CONFORMED 1.
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UNITED STATES SECURITIES AND EXCHANGE
COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2004
or
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
AND EXCHANGE ACT OF 1934
For the transition period from ______ to ______
Commission file number 1-7436
HSBC USA Inc.
(Exact name of registrant as specified in its charter)
Maryland
(State of Incorporation)
13-2764867
(IRS Employer Identification No.)
452 Fifth Avenue, New York, New York 10018
(Address of principal executive offices)
(212) 525-3735
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes |_| No |X|
At July 31, 2004, all voting stock (704 shares of Common Stock, $5 par value) is
owned by an indirect wholly owned subsidiary of HSBC Holdings plc.
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HSBC USA Inc.
Form 10-Q
TABLE OF CONTENTS
Part I FINANCIAL INFORMATION
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Page
----
Item 1. Consolidated Financial Statements
Statement of Income 3
Balance Sheet 4
Statement of Changes in Shareholders' Equity 5
Statement of Cash Flows 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (MD&A)
Average Balances and Interest Rates 17
Forward-Looking Statements 19
Executive Overview 19
Basis of Reporting 20
Results of Operations 24
Business Segments 35
Credit Quality 38
Derivative Instruments and Hedging Activities 40
Off-Balance Sheet Arrangements 41
Special Purpose and Variable Interest Entities 42
Capital 42
Risk Management 43
Item 3. Quantitative and Qualitative Disclosures About Market Risk 49
Item 4. Controls and Procedures 49
Part II OTHER INFORMATION
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Item 1. Legal Proceedings 50
Item 6. Exhibits and Reports on Form 8-K 50
Signature 51
2
Part I. Financial Information
Item 1. Consolidated Financial Statements
HSBC USA Inc.
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CONSOLIDATED STATEMENT OF INCOME
Three months ended June 30, Six months ended June 30,
2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------------
in millions
Interest income:
Loans ................................................ $ 669 $ 585 $ 1,282 $ 1,196
Securities ........................................... 215 212 430 452
Trading assets ....................................... 38 34 71 74
Short-term investments ............................... 18 22 36 43
Other ................................................ 4 7 8 14
------- ------- ------- -------
Total interest income .................................... 944 860 1,827 1,779
------- ------- ------- -------
Interest expense:
Deposits ............................................. 158 173 318 361
Short-term borrowings ................................ 35 21 52 58
Long-term debt ....................................... 62 57 113 106
------- ------- ------- -------
Total interest expense ................................... 255 251 483 525
------- ------- ------- -------
Net interest income ...................................... 689 609 1,344 1,254
Provision for credit losses .............................. 6 31 (19) 87
------- ------- ------- -------
Net interest income after provision for credit losses .... 683 578 1,363 1,167
------- ------- ------- -------
Other revenues:
Trust income ......................................... 24 24 48 46
Service charges ...................................... 53 52 104 103
Other fees and commissions ........................... 122 116 231 224
Other income ......................................... 35 57 82 92
Mortgage banking revenue (expense) ................... (17) (14) (41) (6)
Trading revenues ..................................... 78 91 167 161
Security gains, net .................................. 3 33 41 49
------- ------- ------- -------
Total other revenues ..................................... 298 359 632 669
------- ------- ------- -------
Operating expenses:
Salaries and employee benefits ....................... 240 278 490 557
Occupancy expense, net ............................... 37 37 72 75
Other expenses ....................................... 243 177 447 346
------- ------- ------- -------
Total operating expenses ................................. 520 492 1,009 978
------- ------- ------- -------
Income before income tax expense ......................... 461 445 986 858
Income tax expense ....................................... 130 172 336 331
------- ------- ------- -------
Net income ............................................... $ 331 $ 273 $ 650 $ 527
======= ======= ======= =======
The accompanying notes are an integral part of the consolidated financial
statements.
3
HSBC USA Inc.
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CONSOLIDATED BALANCE SHEET
June 30, December 31,
2004 2003
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in millions
Assets
Cash and due from banks ................................................ $ 3,095 $ 2,534
Interest bearing deposits with banks ................................... 1,667 843
Federal funds sold and securities purchased under resale agreements .... 3,728 2,446
Trading assets ......................................................... 15,779 14,646
Securities available for sale .......................................... 13,802 14,143
Securities held to maturity (fair value $4,213 and $4,648) ............. 4,142 4,512
Loans .................................................................. 62,066 48,474
Less - allowance for credit losses ..................................... 347 399
--------- ---------
Loans, net ....................................................... 61,719 48,075
Properties and equipment, net .......................................... 639 681
Intangible assets, net ................................................. 482 551
Goodwill ............................................................... 2,763 2,777
Other assets ........................................................... 4,975 4,354
--------- ---------
Total assets ........................................................... $ 112,791 $ 95,562
========= =========
Liabilities
Deposits in domestic offices:
Noninterest bearing .................................................. $ 7,084 $ 6,093
Interest bearing ..................................................... 45,719 38,995
Deposits in foreign offices:
Noninterest bearing .................................................. 532 453
Interest bearing ..................................................... 21,199 18,414
--------- ---------
Total deposits ................................................... 74,534 63,955
--------- ---------
Trading account liabilities ............................................ 10,954 10,460
Short-term borrowings .................................................. 9,499 6,782
Interest, taxes and other liabilities .................................. 3,854 3,089
Long-term debt ......................................................... 6,135 3,814
--------- ---------
Total liabilities ...................................................... 104,976 88,100
--------- ---------
Shareholders' equity
Preferred stock ........................................................ 500 500
Common shareholder's equity:
Common stock ($5 par; 150,000,000 shares authorized;
704 shares issued) ............................. --(1) --(1)
Capital surplus ...................................................... 6,026 6,027
Retained earnings .................................................... 1,445 807
Accumulated other comprehensive (loss) income ........................ (156) 128
--------- ---------
Total common shareholder's equity ................................ 7,315 6,962
--------- ---------
Total shareholders' equity ............................................. 7,815 7,462
--------- ---------
Total liabilities and shareholders' equity ............................. $ 112,791 $ 95,562
========= =========
The accompanying notes are an integral part of the consolidated financial
statements.
(1) Less than $500 thousand
4
HSBC USA Inc.
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CONSOLIDATED STATEMENT OF CHANGES
IN SHAREHOLDERS' EQUITY
Six months ended June 30,
2004 2003
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in millions
Preferred stock
Balance, January 1 and June 30, .......................................................... $ 500 $ 500
------- -------
Common stock
Balance, January 1 and June 30, .......................................................... --(1) --(1)
------- -------
Capital surplus
Balance, January 1, ...................................................................... 6,027 6,056
Capital contribution from parent ......................................................... 8 9
Return of capital ........................................................................ (9) (44)
------- -------
Balance, June 30, ........................................................................ 6,026 6,021
------- -------
Retained earnings
Balance, January 1, ...................................................................... 807 578
Net income ............................................................................... 650 527
Cash dividends declared:
Preferred stock ...................................................................... (12) (12)
Common stock ......................................................................... -- (255)
------- -------
Balance, June 30, ........................................................................ 1,445 838
------- -------
Accumulated other comprehensive (loss) income
Balance, January 1, ...................................................................... 128 262
Net change in unrealized (losses) gains on securities .................................... (222) (38)
Net change in unrealized (losses) gains on derivatives classified as cash flow hedges .... (58) 60
Foreign currency translation adjustments ................................................. (4) 23
------- -------
Other comprehensive (loss) income, net of tax ............................................ (284) 45
------- -------
Balance, June 30, ........................................................................ (156) 307
------- -------
Total shareholders' equity, June 30, ..................................................... $ 7,815 $ 7,666
======= =======
Comprehensive income
Net income ............................................................................... $ 650 $ 527
Other comprehensive (loss) income ........................................................ (284) 45
------- -------
Comprehensive income ..................................................................... $ 366 $ 572
======= =======
The accompanying notes are an integral part of the consolidated financial
statements.
(1) Less than $500 thousand
5
HSBC USA Inc.
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CONSOLIDATED STATEMENT OF CASH FLOWS
Six months ended June 30,
2004 2003
- ---------------------------------------------------------------------------------------------------
in millions
Cash flows from operating activities
Net income ........................................................ $ 650 $ 527
Adjustments to reconcile net income to net cash
provided (used) by operating activities
Depreciation, amortization and deferred taxes ................ 52 323
Provision for credit losses .................................. (19) 87
Net change in other accrual accounts ......................... (41) 223
Net change in loans originated for sale ...................... (297) (246)
Net change in trading assets and liabilities ................. 204 (709)
Other, net ................................................... (262) (568)
-------- --------
Net cash provided (used) by operating activities ........ 287 (363)
-------- --------
Cash flows from investing activities
Net change in interest bearing deposits with banks ................ (1,174) (362)
Net change in short-term investments .............................. (1,510) (1,297)
Net change in securities available for sale:
Purchases of securities available for sale ................... (5,919) (6,878)
Proceeds from sales of securities available for sale ......... 2,916 2,826
Proceeds from maturities of securities available for sale .... 3,445 5,753
Net change in securities held to maturity:
Purchases of securities held to maturity ..................... (727) (1,087)
Proceeds from maturities of securities held to maturity ...... 1,099 1,455
Net change in loans:
Net change in credit card receivables ........................ (17) 7
Net change in other short-term loans ......................... (351) (62)
Net originations and maturities of long-term loans ........... (12,266) 278
Loans purchased .............................................. (870) --
Sales of loans/other ......................................... 92 238
Expenditures for properties and equipment ......................... (7) (19)
Net cash provided in acquisitions, net of cash acquired ........... 91 79
Other, net ........................................................ (485) (305)
-------- --------
Net cash (used) provided in investing activities ........ (15,683) 626
-------- --------
Cash flows from financing activities
Net change in deposits ............................................ 10,634 831
Net change in short-term borrowings ............................... 2,976 (710)
Net change in long-term debt:
Issuance of long-term debt ................................... 2,687 102
Repayment of long-term debt .................................. (329) (15)
Dividends paid .................................................... (11) (266)
-------- --------
Net cash provided (used) by financing activities ........ 15,957 (58)
-------- --------
Net change in cash and due from banks ................................. 561 205
Cash and due from banks at beginning of period ........................ 2,534 2,081
-------- --------
Cash and due from banks at end of period .............................. $ 3,095 $ 2,286
======== ========
Pending settlement receivables/payables related to securities and trading assets
and liabilities are treated as non cash items for cash flows reporting.
The accompanying notes are an integral part of the consolidated financial
statements.
6
Notes to Consolidated Financial Statements
1. Organization and Basis of Presentation
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HSBC USA Inc. is an indirect wholly owned subsidiary of HSBC Holdings plc
(HSBC). The accompanying unaudited consolidated financial statements of HSBC USA
Inc. and its subsidiaries (collectively, the Company), including its principal
subsidiary, HSBC Bank USA, National Association (the Bank), have been prepared
in accordance with accounting principles generally accepted in the United States
of America (U.S. GAAP) for interim financial information, with the instructions
to Form 10-Q and with Article 10 of Regulation S-X, as well as in accordance
with predominant practice within the banking industry. Accordingly, they do not
include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements. In the opinion of
management, all adjustments, which are normal and recurring, considered
necessary for a fair presentation of financial position, results of operations
and cash flows for the interim periods, have been made. The unaudited interim
financial information should be read in conjunction with the Company's Annual
Report on Form 10-K (the 2003 Form 10-K) for the year ended December 31, 2003.
Certain reclassifications have been made to prior period amounts to conform to
the current period presentations. The accounting and reporting policies of the
Company are consistent, in all material respects, with those used to prepare the
2003 Form 10-K, except for the impact of new accounting pronouncements
summarized in Note 12.
The preparation of financial statements in conformity with U.S. GAAP requires
the use of estimates and assumptions that affect reported amounts and
disclosures. Actual results could differ from those estimates. Interim results
should not be considered indicative of results in future periods.
Interim financial statement disclosures regarding segments and off-balance sheet
arrangements are included in the Management's Discussion and Analysis of
Financial Condition and Results of Operations (MD&A) section of this Form 10-Q.
In June 2004, the Company filed a Form 8-K with the SEC announcing approval by
the Office of the Comptroller of the Currency for the Company to consolidate its
banking operations under a single national charter, effective July 1, 2004. As a
result, on July 1, 2004, the Bank's legal name was changed from HSBC Bank USA to
HSBC Bank USA, National Association. The change to a national charter is not
expected to have a material effect on the existing operations of the Company.
7
2. Securities
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At June 30, 2004 and December 31, 2003, the Company held no securities of any
single issuer (excluding the U.S. Treasury and federal agencies) with a book
value that exceeded 10% of shareholders' equity.
The following tables provide a summary of the amortized cost and fair value of
the securities available for sale and securities held to maturity portfolios.
