($ in millions) | |
Net interest income | | $ | 74 | | $ | 95 | | $ | (21 | ) | | (22 | ) |
| |
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| |
|
| |
|
| |
|
| |
Servicing related income: | | | | | | | | | | | | | |
Servicing fee income | | | 28 | | | 23 | | | 5 | | | 22 | |
Changes in fair value of MSRs due to (1): | | | | | | | | | | | | | |
Changes in valuation inputs or assumptions used in valuation model | | | 6 | | | 45 | | | (39 | ) | | (87 | ) |
Realization of cash flows | | | (24 | ) | | (21 | ) | | (3 | ) | | (14 | ) |
Trading – Derivative instruments used to offset changes in value of MSRs | | | (3 | ) | | (34 | ) | | 31 | | | 91 | |
| |
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| | | 7 | | | 13 | | | (6 | ) | | (46 | ) |
| |
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Originations and sales related income: | | | | | | | | | | | | | |
Gains on sales of residential mortgages | | | 6 | | | 3 | | | 3 | | | 100 | |
Trading and fair value hedge activity | | | — | | | 1 | | | (1 | ) | | (100 | ) |
| |
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| | | 6 | | | 4 | | | 2 | | | 50 | |
| |
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Other mortgage income | | | 7 | | | 6 | | | 1 | | | 17 | |
| |
|
| |
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| |
|
| |
Total residential mortgage banking revenue included in other revenues | | | 20 | | | 23 | | | (3 | ) | | (13 | ) |
| |
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| |
|
| |
|
| |
|
| |
Total residential mortgage banking related revenue | | $ | 94 | | $ | 118 | | $ | (24 | ) | | (20 | ) |
| |
|
| |
|
| |
|
| |
|
| |
38
All increases and decreases referenced below for the first quarter of 2007 represent comparisons with the same 2006 period.
Net Interest Income
Decreased net interest income for the first quarter of 2007 resulted from a decrease in average residential mortgage loans outstanding as well as a slight narrowing of interest rate spreads. During the quarter, HUSI continued the strategic balance sheet initiative adopted in 2005 to sell the majority of new loan originations to government sponsored enterprises and private investors. The held loans portfolio is expected to continue to decline for the remainder of 2007 as a result of this initiative.
Servicing Related Income
Higher servicing fee income for the first quarter of 2007 resulted from a higher volume of loans included within the average serviced loans portfolio. The average serviced portfolio increased approximately 24% in the first quarter of 2007 due to the following factors:
| |
• | HUSI sold a higher proportion of adjustable rate loans throughout 2006, which previously would have been held on the balance sheet; and |
| |
• | in the first quarter of 2007, HUSI commenced servicing a portfolio of loans previously serviced by a third party. |
The increased serviced loans portfolio, and its positive impact on service fee income, was partially offset by a decrease in value of the hedged MSRs portfolio including an increase in realization of cash flows on the higher serviced for others portfolio.
Trading Revenues
Trading revenues are generated by HUSI’s participation in the foreign exchange, credit derivative and precious metal markets; from trading derivative contracts, including interest rate swaps and options; from trading securities; and as a result of certain residential mortgage banking activities.
The following table summarizes trading related revenues by business. The data in the table includes net interest income earned on trading instruments, as well as an allocation of the funding benefit or cost associated with the trading positions. The trading related net interest income component is included in net interest income on the consolidated income statement. Trading revenues related to the mortgage banking business are included in residential mortgage banking revenue.
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Trading revenues | | $ | 137 | | $ | 279 | | $ | (142 | ) | | (51 | ) |
Net interest expense | | | (24 | ) | | (12 | ) | | (12 | ) | | (100 | ) |
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Trading related revenues | | $ | 113 | | $ | 267 | | $ | (154 | ) | | (58 | ) |
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Derivatives instruments | | $ | 52 | | $ | 90 | | $ | (38 | ) | | (42 | ) |
Economic hedges of loans held for sale to HMUS | | | 2 | | | 84 | | | (82 | ) | | (98 | ) |
Treasury (primarily securities) | | | (12 | ) | | 7 | | | (19 | ) | | (271 | ) |
Foreign exchange and banknotes | | | 55 | | | 43 | | | 12 | | | 28 | |
Precious metals | | | 15 | | | 35 | | | (20 | ) | | (57 | ) |
Other trading | | | 1 | | | 8 | | | (7 | ) | | (88 | ) |
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Trading related revenues | | $ | 113 | | $ | 267 | | $ | (154 | ) | | (58 | ) |
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39
During the first half of 2006, a wider range of product offerings and enhanced sales capabilities within the CIBM business segment drove significant trading gains across all major client-related activities. Favorable market conditions in certain sectors also enhanced trading profits. Successful launches of new products and increased sales of structured products that are tailored to specific customer needs led to unusually high derivatives trading revenues. Gains in the precious metals business reflected volume growth driven by a surge in demand arising from strong commodities markets. Income streams in the foreign exchange business remained robust against the backdrop of a weakening U.S. dollar.
As a consequence of specific economic factors experienced in the U.S. in the first quarter of 2007, particularly the overall weakness of the U.S. housing market which impacted residential mortgage related revenues, trading revenues decreased during the first quarter of 2007 as compared with the same 2006 period. Despite being lower than the first quarter of 2006 trading revenues for the first quarter of 2007 were comparable to the previous two quarters. Foreign exchange activities and revenues have remained strong throughout the first quarter of 2007 against the continuing backdrop of a weak U.S. dollar.
HUSI maintains a portfolio of derivative instruments that are utilized as economic hedges to offset changes in market values of loans held for sale to HMUS. Trading activity related to this program is generally offset by the net impact of gains on sales of loans to HMUS and changes in the valuation allowance related to loans held for sale to HMUS, both of which are recorded in other revenues. Further analysis and commentary regarding these loans and the associated hedges is provided on page 37 of this Form 10-Q.
HUSI recognizes gain or loss at the inception of derivative transactions only when the fair value of the transaction can be verified to market transactions or if all significant pricing model assumptions can be verified to observable market data. Gain or loss not recognized at inception is recorded in trading assets and recognized over the term of the derivative contract, or when market data becomes observable. The availability of observable market data resulted in recognition of $6 million and $29 million in trading revenues for the first quarter of 2007 and 2006, respectively.
Securities Gains, Net
HUSI maintains various securities portfolios as part of its overall balance sheet diversification and risk management strategies. The following table summarizes net securities gains resulting from various strategies.
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Three months ended March 31 | | 2007 | | 2006 | |
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Balance sheet diversity and reduction of risk | | $ | 8 | | $ | 4 | |
Management of Latin American investment exposure | | | 5 | | | — | |
Sales of securities to an HSBC affiliate (1) | | | 8 | | | — | |
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Securities gains, net | | $ | 21 | | $ | 4 | |
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(1) | Represents net gains realized from transfers of various available for sale and non-marketable securities to HMUS as part of a strategy to consolidate certain investments into common HSBC entities. | |
40
Operating Expenses
The following table presents the components of operating expenses.
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Salaries and employee benefits: | | | | | | | | | | | | | |
Salaries | | $ | 245 | | $ | 218 | | $ | 27 | | | 12 | |
Employee benefits | | | 93 | | | 97 | | | (4 | ) | | (4 | ) |
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Total salaries and employee benefits | | | 338 | | | 315 | | | 23 | | | 7 | |
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Occupancy expense, net | | | 58 | | | 51 | | | 7 | | | 14 | |
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Support services from HSBC affiliates: | | | | | | | | | | | | | |
Fees paid to HSBC Finance Corporation for loan servicing and other administrative support | | | 119 | | | 116 | | | 3 | | | 3 | |
Fees paid to HMUS | | | 57 | | | 56 | | | 1 | | | 2 | |
Fees paid to HTSU for technology services | | | 61 | | | 57 | | | 4 | | | 7 | |
Fees paid to other HSBC affiliates | | | 42 | | | 36 | | | 6 | | | 17 | |
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Total support services from HSBC affiliates | | | 279 | | | 265 | | | 14 | | | 5 | |
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Other expenses: | | | | | | | | | | | | | |
Equipment and software | | | 15 | | | 20 | | | (5 | ) | | (25 | ) |
Marketing | | | 32 | | | 21 | | | 11 | | | 52 | |
Outside services | | | 29 | | | 28 | | | 1 | | | 4 | |
Professional fees | | | 17 | | | 17 | | | — | | | — | |
Telecommunications | | | 5 | | | 5 | | | — | | | — | |
Postage, printing and office supplies | | | 9 | | | 7 | | | 2 | | | 29 | |
Insurance business | | | 7 | | | 5 | | | 2 | | | 40 | |
Other | | | 54 | | | 51 | | | 3 | | | 6 | |
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Total other expenses | | | 168 | | | 154 | | | 14 | | | 9 | |
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Total operating expenses | | $ | 843 | | $ | 785 | | $ | 58 | | | 7 | |
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Personnel - average number | | | 12,472 | | | 12,135 | | | 337 | | | 3 | |
All increases and decreases referred to below for the first three months of 2007 represent comparisons with the same 2006 period.
Overview
Increased expenses for the first quarter of 2007 were driven largely by personnel and marketing expense growth associated with continued rollout of various business growth initiatives affecting all business segments.