- --------------------------------------------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
June 30, 2004 Cost Gains Losses Value
- --------------------------------------------------------------------------------------------------
(in millions)
Securities available for sale:
U.S. Treasury ..................... $ 607 $ -- $ 13 $ 594
U.S. Government agency (1) ........ 10,760 79 378 10,461
Asset backed securities ........... 1,431 4 1 1,434
Other domestic debt securities .... 173 -- -- 173
Foreign debt securities ........... 1,000 4 9 995
Equity securities ................. 100 51 6 145
------- ------- ------- -------
$14,071 $ 138 $ 407 $13,802
======= ======= ======= =======
Securities held to maturity:
U.S. Treasury ..................... $ 65 $ -- $ -- $ 65
U.S. Government agency ............ 3,289 125 89 3,325
Obligations of U.S. states and
political subdivisions .......... 498 30 1 527
Other domestic debt securities .... 275 8 2 281
Foreign debt securities ........... 15 -- -- 15
------- ------- ------- -------
$ 4,142 $ 163 $ 92 $ 4,213
======= ======= ======= =======
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Gross Gross
Amortized Unrealized Unrealized Fair
December 31, 2003 Cost Gains Losses Value
- --------------------------------------------------------------------------------------------------
(in millions)
Securities available for sale:
U.S. Government agency (1) ........ $10,778 $ 155 $ 141 $10,792
Asset backed securities ........... 1,785 7 6 1,786
Other domestic debt securities .... 415 1 -- 416
Foreign debt securities ........... 904 12 -- 916
Equity securities ................. 187 50 4 233
------- ------- ------- -------
$14,069 $ 225 $ 151 $14,143
======= ======= ======= =======
Securities held to maturity:
U.S. Treasury ..................... $ 125 $ -- $ -- $ 125
U.S. Government agency ............ 3,513 123 40 3,596
Obligations of U.S. states and
political subdivisions .......... 572 47 -- 619
Other domestic debt securities .... 294 8 2 300
Foreign debt securities ........... 8 -- -- 8
------- ------- ------- -------
$ 4,512 $ 178 $ 42 $ 4,648
======= ======= ======= =======
(1) Includes mortgage backed securities issued or guaranteed by U.S.
Government agencies.
8
The following tables provide a summary of gross unrealized losses and related
fair values, classified as to the length of time the losses have existed.
- ------------------------------------------------------------------------------------------------------------------------------
Less Than One Year Greater Than One Year
----------------------------------------- -----------------------------------------
Number Gross Aggregate Number Gross Aggregate
of Unrealized Fair Value of Unrealized Fair Value
June 30, 2004 Securities Losses of Investment Securities Losses of Investment
- ------------------------------------------------------------------------------------------------------------------------------
(in millions)
Securities available for sale:
U.S. Treasury ................... 2 $ 13 $ 594 -- $ -- $ --
U.S. Government agency (1) ...... 333 190 4,970 182 188 2,155
All other securities ............ 102 13 626 40 3 226
------ ------ ------ ------ ------ ------
437 $ 216 $6,190 222 $ 191 $2,381
====== ====== ====== ====== ====== ======
Securities held to maturity:
U.S. Government agency .......... 46 $ 45 $1,001 17 $ 44 $ 300
All other securities ............ 39 2 37 8 1 11
------ ------ ------ ------ ------ ------
85 $ 47 $1,038 25 $ 45 $ 311
====== ====== ====== ====== ====== ======
- ------------------------------------------------------------------------------------------------------------------------------
Less Than One Year Greater Than One Year
----------------------------------------- -----------------------------------------
Number Gross Aggregate Number Gross Aggregate
of Unrealized Fair Value of Unrealized Fair Value
December 31, 2003 Securities Losses of Investment Securities Losses of Investment
- ------------------------------------------------------------------------------------------------------------------------------
(in millions)
Securities available for sale:
U.S. Government agency (1) ...... 325 $ 141 $4,753 39 $ -- $ 66
All other securities ............ 101 5 388 47 5 257
------ ------ ------ ------ ------ ------
426 $ 146 $5,141 86 $ 5 $ 323
====== ====== ====== ====== ====== ======
Securities held to maturity:
U.S. Government agency .......... 40 $ 40 $ 905 -- $ -- $ --
All other securities ............ 8 1 11 8 1 6
------ ------ ------ ------ ------ ------
48 $ 41 $ 916 8 $ 1 $ 6
====== ====== ====== ====== ====== ======
(1) Includes mortgage backed securities issued or guaranteed by U.S.
Government agencies.
Total gross unrealized losses for the available for sale and held to maturity
security portfolios have increased during the first six months of 2004. In
particular, market values of U.S. Government agency securities were negatively
impacted by rising interest rates associated with agency issued collateralized
mortgage obligations during the second quarter of 2004. The rise in interest
rates has also extended the average durations of the portfolios. The securities
are high credit grade (i.e. AAA or AA), and no permanent impairment is expected
to be realized.
9
3. Loans
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The following table shows the composition of the loan portfolio.
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June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
(in millions)
Domestic:
Commercial:
Construction and mortgage loans ............ $ 7,705 $ 7,075
Other business and financial ............... 8,961 8,658
Consumer:
Residential mortgages ...................... 38,934 26,294
Credit card receivables .................... 1,093 1,112
Other consumer loans ....................... 1,972 1,905
International .................................. 3,401 3,430
------- -------
$62,066 $48,474
======= =======
On March 31, 2004, the Company purchased approximately $900 million of domestic
residential mortgage loans at fair value from subsidiaries of Household
International, Inc. (Household), a related HSBC entity. The remaining net
increase in residential mortgages resulted from new originations during the
first six months of 2004.
4. Allowance for Credit Losses
- --------------------------------------------------------------------------------
The following table provides a summary of changes in the allowance for credit
losses.
- -------------------------------------------------------------------------------------------------------------
Three Months Six Months
Ended June 30 Ended June 30
---------------- -----------------
2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------
(in millions)
Beginning balance ............................................. $ 357 $ 496 $ 399 $ 493
Allowance related to acquisitions and (dispositions), net ..... -- (3) (9) (8)
Provision charged (credited) to income ........................ 6 31 (19) 88
Charge offs:
Commercial .................................................. 11 35 14 75
Consumer .................................................... 23 19 44 38
International ............................................... 1 2 7 4
----- ----- ----- -----
Total charge offs ............................................. 35 56 65 117
----- ----- ----- -----
Recoveries on loans charged off:
Commercial .................................................. 14 4 32 12
Consumer .................................................... 4 3 7 6
International ............................................... 1 1 2 2
----- ----- ----- -----
Total recoveries .............................................. 19 8 41 20
----- ----- ----- -----
Total net charge offs ......................................... 16 48 24 97
----- ----- ----- -----
Ending balance ................................................ $ 347 $ 476 $ 347 $ 476
===== ===== ===== =====
10
5. Intangible Assets, Net
- --------------------------------------------------------------------------------
The following table summarizes the composition of intangible assets.
- -----------------------------------------------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- -----------------------------------------------------------------------------------------------------------------------
(in millions)
Mortgage servicing rights, net of accumulated amortization and valuation allowance ...... $437 $503
Favorable lease arrangements, net of accumulated depreciation ........................... 45 48
---- ----
Intangible assets, net .................................................................. $482 $551
==== ====
Mortgage Servicing Rights (MSRs)
The Company recognizes the right to service mortgages as a separate and distinct
asset at the time the related loans are sold, or at the time the MSRs are
purchased. MSRs are amortized in proportion to net servicing income and carried
on the balance sheet at the lower of their initial carrying value, adjusted for
amortization, or fair value. The carrying value of MSRs is periodically
evaluated for impairment. Permanent impairment results in direct write-down of
the gross MSRs balance. Temporary impairment is recorded through use of a
valuation allowance account.
The following table summarizes activity for MSRs and the related valuation
allowance.
- -------------------------------------------------------------------------------------------------------------
Three Months Six Months
Ended June 30 Ended June 30
---------------- ----------------
2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------
(in millions)
MSRs, net of accumulated amortization:
Beginning balance ............................................ $ 459 $ 426 $ 526 $ 395
Additions related to loan sales .............................. 18 76 36 136
Net MSRs acquisitions (sales) ................................ 3 8 (53) 27
Permanent impairment charges ................................. (5) (4) (7) (14)
Amortization ................................................. (38) (47) (65) (85)
----- ----- ----- -----
Ending balance ............................................... 437 459 437 459
----- ----- ----- -----
Valuation allowance for MSRs:
Beginning balance ............................................ (81) (42) (23) (41)
Temporary impairment (provision) recovery .................... 75 (46) 13 (58)
Permanent impairment charges ................................. 6 3 7 14
Release of allowance related to MSRs sold .................... -- -- 3 --
----- ----- ----- -----
Ending balance ............................................... -- (85) -- (85)
----- ----- ----- -----
MSRs, net of accumulated amortization and valuation allowance .... $ 437 $ 374 $ 437 $ 374
===== ===== ===== =====
Normally scheduled amortization for the current MSRs portfolios is expected to
be approximately $115 million for the year ending December 31, 2004, declining
gradually to approximately $38 million for the year ending December 31, 2008.
Actual levels of amortization could increase or decrease depending upon changes
in interest rates, loan prepayment activity, saleable loan production levels and
associated levels of MSRs assets.
Favorable Lease Arrangements
Favorable lease arrangements resulted from various business acquisitions.
Scheduled amortization of favorable lease arrangements will approximate $5
million per year for 2004 through 2008.
11
6. Goodwill
- --------------------------------------------------------------------------------
During the second quarter of 2004, the Company completed its annual impairment
test of goodwill and determined that the fair value of each of the reporting
units exceeded its carrying value. As a result, no impairment loss was required
to be recognized.
7. Long-Term Debt
- --------------------------------------------------------------------------------
The following table presents a summary of long-term debt.
- --------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
(in millions)
Subordinated debt .............................. $4,113 $3,149
All other ...................................... 2,022 665
------ ------
Total long-term debt ........................... $6,135 $3,814
====== ======
In March 2004, the Bank issued $1 billion of Global Subordinated Notes, which
bear interest at 4.625% and mature in April 2014.
In June 2004, the Bank finalized a $10 billion Global Bank Note Program which
provides for the issuance of subordinated and senior global notes. In July 2004,
the Global Bank Note Program was expanded to $20 billion. The following debt
offerings were made under this program during 2004.
- In June 2004, the Bank issued $550 million of Floating Rate Senior
notes due 2009. The initial interest rate on these notes is 1.55%
per annum, payable on September 10, 2004. The rate then resets
quarterly based on the London Interbank Offered Rate rate plus .14%
per annum until the final interest payment date on June 10, 2009.
- In June 2004, the Bank issued $39 million of Fixed Rate Senior notes
due 2006. Interest is paid semi-annually at an initial rate of 2.75%
through the interest payment period ending on June 27, 2005 and at
4.10% per annum thereafter. The Bank may redeem these notes, in
whole but not in part, on June 27, 2005.
In June 2004, the Bank issued debt for the Euro equivalent of $500 million. The
non-subordinated loan, which matures in 2044, provides for quarterly payments of
principal and interest at a floating rate, initially 3.99%.
The Bank has a Global Medium-Term Note Program, which provides for the issuance
of up to $4 billion of equity linked notes having maturities of 7 days of more
from the date of issuance. During the six months ended June 30, 2004 the Bank
had net advances under this program of $274 million due 2004 to 2010. It is
expected that future issuances of this debt type will be made under the Global
Bank Note Program.
8. Income Taxes
The following table presents the effective tax rate for the three months and six
months ended June 30, 2004 and 2003.
- --------------------------------------------------------------------------------
Three Months Six Months
Ended June 30 Ended June 30
-------------- ---------------
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Effective tax rate ..................... 28.2% 38.7% 34.1% 38.6%
In June 2004, approximately $51 million of income tax liability related to the
anticipated completion of an outstanding audit was released, reducing the
effective tax rate by 10.9% for the second quarter and 5.2% for the first six
months of 2004. Excluding the impact of this adjustment, the moderate increases
in the effective tax rate for the three months and six months ended June 30,
2004 were due to increased taxable income, which was taxed at the full corporate
rate.
12
9. Related Party Transactions
- --------------------------------------------------------------------------------
In the normal course of business, the Company conducts transactions with HSBC
and its subsidiaries (HSBC Group). These transactions occur at prevailing market
rates and terms. All extensions of credit by the Company to other HSBC
affiliates are legally required to be secured by eligible collateral. The
following table presents related party balances and the income and expense
generated by related party transactions.
- --------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
(in millions)
Assets:
Interest bearing deposits with banks ............... $ 165 $ 139
Loans .............................................. 660 330
Trading assets ..................................... 2,231 1,811
Other .............................................. 85 34
------- -------
Total assets ..................................... $ 3,141 $ 2,314
======= =======
Liabilities:
Deposits ........................................... $ 7,010 $ 7,512
Trading account liabilities ........................ 3,574 3,434
Short-term borrowings .............................. 434 735
Other .............................................. 191 79
------- -------
Total liabilities ................................ $11,209 $11,760
======= =======
- -----------------------------------------------------------------------------------------------------------
Three Months Six Months
Ended June 30 Ended June 30
---------------- ----------------
2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------
(in millions)
Interest income ................................................. $ 1 $ 7 $ 4 $ 10
Interest expense ................................................ 18 26 39 48
Trading (losses) revenues ....................................... (137) 64 (70) 134
HSBC Group charges:
Fees paid to HTSU for technology services ..................... 44 -- 82 --
Fees paid to Household for loan origination, loan servicing
and other administrative support ............................. 7 -- 11 --
Other fees, primarily treasury and traded markets services .... 55 33 99 61
During 2004, HSBC has instituted certain changes to its organization structure
in an effort to integrate its North American operations. The following
organizational changes have resulted in changes in the classification of
revenues and/or expenses in 2004, as compared with 2003.
- - Efforts to centralize technology services resulted in creation of a new
HSBC subsidiary, HSBC Technology and Services (USA) Inc. (HTSU), effective
January 1, 2004. The Company's technology services employees, as well as
technology services employees from other HSBC entities in the United
States, were transferred to HTSU. All technology related assets and
software purchased subsequent to January 1, 2004 are generally purchased
and owned by HTSU. Technology related assets owned by the Company prior to
January 1, 2004 remain in place and were not transferred to HTSU. Pursuant
to a master service level agreement, HTSU charges the Company for its
share of technology services and software development costs. As a result,
HSBC charges for 2004 include amounts previously recorded as "salaries and
benefits" and "occupancy expense, net" and "other expenses" on the
consolidated statement of income for 2003.
- - As part of efforts to centralize certain securities underwriting and
broker-dealer functions in North America, several employees of the Company
were transferred to a related HSBC entity, HSBC Securities (USA) Inc.
(HSUI), effective January 1, 2004. Pursuant to various service level
agreements, HSUI provides underwriting, broker-dealer, and administrative
support to the Company. As a result, HSBC charges for 2004 include amounts
previously recorded as "salaries and benefits" on the consolidated
statement of income for 2003.
13
- - On June 1, 2004, The Company transferred its wholly owned subsidiary, HSBC
Brokerage (USA) Inc. (HBUI) to a related HSBC entity. As a result, HSBC
charges in 2004 include amounts previously recorded as "salaries and
benefits" on the consolidated statement of income for 2003.
HSBC charges also include charges by Household under various service level
agreements for certain loan origination and servicing as well as other
operational and administrative support. Amounts reported in the preceeding table
do not include fees associated with loan originations that have been deferred
and are being amortized over the life of the related loans.
At June 30, 2004 and December 31, 2003, the aggregate notional amounts of all
derivative contracts with other HSBC affiliates were approximately $208 billion
and $168 billion respectively. The net credit risk exposure related to these
contracts was approximately $2 billion at June 30, 2004 and December 31, 2003.
Employees of the Company participate in one or more stock compensation plans
sponsored by HSBC. The Company's share of the expense of the plans for the first
six months of 2004 and 2003 was $36 million and $28 million respectively. A
description of these plans is included on pages 91 and 92 of the Company's 2003
Form 10-K.
On March 31, 2004, the Company purchased approximately $900 million of domestic
residential mortgage loan assets at fair value from Household. In addition,
approximately $1.5 billion of loans were purchased from originating lenders
during the first six months of 2004 pursuant to a Household correspondent loan
program.
On July 1, 2004, certain consumer credit card customer relationships were sold
to Household at a premium of approximately $99 million. Receivable balances of
approximately $970 million associated with these relationships were not sold as
part of the transaction. Servicing for these relationships will also be
transferred to Household at a future date, subject to successful transition of
certain accounting systems and processes. Also effective July 1, 2004, new
receivable balances generated by these relationships will be purchased from
Household on a daily basis.
The Company is in the process of transferring its Panamanian operations to
another HSBC Group entity at an amount that approximates fair value. These
operations accounted for approximately $1.5 billion of consolidated total assets
and approximately $1.3 billion of consolidated foreign deposits at June 30,
2004. For the six months ended June 30, 2004, these operations contributed
approximately $17 million of the Company's income before taxes.
It was previously reported that subject to receipt of regulatory and other
approvals the Company expected to purchase approximately $18 billion of credit
card receivables and approximately $9 billion of residual interests in
securitized credit card receivables pools from Household during 2004. It was
also reported that subsequent to the initial transfer, additional credit card
receivables would be purchased from Household on a daily basis and that various
methods of funding these transfers were being explored. Given recent growth and
funding needs, the Company now expects to apply for regulatory approval to
purchase only Household's private label credit card portfolio in 2004. Potential
assignment will be considered for some of Household's MasterCard and Visa
receivables in the future based upon continuing evaluations of capital and
liquidity at each entity.
Subject to regulatory and other approvals, the private label receivables
expected to be purchased from Household by year-end will have a principal
balance of approximately $11 billion. Residual interests in securitized private
label credit card receivables pools of approximately $4 billion will also be
acquired. These increases in credit card receivables will have significant
impact on net interest income and the provision and allowance for credit losses
in future periods. However, the impact on future period results cannot currently
be estimated due to the uncertainty as to the timing of the purchases.
Additional information on the financial impact of the proposed transfer will be
reported as the regulatory and other approval processes progress and the amounts
become quantifiable.
14
10. Pledged Assets
- --------------------------------------------------------------------------------
The following table presents pledged assets included in the consolidated balance
sheet.
- --------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
(in millions)
Interest bearing deposits with banks ............... $ 382 $ 140
Interest bearing deposits with nonbanks ............ 798 500
Trading assets ..................................... 432 647
Securities available for sale ...................... 5,679 4,171
Securities held to maturity ........................ 728 956
Loans .............................................. 1,553 360
------ ------
Total .............................................. $9,572 $6,774
====== ======
11. Pensions and Other Postretirement Benefits
- --------------------------------------------------------------------------------
The Company, the Bank and certain other subsidiaries maintain noncontributory
defined benefit pension plans covering substantially all of their employees
hired prior to January 1, 1997 and those employees who joined the Company
through acquisitions and were participating in a defined benefit plan at the
time of acquisition. Certain other HSBC subsidiaries participate in these plans.
The Company also maintains unfunded noncontributory health and life insurance
coverage for all employees who retired from the Company and were eligible for
immediate pension benefits from the Company's retirement plan. Employees
retiring after 1992 will absorb a portion of the cost of these benefits.
Employees hired after that same date are not eligible for these benefits. A
premium cap has been established for the Company's share of retiree medical
cost.
The following tables present the components of net periodic benefit cost.
- ----------------------------------------------------------------------------------------------------
Pension Benefits Other Postretirement Benefits
----------------- -----------------------------
2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------
(in millions)
Three months ended June 30
Net periodic benefit cost
Service cost ....................... $ 9 $ 8 $ 1 $ 1
Interest cost ...................... 20 16 1 1
Expected return on plan assets ..... (28) (22) -- --
Prior service cost amortization .... --(1) --(1) -- --
Actuarial loss ..................... 6 8 -- --
Transition amount amortization ..... -- -- 1 1
---- ---- ---- ----
Net periodic benefit cost .......... $ 7 $ 10 $ 3 $ 3
==== ==== ==== ====
Six months ended June 30
Net periodic benefit cost
Service cost ....................... $ 16 $ 15 $ 1 $ 1
Interest cost ...................... 34 32 4 3
Expected return on plan assets ..... (48) (44) -- --
Prior service cost amortization .... 1 1 -- --
Actuarial loss ..................... 13 16 -- --
Transition amount amortization ..... -- -- 2 1
---- ---- ---- ----
Net periodic benefit cost .......... $ 16 $ 20 $ 7 $ 5
==== ==== ==== ====
(1) Less than $500 thousand.
The Company expects to make no contribution for pension benefits and contribute
approximately $9 million for other postretirement benefits during fiscal year
2004.
15
12. New Accounting Pronouncements
- --------------------------------------------------------------------------------
In December 2003, the American Institute of Certified Public Accountants (AICPA)
released Statement of Position 03-3, Accounting for Certain Loans or Debt
Securities Acquired in a Transfer (SOP 03-3). SOP 03-3 addresses accounting for
differences between contractual cash flows and cash flows expected to be
collected from an investor's initial investment in loans or debt securities
acquired in a transfer if those differences are attributable to credit quality.
SOP 03-3 is effective for loans acquired in fiscal years beginning after
December 15, 2004. Adoption is not expected to have a material impact on the
Company's financial position or results of operations.
In December 2003, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 132 (revised), Employers'
Disclosures about Pensions and Other Postretirement Benefits (SFAS 132
(revised)). SFAS 132 (revised) revises employers' disclosures about pension
plans and other postretirement benefit plans. It does not change the measurement
or recognition of those plans. SFAS 132 (revised) revises certain disclosure
requirements contained in the original SFAS 132. It also requires additional
disclosures about the assets, obligations, cash flows, and net periodic benefit
cost of defined benefit pension plans and other postretirement benefit plans.
The annual disclosure requirements for SFAS 132 (revised) were adopted in the
2003 Form 10-K and the interim period disclosure requirements were adopted in
the Form 10-Q beginning with the quarter ended March 31, 2004.
In January 2004, the FASB issued FASB Staff Position 106-1, Accounting and
Disclosure Requirements Related to the Medicare Prescription Drug, Improvement
and Modernization Act of 2003 (FSP 106-1). FSP 106-1 was issued in response to a
new Medicare bill that provides prescription drug coverage to Medicare-eligible
retirees and was signed into law in December 2003. FSP 106-1 allowed plan
sponsors the option of accounting for the effects of this new law in financial
statements for periods that cover the date of enactment or making a one-time
election to defer the accounting for the effects of the new law. The Company
elected to defer the accounting for the effects of the new law. In May 2004, the
FASB issued FASB Staff Position FAS 106-2, Accounting and Disclosure
Requirements Related to the Medicare Prescription Drug, Improvement and
Modernization Act of 2003 (FSP 106-2), which superceded FSP 106-1. FSP 106-2 is
effective for the first interim period beginning after June 15, 2004. For
companies that elected deferral under FSP 106-1, and for which enactment is
deemed to be a "significant event", FSP 106-2 provides two methods of transition
- - retroactive application or prospective application from the date of adoption.
If the effects of the new law are deemed not to be a "significant event", the
effect can be incorporated into the next measurement date following the
effective date. Adoption of FSP 106-2 is not expected to have a material impact
on the accumulated postretirement benefit obligation and the net periodic
benefit cost.
In March 2004, the FASB reached a consensus on EITF 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF
03-1). EITF 03-1 provides guidance for determining when an investment is
impaired and whether the impairment is other than temporary. EITF 03-1 also
incorporates into its consensus the required disclosures about unrealized losses
on investments announced by the EITF in late 2003 and adds new disclosure
requirements relating to cost-method investments. The impairment accounting
guidance is effective for reporting periods beginning after June 15, 2004 and
the new disclosure requirements for annual reporting periods ending after June
15, 2004. The adoption of the impairment guidance contained in EITF 03-1 is not
expected to have a material impact on the financial position or results of
operations of the Company.
In December 2003, the FASB issued Interpretation No. 46 Revised, Consolidation
of Variable Interest Entities (FIN 46R). The Company has adopted all of the
provisions of FIN 46R. All required disclosures are included in the MD&A section
of this Form 10-Q or in the Company's 2003 10-K under "Special Purpose and
Variable Interest Entities".
In March 2004, the SEC released Staff Accounting Bulletin No. 105, Application
of Accounting Principles to Loan Commitments (SAB 105) which provides guidance
regarding commitments related to loans to be held for sale, and accounted for as
derivative instruments. The guidance indicates that, for commitments issued
after March 31, 2004, expected future cash flows from servicing may not be
considered in valuing the derivatives and may only be recorded upon sale of the
related loans. The Company previously recorded those cash flows as assets and
income upon the issuance of the commitment. Implementation of the guidance for
commitments issued subsequent to March 31, 2004 is not expected to have material
impact on total mortgage banking revenue.
16
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
HSBC USA Inc.
- --------------------------------------------------------------------------------
CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES (Taxable Equivalent Basis)
Three Months Ended June 30,
-------------------------------------------------------------------------
2004 2003
--------------------------------- ----------------------------------
Balance Interest Rate* Balance Interest Rate*
- ------------------------------------------------------------------------------------------------------------------------------
in millions
Assets
Interest bearing deposits with banks ........... $ 2,467 $ 7 1.22% $ 1,870 $ 7 1.50%
Federal funds sold and securities
purchased under resale agreements .......... 3,682 11 1.17 4,626 15 1.33
Trading assets ................................. 14,550 38 1.04 11,723 34 1.17
Securities ..................................... 17,584 220 5.02 18,618 217 4.67
Loans
Domestic
Commercial ................................. 15,493 159 4.12 16,733 201 4.80
Consumer
Residential mortgages ................. 34,425 413 4.80 20,662 293 5.67
Other consumer ........................ 3,367 69 8.30 2,980 61 8.29
--------- --------- ---- --------- --------- ----
Total domestic ........................... 53,285 641 4.84 40,375 555 5.51
International ................................ 3,608 27 3.06 3,167 31 3.86
--------- --------- ---- --------- --------- ----
Total loans .............................. 56,893 668 4.73 43,542 586 5.39
--------- --------- ---- --------- --------- ----
Other .......................................... 544 4 3.26 485 7 5.59
--------- --------- ---- --------- --------- ----
Total earning assets ........................... 95,720 $ 948 3.99% 80,864 $ 866 4.29%
--------- --------- ---- --------- --------- ----
Allowance for credit losses .................... (350) (502)
Cash and due from banks ........................ 3,204 2,402
Other assets ................................... 7,551 7,043
--------- ---------
Total assets ................................... $ 106,125 $ 89,807
========= =========
Liabilities and Shareholders' Equity
Deposits in domestic offices
Savings deposits ........................... $ 27,762 $ 45 0.66% $ 24,462 $ 51 0.83%
Other time deposits ........................ 14,846 64 1.72 10,291 56 2.20
Deposits in foreign offices .................... 21,867 49 0.90 19,135 66 1.38
--------- --------- ---- --------- --------- ----
Total interest bearing deposits ................ 64,475 158 0.98 53,888 173 1.29
--------- --------- ---- --------- --------- ----
Short-term borrowings .......................... 9,782 35 1.44 8,850 21 0.93
Long-term debt ................................. 5,142 62 4.88 3,741 57 6.14
--------- --------- ---- --------- --------- ----
Total interest bearing liabilities ............. 79,399 255 1.29% 66,479 251 1.51%
--------- --------- ---- --------- --------- ----
Net interest income / Interest rate spread ..... $ 693 2.70% $ 615 2.78%
--------- ---- --------- ----
Noninterest bearing deposits ................... 7,636 6,197
Other liabilities .............................. 11,298 9,608
Total shareholders' equity ..................... 7,792 7,523
--------- ---------
Total liabilities and shareholders' equity ..... $ 106,125 $ 89,807
========= =========
* Rates are calculated on unrounded numbers
17
HSBC USA Inc.