Salaries and Employee Benefits
Higher salaries expenses for the first quarter of 2007 were mainly due to:
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• | higher staff counts and a changing mix of staffing to support various business growth initiatives, primarily within the PFS, CIBM and PB business segments; |
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• | higher average salaries and pay rates, due to normal annual pay increases; and |
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• | higher personnel costs within the CIBM segment associated with the expansion of various businesses that are better positioned to leverage HSBC’s global markets capabilities, and with repositioning certain other businesses in order to focus on building a financing and emerging markets led wholesale banking business. |
Occupancy Expense, Net
Expansion of the core banking and commercial lending networks within the PFS and CMB business segments has been a key component of recent business expansion initiatives. New branches have been opened and lending operations have been expanded, which have resulted in higher rental expenses, depreciation of leasehold improvements, utilities and other occupancy expenses during the first quarter of 2007.
41
Support Services from HSBC Affiliates
HUSI has routinely purchased private label credit card receivables from HSBC Finance Corporation since December 2004. In addition, higher quality nonconforming residential mortgage loans were acquired from HSBC Finance Corporation’s correspondent network from December 2003 until September 2005. In most cases, HSBC Finance Corporation retained the right to service these portfolios. Fees charged by HSBC Finance Corporation for loan origination and servicing expenses, which are primarily recorded in the CF segment, have increased moderately for 2007 due to an increased number of private label credit card accounts serviced.
HUSI utilizes HMUS for broker dealer, debt underwriting, and for treasury and traded markets related services pursuant to service level agreements, primarily within the CIBM business segment. Debt underwriting fees charged by HMUS are deferred as a reduction of long-term debt and amortized to interest expense over the life of the related debt. Preferred stock issuance costs charged by HMUS are recorded as a reduction of capital surplus. Customer referral fees paid to HMUS are netted against customer fee income, which is included in other fees and commissions in other revenues. All other fees charged by HMUS are included in support services from HSBC affiliates.
HSBC’s technology services in North America are centralized within HSBC Technology & Services (USA) Inc. (HTSU). Technology related assets and software acquired for HUSI are generally purchased and owned by HTSU. Pursuant to a master service level agreement, HTSU charges HUSI for equipment related costs and technology services. Fees charged by HTSU to HUSI for technology services increased moderately in the first quarter of 2007, as HUSI continued to upgrade its technology environment within all business segments.
HUSI also utilizes other HSBC affiliates in support of global outsourcing initiatives and, to a lesser extent, for treasury and traded markets services. Higher expense for the first quarter of 2007 primarily resulted from expanded data processing and other global outsourcing services.
Other Expenses
Higher marketing and promotional expenses resulted from continuing investment in HSBC brand activities, promotion of the internet savings account and marketing support for branch expansion initiatives, primarily within the PFS business segment.
Efficiency Ratio
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Three months ended March 31 | | 2007 | | 2006 | |
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Efficiency ratio | | 59.17 | % | 56.38 | % |
The higher efficiency ratio for the first quarter of 2007 was due to increased operating expenses, primarily salaries, marketing and fees paid to HSBC affiliates, and lower non-interest revenues, which were partially offset by increased net interest income.
42
HUSI has five distinct segments that are utilized for management reporting and analysis purposes. The segments, which are based upon customer groupings as well as products and services offered, are described in Note 13 of the consolidated financial statements, beginning on page 19 of this Form 10-Q.
Effective January 1, 2007, corporate goals of HUSI are based upon results reported under International Financial Reporting Standards (IFRSs), which are utilized by HSBC to prepare its consolidated financial statements. Operating results for HUSI are now being monitored and reviewed, trends are being evaluated, and decisions are being made about allocating certain resources, such as employees, on an IFRSs basis. As a result, effective with this Form 10-Q, business segment results are reported on an IFRSs basis to align with the revised internal reporting mechanism for monitoring performance. Results in the tables that follow for the first quarter of 2007 and 2006 are reflected on an IFRSs basis.
Results for each business segment on an IFRSs basis are summarized in the following tables. All increases and decreases referenced below for the first quarter of 2007 represent comparisons to the same 2006 period.
Personal Financial Services (PFS)
Overview
Higher overall results for the PFS segment for the first quarter of 2007 were primarily due to a $17 million gain on sale of property and reduced provisions for credit losses. Higher net interest income from the growing personal deposit base was offset by lower net interest income related to the residential mortgage banking business.
Balance sheet growth for the first quarter of 2007 was highlighted by a 26% increase in average deposits, as compared with the same 2006 period, from individuals resulting from successful rollout of a strategy to build deposits across multiple markets and business segments, utilizing multiple delivery systems. Additional resources continue to be directed towards expansion of core retail banking businesses outside of residential mortgage banking, including investment in the HSBC brand, expansion of the core branch network in existing and new geographic areas, and continued rollout of HSBC Direct, the internet banking business.
Operating Results
The following table summarizes results for the PFS segment.
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Three months ended March 31 | | 2007 | | 2006 | | Amount | | % | |
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Net interest income | | $ | 287 | | $ | 287 | | $ | — | | | — | |
Other revenues | | | 150 | | | 136 | | | 14 | | | 10 | |
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Total revenues | | | 437 | | | 423 | | | 14 | | | 3 | |
Provision for credit losses | | | 5 | | | 16 | | | (11 | ) | | (69 | ) |
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| | | 432 | | | 407 | | | 25 | | | 6 | |
Operating expenses | | | 292 | | | 289 | | | 3 | | | 1 | |
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Income before income tax expense | | $ | 140 | | $ | 118 | | $ | 22 | | | 19 | |
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Higher net interest income from core banking activities for the first quarter of 2007 was primarily due to the impact of a growing personal deposit base. Personal deposits are the primary, and relatively low cost, funding source for the PFS segment. These deposits continued to grow in 2007 as a result of continued success of the internet savings product introduced in 2005, and expansion of the branch network. The positive impact of the growing personal deposit base was partially offset by customers continuing to migrate to higher yielding deposit products, such as the internet savings product, leading to a change in product mix and resulting in narrowing of deposit spreads. Refer to page 33 of this Form 10-Q for commentary regarding HUSI’s deposit strategy and growth.
43
The positive impact of the growing personal deposit base was also partially offset by lower interest earned and lower interest rate spreads on the residential mortgage loan portfolio. Average residential mortgage loans decreased 10% for the first quarter of 2007, as compared with the same 2006 period. As a result of a continuing strategy to reduce prepayment risk and improve HBUS’s structural liquidity, HUSI continues to sell a majority of its residential mortgage loan originations and allow the residential mortgage loan portfolio to run off.
Higher other revenues for the first quarter of 2007 were due to a $17 million gain realized on sale of branch premises to an unaffiliated third party.
During the first quarter of 2007, HUSI refined its allowance methodology associated with MasterCard/Visa credit card receivables, resulting in a $13 million reduction in the allowance balance and provision expense for the PFS business segment.
Consumer Finance (CF)
Overview
The CF segment includes the private label receivable portfolio (the PLRP) and other loans acquired from HSBC Finance Corporation and its correspondents. Results of the CF segment have been positively impacted by growth of private label credit card receivables, which are 19% higher at March 31, 2007 compared with the prior year, and by lower amortization of premiums paid to HSBC Finance Corporation for those receivables.
Operating Results
The following table summarizes results for the CF segment.
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Net interest income | | $ | 199 | | $ | 161 | | $ | 38 | | | 24 | |
Other revenues (1) | | | 48 | | | 11 | | | 37 | | | 336 | |
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Total revenues | | | 247 | | | 172 | | | 75 | | | 44 | |
Provision for credit losses | | | 174 | | | 145 | | | 29 | | | 20 | |
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| | | 73 | | | 27 | | | 46 | | | 170 | |
Operating expenses | | | 8 | | | 7 | | | 1 | | | 14 | |
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Income before income tax expense | | $ | 65 | | $ | 20 | | $ | 45 | | | 225 | |
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(1) | For IFRSs reporting purposes, fees charged by HSBC Finance Corporation for servicing various loan and receivable portfolios are netted against other revenues. These fees totaled $107 million and $104 million for the first quarter of 2007 and 2006, respectively. |
The following table summarizes the impact of the PLRP on earnings for the CF segment in comparison with the other portfolios.
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Three months ended March 31 | | PLRP | | Other | | Total | |
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2007 | | | | | | | | | | |
Net interest income | | $ | 182 | | $ | 17 | | $ | 199 | |
Other revenues | | | 53 | | | (5 | ) | | 48 | |
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Total revenues | | | 235 | | | 12 | | | 247 | |
Provision for credit losses | | | 165 | | | 9 | | | 174 | |
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| | | 70 | | | 3 | | | 73 | |
Operating expenses | | | 8 | | | — | | | 8 | |
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Income before income tax expense | | $ | 62 | | $ | 3 | | $ | 65 | |
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2006 | | | | | | | | | | |
Net interest income | | $ | 132 | | $ | 29 | | $ | 161 | |
Other revenues | | | 15 | | | (4 | ) | | 11 | |
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Total revenues | | | 147 | | | 25 | | | 172 | |
Provision for credit losses | | | 139 | | | 6 | | | 145 | |
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| | | 8 | | | 19 | | | 27 | |
Operating expenses | | | 6 | | | 1 | | | 7 | |
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Income before income tax expense | | $ | 2 | | $ | 18 | | $ | 20 | |
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44
Higher net interest income for the first quarter of 2007 resulted from:
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• | higher interest income from increased credit card receivable balances, due to the addition of new private label merchant relationships during 2006 and 2007; and |
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• | lower amortization of premiums paid for purchases of receivables included within the PLRP. Although premiums associated with daily purchases of receivables from HSBC Finance Corporation continue to be recorded and amortized, the premium associated with the initial portfolio acquisition in 2004 was significantly lower for the first quarter of 2007. |
Higher other revenues for the PLRP are directly related to increased credit card fees (refer to page 38 of this Form 10-Q).