- --------------------------------------------------------------------------------
CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES (Taxable Equivalent Basis)
Six Months Ended June 30,
-------------------------------------------------------------------------
2004 2003
--------------------------------- ----------------------------------
Balance Interest Rate* Balance Interest Rate*
- ------------------------------------------------------------------------------------------------------------------------------
in millions
Assets
Interest bearing deposits with banks ........... $ 2,022 $ 14 1.36% $ 1,545 $ 13 1.66%
Federal funds sold and securities
purchased under resale agreements .......... 3,842 22 1.16 4,496 30 1.36
Trading assets ................................. 15,129 71 0.94 12,727 74 1.17
Securities ..................................... 17,873 439 4.94 18,909 463 4.94
Loans
Domestic
Commercial ................................. 15,277 323 4.26 16,449 409 5.02
Consumer
Residential mortgages ................. 30,991 764 4.93 20,783 599 5.76
Other consumer ........................ 3,313 138 8.36 2,978 125 8.51
--------- --------- ---- --------- --------- ----
Total domestic ........................... 49,581 1,225 4.97 40,210 1,133 5.68
International ................................ 3,742 57 3.06 3,162 63 4.00
--------- --------- ---- --------- --------- ----
Total loans .............................. 53,323 1,282 4.84 43,372 1,196 5.56
--------- --------- ---- --------- --------- ----
Other .......................................... 517 8 3.28 480 14 5.72
--------- --------- ---- --------- --------- ----
Total earning assets ........................... 92,706 $ 1,836 4.01% 81,529 $ 1,790 4.45%
--------- --------- ---- --------- --------- ----
Allowance for credit losses .................... (371) (502)
Cash and due from banks ........................ 3,150 2,352
Other assets ................................... 7,396 6,998
--------- ---------
Total assets ................................... $ 102,881 $ 90,377
========= =========
Liabilities and Shareholders' Equity
Deposits in domestic offices
Savings deposits ........................... $ 27,199 $ 90 0.67% $ 23,810 $ 100 0.85%
Other time deposits ........................ 13,271 116 1.76 11,004 121 2.22
Deposits in foreign offices .................... 21,656 111 1.03 19,124 140 1.47
--------- --------- ---- --------- --------- ----
Total interest bearing deposits ................ 62,126 317 1.03 53,938 361 1.35
--------- --------- ---- --------- --------- ----
Short-term borrowings .......................... 9,161 53 1.16 9,745 58 1.21
Long-term debt ................................. 4,547 113 5.01 3,708 106 5.75
--------- --------- ---- --------- --------- ----
Total interest bearing liabilities ............. 75,834 483 1.28% 67,391 525 1.57%
--------- --------- ---- --------- --------- ----
Net interest income / Interest rate spread ..... $ 1,353 2.73% $ 1,265 2.88%
--------- ---- --------- ----
Noninterest bearing deposits ................... 7,413 6,074
Other liabilities .............................. 11,924 9,486
Total shareholders' equity ..................... 7,710 7,426
--------- ---------
Total liabilities and shareholders' equity ..... $ 102,881 $ 90,377
========= =========
* Rates are calculated on unrounded numbers
18
Forward-Looking Statements
- --------------------------------------------------------------------------------
This report includes forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. The Company's results may
differ materially from those noted in the forward-looking statements. Words such
as "believe", "expects", "estimates", "targeted", "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 are
made. Statements that are not historical facts, including statements about
management's beliefs and expectations, are forward-looking statements and
involve inherent risks and uncertainties and are based on current views and
assumptions. A number of important factors could cause actual results to differ
materially from those contained in any forward-looking statements. Such factors
include, but are not limited to: sharp and/or rapid changes in interest rates;
significant changes in the economic conditions which could materially change
anticipated credit quality trends and the ability to generate loans; technology
changes and challenges; significant changes in accounting, tax or regulatory
requirements; consumer behavior; marketplace perceptions of the Company's
reputation and competition in the geographic and business areas in which the
Company conducts its operations. For a list of important factors that may affect
the Company's actual results, see Forward-Looking Statements in Part I, Item 7
of the Company's 2003 Form 10-K.
Executive Overview
- --------------------------------------------------------------------------------
Net income increased $58 million in the second quarter of 2004, as compared with
the second quarter of 2003. Significantly improved net interest income, a
decreased provision for credit losses, and a reduction in income tax expense
were partially offset by decreased other revenues and increased operating
expenses.
For the six months ended June 30, 2004, net income increased $123 million from
the same 2003 period. Increased net interest income and a decreased provision
for credit losses were partially offset by decreased other revenues, increased
operating expenses, and increased income tax expense.
Balance sheet growth during the second quarter and first six months of 2004 was
highlighted by significant growth in residential mortgage loans. Asset growth
was primarily funded by low cost interest bearing deposits, short-term
borrowings, and long-term debt.
Net interest income increased $80 million in the second quarter of 2004, and
increased $90 million in the first half of 2004, as compared with the same 2003
periods. Increased residential mortgage loans and other loan balances were
primarily funded by lower cost funding sources. Net interest spreads were
negatively impacted, however, by a continued trend toward lower interest rates.
The provision for credit losses decreased $25 million during the second quarter
of 2004 and $106 million during the first half of 2004, as compared with the
same 2003 periods, reflecting the continuing trend of improved credit quality
within the commercial lending portfolios.
Other revenues decreased $61 million in the second quarter of 2004 and decreased
$37 million in the first half of 2004, as compared with the same 2003 periods.
Modest increases in fee-based income were more than offset by decreases in
mortgage banking revenue, trading related revenues, securities gains and other
income amounts.
Income tax expense decreased $42 million in the second quarter of 2004, and
increased $5 million during the first six months of 2004, as compared with the
same 2003 periods. In June 2004, approximately $51 million of income tax
liability related to the anticipated completion of an outstanding audit was
released. Excluding the impact of this adjustment, income tax expense for the
second quarter and the first six months of 2004 increased as a direct result of
increased taxable income, which is taxed at the full corporate rate.
19
The following table presents a five quarter summary of selected financial
information.
- -----------------------------------------------------------------------------------------------------------------------------------
June 30 March 31 December 31 September 30 June 30
Three months ended 2004 2004 2003 2003 2003
- -----------------------------------------------------------------------------------------------------------------------------------
(in millions)
Income statement data:
Net interest income ........................... $ 689 $ 655 $ 627 $ 629 $ 609
Provision for credit losses ................... 6 (25) 27 (1) 31
Other revenues ................................ 298 334 280 205 359
Operating expenses ............................ 520 489 539 523 492
Income tax expense ............................ 130 207 125 114 172
Net income .................................... 331 318 216 198 273
Balance sheet data (period end balances):
Loans, net .................................... $ 61,719 $ 52,075 $ 48,075 $ 44,473 $ 42,771
Total assets .................................. 112,791 102,502 95,562 92,718 92,990
Total deposits ................................ 74,534 67,994 63,955 62,098 60,381
Long-term debt ................................ 6,135 4,871 3,814 3,740 3,773
Total common shareholder's equity ............. 7,315 7,339 6,962 7,236 7,166
Total shareholders' equity .................... 7,815 7,839 7,462 7,736 7,666
Total tangible common shareholder's equity .... 4,673 4,341 4,022 4,196 4,000
Financial performance:
Net yield on average earning assets ........... 2.91% 2.96% 2.95% 3.09% 3.05%
Net yield on average total assets ............. 2.63 2.66 2.65 2.74 2.75
Basis of Reporting
- --------------------------------------------------------------------------------
HSBC reports results in accordance with accounting principles generally accepted
in the United Kingdom (U.K. GAAP). Therefore, management separately monitors net
income and earnings excluding goodwill amortization under U.K. GAAP (non-GAAP
financial measures). The following table reconciles net income of the Company on
a U.S. GAAP basis to net income on a U.K. GAAP basis.
- ----------------------------------------------------------------------------------------------------------
Three Months Six Months
Ended June 30 Ended June 30
---------------- ----------------
2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------
(in millions)
Net income - U.S. GAAP basis .................................. $ 331 $ 273 $ 650 $ 527
Deferred loan origination fees and costs ...................... (13) -- (17) --
Derivative financial instruments .............................. (14) -- (6) --
Deferred taxation ............................................. (4) 3 14 18
Depreciation .................................................. 4 4 8 8
Software amortization ......................................... -- (1) 5 (1)
Other ......................................................... -- (1) -- (1)
----- ----- ----- -----
Earnings excluding goodwill amortization - U.K. GAAP basis .... 304 278 654 551
Goodwill amortization ......................................... (35) (40) (71) (81)
----- ----- ----- -----
Net income - U.K. GAAP basis .................................. $ 269 $ 238 $ 583 $ 470
===== ===== ===== =====
20
Differences between U.S. and U.K. GAAP are as follows:
Deferred loan origination fees and costs
U.K. GAAP
- - Fee and commission income is accounted for in the period when receivable,
except when it is charged to cover the costs of a continuing service to,
or risk borne for, the customer, or is interest in nature. In these cases,
it is recognized on an appropriate basis over the relevant period.
- - Loan origination costs are generally expensed as incurred. As permitted by
U.K. GAAP, HSBC applies a restricted definition of the incremental,
directly attributable origination expenses that are deferred and
subsequently amortized over the life of the loans.
U.S. GAAP
- - In accordance with Statement of Financial Accounting Standards No. 91,
Accounting for Nonrefundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases (SFAS 91), certain loan
fee income and direct loan origination costs are amortized to the profit
and loss account over the life of the loan as an adjustment to interest
income.
Derivative financial instruments
U.K. GAAP
- - Non-trading derivatives are those which are held for hedging purposes as
part of our risk management strategy against cash flows, assets,
liabilities, or positions measured on an accruals basis. Non-trading
transactions include qualifying hedges and positions that synthetically
alter the characteristics of specified financial instruments.
- - Non-trading derivatives are accounted for on an equivalent basis to the
underlying assets, liabilities or net positions. Any profit or loss
arising is recognized on the same basis as that arising from the related
assets, liabilities or positions.
- - To qualify as a hedge, a derivative must effectively reduce the price,
foreign exchange or interest rate risk of the asset, liability or
anticipated transaction to which it is linked and be designated as a hedge
at inception of the derivative contract. Accordingly, changes in the
market value of the derivative must be highly correlated with changes in
the market value of the underlying hedged item at inception of the hedge
and over the life of the hedge contract. If these criteria are met, the
derivative is accounted for on the same basis as the underlying hedged
item. Derivatives used for hedging purposes include swaps, forwards and
futures.
- - Interest rate swaps are also used to alter synthetically the interest rate
characteristics of financial instruments. In order to qualify for
synthetic alteration, a derivative instrument must be linked to specific
individual, or pools of similar, assets or liabilities by the notional
principal and interest rate risk of the associated instruments, and must
achieve a result that is consistent with defined risk management
objectives. If these criteria are met, accrual based accounting is
applied, i.e. income or expense is recognized and accrued to the next
settlement date in accordance with the contractual terms of the agreement.
- - Any gain or loss arising on the termination of a qualifying derivative is
deferred and amortized to earnings over the original life of the
terminated contract. Where the underlying asset, liability or position is
sold or terminated, the qualifying derivative is immediately
marked-to-market through the profit and loss account.
- - Derivatives that do not qualify as hedges or synthetic alterations at
inception are marked-to-market through the profit and loss account, with
gains and losses included within "other income".
21
U.S. GAAP
- - All derivatives must be recognized as either assets or liabilities in the
balance sheet and be measured at fair value, in accordance with Statement
of Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS 133).
- - The accounting for changes in the fair value of a derivative (that is,
gains and losses) depends on the intended use of the derivative and the
resulting designation as described below:
o For a derivative designated as hedging exposure to changes in the
fair value of a recognized asset or liability or a firm commitment,
the gain or loss is recognized in earnings in the period of change
together with the associated loss or gain on the hedged item
attributable to the risk being hedged. Any resulting net gain or
loss represents the ineffective portion of the hedge.
o For a derivative designated as hedging exposure to variable cash
flows of a recognized asset or liability, or of a forecast
transaction, the derivative's gain or loss associated with the
effective portion of the hedge is initially reported as a component
of other comprehensive income and subsequently reclassified into
earnings when the forecast transaction affects earnings. The
ineffective portion is reported in earnings immediately.
o For net investment hedges in which derivatives hedge the foreign
currency exposure of a net investment in a foreign operation, the
change in fair value of the derivative associated with the effective
portion of the hedge is included as a component of other
comprehensive income, together with the associated loss or gain on
the hedged item. The ineffective portion is reported in earnings
immediately.
o In order to apply hedge accounting it is necessary to comply with
documentation requirements and to demonstrate the effectiveness of
the hedge on an ongoing basis.
o For a derivative not designated as a hedging instrument, the gain or
loss is recognized in earnings in the period of change in fair
value.
Deferred taxation
U.K. GAAP
- - Deferred tax is generally recognized for all timing differences subject to
exceptions in FRS 19, Deferred Tax, and the assessment of the
recoverability of deferred tax assets.
- - Fair value adjustments on acquisition are treated as if they were timing
differences arising in the acquired entity's own accounts. Deferred tax is
recognized on fair value adjustments where they give rise to deferral or
acceleration of taxable cash flows.
U.S. GAAP
- - In accordance with Statement of Financial Accounting Standards No. 109,
Accounting For Income Taxes (SFAS 109), deferred tax liabilities and
assets are recognized for all temporary differences. A valuation allowance
is raised against any deferred tax asset where it is more likely than not
that the asset, or a part thereof, will not be realized (SFAS 109
`Accounting for Income Taxes').
- - The deferred taxation impact of all temporary differences arising from
fair value adjustments on acquisition is recognized as part of the
purchase accounting adjustment.
Depreciation
U.K. GAAP
- - HSBC revalues its properties on an annual basis. HSBC depreciates
non-investment properties based on their cost or revalued amounts. No
depreciation is charged on investment properties, other than leaseholds,
with useful lives of 20 years or less.
U.S. GAAP
- - U.S. GAAP does not permit revaluation of property, although it requires
recognition of asset impairment. Depreciation is recognized on all
properties, based on cost, over the useful lives of the assets.
22
Software amortization
U.K. GAAP
- - HSBC generally expenses costs of software developed for internal use. If
it can be shown that conditions for capitalization are met under FRS 10,
Goodwill and Intangible Assets, or FRS 15, Tangible Fixed Assets, the
software is capitalized and amortized over its useful life. Website design
and content development costs are capitalized only to the extent that they
lead to the creation of an enduring asset delivering benefits at least as
great as the amount capitalized.
U.S. GAAP
- - The American Institute of Certified Public Accountants' (AICPA) Statement
of Position 98-1, Accounting For the Costs of Computer Software Developed
or Obtained For Internal Use, requires that all costs incurred in the
preliminary project and post implementation stages of internal software
development be expensed. Costs incurred in the application development
stage must be capitalized and amortized over their estimated useful life.
Website design costs are capitalized and website content development costs
are expensed as they are incurred.
Goodwill amortization
U.K. GAAP
- - Goodwill arising on acquisitions of subsidiary undertakings, associates or
joint ventures prior to 1998 was charged against reserves in the year of
acquisition.
- - For acquisitions made on or after January 1, 1998, goodwill is included in
the balance sheet and amortized over its estimated useful life on a
straight-line basis. U.K. GAAP allows goodwill previously eliminated
against reserves to be reinstated, but does not require it.
- - Goodwill included in the balance sheet is tested for impairment when
necessary by comparing the recoverable amount of an entity with the
carrying value of its net assets, including attributable goodwill. The
recoverable amount of an entity is the higher of its value in use,
generally the present value of the expected future cash flows from the
entity, and its net realizable value.
- - At the date of disposal of subsidiaries, associates or joint ventures, any
unamortized goodwill or goodwill charged directly against reserves is
included in our share of the undertakings' total net assets in the
calculation of the gain or loss on disposal.
- - Where quoted securities are issued as part of the purchase consideration
in an acquisition, the fair value of those securities for the purpose of
determining the cost of acquisition is the market price at the date of
completion.
U.S. GAAP
- - Goodwill acquired up to June 30, 2001 was capitalized and amortized over
its useful life but not more than 25 years. The amortization of previously
acquired goodwill ceased from December 31, 2001.
- - Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets (SFAS 142) requires that goodwill should not be
amortized but should be tested for impairment annually at the reporting
unit level by applying a fair-value-based test.
- - The goodwill of a reporting unit should be tested for impairment between
annual tests in response to events or changes in circumstance which could
result in an impairment.
- - Where quoted securities are issued as part of the purchase consideration
in an acquisition, the fair value of those securities for the purpose of
determining the cost of acquisition is the average market price of the
securities for a reasonable period before and after the date that the
terms of the acquisition are agreed and announced.
Other
- - Includes various immaterial items.
23
Results of Operations
- --------------------------------------------------------------------------------
Net Interest Income
In the discussion that follows, interest income and rates are presented and
analyzed on a taxable equivalent basis to permit comparisons of yields on
tax-exempt and taxable assets. An analysis of consolidated average balances and
interest rates on a taxable equivalent basis is presented on pages 17-18 of this
Form 10-Q.
All increases and decreases referred to below for the second quarter and the
first six months of 2004 represent comparisons with the same 2003 periods.
Interest Income - Commercial Lending
Interest income earned from commercial loans decreased $42 million (21%) in the
second quarter of 2004, and decreased $86 million (21%) in the first six months
of 2004. Average commercial loan balances decreased approximately $1 billion
during both reporting periods, principally due to decisions made to exit or
restructure certain business lines, including equipment finance, commercial
finance and domestic receivables factoring businesses.
Operating and financial performance continue to stabilize and improve for large
corporate clients, leading to a generally improving credit profile within most
industry sectors. Demand for ongoing credit support for these customers during
the first half of 2004 was comparable to the same 2003 period. This stability is
expected to continue for the remainder of 2004.
The Company will continue efforts to improve its commercial loan mix as well as
grow certain commercial banking businesses. Additional resources are being
allocated to commercial middle market, real estate and small business lending,
particularly in the New York City, California and Florida markets. Overall
commercial loan growth will be limited, however, due to the 2003 sale of the
U.S. factoring business, and planned run-off of equipment financing and
commercial finance portfolios.
The supply of credit in the overall commercial lending market is increasing. The
increased credit supply is partially offset, however, by marginal credit supply
restrictions stemming from ongoing bank industry consolidation. The overall
increase in credit supply is placing downward competitive pressure on pricing
and fees. This trend may continue throughout the balance of the year, absent a
material change in economic conditions.
Interest Income - Residential Mortgage Loans
Interest income earned from residential mortgage loans increased $120 million
(41%) in the second quarter of 2004, and increased $165 million (28%) in the
first six months of 2004. Average residential mortgage loans increased $14
billion (67%) in the second quarter of 2004, and increased $10 billion (49%) in
the first six months of 2004.
On December 31, 2003, approximately $2.8 billion of domestic residential
mortgage loan assets were purchased from Household at fair value. On March 31,
2004, approximately $900 million of additional mortgages were purchased from
Household. During 2004, approximately $1.5 billion of residential mortgages have
been purchased from originating lenders pursuant to a Household correspondent
loan program. Originations of other residential mortgage loans during the first
half of 2004 continued to be strong, due to competitive pricing, expanded sales
force, development of a correspondent network, and increased marketing efforts.
The increased loan balances, and their positive effect on earnings, were
partially offset by continued decreases in the average yield on residential
mortgages during the second quarter and first half of 2004, as consumers
continued to take advantage of lower coupon adjustable rate products.
Competitive pricing in a contracting national mortgage originations market
contributed to a general trend toward declining mortgage rates in 2004, as
compared with 2003. The lower level of refinancings in 2004, and a reduction in
loans originated for sale, resulted in lower interest income on mortgages held
for sale.
24
Residential mortgage growth is expected to continue at a more moderate level
through the remainder of 2004 by expanding product offerings, including, jumbo
(mortgages greater than Government Sponsored Enterprise limits), other prime
(adjustable rate mortgages not sold to Government Sponsored Enterprises) and
limited documentation products. Loan originations from the relationship with
Household are also expected to provide some level of growth.
Interest Income - Other Consumer Lending
Interest earned from various other consumer lending programs increased $8
million (13%) in the second quarter of 2004, and $13 million (10%) in the first
six months of 2004. These increases resulted directly from increases in average
loan balances, especially in automobile and other installment lending programs.
Moderate expansion of these programs is expected to continue for the remainder
of 2004, driven mainly by increased consumer loan originations arising from the
relationship with Household.
On July 1, 2004, certain consumer credit card customer relationships were sold
to Household at a premium of approximately $99 million. Receivable balances of
approximately $970 million associated with these relationships were not sold as
part of the transaction. Servicing for these relationships will also be
transferred to Household at a future date, subject to successful transition of
certain accounting systems and processes. Also effective July 1, 2004, new
receivable balances generated by these relationships will be purchased at fair
value from Household on a daily basis.
It was previously reported that subject to receipt of regulatory and other
approvals the Company expected to purchase approximately $18 billion of credit
card receivables and approximately $9 billion of residual interests in
securitized credit card receivables pools from Household during 2004. It was
also reported that subsequent to the initial transfer, additional credit card
receivables would be purchased from Household on a daily basis and that various
methods of funding these transfers were being explored. Given recent growth and
funding needs, the Company now expects to apply for regulatory approval to
purchase only Household's private label credit card portfolio in 2004. Potential
assignment will be considered for some of Household's MasterCard and Visa
receivables in the future based upon continuing evaluations of capital and
liquidity at each entity.
Subject to regulatory and other approvals, the private label receivables
expected to be purchased from Household by year-end will have a principal
balance of approximately $11 billion. Residual interests in securitized private
label credit card receivables pools of approximately $4 billion will also be
acquired. These increases in credit card receivables will have significant
impact on net interest income and the provision and allowance for credit losses
in future periods. However, the impact on future period results cannot currently
be estimated due to the uncertainty as to the timing of the purchases.
Additional information on the financial impact of the proposed transfer will be
reported as the regulatory and other approval processes progress and the amounts
become quantifiable.
Interest Expense - Deposits in Domestic Offices
Interest expense on domestic interest bearing deposits for the second quarter of
2004 was relatively consistent with the prior year. For the first six months of
2004, interest expense decreased $15 million (7%). General increases in average
deposit balances were offset by decreases in average interest rates paid during
2004.
Total average domestic interest bearing deposits increased $8 billion (23%) in
the second quarter of 2004, and increased $6 billion (16%) in the first six
months of 2004. General increases were noted for commercial and personal
interest bearing deposit balances. Increased marketing efforts have also
resulted in increases in noninterest bearing demand deposit balances.
Interest rates paid on deposits have generally decreased in the second quarter
and the first half of 2004. The low interest rate environment, combined with
continued uncertainty of the equity markets, continues to cause many personal
and commercial customers to show preference for highly liquid but low yielding
demand and savings deposits as opposed to longer term time deposits and mutual
funds. This accounts for the significant increase in deposit balances, and also
effectively continues to reduce the overall rate paid on liabilities.
25
Balance sheet growth will continue to be partially funded by deposit growth for
the remainder of 2004, as marketing of deposit products will continue.
Interest Expense - Deposits in Foreign Offices
Interest expense on foreign deposits decreased $17 million (26%) in the second
quarter of 2004 and $29 million (21%) in the first half of 2004. Increases in
average balances were more than offset by significant decreases in rates paid on
these deposits.
Interest Expense - Long-Term Debt
Interest expense on long-term debt increased $5 million in the second quarter of
2004 and $7 million in the first six months of 2004, due mainly to new debt
issued in 2004. Long-term debt will be used as a primary funding source for
balance sheet growth for the remainder of 2004. For further details regarding
long-term debt, refer to Note 7 of the financial statements on page 12 of this
Form 10-Q.
Other Revenues
The following tables present the components of other revenues for the three
months and six months ended June 30, 2004 and 2003.
- --------------------------------------------------------------------------------------
Increase (Decrease)
Three months ended June 30 2004 2003 Amount %
- --------------------------------------------------------------------------------------
(in millions)
Trust income .......................... $ 24 $ 24 $ -- --
Service charges ....................... 53 52 1 1.9
Other fees and commissions:
Letter of credit fees ............... 18 17 1 5.9
Credit card fees .................... 23 20 3 15.0
Investment product fees ............. 16 21 (5) (23.8)
Wealth and tax advisory services .... 13 12 1 8.3
Other fee-based income .............. 52 46 6 13.0
------ ------ ------ ------
Total other fees and commissions .... 122 116 6 5.2
------ ------ ------ ------
Other income:
Insurance ........................... 21 17 4 23.5
Other ............................... 14 19 (5) (26.3)
Interest on tax settlement .......... -- 21 (21) (100.0)
------ ------ ------ ------
Total other income .................. 35 57 (22) (38.6)
------ ------ ------ ------
Mortgage banking revenue (expense) .... (17) (14) (3) (21.4)
Trading revenues ...................... 78 91 (13) (14.3)
Securities gains, net ................. 3 33 (30) (90.9)
------ ------ ------ ------
Total other revenues .................. $ 298 $ 359 $ (61) (17.0)
====== ====== ====== ======
26
- --------------------------------------------------------------------------------------
Increase (Decrease)
Six months ended June 30 2004 2003 Amount %
- --------------------------------------------------------------------------------------
(in millions)
Trust income .......................... $ 48 $ 46 $ 2 4.3
Service charges ....................... 104 103 1 1.0
Other fees and commissions:
Letter of credit fees ............... 35 34 1 2.9
Credit card fees .................... 41 39 2 5.1
Investment product fees ............. 36 40 (4) (10.0)
Wealth and tax advisory services .... 24 23 1 4.3
Other fee-based income .............. 95 88 7 8.0
------ ------ ------ ------
Total other fees and commissions .... 231 224 7 3.1
------ ------ ------ ------
Other income:
Insurance ........................... 31 33 (2) (6.1)
Other ............................... 51 38 13 34.2
Interest on tax settlement .......... -- 21 (21) (100.0)
------ ------ ------ ------
Total other income .................. 82 92 (10) (10.9)
------ ------ ------ ------
Mortgage banking revenue (expense) .... (41) (6) (35) (583.3)
Trading revenues ...................... 167 161 6 3.7
Securities gains, net ................. 41 49 (8) (16.3)
------ ------ ------ ------
Total other revenues .................. $ 632 $ 669 $ (37) (5.5)
====== ====== ====== ======
Trust Income and Service Charges
The modest growth noted for the first six months of 2004 is expected to continue
through the remainder of the year.
Other Fees and Commissions
Investment product fees decreased in the second quarter of 2004, due to the June
1, 2004 transfer at fair value of a brokerage subsidiary to a related HSBC
entity. As a result of the transfer, income recorded as investment product fees
prior to June 1 is now recorded as other fee-based income (see below). Refer to
Note 9 to the financial statements in Part I of this Form 10-Q for further
discussion.
Increases in other fee-based income in the quarter and six months ended June 30,
2004 are primarily due to increased fees from related HSBC entities.