Higher provisions for credit losses for the PLRP resulted from higher allowance for credit losses required for private label credit card receivable growth.
Commercial Banking (CMB)
Overview
Significant resources have been dedicated to expansion of various commercial lending businesses and regional offices, which has resulted in growth in loans and deposits balances. Office locations and staffing levels were expanded in 2005 and 2006, as were loan and deposit products offered to small businesses and middle-market commercial customers, in conjunction with increased marketing efforts. As a result of these initiatives, commercial loans and deposits are 4% and 25% higher, respectively, for the first quarter of 2007. HUSI continues to leverage its status as one of the top ranked small business lenders in New York State.
Operating Results
The following table summarizes results for the CMB segment.
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| | ($ in millions) | |
Net interest income | | $ | 196 | | $ | 178 | | $ | 18 | | | 10 | |
Other revenues | | | 62 | | | 61 | | | 1 | | | 2 | |
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Total revenues | | | 258 | | | 239 | | | 19 | | | 8 | |
Provision for credit losses | | | 18 | | | 4 | | | 14 | | | 350 | |
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| | | 240 | | | 235 | | | 5 | | | 2 | |
Operating expenses | | | 140 | | | 119 | | | 21 | | | 18 | |
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Income before income tax expense | | $ | 100 | | $ | 116 | | $ | (16 | ) | | (14 | ) |
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Higher net interest income for the first quarter of 2007 primarily resulted from expansion of various small business and middle-market commercial lending programs, which has resulted in growth in the respective loan portfolios. The average yield earned on commercial loans also increased for the first quarter of 2007, due to increases in general market rates, which resulted in corresponding increases in HBUS’s prime lending rate.
Deposits are the primary funding source for the CMB business segment. Although the CMB business segment generally earns favorable spreads on the growing deposit base, net interest income growth has been partially offset by narrowing deposit spreads, as customers continue to migrate to higher yielding deposit products.
Increased provisions for credit losses for the first quarter of 2007 reflect a more normalized credit environment in comparison to relatively low charge offs and high recoveries recorded in the same 2006 period. In addition, growth in commercial loan portfolio balances and higher criticized assets have resulted in higher collective allowance requirements for the current quarter. Additional commentary regarding credit quality begins on page 47 of this Form 10-Q.
Higher operating expenses are primarily associated with branch expansion initiatives and new lending offices.
45
Corporate, Investment Banking and Markets (CIBM)
Overview
Various treasury and traded markets activities were expanded in 2005 and 2006, resulting in new products offered to customers, increased marketing efforts for those products, and an expanded infrastructure to support growth initiatives. As a result of these initiatives, average commercial loans, trading assets and deposits are 22%, 16% and 38% higher, respectively, for the first quarter of 2007 in comparison with the same 2006 period.
As a consequence of specific economic factors experienced in the U.S. in the first quarter of 2007, particularly the overall weakness of the U.S. housing market which impacted residential mortgage related revenues, trading revenues decreased during the first quarter of 2007 as compared with the same 2006 period. Despite being lower than the first quarter of 2006 trading revenues for the first quarter of 2007 were comparable to the previous two quarters. Foreign exchange activities and revenues have remained strong throughout the first quarter of 2007 against the continuing backdrop of a weakening U.S. dollar.
Revenues from the payments and cash management business were significantly higher for the first quarter of 2007, as compared with the same 2006 period, reflecting higher deposits balances and higher associated transaction fee revenues.
A persistently flat yield curve has reduced net interest income from balance sheet management activities for the first quarter of 2007 and has continued to limit opportunities to generate additional net funds income within the CIBM segment.
During the first half of 2006, a wider range of product offerings and enhanced sales capabilities within the CIBM business segment drove significant trading gains across all major client-related activities. Favorable market conditions in certain sectors also enhanced trading profits. Successful launches of new products and increased sales of structured products that are tailored to specific customer needs led to strong derivatives trading revenues. Gains in the precious metals business reflected volume growth driven by a surge in demand arising from strong commodities markets. Income streams in the foreign exchange business remained robust against the backdrop of a weak U.S. dollar.
Operating Results
The following table summarizes results for the CIBM segment.
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Three months ended March 31 | | 2007 | | 2006 | | Amount | | % | |
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| | ($ in millions) | |
Net interest income (expense) | | $ | (3 | ) | $ | 25 | | $ | (28 | ) | | (112 | ) |
Other revenues | | | 254 | | | 289 | | | (35 | ) | | (12 | ) |
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Total revenues | | | 251 | | | 314 | | | (63 | ) | | (20 | ) |
(Credit) provision for credit losses | | | (5 | ) | | 2 | | | (7 | ) | | (350 | ) |
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| | | 256 | | | 312 | | | (56 | ) | | (18 | ) |
Operating expenses | | | 189 | | | 171 | | | 18 | | | 11 | |
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Income before income tax expense | | $ | 67 | | $ | 141 | | $ | (74 | ) | | (52 | ) |
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Lower revenues primarily resulted from lower trading related revenues (refer to page 39 of this Form 10-Q) and lower balance sheet management income, which were partially offset by higher gains realized from sales of securities (refer to page 40 of this Form 10-Q).
Higher operating expenses for the first quarter of 2007, as compared with the same 2006 period, resulted from higher personnel costs associated with expansion of various businesses that are better positioned to leverage HSBC’s global markets capabilities. Expenses for the first quarter of 2007 also included incremental costs associated with repositioning certain other non-strategic businesses in order to focus on building a financing and emerging markets led wholesale banking business.
46
Private Banking (PB)
Overview
During 2005 and 2006, additional resources were allocated to expand products offered and services provided to high net worth customers served by the PB business segment. For the first quarter of 2007, higher income from deposits growth and higher service fee income was offset by lower earnings from equity investments and higher provisions for credit losses.
Operating Results
The following table summarizes results for the PB segment.
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Three months ended March 31 | | 2007 | | 2006 | | Amount | | % | |
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| | ($ in millions) | |
Net interest income | | $ | 50 | | $ | 48 | | $ | 2 | | | 4 | |
Other revenues | | | 73 | | | 77 | | | (4 | ) | | (5 | ) |
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Total revenues | | | 123 | | | 125 | | | (2 | ) | | (2 | ) |
Provision for credit losses | | | 7 | | | — | | | 7 | | | * | |
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| | | 116 | | | 125 | | | (9 | ) | | (7 | ) |
Operating expenses | | | 82 | | | 77 | | | 5 | | | 6 | |
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Income before income tax expense | | $ | 34 | | $ | 48 | | $ | (14 | ) | | (29 | ) |
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The PB business segment includes an equity investment in a non-consolidated foreign HSBC affiliate (the foreign equity investment). During the third quarter of 2006, the foreign equity investment sold its investment in a foreign equity fund to another HSBC affiliate. The resulting decrease in equity investment holdings resulted in lower equity earnings included in other revenues for the first quarter of 2007.
The provision for credit losses for the current quarter includes the impact of a specific $7 million charge off related to a commercial customer relationship within the PB business segment, for which no allowance was previously recorded.
HUSI enters into a variety of transactions in the normal course of business that involve both on and off-balance sheet credit risk. Principal among these activities is lending to various commercial, institutional, governmental and individual customers. HUSI participates in lending activity throughout the U.S. and, on a limited basis, internationally.
HUSI’s allowance for credit losses methodology and its accounting policies related to the allowance for credit losses are presented in Critical Accounting Policies beginning on page 25 of its 2006 Form 10-K and in Note 2 of the consolidated financial statements beginning on page 99 of its 2006 Form 10-K.
HUSI’s approach toward credit risk management is summarized on pages 72-74 of its 2006 Form 10-K. There have been no material revisions to policies or methodologies during the first quarter of 2007.
Overview
The allowance for credit losses decreased $35 million (4%) during the first quarter of 2007, due primarily to lower allowances associated with private label credit card receivables and, to a lesser extent, to refinement of the allowance methodology associated with MasterCard/Visa credit card receivables, which resulted in a $13 million reduction in the allowance balance. The allowance increased $25 million (3%) from March 31, 2006 to March 31, 2007, due to higher commercial loan balances and to higher criticized commercial and consumer assets (refer to pages 48 and 50 of this Form 10-Q).
47
The provision for credit losses increased $48 million (31%) for the first quarter of 2007, as compared with the same 2006 period, primarily due to higher commercial loan balances, to higher criticized assets within various commercial and consumer loan portfolios and to higher private label credit card receivables. The provision for credit losses associated with various loan portfolios is summarized on page 49 of this Form 10-Q.
Problem Loan Management
Nonaccruing loans by portfolio and impaired loans are summarized in Note 4 of the consolidated financial statements beginning on page 10 of this Form 10-Q.