Ongoing efforts to maximize the "cross-sell" potential of the existing customer
base and of the relationship with Household will continue to be a key business
development theme for the remainder of 2004. Slow to moderate growth in fees and
commissions income is expected to continue from these efforts.
Other Income
Other income for the second quarter and six months ended 2003 included $21
million of interest on an income tax refund. Excluding this non-recurring item
from 2003, other income for the second quarter 2004 remained relatively constant
in comparison with the prior year. Other income for the first six months of
2004, excluding the non-recurring item noted above, increased from last year due
to significantly higher than usual earnings on a foreign investment recorded
during the first quarter of 2004.
In July 2004, certain consumer credit card relationships were sold to Household
at a premium of approximately $99 million, which will be recorded as other
income in the consolidated statement of income for the third quarter of 2004.
27
Mortgage Banking Revenue
The following tables present the components of mortgage banking revenue for the
three months and six months ended June 30, 2004 and 2003. The tables include net
interest income earned on assets and liabilities of the mortgage banking
business as well as an allocation of the funding benefit or cost associated with
these balances. The net interest income component is included in net interest
income in the consolidated statement of income.
- ----------------------------------------------------------------------------------------------------------------
Increase (Decrease)
---------------------
Three months ended June 30 2004 2003 Amount %
- ----------------------------------------------------------------------------------------------------------------
(in millions)
Net interest income .......................................... $ 157 $ 110 $ 47 42.7
----- ----- ----- ------
Servicing related income (expense):
Servicing fee income ....................................... 18 17 1 5.9
MSRs amortization .......................................... (38) (48) 10 20.8
MSRs temporary impairment (provision) recovery ............. 75 (46) 121 263.0
Trading - Derivative instruments used to offset changes in
value of MSRs ............................................ (61) 20 (81) (405.0)
Gains on sales of available for sale securities ............ -- 5 (5) (100.0)
Other ...................................................... (1) -- (1) --
----- ----- ----- ------
Total net servicing related expense ..................... (7) (52) 45 86.5
----- ----- ----- ------
Originations and sales related income (expense):
(Losses) gains on sales of mortgages ....................... (8) 59 (67) (113.6)
Trading - Forward loan sale commitments .................... 6 (12) 18 150.0
- Interest rate lock commitments ................... (9) (11) 2 18.2
Fair value hedge activity (1) .............................. (2) (1) (1) (100.0)
----- ----- ----- ------
Total net originations and sales related income (expense) (13) 35 (48) (137.1)
----- ----- ----- ------
Other mortgage income ........................................ 3 3 -- --
----- ----- ----- ------
Total mortgage banking revenue (expense)
included in other revenues .................................. (17) (14) (3) (21.4)
----- ----- ----- ------
Total mortgage banking related revenue ....................... $ 140 $ 96 $ 44 45.8
===== ===== ===== ======
(1) Includes SFAS 133 qualifying fair value adjustments related to residential
mortgage banking warehouse fair value hedging activity.
28
- --------------------------------------------------------------------------------------------------------------
Increase (Decrease)
--------------------
Six months ended June 30 2004 2003 Amount %
- --------------------------------------------------------------------------------------------------------------
(in millions)
Net interest income .......................................... $ 306 $ 216 $ 90 41.7
----- ----- ----- ------
Servicing related income (expense):
Servicing fee income ....................................... 40 35 5 14.3
MSRs amortization .......................................... (64) (85) 21 24.7
MSRs temporary impairment (provision) recovery ............. 13 (58) 71 122.4
Trading - Derivative instruments used to offset changes in
value of MSRs ............................................ (25) 14 (39) (278.6)
Gains on sales of available for sale securities ............ 8 16 (8) (50.0)
Other ...................................................... (3) -- (3) --
----- ----- ----- ------
Total net servicing related expense ..................... (31) (78) 47 60.3
----- ----- ----- ------
Originations and sales related income (expense):
(Losses) gains on sales of mortgages ....................... (7) 111 (118) (106.3)
Trading - Forward loan sale commitments .................... 3 (21) 24 114.3
- Interest rate lock commitments ................... (10) (23) 13 56.5
Fair value hedge activity (1) .............................. (1) (1) -- --
----- ----- ----- ------
Total net originations and sales related income (expense) (15) 66 (81) (122.7)
----- ----- ----- ------
Other mortgage income ........................................ 5 6 (1) (16.7)
----- ----- ----- ------
Total mortgage banking revenue (expense)
included in other revenues .................................. (41) (6) (35) (583.3)
----- ----- ----- ------
Total mortgage banking related revenue ....................... $ 265 $ 210 $ 55 26.2
===== ===== ===== ======
(1) Includes SFAS 133 qualifying fair value adjustments related to residential
mortgage banking warehouse fair value hedging activity.
Overview
Increased mortgage banking related revenue for the second quarter and for the
first six months of 2004 was primarily due to increased net interest income and
decreased net servicing related expense, which were partially offset by
decreased net originations and sales related income.
All increases and decreases referred to below for the second quarter and the
first six months of 2004 represent comparisons with the same 2003 periods.
Net Interest Income
Increased net interest income for the second quarter and for the first six
months of 2004 primarily resulted from the mortgage loans acquired from
Household, and from originating lenders pursuant to a Household correspondent
loan program. Other volume increases were offset by lower interest rate spreads
on originated mortgages as a result of increased competition in a contracting
originations market, and lower income on loans held for sale due to reduced
levels of loans originated for sale and a more normalized market for secondary
mortgage sales. Refer to "Originations and Sales Related Income (Expense)" for
further discussion of market factors. Commentary regarding residential mortgage
interest income is presented on page 24 of this Form 10-Q.
Servicing Related Income (Expense)
Decreased net servicing related expense for the second quarter and for the first
six months of 2004 is a direct result of decreased MSRs amortization expense and
recovery of temporary impairment reserves associated with MSRs. Normal
amortization of MSRs decreased $10 million for the second quarter and decreased
$21 million for the first six months 2004.
29
The recorded net book value of MSRs, as well as related MSRs amortization
expense, are directly impacted by levels of residential mortgage prepayments.
Higher levels of prepayments will generally increase amortization expense and
decrease the net book value of MSRs. Conversely, lower levels of prepayments
will generally decrease amortization expense and increase the net book value of
MSRs. During 2004, prepayments of residential mortgages, mostly in the form of
loan refinancings, have decreased in comparison with 2003 levels. Mortgage rates
generally rose in the second quarter of 2004 from the historically low rates
experienced in 2003, causing a decrease in loan refinance activity to 59% of
total originations in the first half of 2004, as compared with 80% in the first
half of 2003. The reduction in amortization is also partially due to lower MSRs
balances in 2004, as compared with 2003.
The positive impacts on amortization and temporary impairment of MSRs for 2004
were partially offset by reductions in trading revenue associated with
derivative instruments used to offset changes in the economic value of MSRs. The
net servicing related expense amounts in the tables do not reflect approximately
$36 million of unrealized losses, recorded as other comprehensive income, on
available for sale securities used to offset changes in the economic value of
MSRs as well as net interest income of $14 million on these securities.
Additional commentary regarding risk management associated with the MSRs hedging
program is presented on page 47 of this Form 10-Q.
Originations and Sales Related Income (Expense)
The overall decrease in originations and sales related income throughout the
first half of 2004 reflects decreased gains on sale of mortgages due mainly to
significantly lower volume of loans originated with the intention to sell.
During the first six months of 2004, residential mortgages originated with the
intention to sell declined 60% from the same 2003 period, as a direct result of
lower mortgage refinancings. In the low interest rate environment that existed
prior to 2004, customers tended to refinance with fixed rate loans, which are
sold. As interest rates have risen during 2004, and refinancing activity has
decreased, origination of fixed rate loans originated for sale also has
decreased.
General market conditions and industry factors have affected the ability of
lenders to recognize the same level of gains in 2004 when compared to 2003.
During 2003, the market demand for residential mortgages far outweighed the
supply of such mortgages originated by lenders, which drove up pricing and
associated gains recorded on the sales. During 2004, due to rising interest
rates and lower mortgage refinancings, the demand has weakened relative to
supply, which in turn has driven down pricing and net gains associated with each
sales transaction. Secondary market gains on sales now reflect a more normalized
environment when compared with the unusually high levels of 2003.
The adoption of Securities and Exchange Commission (SEC) Staff Accounting
Bulletin No. 105, Applications of Accounting Principles to Loan Commitments (SAB
105), effective April 1, 2004, also decreased originations and sales related
income by approximately $18 million in the second quarter of 2004. This income
is expected to be realized in future reporting periods.
30
Trading Revenues
Trading revenues are generated by the Company's participation in the foreign
exchange, credit derivative and precious metals 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 tables present trading related revenues by business for the three
months and six months ended June 30, 2004 and 2003. 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 not included in other
operating income, but is included in net interest income. Trading revenues
related to the mortgage banking business are included in mortgage banking
revenue. See analysis of mortgage banking revenue for details.
- ---------------------------------------------------------------------------------------------------------------
Increase (Decrease)
--------------------------
Three months ended June 30 2004 2003 Amount %
- ---------------------------------------------------------------------------------------------------------------
(in millions)
Trading revenues ............................. $ 78 $ 91 $(13) (14.3)
Net interest income .......................... 20 20 -- --
---- ---- ---- -----
Trading related revenues ..................... $ 98 $111 $(13) (11.7)
==== ==== ==== =====
Business:
Derivatives and treasury ................... $ 57 $ 66 $ (9) (13.6)
Foreign exchange ........................... 29 17 12 70.6
Precious metals ............................ 11 21 (10) (47.6)
Other trading .............................. 1 7 (6) (85.7)
---- ---- ---- -----
Trading related revenues ..................... $ 98 $111 $(13) (11.7)
==== ==== ==== =====
- ---------------------------------------------------------------------------------------------------------------
Increase (Decrease)
--------------------------
Six months ended June 30 2004 2003 Amount %
- ---------------------------------------------------------------------------------------------------------------
(in millions)
Trading revenues ............................. $167 $161 $ 6 3.7
Net interest income .......................... 37 46 (9) (19.6)
---- ---- ---- -----
Trading related revenues ..................... $204 $207 $ (3) (1.4)
==== ==== ==== =====
Business:
Derivatives and treasury ................... $101 $116 $(15) (12.9)
Foreign exchange ........................... 63 39 24 61.5
Precious metals ............................ 28 39 (11) (28.2)
Other trading .............................. 12 13 (1) (7.7)
---- ---- ---- -----
Trading related revenues ..................... $204 $207 $ (3) (1.4)
==== ==== ==== =====
All increases and decreases referred to below for the second quarter and the
first six months of 2004 represent comparisons with the same 2003 periods.
Derivatives and Treasury
Derivatives trading related income increased $10 million in the second quarter
and increased $14 million in the first six months of 2004. Increased trading
related income from equity and credit derivatives, which was driven by higher
levels of customer activity, was partially offset by decreased income from
interest rate derivatives.
Treasury trading related income decreased $19 million in the second quarter and
decreased $29 million in the first six months of 2004, driven by decreased gains
on sales of securities and decreased net interest income on the trading
securities portfolio.
31
Foreign Exchange
Increased foreign exchange trading related revenue is primarily due to improved
economic conditions in 2004, as compared with 2003 when trading activity was
impacted by the SARS scare and the war in Iraq. As a result, the foreign
exchange and banknotes businesses experienced increased customer activity and
improved proprietary results.
Precious Metals
The second quarter and six month 2004 decreases in precious metals trading
related revenue are due to decreased customer activity, and adverse movements in
prices for certain metals in which the Company transacts for proprietary
purposes.
Security Gains, Net
The following tables present realized security gains and losses included in the
income statement for the three months and six months ended June 30, 2004 and
2003.
- -------------------------------------------------------------------------------------------------------------------------------
2004 2003
----------------------------------------- ---------------------------------------
Gross Gross Net Gross Gross Net
Realized Realized Realized Realized Realized Realized
Gains (Losses) Gains (Losses) Gains (Losses) Gains (Losses)
- -------------------------------------------------------------------------------------------------------------------------------
(in millions)
Three months ended June 30
Net security gains included in:
Mortgage banking revenue
(expense) ........................ $ -- $ -- $-- $ 5 $ -- $ 5
Security gains, net ............... 3 -- 3 38 (5) 33
---- ---- --- ---- ---- ---
$ 3 $ -- $ 3 $ 43 $ (5) $38
==== ==== === ==== ==== ===
Six months ended June 30
Net security gains included in:
Mortgage banking revenue
(expense) ........................ $ 8 $ -- $ 8 $ 16 $ -- $16
Security gains, net ............... 47 (6) 41 55 (6) 49
---- ---- --- ---- ---- ---
$ 55 $ (6) $49 $ 71 $ (6) $65
==== ==== === ==== ==== ===
Net realized gains on sales of securities decreased $46 million in the second
quarter and decreased $27 million in the first six months of 2004. Rising
interest rates and other market factors significantly decreased sales activity
during 2004.
The Company is in the process of selling its investment in NYCE Corporation,
which is expected to result in a gain of approximately $45 million in the third
quarter of 2004.
32
Operating Expenses
The following table presents the components of operating expenses. For
presentation purposes, amounts paid to HSBC group entities have been excluded
from functional expense categories in the table, and are presented as "HSBC
group charges".