HUSI’s policies and practices for placing loans on nonaccruing status are summarized in Note 2 of the consolidated financial statements, beginning on page 99 of its 2006 Form 10-K.
Criticized Assets
Criticized asset classifications are based on the risk rating standards of HUSI’s primary regulator. Problem credit facilities, which include loans and other credit arrangements such as letters of credit, are assigned various criticized facility grades under HUSI’s allowance for credit losses methodology. The following facility grades are deemed to be criticized.
Special Mention – generally includes credit facilities that are protected by collateral and/or the credit worthiness of the customer, but are potentially weak based upon economic or market circumstances which, if not checked or corrected, could weaken HUSI’s credit position at some future date.
Substandard – includes credit facilities that are inadequately protected by the underlying collateral and/or general credit worthiness of the customer. These credit facilities present a distinct possibility that HUSI will sustain some loss if the deficiencies are not corrected.
Doubtful– includes credit facilities that have all the weaknesses exhibited by substandard credit facilities, with the added characteristic that the weaknesses make collection or liquidation in full of the recorded loan highly improbable. However, although the possibility of loss is extremely high, certain factors exist which may strengthen the credit at some future date, and therefore the decision to charge off the loan is deferred. Loans graded as doubtful are required to be placed in nonaccruing status.
Criticized credit facilities are summarized in the following table.
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| | | | Increase (Decrease) from | |
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|
| | | | December 31, 2006 | | March 31, 2006 | |
| | March 31,
2007 | |
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Balance at | | | Amount | | % | | Amount | | % | |
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| | ($ in millions) | |
Special mention: | | | | | | | | | | | | | | | | |
Commercial loans | | $ | 1,238 | | $ | (13 | ) | | (1 | ) | $ | 630 | | | 104 | |
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Substandard: | | | | | | | | | | | | | | | | |
Commercial loans | | | 501 | | | (180 | ) | | (26 | ) | | 271 | | | 118 | |
Consumer loans | | | 607 | | | 6 | | | 1 | | | 143 | | | 31 | |
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| | | 1,108 | | | (174 | ) | | (14 | ) | | 414 | | | 60 | |
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Doubtful: | | | | | | | | | | | | | | | | |
Commercial loans | | | 33 | | | 1 | | | 3 | | | 12 | | | 57 | |
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Total | | $ | 2,379 | | $ | (186 | ) | | (7 | ) | $ | 1,056 | | | 80 | |
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48
Provision and Allowance for Credit Losses
An analysis of the provision for credit losses is provided on page 50 of this Form 10-Q.
Changes in the allowance for credit losses by general loan categories are summarized in the following table.
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Quarter ended | | March 31,
2007 | | December 31,
2006 | | September 30,
2006 | | June 30,
2006 | | March 31,
2006 | |
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| | ($ in millions) | |
Total loans at quarter end | | $ | 88,893 | | $ | 90,237 | | $ | 90,020 | | $ | 91,205 | | $ | 88,651 | |
Average total loans | | | 88,092 | | | 89,343 | | | 88,739 | | | 88,699 | | | 88,622 | |
| | | | | | | | | | | | | | | | |
Allowance balance at beginning of quarter | | | 897 | | | 886 | | | 869 | | | 837 | | | 846 | |
Allowance related to disposal of certain credit card receivables | | | — | | | (2 | ) | | — | | | — | | | (6 | ) |
| | | | | | | | | | | | | | | | |
Charge offs: | | | | | | | | | | | | | | | | |
Commercial | | | 36 | | | 43 | | | 29 | | | 44 | | | 20 | |
Consumer: | | | | | | | | | | | | | | | | |
Residential mortgages | | | 14 | | | 10 | | | 9 | | | 7 | | | 11 | |
Credit card receivables | | | 224 | | | 205 | | | 188 | | | 165 | | | 170 | |
Other consumer loans | | | 31 | | | 32 | | | 27 | | | 23 | | | 29 | |
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Total consumer loans | | | 269 | | | 247 | | | 224 | | | 195 | | | 210 | |
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Total charge offs | | | 305 | | | 290 | | | 253 | | | 239 | | | 230 | |
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| | | | | | | | | | | | | | | | |
Recoveries on loans charged off: | | | | | | | | | | | | | | | | |
Commercial | | | 6 | | | 9 | | | 8 | | | 6 | | | 15 | |
Consumer: | | | | | | | | | | | | | | | | |
Residential mortgages | | | — | | | 1 | | | 1 | | | — | | | — | |
Credit card receivables | | | 49 | | | 47 | | | 49 | | | 28 | | | 46 | |
Other consumer loans | | | 10 | | | 9 | | | 5 | | | 15 | | | 9 | |
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Total consumer loans | | | 59 | | | 57 | | | 55 | | | 43 | | | 55 | |
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Total recoveries | | | 65 | | | 66 | | | 63 | | | 49 | | | 70 | |
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| | | | | | | | | | | | | | | | |
Total net charge offs | | | 240 | | | 224 | | | 190 | | | 190 | | | 160 | |
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| | | | | | | | | | | | | | | | |
Provision charged to income | | | 205 | | | 237 | | | 207 | | | 222 | | | 157 | |
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| | | | | | | | | | | | | | | | |
Allowance balance at end of quarter | | $ | 862 | | $ | 897 | | $ | 886 | | $ | 869 | | $ | 837 | |
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Allowance ratios: | | | | | | | | | | | | | | | | |
Annualized net charge offs to average loans: | | | | | | | | | | | | | | | | |
Commercial | | | .43 | % | | .47 | % | | .29 | % | | .54 | % | | .08 | % |
Consumer: | | | | | | | | | | | | | | | | |
Residential mortgages | | | .15 | | | .09 | | | .08 | | | .07 | | | .10 | |
Credit card receivables | | | 4.01 | | | 3.62 | | | 3.39 | | | 3.61 | | | 3.32 | |
Other consumer loans | | | 3.20 | | | 3.27 | | | 2.95 | | | 1.06 | | | 2.61 | |
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Total consumer | | | 1.43 | | | 1.25 | | | 1.12 | | | 1.00 | | | 1.01 | |
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Total loans | | | 1.11 | % | | 1.00 | % | | .85 | % | | .86 | % | | .73 | % |
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Quarter-end allowance to: | | | | | | | | | | | | | | | | |
Quarter-end total loans | | | .97 | % | | .99 | % | | .98 | % | | .95 | % | | .94 | % |
Quarter-end total nonaccruing loans | | | 280.78 | % | | 314.74 | % | | 331.84 | % | | 354.69 | % | | 367.11 | % |
49
An analysis of changes in the allowance for credit losses by general loan categories is provided in the following table.
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| | Commercial | | Residential
Mortgage | | Credit
Card | | Other
Consumer | | Unallocated | | Total | |
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| | (in millions) | |
Quarter ended March 31, 2007: | | | | | | | | | | | | | | | | | | | |
Balance at beginning of period | | $ | 203 | | $ | 31 | | $ | 626 | | $ | 26 | | $ | 11 | | $ | 897 | |
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Charge offs | | | 36 | | | 14 | | | 224 | | | 31 | | | — | | | 305 | |
Recoveries | | | 6 | | | — | | | 49 | | | 10 | | | — | | | 65 | |
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Net charge offs | | | 30 | | | 14 | | | 175 | | | 21 | | | — | | | 240 | |
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Provision charged to income | | | 33 | | | 14 | | | 140 | | | 18 | | | — | | | 205 | |
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Balance at end of period | | $ | 206 | | $ | 31 | | $ | 591 | | $ | 23 | | $ | 11 | | $ | 862 | |
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Quarter ended March 31, 2006: | | | | | | | | | | | | | | | | | | | |
Balance at beginning of period | | $ | 162 | | $ | 34 | | $ | 600 | | $ | 36 | | $ | 14 | | $ | 846 | |
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Allowance related to disposals | | | — | | | — | | | (6 | ) | | — | | | — | | | (6 | ) |
Charge offs | | | 20 | | | 11 | | | 170 | | | 29 | | | — | | | 230 | |
Recoveries | | | 15 | | | — | | | 46 | | | 9 | | | — | | | 70 | |
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Net charge offs | | | 5 | | | 11 | | | 124 | | | 20 | | | — | | | 160 | |
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Provision charged to income | | | 14 | | | 7 | | | 119 | | | 16 | | | 1 | | | 157 | |
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Balance at end of period | | $ | 171 | | $ | 30 | | $ | 589 | | $ | 32 | | $ | 15 | | $ | 837 | |
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Commercial Loan Credit Quality
Components of the commercial allowance for credit losses, as well as movements in comparison with prior periods, are summarized in the following table.
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| | | | Increase (Decrease) from | |
| | | |
|
|
| | | | December 31, 2006 | | March 31, 2006 | |
| | March 31,
2007 | |
| |
|
|
| | | Amount | | % | | Amount | | % | |
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|
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| | ($ in millions) | |
On-balance sheet allowance: | | | | | | | | | | | | | | | | |
Specific | | $ | 14 | | $ | — | | | — | | $ | 7 | | | 100 | |
Collective | | | 192 | | | 3 | | | 2 | | | 32 | | | 20 | |
Transfer risk | | | — | | | — | | | — | | | (4 | ) | | (100 | ) |
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| | | 206 | | | 3 | | | 1 | | | 35 | | | 20 | |
Unallocated | | | 11 | | | — | | | — | | | (4 | ) | | (27 | ) |
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Total on-balance sheet allowance | | | 217 | | | 3 | | | 1 | | | 31 | | | 17 | |
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Off-balance sheet allowance | | | 95 | | | (3 | ) | | (3 | ) | | 8 | | | 9 | |
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Total commercial allowances | | $ | 312 | | $ | — | | | — | | $ | 39 | | | 14 | |
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Growth initiatives during 2005 and 2006 have resulted in a continuing trend of growth in the size and complexity of HUSI’s commercial loan portfolio. In addition, certain segments of the economy continue to show signs of slowing, resulting in higher probabilities of default, which is a key driver for credit grading. Criticized assets have increased (refer to page 48 of this Form 10-Q), which, in combination with increased loan balances, resulted in higher specific and collective allowances.
Criticized asset classifications are based on the risk rating standards of HUSI’s primary regulator. Higher criticized credit facilities (refer to page 48 of this Form 10-Q) resulted mainly from downgrades in real estate and middle market exposures within the CMB business segment and, to a lesser extent, from downgrades within the PB business segment. The downgrades resulted in part from changes in the credit metrics for specific credits within these portfolios. Total nonaccruing commercial loans remain low as a percentage of total commercial loans. Based upon evaluation of the repayment capacity of the obligors, including support from adequately margined collateral, performance on guarantees, and other mitigating factors, impairment is modestly higher at March 31, 2007 as compared with prior reporting periods, and is adequately reflected in the allowances for specific and collective impairment.
50
Continued increases in provisions and allowances for credit losses are expected in the near future due to growing portfolio risk resulting from:
| |
• | HUSI’s continued geographic expansion; |
| |
• | increased borrower concentrations; |
| |
• | increased number and complexity of products offered; and |
| |
• | continuing signs of stress within certain segments of the economy. |
HUSI management continues to monitor and reduce exposures to those industries considered to be higher risk. During 2006, HUSI management began to make more extensive use of available tools to more actively manage net exposure within its corporate loan portfolios with an increased syndication capacity as well as increased use of credit default swaps to economically hedge and reduce certain exposures.
Any sudden and/or unexpected adverse economic events or trends could significantly affect credit quality and increase provisions for credit losses. For example, HUSI management is monitoring rising interest rates and high energy prices, which could potentially lead to a deceleration of U.S. economic activity. Ongoing events in the Middle East may also worsen the overall energy picture.
Credit Card Receivable Credit Quality
Credit card receivables are primarily private label receivables, including closed and open ended contracts, acquired from HSBC Finance Corporation. Receivables included in the private label credit card portfolio are generally maintained in accruing status until being charged off six months after delinquency. The following table provides credit quality data for credit card receivables.
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|
| | March 31,
2007 | | December 31,
2006 | | March 31,
2006 | |
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|
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|
| | ($ in millions) | |
Accruing balances contractually past due 90 days or more: | | | | | | | | | | |
Balance at end of quarter | | $ | 318 | | $ | 339 | | $ | 244 | |
As a percent of total credit card receivables | | | 1.84 | % | | 1.86 | % | | 1.69 | % |
| | | | | | | | | | |
Allowance for credit losses associated with credit card receivables: | | | | | | | | | | |
Balance at end of quarter | | $ | 591 | | $ | 626 | | $ | 589 | |
As a percent of total credit card receivables | | | 3.41 | % | | 3.43 | % | | 4.07 | % |
| | | | | | | | | | |
Net charge offs of credit card receivables: | | | | | | | | | | |
Total for the quarter ended | | $ | 175 | | $ | 158 | | $ | 124 | |
Annualized net charge offs as a percent of average credit card receivables | | | 4.01 | % | | 3.62 | % | | 3.32 | % |
The allowance for credit losses associated with credit card receivables decreased $35 million (6%) during the first quarter of 2007 and increased by a nominal amount from March 31, 2006 to March 31, 2007. Net charge off and provision activity during the first quarter of 2007, as well as the allowance balance at March 31, 2007, are generally consistent with increased private label credit card receivable balances (refer to page 35 of this Form 10-Q for commentary regarding credit card receivables).
51
Residential Mortgage Loan Credit Quality
The allowance for credit losses related to residential mortgage loans increased nominally during the first quarter of 2007. HUSI’s residential mortgage portfolio is primarily comprised of prime mortgage loans, for which credit quality remained strong during the first quarter of 2007.
Certain credit risk concentrations are inherent within the residential mortgage loan portfolio. A concentration of credit risk is defined as a significant credit exposure with an individual or group engaged in similar activities or affected similarly by economic conditions. As is true for all loan portfolios, HUSI utilizes high underwriting standards and prices loans in a manner that is appropriate to compensate for the higher risk associated with these concentrations. Concentrations of credit risk include:
| |
• | residential mortgage loans with high loan-to-value (LTV) ratios and no mortgage insurance, which could result in potential inability to recover the entire investment in loans involving foreclosed or damaged properties; |
| |
• | interest-only residential mortgage loans, which allow customers to pay only the accruing interest for a period of time, resulting in lower payments during the initial loan period; |
| |
• | concentrations of second liens within the residential mortgage loan portfolio; and |
| |
• | adjustable rate residential mortgage loans that will experience their first interest rate resets within the next two years. |
Additional disclosures regarding credit risk concentrations are provided in Note 4 of the consolidated financial statements, beginning on page 10 of this Form 10-Q.
Reserve for Off-Balance Sheet Exposures
HUSI maintains a separate reserve for credit risk associated with certain off-balance sheet exposures including letters of credit, unused commitments to extend credit and financial guarantees. This reserve, included in other liabilities, was $95 million, $98 million and $86 million at March 31, 2007, December 31, 2006 and March 31, 2006, respectively. Off-balance sheet exposures are summarized on page 55 of this Form 10-Q.
Credit and Market Risks Associated with Derivative Contracts
Credit (or repayment) risk in derivative instruments is minimized by entering into transactions with high quality counterparties, including other HSBC entities. 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 subject to regular credit review by the credit risk management department. Most derivative contracts are governed by an International Swaps and Derivatives Association Master Agreement. Depending on the type of counterparty and the level of expected activity, bilateral collateral arrangements may also be required.
The total risk in a derivative contract is a function of a number of variables, such as:
| |
• | whether counterparties exchange notional principal; |
| |
• | volatility of interest rates, currencies, equity or corporate reference entity used as the basis for determining contract payments; |
| |
• | maturity and liquidity of contracts; |
| |
• | credit worthiness of the counterparties in the transaction; and |
| |
• | existence and value of collateral received from counterparties to secure exposures. |
The following table presents credit risk exposure and net fair value associated with derivative contracts. In the table, current credit risk exposure is the recorded fair value of derivative receivables, which represents revaluation gains from the marking to market of derivative contracts held for trading purposes, for all counterparties with an International Swaps and Derivatives Association Master Agreement in place.
52
Future credit risk exposure in the following table is measured using rules contained in the risk-based capital guidelines published by U.S. banking regulatory agencies. The risk exposure calculated in accordance with the risk-based capital guidelines potentially overstates actual credit exposure, because:
| |
• | the risk-based capital guidelines ignore collateral that may have been received from counterparties to secure exposures; and |
| |
• | 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 the impact of bilateral netting (i.e., netting with a single counterparty when a bilateral netting agreement is in place). However, the risk-based capital guidelines recognize that bilateral netting agreements reduce credit risk and therefore allow for reductions of risk-weighted assets when netting requirements have been met. Therefore, risk-weighted amounts for regulatory capital purposes are a fraction of the original gross exposures.
| | | | | | | |
|
| | March 31,
2007 | | December 31,
2006 | |
|
| | (in millions) | |
Risk associated with derivative contracts: | | | | | | | |
Current credit risk exposure | | $ | 10,554 | | $ | 11,398 | |
Future credit risk exposure | | | 66,472 | | | 72,447 | |
| |
|
| |
|
| |
Total risk exposure | | | 77,026 | | | 83,845 | |
Less: collateral held against exposure | | | (4,755 | ) | | (3,989 | ) |
| |
|
| |
|
| |
Net credit risk exposure | | $ | 72,271 | | $ | 79,856 | |
| |
|
| |
|
| |
Market risk is the adverse effect that a change in interest rates, currency, or implied volatility rates has on the value of a financial instrument. HUSI manages the market risk associated with interest rate and foreign exchange contracts by establishing and monitoring limits as to the types and degree of risk that may be undertaken. HUSI also manages the market risk associated with the trading derivatives through hedging strategies that correlate the rates, price and spread movements. HUSI measures this risk daily by using Value at Risk (VAR) and other methodologies (refer to pages 59-61 of this Form 10-Q).
HUSI’s Asset and Liability Policy Committee is responsible for monitoring and defining the scope and nature of various strategies utilized to manage interest rate risk that are developed through its analysis of data from financial simulation models and other internal and industry sources. The resulting hedge strategies are then incorporated into HUSI’s overall interest rate risk management and trading strategies.