- -------------------------------------------------------------------------------------------------------------------
Increase (Decrease)
------------------------
Three months ended June 30 2004 2003 Amount %
- -------------------------------------------------------------------------------------------------------------------
(in millions)
Salaries and employee benefits ................... $ 242 $ 279 $ (37) (13.3)
Occupancy expense, net ........................... 42 39 3 7.7
Other expenses:
Equipment and software ......................... 29 35 (6) (17.1)
Marketing ...................................... 9 10 (1) (10.0)
Outside services ............................... 27 26 1 3.8
Professional fees .............................. 12 15 (3) (20.0)
Telecommunications ............................. 5 9 (4) (44.4)
Postage, printing and office supplies .......... 6 7 (1) (14.3)
Insurance business ............................. 8 9 (1) (11.1)
HSBC group charges ............................. 106 33 73 221.2
Other .......................................... 34 30 4 13.3
------- ------- ------- -----
Total other expenses ........................... 236 174 62 35.6
------- ------- ------- -----
Total operating expenses ......................... $ 520 $ 492 $ 28 5.7
======= ======= ======= =====
Personnel - average number ....................... 11,776 13,421 (1,645) (12.3)
- -------------------------------------------------------------------------------------------------------------------
Increase (Decrease)
------------------------
Six months ended June 30 2004 2003 Amount %
- -------------------------------------------------------------------------------------------------------------------
(in millions)
Salaries and employee benefits ................... $ 494 $ 560 $ (66) (11.8)
Occupancy expense, net ........................... 82 79 3 3.8
Other expenses:
Equipment and software ......................... 57 68 (11) (16.2)
Marketing ...................................... 21 20 1 5.0
Outside services ............................... 51 51 -- --
Professional fees .............................. 20 23 (3) (13.0)
Telecommunications ............................. 8 19 (11) (57.9)
Postage, printing and office supplies .......... 12 15 (3) (20.0)
Insurance business ............................. 12 16 (4) (25.0)
HSBC group charges ............................. 192 61 131 214.8
Other .......................................... 60 66 (6) (9.1)
------- ------- ------- -----
Total other expenses ........................... 433 339 94 27.7
------- ------- ------- -----
Total operating expenses ......................... $ 1,009 $ 978 $ 31 3.2
======= ======= ======= =====
Personnel - average number ....................... 11,897 13,537 (1,640) (12.1)
All increases and decreases referred to below for the second quarter and the
first six months of 2004 represent comparisons with the same 2003 periods.
Overview
Total operating expenses increased $28 million (6%) in the second quarter and
increased $31 million (3%) in the first six months of 2004. Increases in various
HSBC charges were offset by a decrease in salaries and employee benefits, and by
general decreases in several other expense categories.
HSBC group charges include amounts paid to various HSBC group entities for
information technology, loan origination and servicing, administrative and other
operational support. During 2003 and into 2004, HSBC instituted certain
organizational changes that resulted in employees and other aspects of
operations being transferred to other HSBC entities in North America. These
other HSBC group entities in turn charge us for services in accordance with
service level agreements. These organizational changes have impacted the amounts
recorded in various functional expense categories included in operating expenses
on the consolidated statement of income. As a
33
result, direct expenses recorded in "salaries and employee benefits" and
"occupancy expense, net" on the consolidated statement of income for 2003 are
now recorded in "other expenses" for 2004. In the preceding table, the increase
in HSBC group charges, as well as the decreases for salaries and employee
benefits, equipment and software, and telecommunications expenses, primarily
resulted from these organizational changes. Additional details regarding HSBC
group charges are included in Note 9 of the consolidated financial statements
included in Part I of this Form 10-Q.
During the remainder of 2004, we will continue to work towards keeping the
operating expense base relatively flat while supporting new business initiatives
and systems conversions/upgrades. Ongoing business initiatives for 2004 include:
- - supporting planned mortgage banking expansion and portfolio growth
- - hiring relationship managers and staff and opening new offices to support
commercial middle market, small business and commercial real estate
expansion
- - growing the emerging markets derivatives business
- - supporting planned expansion of our corporate investment banking business
- - opening new retail branches in selected growth markets
Increased costs for independent audit fees and costs for implementing a
Sarbanes-Oxley Section 404 compliance environment have been recorded in the
first six months of 2004 and are expected to continue through year end.
Continued benefit is also expected from expense reduction initiatives, begun in
2003, including Household related synergies and global resourcing. The Company
will also benefit from expense saves related to business exits, such as the sale
of equipment finance, commercial finance and the domestic receivables factoring
businesses in 2003.
Salaries and Employee Benefits
The decrease in salaries and employee benefits in the second quarter and in the
first six months of 2004 was primarily due to the transfer of employees to other
HSBC group entities, as previously described. Additional decreases in salaries
have resulted from ongoing efforts to integrate and centralize operations of
various departments with those of Household, and the sale of various business
units in 2003. As a result of the organizational changes and other efforts, the
average number of employed personnel has decreased during 2004.
HSBC Group Charges
Fees are charged by various related HSBC group entities for technology services,
for underwriting and broker-dealer services, for loan origination and servicing,
and for other operational and administrative support functions. As noted above,
a significant number of employees were transferred to these entities during
2004. Fees charged by these entities in accordance with various service level
agreements either began on January 1, 2004, or have increased during the year
due to expansion of the services they provide.
34
Business Segments
- --------------------------------------------------------------------------------
Business segments are managed consistently with the line of business groupings
used by HSBC. The segments are based upon customer groupings and products and
services offered. These segments are described on page 30 of the 2003 Form 10-K.
Prior period disclosures previously reported for 2003 have been conformed herein
to the presentation of current segments, including methodology changes related
to the transfer pricing of assets and liabilities.
The following tables summarize the results for each segment for the three months
and six months ended June 30, 2004 and 2003.
- ------------------------------------------------------------------------------------------------------------------------------------
Corporate,
Personal Investment
Financial Commercial Banking and Private
Services Banking Markets Banking Other Total
- ------------------------------------------------------------------------------------------------------------------------------------
(in millions)
Three months ended June 30
2004
Net interest income (1) ................... $ 357 $ 144 $ 159 $ 31 $ (2) $ 689
Other revenues ............................ 74 45 121 53 5 298
------- ------- -------- ------- ----- --------
Total revenues ............................ 431 189 280 84 3 987
Operating expenses (2) .................... 241 91 129 59 -- 520
------- ------- -------- ------- ----- --------
Working contribution ...................... 190 98 151 25 3 467
Provision for credit losses (3) ........... 25 7 (27) 1 -- 6
------- ------- -------- ------- ----- --------
Income before income tax expense .......... $ 165 $ 91 $ 178 $ 24 $ 3 $ 461
======= ======= ======== ======= ===== ========
Average assets ............................ $42,882 $13,660 $ 45,474 $ 3,813 $ 296 $106,125
Average liabilities/equity (4) ............ 33,295 14,626 49,027 9,177 -- 106,125
Goodwill at June 30, 2004 (5) ............. 1,209 495 631 428 -- 2,763
------- ------- -------- ------- ----- --------
2003
Net interest income (1) ................... $ 302 $ 146 $ 134 $ 30 $ (3) $ 609
Other revenues ............................ 84 41 178 51 5 359
------- ------- -------- ------- ----- --------
Total revenues ............................ 386 187 312 81 2 968
Operating expenses (2) .................... 229 101 102 60 -- 492
------- ------- -------- ------- ----- --------
Working contribution ...................... 157 86 210 21 2 476
Provision for credit losses (3) ........... 12 8 12 (1) -- 31
------- ------- -------- ------- ----- --------
Income before income tax expense .......... $ 145 $ 78 $ 198 $ 22 $ 2 $ 445
======= ======= ======== ======= ===== ========
Average assets ............................ $27,713 $14,002 $ 44,937 $ 2,872 $ 283 $ 89,807
Average liabilities/equity (4) ............ 31,050 13,197 37,487 8,073 -- 89,807
Goodwill at June 30, 2003 (5) ............. 1,223 534 631 428 -- 2,816
------- ------- -------- ------- ----- --------
(1) Net interest income of each segment represents the difference between
actual interest earned on assets and interest paid on liabilities of the
segment adjusted for a funding charge or credit. Segments are charged a
cost to fund assets (e.g. customer loans) and receive a funding credit for
funds provided (e.g. customer deposits) based on equivalent market rates.
(2) Expenses for the segments include fully apportioned corporate overhead
expenses.
(3) The provision apportioned to the segments is based on the segments' net
charge offs and the change in allowance for credit losses. Credit loss
reserves are established at a level sufficient to absorb the losses
considered to be inherent in the portfolio.
(4) Common shareholder's equity and earnings on common shareholder's equity
are allocated back to the segments based on the percentage of capital
assigned to the business.
(5) The reduction in goodwill from June 30, 2003 to June 30, 2004 includes
goodwill associated with the sale of the domestic factoring business on
December 31, 2003.
35
- ------------------------------------------------------------------------------------------------------------------------------------
Corporate,
Personal Investment
Financial Commercial Banking and Private
Services Banking Markets Banking Other Total
- ------------------------------------------------------------------------------------------------------------------------------------
(in millions)
Six months ended June 30
2004
Net interest income (1) ..................... $ 701 $ 289 $ 297 $ 62 $ (5) $ 1,344
Other revenues .............................. 139 84 284 113 12 632
------- -------- -------- ------- ----- ---------
Total revenues .............................. 840 373 581 175 7 1,976
Operating expenses (2) ...................... 476 174 239 120 -- 1,009
------- -------- -------- ------- ----- ---------
Working contribution ........................ 364 199 342 55 7 967
Provision for credit losses (3) ............. 46 (3) (60) (2) -- (19)
------- -------- -------- ------- ----- ---------
Income before income tax expense ............ $ 318 $ 202 $ 402 $ 57 $ 7 $ 986
======= ======== ======== ======= ===== =========
Average assets .............................. $39,419 $ 13,363 $ 46,088 $ 3,714 $ 297 $ 102,881
Average liabilities/equity (4) .............. 32,552 14,106 47,054 9,169 -- 102,881
------- -------- -------- ------- ----- ---------
2003
Net interest income (1) ..................... $ 597 $ 300 $ 305 $ 60 $ (8) $ 1,254
Other revenues .............................. 177 79 303 97 13 669
------- -------- -------- ------- ----- ---------
Total revenues .............................. 774 379 608 157 5 1,923
Operating expenses (2) ...................... 465 191 203 119 -- 978
------- -------- -------- ------- ----- ---------
Working contribution ........................ 309 188 405 38 5 945
Provision for credit losses (3) ............. 32 37 17 1 -- 87
------- -------- -------- ------- ----- ---------
Income before income tax expense ............ $ 277 $ 151 $ 388 $ 37 $ 5 $ 858
======= ======== ======== ======= ===== =========
Average assets .............................. $27,895 $ 14,131 $ 45,233 $ 2,835 $ 283 $ 90,377
Average liabilities/equity (4) .............. 30,744 13,162 38,389 8,082 -- 90,377
------- -------- -------- ------- ----- ---------
(1) Net interest income of each segment represents the difference between
actual interest earned on assets and interest paid on liabilities of the
segment adjusted for a funding charge or credit. Segments are charged a
cost to fund assets (e.g. customer loans) and receive a funding credit for
funds provided (e.g. customer deposits) based on equivalent market rates.
(2) Expenses for the segments include fully apportioned corporate overhead
expenses.
(3) The provision apportioned to the segments is based on the segments' net
charge offs and the change in allowance for credit losses. Credit loss
reserves are established at a level sufficient to absorb the losses
considered to be inherent in the portfolio.
(4) Common shareholder's equity and earnings on common shareholder's equity
are allocated back to the segments based on the percentage of capital
assigned to the business.
All increases and decreases referred to below for the second quarter and the
first six months of 2004 represent comparisons with the same 2003 periods.
Personal Financial Services
Income before income tax expense increased $20 million (14%) in the second
quarter and $41 million (15%) in the first six months of 2004, due primarily to
increased interest income, which was partially offset by reduced other revenues,
increased operating expenses, and increased provision for credit losses.
Net interest income increased $55 million in the second quarter and $104 million
in the first six months of 2004, primarily due to increased residential mortgage
balances. On-balance sheet residential mortgage balances have grown
significantly during the six months ended June 30, 2004. An analysis of net
interest income from residential mortgages is presented on page 24 of this Form
10-Q.
Operating expenses increased $12 million (5%) in the second quarter and $11
million (2%) in the first six months of 2004, primarily due to increased salary
costs associated with the expansion of the residential mortgage business. The
loan origination and servicing workforces have been increased during 2004 to
accommodate business growth. Increased technology related costs also have
contributed to overall expense increases. Commentary regarding operating
expenses is presented on pages 33-34 of this Form 10-Q.
36
The provision for credit losses increased $13 million (108%) in the second
quarter and $14 million (44%) in the first six months of 2004, primarily due to
increases in the allowance and provision for credit losses associated with the
growing residential mortgage portfolio. An analysis of credit quality associated
with various lending portfolios is presented on pages 38-39 of this Form 10-Q.
The decrease in other revenues is primarily due to reduced non-interest mortgage
banking revenue. An analysis of mortgage banking revenue is presented on pages
28-30 of this Form 10-Q.
Commercial Banking
Income before income tax expense increased $13 million (17%) in the second
quarter and $51 million (34%) in the first six months of 2004. Reduced operating
expenses, decreased provision for credit losses, and increased other revenues
were partially offset by decreased net interest income.
Net interest income decreased $2 million in the second quarter and decreased $11
million in the first six months of 2004. During 2003, certain equipment finance,
commercial finance and U.S. factoring businesses and customer relationships were
sold. Those transactions resulted in reductions in net interest income of
approximately $16 million for the second quarter and $32 million for the first
six months of 2004. Excluding the effect of these transactions, net interest
income increased $14 million in the second quarter and $21 million in the first
six months of 2004, due to more favorable spreads associated with commercial
loans and related deposit balances.