53
The following table summarizes the notional values of derivative contracts.
| | | | | | | |
|
| | March 31,
2007 | | December 31,
2006 | |
|
| | (in millions) | |
Interest rate: | | | | | | | |
Futures and forwards | | $ | 166,911 | | $ | 94,204 | |
Swaps | | | 2,087,157 | | | 1,906,688 | |
Options written | | | 916,201 | | | 510,023 | |
Options purchased | | | 947,007 | | | 544,026 | |
| |
|
| |
|
| |
| | | 4,117,276 | | | 3,054,941 | |
| |
|
| |
|
| |
Foreign exchange: | | | | | | | |
Swaps, futures and forwards | | | 401,969 | | | 394,621 | |
Options written | | | 74,019 | | | 61,406 | |
Options purchased | | | 75,303 | | | 63,795 | |
Spot | | | 57,454 | | | 32,654 | |
| |
|
| |
|
| |
| | | 608,745 | | | 552,476 | |
| |
|
| |
|
| |
Commodities, equities and precious metals: | | | | | | | |
Swaps, futures and forwards | | | 56,252 | | | 43,620 | |
Options written | | | 12,770 | | | 12,263 | |
Options purchased | | | 17,383 | | | 16,115 | |
| |
|
| |
|
| |
| | | 86,405 | | | 71,998 | |
| |
|
| |
|
| |
| | | | | | | |
Credit derivatives | | | 891,526 | | | 816,422 | |
| |
|
| |
|
| |
| | | | | | | |
Total | | $ | 5,703,952 | | $ | 4,495,837 | |
| |
|
| |
|
| |
The total notional amounts in the table above relate primarily to HUSI’s trading activities. Notional amounts included in the table related to non-trading fair value, cash flow and economic hedging activities were $26 billion and $27 billion at March 31, 2007 and December 31, 2006, respectively.
54
|
OFF-BALANCE SHEET ARRANGEMENTS |
|
The following table provides maturity information related to off-balance sheet arrangements. Descriptions of these arrangements are found on pages 68-69 of HUSI’s 2006 Form 10-K.
| | | | | | | | | | | | | | | | |
|
| | Balance at March 31, 2007 | | | | |
| |
| | | | |
| | One
Year
or Less | | Over One
Through
Five Years | | Over
Five
Years | | Total | | Balance at
December 31,
2006 | |
|
|
|
|
|
|
|
|
|
|
|
|
| | (in millions) | |
Standby letters of credit, net of participations (1) | | $ | 4,615 | | $ | 3,408 | | $ | 95 | | $ | 8,118 | | $ | 7,259 | |
Commercial letters of credit | | | 719 | | | 67 | | | — | | | 786 | | | 795 | |
Loan sales with recourse (2) | | | 1 | | | — | | | 6 | | | 7 | | | 8 | |
Credit derivative contracts (3) | | | 19,917 | | | 255,688 | | | 194,922 | | | 470,527 | | | 431,631 | |
Commitments to extend credit: | | | | | | | | | | | | | | | | |
Commercial | | | 19,679 | | | 30,928 | | | 4,670 | | | 55,277 | | | 55,862 | |
Consumer | | | 9,430 | | | — | | | — | | | 9,430 | | | 9,627 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Total | | $ | 54,361 | | $ | 290,091 | | $ | 199,693 | | $ | 544,145 | | $ | 505,182 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
| |
(1) | Includes $525 million and $542 million issued for the benefit of related parties at March 31, 2007 and December 31, 2006, respectively. |
| |
(2) | $6 million and $7 million are indemnified by third parties at March 31, 2007 and December 31, 2006, respectively. |
| |
(3) | Includes $80,692 million and $71,908 million issued for the benefit of related parties at March 31, 2007 and December 31, 2006, respectively. |
Letters of Credit
Fees are charged for issuing letters of credit commensurate with the customer’s credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of the “stand ready obligation to perform” under these guarantees, amounting to $23 million and $21 million at March 31, 2007 and December 31, 2006, respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $22 million and $25 million at March 31, 2007 and December 31, 2006, respectively.
Credit Derivatives
HUSI enters into credit derivative contracts primarily to satisfy the needs of its customers and, in certain cases, for its own benefit. Credit derivatives are arrangements that provide for one party (the “protection buyer”) to transfer the credit risk of a “reference asset” to another party (the “protection seller”). Under this arrangement the protection seller assumes the credit risk associated with the reference asset without directly purchasing it. The protection buyer agrees to pay a specified fee to the protection seller. In return, the protection seller agrees to pay the protection buyer an agreed upon amount if there is a default during the term of the contract.
In accordance with its policy, HUSI offsets most of the risk it assumes in selling credit protection through a credit derivative contract with another counterparty. Credit derivatives are recorded at fair value. The commitment amount included in the table is the maximum amount that HUSI could be required to pay, without consideration of the approximately equal amount receivable from third parties and any associated collateral.
55
Securitizations and Secured Financings
On December 29, 2004, HUSI acquired a domestic private label loan portfolio from HSBC Finance Corporation, without recourse, which included securitized private label credit card receivables, and retained interest assets related to these securitizations. These credit card securitization transactions were structured to receive sale treatment under Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of FASB Statement No. 125 (SFAS 140).
In a securitization, a designated pool of receivables is removed from the balance sheet and transferred to an unaffiliated revolving trust. This unaffiliated revolving trust is a qualifying special purpose entity (QSPE) as defined by SFAS 140 and, therefore, is not consolidated. The QSPE funds its receivable purchase through the issuance of securities to investors, entitling them to receive specified cash flows during the life of the securities. The securities are collateralized by the underlying receivables transferred to the QSPE. These revolving securitization trusts require replenishments of receivables to support previously issued securities.
In the third quarter of 2006, the last remaining securitization trust agreement related to the private label portfolio acquired from HSBC Finance Corporation in 2004 was amended. As a result, the securitization trust no longer qualifies for sale treatment in accordance with U.S. GAAP, and the transaction is now recorded as a secured financing transaction. At the transaction date, all outstanding investments, credit card receivables and liabilities related to the trust were recorded on HUSI’s consolidated balance sheet.
Under IFRSs, HUSI’s securitizations are treated as secured financings. In order to align its accounting treatment with that of HSBC, all of HUSI’s collateralized funding transactions have been structured as secured financings under U.S. GAAP since the third quarter of 2004. In a secured financing, a designated pool of receivables is conveyed to a wholly owned limited purpose subsidiary, which in turn transfers the receivables to a trust that sells interests to investors. Repayment of the debt issued by the trust is secured by the receivables transferred. The transactions are structured as secured financings under SFAS 140. Therefore, the receivables and the underlying debt of the trust remain on HUSI’s balance sheet. HUSI does not recognize a gain in a secured financing transaction. Because the receivables and debt remain on the balance sheet, revenues and expenses are reported consistent with the owned balance sheet portfolio. There have been no new secured financing transactions in the first three months of 2007.
HUSI’s securitized receivables and secured financings are summarized in the following table.
| | | | | | | |
|
|
| | March 31,
2007 | | December 31,
2006 | |
|
|
|
|
|
|
| | (in millions) | |
Secured financings included in long-term debt: | | | | | | | |
Balance at period end | | $ | 1,488 | | $ | 2,134 | |
| |
|
| |
|
| |
Private label credit card receivables collateralizing secured financings at period end | | $ | 1,816 | | $ | 2,439 | |
| |
|
| |
|
| |
56
Overview
Some degree of risk is inherent in virtually all of HUSI’s activities. For the principal activities undertaken by HUSI, the most important types of risks are considered to be credit, interest rate, market, liquidity, operational, fiduciary and reputational. Market risk broadly refers to price risk inherent in mark to market positions taken on trading and non-trading instruments. Operational risk technically includes legal and compliance risk. However, since compliance risk, including anti-money laundering (AML) risk, has such broad scope within HUSI’s businesses, it is addressed as a separate functional discipline. During the first quarter of 2007, there have been no significant changes in policies or approach for managing various types of risk.
Liquidity Management
HUSI’s approach to address liquidity risk is summarized on pages 75-76 of HUSI’s 2006 Form 10-K. There have been no changes in HUSI’s approach toward liquidity risk management during 2007.
HUSI’s ability to regularly attract wholesale funds at a competitive cost is enhanced by strong ratings from the major credit rating agencies. At March 31, 2007, HUSI and HBUS maintained the following debt and preferred stock ratings.
| | | | | | | | | | |
|
At March 31, 2007 | | | Moody’s | | | S&P | | | Fitch | |
|
HUSI: | | | | | | | | | | |
Short-term borrowings | | | P-1 | | | A-1+ | | | F1+ | |
Long-term debt | | | Aa3 | | | AA- | | | 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, to meet cash and capital needs, or to fund investments in subsidiaries. In December 2005, the United States Securities and Exchange Commission (SEC) amended its rules regarding registration, communications and offerings under the Securities Act of 1933. The amended rules facilitate access to capital markets by well-established public companies, provide more flexibility regarding restrictions on corporate communications during a securities offering and further integrate disclosures under the Securities Act of 1933 and the Securities Exchange Act of 1934. The amended rules provide the most flexibility to “well-known seasoned issuers”, including the option of automatic effectiveness upon filing of shelf registration statements and relief under the liberalized communications rules. HUSI currently satisfies the eligibility requirements for designation as a “well-known seasoned issuer”, and has an effective shelf registration statement with the SEC under which it may issue debt securities, preferred stock, either separately or represented by depositary shares, warrants, purchase contracts and units.
Interest Rate Risk Management
Various techniques are utilized to quantify and monitor risks associated with the repricing characteristics of HUSI’s assets, liabilities, and derivative contracts. The approach toward managing interest rate risk is summarized on pages 77-79 of HUSI’s 2006 Form 10-K. During the first three months of 2007, there were no significant changes in policies or approach for managing interest rate risk.
57
Present Value of a Basis Point (PVBP) Analysis
PVBP is the change in value of the balance sheet for a one basis point upward movement in all interest rates. The following table reflects the PVBP position at March 31, 2007.
| | | | |
|
|
|
|
|
March 31, 2007 | | Values | |
|
|
|
|
| | (in millions) | |
Institutional PVBP movement limit | | $ | 6.5 | |
PVBP position at period end | | | .9 | |
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 gradual rate increase or decrease. The following table reflects the economic value of equity position at March 31, 2007.
| | | | |
|
|
|
|
March 31, 2007 | | Values (%) | |
|
|
|
|
Institutional economic value of equity limit | | +/- | 20 | |
Projected change in value (reflects projected rate movements on April 1, 2007): | | | | |
Change resulting from a gradual 200 basis point increase in interest rates | | | (5 | ) |
Change resulting from a gradual 200 basis point decrease in interest rates | | | (5 | ) |
The loss in value for a 200 basis point increase or decrease in rates is a result of the negative convexity of the residential whole loan and mortgage backed securities portfolios. If rates decrease, the projected prepayments related to these portfolios will accelerate, causing less appreciation than a comparable term, non-convex instrument. If rates increase, projected prepayments will slow, which will cause the average lives of these positions to extend and result in a greater loss in market value.
Dynamic Simulation Modeling
Various modeling techniques are utilized to monitor a number of interest rate scenarios for their impact on net interest income. These techniques include both rate shock scenarios which assume immediate market rate movements by as much as 200 basis points, as well as scenarios in which rates rise or fall by as much as 200 basis points over a twelve month period. The following table reflects the impact on net interest income of the scenarios utilized by these modeling techniques.
| | | | | | | |
|
|
|
|
|
|
|
|
| | March 31, 2007 Values | |
| |
|
|
|
|
|
|
| | Amount | | % | |
|
|
|
|
|
|
| | ($ in millions) | | | | |
| | | | | | | |
Projected change in net interest income (reflects projected rate movements on April 1, 2007): | | | | | | | |
Institutional base earnings movement limit | | | | | | (10 | ) |
Change resulting from a gradual 200 basis point increase in the yield curve | | $ | (167 | ) | | (6 | ) |
Change resulting from a gradual 200 basis point decrease in the yield curve | | | 221 | | | 7 | |
Change resulting from a gradual 100 basis point increase in the yield curve | | | (74 | ) | | (2 | ) |
Change resulting from a gradual 100 basis point decrease in the yield curve | | | 107 | | | 3 | |
| | | | | | | |
Other significant scenarios monitored (reflects projected rate movements on April 1, 2007): | | | | | | | |
Change resulting from an immediate 100 basis point increase in the yield curve | | | (136 | ) | | (5 | ) |
Change resulting from an immediate 100 basis point decrease in the yield curve | | | 177 | | | 6 | |
Change resulting from an immediate 200 basis point increase in the yield curve | | | (302 | ) | | (10 | ) |
Change resulting from an immediate 200 basis point decrease in the yield curve | | | 249 | | | 8 | |
The projections do not take into consideration possible complicating factors such as the effect of changes in interest rates on the credit quality, size and composition of the balance sheet. Therefore, although this provides a reasonable estimate of interest rate sensitivity, actual results will vary from these estimates, possibly by significant amounts.
58
Capital Risk/Sensitivity of Other Comprehensive Income
Large movements of interest rates could directly affect some reported capital and capital ratios. The mark to market valuation of available for sale securities is adjusted on a tax effective basis through other comprehensive income 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 tangible common equity to tangible assets and the tangible common equity to risk weighted assets. As of March 31, 2007, HUSI had an available for sale securities portfolio of approximately $18 billion with a net negative mark to market of $357 million included in tangible common equity of $8 billion. An increase of 25 basis points in interest rates of all maturities would lower the mark to market by approximately $156 million to a net loss of $513 million with the following results on the tangible capital ratios.
| | | | | | | |
|
|
|
|
|
|
March 31, 2007 | | Actual | | Proforma – Reflecting
25 Basis Points
Increase in Rates | |
|
|
|
|
|
|
Tangible common equity to tangible assets | | | 4.70 | % | | 4.65 | % |
Tangible common equity to risk weighted assets | | | 6.59 | | | 6.52 | |
Market Risk Management
Value at Risk (VAR)
VAR analysis is used to estimate the potential losses that could occur on risk positions as a result of movements in market rates and prices over a specified time horizon and to a given level of confidence. VAR calculations are performed for all material trading activities and as a tool for managing interest rate risk inherent in non-trading activities. HUSI calculates VAR daily for a one-day holding period to a 99% confidence level. At a 99% confidence level for a two-year observation period, HUSI is setting as its limit the fifth worst loss performance in the last 500 business days.
VAR - - Trading Activities
HUSI’s management of market risk is based on restricting individual operations to trading within a list of permissible instruments, and enforcing rigorous approval procedures for new products. In particular, trading in the more complex derivative products is restricted to offices with appropriate levels of product expertise and robust control systems.
In addition, at both portfolio and position levels, market risk in trading portfolios is monitored and controlled using a complementary set of techniques, including VAR and various techniques for monitoring interest rate risk (refer to pages 57-58 of this Form 10-Q). These techniques quantify the impact on capital of defined market movements.
Trading portfolios reside primarily within the Markets unit of the CIBM business segment, which include warehoused residential mortgage loans purchased for securitizations and within the mortgage banking subsidiary included within the PFS business segment. Portfolios include foreign exchange, derivatives, precious metals (gold, silver, platinum), equities, money market instruments and securities. Trading occurs as a result of customer facilitation, proprietary position taking, and economic hedging. In this context, economic hedging may include, for example, forward contracts to sell residential mortgages and derivative contracts which, while economically viable, may not satisfy the hedge requirements of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133).
The trading portfolios have defined limits pertaining to items such as permissible investments, risk exposures, loss review, balance sheet size and product concentrations. “Loss review” refers to the maximum amount of loss that may be incurred before senior management intervention is required.
59
The following table summarizes trading VAR for the first quarter of 2007.
| | | | | | | | | | | | | | | | |
|
|
|
|
|
|
|
|
| | March 31,
2007 | | Three months ended March 31, 2007 | | December 31,
2006 | |
| |
Minimum | | Maximum | | Average | |
|
|
|
|
|
|
|
|
|
|
|
|
| | (in millions) | |
Total trading | | $ | 16 | | $ | 9 | | $ | 18 | | $ | 13 | | $ | 9 | |
Precious metals | | | — | (1) | | — | (1) | | 4 | | | 1 | | | 2 | |
Credit derivatives | | | 5 | | | 3 | | | 9 | | | 5 | | | 4 | |
Equities | | | — | (1) | | — | (1) | | 4 | | | — | (1) | | — | (1) |
Foreign exchange | | | 1 | | | 1 | | | 3 | | | 1 | | | 2 | |
Interest rate | | | 16 | | | 8 | | | 20 | | | 13 | | | 13 | |
| |
(1) | Less than $500 thousand. |
The following table summarizes the frequency distribution of daily market risk-related revenues for Treasury trading activities during the first quarter of 2007. Market risk-related Treasury trading revenues include realized and unrealized gains (losses) related to Treasury trading activities, but exclude the related net interest income. Analysis of the gain (loss) data for the quarter shows that the largest daily gain was $7 million and the largest daily loss was $12 million.
| | | | | | | | | | | | | | | | |
|
|
|
|
|
|
|
|
|
|
|
|
Ranges of daily Treasury trading revenue earned from market risk-related activities (in millions) | | Below
$(10) | | $(10) to
$(5) | | $(5) to
$0 | | $0 to
$5 | | Over
$5 | |
|
|
|
|
|
|
|
|
|
|
|
|
Number of trading days market risk-related revenue was within the stated range | | | 2 | | | 10 | | | 29 | | | 20 | | | 1 | |
VAR - - Non-trading Activities
The principal objective of market risk management of non-trading portfolios is to optimize net interest income. Market risk in non-trading portfolios arises principally from mismatches between the future yield on assets and their funding cost, as a result of interest rate changes. Analysis of this risk is complicated by having to make assumptions on optionality in certain product areas, for example, mortgage prepayments, and from behavioral assumptions regarding the economic duration of liabilities which are contractually repayable on demand. The prospective change in future net interest income from non-trading portfolios will be reflected in the current realizable value of these positions, should they be sold or closed prior to maturity. In order to manage this risk optimally, market risk in non-trading portfolios is transferred to Global Markets or to separate books managed under the supervision of ALCO. Once market risk has been consolidated in Global Markets or ALCO-managed books, the net exposure is typically managed through the use of interest rate swaps within agreed-upon limits.
The following table summarizes non-trading VAR for the first quarter of 2007, assuming a 99% confidence level for a two-year observation period and a one-day “holding period”.
| | | | | | | | | | | | | | | | |
|
|
|
|
|
|
|
|
| | March 31,
2007 | | Three months ended March 31, 2007 | | December 31,
2006 | |
| |
Minimum | | Maximum | | Average | |
|
|
|
|
|
|
|
|
|
|
|
|
| | (in millions) | |
Interest rate | | $ | 24 | | $ | 22 | | $ | 38 | | $ | 28 | | $ | 24 | |
Trading Activities – HSBC Mortgage Corporation (USA)
HSBC Mortgage Corporation (USA) is HUSI’s mortgage banking subsidiary. Trading occurs in mortgage banking operations as a result of an economic hedging program intended to offset changes in value of mortgage servicing rights and the salable loan pipeline. Economic hedging may include, for example, forward contracts to sell residential mortgages and derivative contracts used to protect the value of MSRs.
MSRs are assets that represent the present value of net servicing income (servicing fees, ancillary income, escrow and deposit float, net of servicing costs). MSRs are recognized upon the sale of the underlying loans or at the time that servicing rights are purchased. MSRs are subject to interest rate risk, in that their value will fluctuate as a result of a changing interest rate environment.
60
Interest rate risk is mitigated through an active hedging program that uses trading securities and derivative instruments to offset changes in value of MSRs. Since the hedging program involves trading activity, risk is quantified and managed using a number of risk assessment techniques.
Rate Shock Analysis
Modeling techniques are used to monitor certain interest rate scenarios for their impact on the economic value of net hedged MSRs, as reflected in the following table.
| | | | |
|
|
|
|
|
March 31, 2007 | | Values | |
|
|
|
|
| | (in millions) | |
Projected change in net market value of hedged MSRs portfolio (reflects projected rate movements on April 1, 2007): | | | | |
Value of hedged MSRs portfolio | | $ | 486 | |
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 | | | 5 | |
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 | | | 5 | |
Economic Value of MSRs
The economic value of the net, hedged MSRs portfolio is monitored on a daily basis for interest rate sensitivity. If the economic value declines by more than established limits for one day or one month, various levels of management review, intervention and/or corrective actions are required.
Hedge Volatility
The following table summarizes the frequency distribution of the weekly economic value of the MSR asset during the first quarter of 2007. This includes the change in the market value of the MSR asset net of changes in the market value of the underlying hedging positions used to hedge the asset. The changes in economic value are adjusted for changes in MSR valuation assumptions that were made during the course of the quarter, if applicable.
| | | | | | | | | | | | | | | | |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ranges of mortgage economic value from market risk-related activities (in millions) | | | Below
$(2) | | | $(2) to
$0 | | | $0 to
$2 | | | $2 to
$4 | | | Over
$4 | |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three months ended March 31, 2007: | | | | | | | | | | | | | | | | |
Number of trading weeks market risk-related revenue was within the stated range | | | 2 | | | 3 | | | 5 | | | 2 | | | 1 | |
61
CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES
The following table shows the year to date average balances of the principal components of assets, liabilities and shareholders’ equity together with their respective interest amounts and rates earned or paid, presented on a taxable equivalent basis.
| | | | | | | | | | | | | | | | | | | |
| | Three months ended March 31, | |
| |
|
|
| | 2007 | | 2006 | |
| |
| |
|
|
| | Balance | | Interest | | Rate* | | Balance | | Interest | | Rate* | |
| |
| |
|
|
| | (in millions) | |
Assets | | | |
Interest bearing deposits with banks | | $ | 4,340 | | $ | 57 | | | 5.31 | % | $ | 4,710 | | $ | 52 | | | 4.50 | % |
Federal funds sold and securities purchased under resale agreements | | | 12,075 | | | 162 | | | 5.46 | | | 6,683 | | | 74 | | | 4.47 | |
Trading assets | | | 10,762 | | | 141 | | | 5.30 | | | 10,096 | | | 108 | | | 4.33 | |
Securities | | | 22,523 | | | 294 | | | 5.30 | | | 21,313 | | | 270 | | | 5.14 | |
Loans | | | | | | | | | | | | | | | | | | | |
Commercial | | | 28,665 | | | 459 | | | 6.50 | | | 26,472 | | | 385 | | | 5.90 | |
Consumer: | | | | | | | | | | | | | | | | | | | |
Residential mortgages | | | 39,085 | | | 528 | | | 5.48 | | | 43,885 | | | 569 | | | 5.26 | |
Credit cards | | | 17,684 | | | 392 | | | 8.98 | | | 15,161 | | | 267 | | | 7.16 | |
Other consumer | | | 2,658 | | | 63 | | | 9.72 | | | 3,104 | | | 65 | | | 8.52 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Total consumer | | | 59,427 | | | 983 | | | 6.71 | | | 62,150 | | | 901 | | | 5.88 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Total loans | | | 88,092 | | | 1,442 | | | 6.64 | | | 88,622 | | | 1,286 | | | 5.89 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Other | | | 1,457 | | | 32 | | | 8.95 | | | 676 | | | 14 | | | 8.11 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Total earning assets | | | 139,249 | | $ | 2,128 | | | 6.20 | % | | 132,100 | | $ | 1,804 | | | 5.54 | % |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Allowance for credit losses | | | (937 | ) | | | | | | | | (935 | ) | | | | | | |
Cash and due from banks | | | 3,176 | | | | | | | | | 4,148 | | | | | | | |
Other assets | | | 25,764 | | | | | | | | | 23,165 | | | | | | | |
| |
|
| | | | | | | |
|
| | | | | | | |
Total assets | | $ | 167,252 | | | | | | | | $ | 158,478 | | | | | | | |
| |
|
| | | | | | | |
|
| | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Liabilities and Shareholders’ Equity | | | | | | | | | | | | | | | | | | | |
Deposits in domestic offices | | | | | | | | | | | | | | | | | | | |
Savings deposits | | $ | 40,427 | | $ | 322 | | | 3.23 | % | $ | 29,149 | | $ | 153 | | | 2.14 | % |
Other time deposits | | | 25,543 | | | 309 | | | 4.90 | | | 28,589 | | | 281 | | | 3.99 | |
Deposits in foreign offices | | | | | | | | | | | | | | | | | | | |
Foreign banks deposits | | | 9,126 | | | 112 | | | 4.99 | | | 7,186 | | | 77 | | | 4.33 | |
Other time and savings | | | 13,165 | | | 146 | | | 4.51 | | | 14,813 | | | 138 | | | 3.78 | |
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Total interest bearing deposits | | | 88,261 | | | 889 | | | 4.09 | | | 79,737 | | | 649 | | | 3.30 | |
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Short-term borrowings | | | 8,643 | | | 71 | | | 3.35 | | | 10,040 | | | 73 | | | 2.92 | |
Long-term debt | | | 29,255 | | | 372 | | | 5.15 | | | 28,911 | | | 340 | | | 4.77 | |
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Total interest bearing liabilities | | | 126,159 | | | 1,332 | | | 4.28 | | | 118,688 | | | 1,062 | | | 3.63 | |
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Net interest income / Interest rate spread | | | | | $ | 796 | | | 1.92 | % | | | | $ | 742 | | | 1.91 | % |
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Noninterest bearing deposits | | | 13,933 | | | | | | | | | 13,001 | | | | | | | |
Other liabilities | | | 14,922 | | | | | | | | | 15,077 | | | | | | | |
Total shareholders’ equity | | | 12,238 | | | | | | | | | 11,712 | | | | | | | |
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Total liabilities and shareholders’ equity | | $ | 167,252 | | | | | | | | $ | 158,478 | | | | | | | |
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Net interest margin on average earning assets | | | | | | | | | 2.32 | % | | | | | | | | 2.28 | % |
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Net interest margin on average total assets | | | | | | | | | 1.93 | % | | | | | | | | 1.90 | % |
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* Rates are calculated on unrounded numbers.
Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest for the first three months of 2007 and 2006 included fees of $10 million and $12 million, respectively.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk |
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Refer to Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the captions “Interest Rate Risk Management” and “Trading Activities”, beginning on page 57 of this Form 10-Q.
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Item 4. Controls and Procedures |
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HUSI maintains a system of internal and disclosure controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, as amended, (the Exchange Act), is recorded, processed, summarized and reported on a timely basis. HUSI’s Board of Directors, operating through its Audit Committee, which is composed entirely of independent outside directors, provides oversight to the financial reporting process.
An evaluation was conducted, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of HUSI’s disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that HUSI’s disclosure controls and procedures were effective as of the end of the period covered by this report so as to alert them in a timely fashion to material information required to be disclosed in reports filed under the Exchange Act.
There have been no changes in HUSI’s internal controls or in other factors that could significantly affect internal and disclosure controls subsequent to the date that the evaluation was carried out.
HUSI continues the process to complete a thorough review of its internal controls as part of its preparation for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404). Section 404 requires management to report on, and external auditors to attest to, the effectiveness of HUSI’s internal control structure and procedures for financial reporting. 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 the period ended December 31, 2007.
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Part II – OTHER INFORMATION |
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Item 1A. Risk Factors |
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Risk factors were set forth in HUSI’s Form 10-K for the period ended December 31, 2006. There have been no material changes from the risk factors disclosed in that Form 10-K.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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| | HSBC USA Inc. |
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| | (Registrant) |
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Date: May 14, 2007 | /s/ Gerard Mattia |
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| | Gerard Mattia |
| | Senior Executive Vice President and |
| | Chief Financial Officer |
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