Operating expenses decreased $10 million (10%) in the second quarter and $17
million (9%) in the first six months of 2004. Excluding the impact of the sale
transactions noted above, operating expenses remained relatively constant for
the second quarter and for the first six months of 2004.
The decrease in the provision for credit losses is due to general improvement in
commercial credit quality, as evidenced by general decreases in problem loan
balances and in the allowance for credit losses.
Corporate, Investment Banking and Markets
Income before income tax expense increased $14 million (4%) in the first six
months of 2004, despite decreasing $20 million (10%) in the second quarter. A
significant decrease in the provision for credit losses in 2004 was offset by
increased operating expenses for the year, and by reduced total revenues in the
second quarter of 2004.
Total revenues decreased $32 million in the second quarter and $27 million in
the first six months of 2004, due to reduced total trading related revenues and
net securities gains. Commentary regarding trading related revenues is presented
on pages 31-32 of this Form 10-Q. Commentary regarding net securities gains is
presented on page 32 of this Form 10-Q.
Operating expenses increased $27 million (26%) in the second quarter and
increased $36 million (18%) in the first six months of 2004. Increased
technology related costs, increased incentive compensation expenses and
increased fees charged by related HSBC group entities for brokerage and
underwriting services were primarily responsible for increased overall expenses.
The provision for credit losses decreased $39 million in the second quarter and
decreased $77 million in the first six months of 2004 reflecting continuation of
the general improvement in credit quality in 2004.
Private Banking
Income before income tax expense increased $2 million (9%) in the second
quarter, and increased $20 million (54%) in the first six months of 2004.
Increased equity investment revenue and increased gains on sale of securities
during the first quarter of 2004 were the primary drivers of the year to date
increases.
37
Credit Quality
- --------------------------------------------------------------------------------
The following table provides a summary of credit quality statistics for the past
five quarters.
- -----------------------------------------------------------------------------------------------------------------------------------
June 30, March 31, December 31, September 30, June 30,
2004 2004 2003 2003 2003
- -----------------------------------------------------------------------------------------------------------------------------------
(in millions)
Nonaccruing loans
Balance at end of period:
Commercial ....................................... $ 185 $ 231 $ 235 $ 222 $ 259
Consumer ......................................... 99 87 93 96 91
International .................................... 15 11 38 30 44
------ ------ ------ ------ ------
Total ........................................... $ 299 $ 329 $ 366 $ 348 $ 394
====== ====== ====== ====== ======
As a percent of loans:
Commercial ...................................... 1.11% 1.44% 1.49% 1.29% 1.47%
Consumer ........................................ .24 .26 .32 .40 .40
International ................................... .44 .31 1.11 .82 1.52
Total ........................................... .48 .63 .76 .77 .91
Criticized assets
Balance at end of period:
Special mention ................................. $ 673 $ 707 $ 618 $ 637 $ 807
Substandard ..................................... 532 632 682 676 699
Doubtful ........................................ 66 87 128 129 146
------ ------ ------ ------ ------
Total ........................................... $1,271 $1,426 $1,428 $1,442 $1,652
====== ====== ====== ====== ======
Impaired loans
Balance at end of period ........................ $ 281 $ 314 $ 267 $ 240 $ 309
Amount with impairment reserve .................. 263 296 179 161 193
Impairment reserve .............................. 38 61 86 91 120
Overview
Unless otherwise noted all increases and decreases referred to below for the
second quarter and the first six months of 2004 represent comparisons with the
same 2003 periods.
The allowance for credit losses decreased $10 million (3%) from March 31, 2004,
$52 million (13%) from December 31, 2003, and $129 million (27%) from June 30,
2003 to June 30, 2004. Reductions in the allowance attributable to domestic
commercial loans and loans recorded in foreign offices were partially offset by
moderate increases in the allowance attributed to domestic consumer loans.
Changes in the allowance for credit losses are summarized in Note 4 of the
consolidated financial statements on page 10 of this Form 10-Q.
The provision for credit losses decreased $25 million (81%) in the second
quarter of 2004, and $107 million (122%) in the first six months of 2004.
Reduced provision associated with domestic commercial loan portfolios and loans
in foreign offices were partially offset by increased provision associated with
domestic consumer loan portfolios.
Commercial Credit Quality
Overall reductions in the allowance for credit losses and the provision for
credit losses during the second quarter of 2004 are a direct result of continued
improvement in the overall credit quality associated with commercial loan
portfolios, as evidenced by decreases in total nonaccruing loan balances, the
percentage of nonaccruing loans to total loans, and criticized assets balances.
These improvements resulted partially from the strategy to exit various
commercial lending relationships, which have not provided acceptable levels of
profitability to offset associated credit risk, and partially from continued
improvement in economic conditions, which have resulted in pay downs on problem
loans and upgrades of criticized assets. The improving economic environment also
presented opportunities to sell certain criticized assets during 2004 at
favorable prices to third parties resulting in the release of certain loan loss
reserves and recoveries of previously recorded charge offs.
38
Although there are numerous economic and geopolitical factors that can impact
credit quality, it is anticipated that the recent trend of improved credit
quality will continue throughout the remainder of 2004. Key economic indicators,
consumer confidence, and corporate performance, as well as governmental and
private sector spending priorities and political events will continue to be
closely monitored.
Consumer Credit Quality
Second quarter and six month 2004 increases in the allowance for credit losses
and in the provision for credit losses were primarily attributable to increasing
consumer loan balances, particularly residential mortgages. Although nonaccruing
consumer loans have increased during 2004, the percentage of nonaccruing loans
to total consumer loans has decreased.
On December 31, 2003 $2.8 billion of residential mortgage loan assets were
purchased at fair value from Household. On March 31, 2004, approximately $900
million of additional residential mortgage loan assets at fair value were also
purchased from Household. The purchase of these loans effectively increased the
allowance for credit losses by approximately $5 million as of June 30, 2004.
Through June 30, 2004, these loans have not had a significant impact on credit
quality.
Continued utilization of Household services for origination of residential
mortgage loans is planned for the remainder of 2004. The credit quality of all
such loans will be closely monitored. In addition, further organic growth in the
mortgage lending business is planned, which would effectively increase the
reserve for credit losses.
It was previously reported that subject to receipt of regulatory and other
approvals the Company expected to purchase approximately $18 billion of credit
card receivables and approximately $9 billion of residual interests in
securitized credit card receivables pools from Household during 2004. It was
also reported that subsequent to the initial transfer, additional credit card
receivables would be purchased from Household on a daily basis and that various
methods of funding these transfers were being explored. Given recent growth and
funding needs, the Company now expects to apply for regulatory approval to
purchase only Household's private label credit card portfolio in 2004. Potential
assignment will be considered for some of Household's MasterCard and Visa
receivables in the future based upon continuing evaluations of capital and
liquidity at each entity.
Subject to regulatory and other approvals, the private label receivables
expected to be purchased from Household by year-end will have a principal
balance of approximately $11 billion. Residual interests in securitized private
label credit card receivables pools of approximately $4 billion will also be
acquired. These increases in credit card receivables will have significant
impact on net interest income and the provision and allowance for credit losses
in future periods. However, the impact on future period results cannot currently
be estimated due to the uncertainty as to the timing of the purchases.
Additional information on the financial impact of the proposed transfer will be
reported as the regulatory and other approval processes progress and the amounts
become quantifiable.
International Credit Quality
During the first six months of 2004, the allowance for credit losses, the
provision for credit losses, and total nonaccruing loans associated with foreign
operations have all decreased. The transfer of certain foreign operations to
affiliated companies, combined with payments received from customers on certain
foreign nonaccruing loans, contributed to the overall decreases.
39
Derivative Instruments and Hedging Activities
- --------------------------------------------------------------------------------
The Company is party to various derivative financial instruments as an end user,
as an international dealer in derivative instruments, and for purely trading
purposes in order to realize profits from short-term movements in interest
rates, commodity prices, foreign exchange rates and credit spreads. Additional
information regarding the use of various derivative instruments is included on
pages 98 and 99 of the 2003 Form 10-K.
Notional Values of Derivative Contracts
The following table summarizes the notional values of derivative contracts.
- --------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
(in millions)
Interest rate:
Futures and forwards ....................... $ 116,484 $ 107,646
Swaps ...................................... 824,817 625,670
Options written ............................ 146,943 161,824
Options purchased .......................... 141,942 197,081
---------- ----------
1,230,186 1,092,221
---------- ----------
Foreign exchange:
Swaps, futures and forwards ................ 217,978 147,741
Options written ............................ 41,176 16,583
Options purchased .......................... 41,798 16,769
Spot ....................................... 25,468 14,320
---------- ----------
326,420 195,413
---------- ----------
Commodities, equities and precious metals:
Swaps, futures and forwards ................ 36,585 33,897
Options written ............................ 8,297 7,048
Options purchased .......................... 8,210 7,081
Credit derivatives ......................... 68,590 31,302
---------- ----------
121,682 79,328
---------- ----------
Total ........................................ $1,678,288 $1,366,962
========== ==========
Credit and Market Risk Associated with Derivative Contracts
The notional value of derivative contracts only provides an indicator of the
transaction volume in these types of instruments. It does not represent exposure
to market or credit risks under these contracts.
Credit (or repayment) risk in derivative instruments is minimized by entering
into transactions with high quality counterparties including other members of
the HSBC Group. 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 be required as
well.
The following table presents credit risk exposure and net fair value associated
with derivative contracts. Credit risk exposure and derivative contract fair
values are calculated in a manner consistent with regulatory guidelines. Total
fair value of derivative receivables reflects 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. The net fair value of all derivative contracts represents
the total fair value above, less the net liability balance representing
revaluation losses from the "marking to market" of derivative contracts held for
trading purposes.
40
- --------------------------------------------------------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------------------------------------------------------
(in millions)
Credit risk exposure associated with derivative contracts:
Total fair value of derivative receivables ................................................. $ 7,442 $ 7,653
Collateral held against exposure ........................................................... (2,120) (2,580)
------- -------
Net credit risk exposure ..................................................................... $ 5,322 $ 5,073
======= =======
Net fair value of all derivative contracts ................................................... $ (432) $ (566)
======= =======
Off-Balance Sheet Arrangements
- --------------------------------------------------------------------------------
The following table provides information at June 30, 2004 related to the
off-balance sheet arrangements and lending and sales commitments. Descriptions
of these arrangements are found on pages 44-45 of the 2003 Form 10-K.
- -------------------------------------------------------------------------------------------------------------------------------
One Over One Over
Year Through Five
June 30, 2004 or Less Five Years Years Total
- -------------------------------------------------------------------------------------------------------------------------------
(in millions)
Standby letters of credit, net of participations ............. $3,245 $ 1,654 $ 92 $ 4,991(1)
Loan sales with recourse ...................................... -- 2 10 12(2)
Credit derivative contracts ................................... 1,356 31,389 5,829 38,574(3)
Securities lending indemnifications ........................... 3,206 -- -- 3,206
------ ------- ------ -------
Total ......................................................... $7,807 $33,045 $5,931 $46,783
====== ======= ====== =======
(1) Includes $311 million issued for the benefit of related parties.
(2) $9 million of this amount is indemnified by third parties.
(3) Includes $5,173 million issued for the benefit of related parties.
Standby 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 $13 million and $12 million at June 30, 2004 and December 31, 2003
respectively. Also included in other liabilities is an allowance for credit
losses on unfunded standby letters of credit of $21 million and $25 million at
June 30, 2004 and December 31, 2003 respectively.
Credit Derivative Contracts
The Company enters into credit derivative contracts both for its own benefit and
to satisfy the needs of our customers. Credit derivatives are arrangements that
provide for one party (the "beneficiary") to transfer the credit risk of a
"reference asset" to another party (the "guarantor"). Under this arrangement the
guarantor assumes the credit risk associated with the reference asset without
directly purchasing it. The beneficiary agrees to pay to the guarantor a
specified fee. In return, the guarantor agrees to pay the beneficiary an agreed
upon amount if there is a default during the term of the contract.
Virtually all of the market risk assumed in selling credit guarantees through
credit derivative contracts is offset with another counterparty. Credit
derivatives, although having characteristics of a guarantee, are accounted for
as derivative instruments and are carried at fair value. The commitment amount
included in the table above is the maximum amount that the Company could be
required to pay, without consideration of the approximately equal amount
receivable from third parties and any associated collateral.
Securities Lending Indemnifications
The Company may lend securities of customers, on a fully collateralized basis,
as an agent to third party borrowers. Customers are indemnified against the risk
of loss, and collateral is obtained from the borrower with a market value
exceeding the value of the loaned securities. At June 30, 2004, the fair value
of that collateral was approximately $3,264 million.
41
Special Purpose and Variable Interest Entities
- --------------------------------------------------------------------------------
The provisions of Financial Accounting Standards Board issued Interpretation No.
46 Revised, Consolidation of Variable Interest Entities (FIN 46R) were adopted
as of March 31, 2004. At June 30, 2004, none of the Variable Interest Entities
(VIEs) that the Company is involved with are required to be consolidated under
FIN 46R.
The following table provides information for unconsolidated VIEs at June 30,
2004. Descriptions of these VIE relationships are included in pages 45-47 of the
2003 Form 10-K.
- -----------------------------------------------------------------------------------------------------------------
Maximum
Total Exposure
Assets to Loss
- -----------------------------------------------------------------------------------------------------------------
(in millions)
Asset-backed commercial paper conduit ............................... $ 2,595 $3,266
Securitization vehicles ............................................. 970 541
Investment funds .................................................... 8,217 151
Capital funding vehicles ............................................ 1,093 32
Low income housing tax credits ...................................... 1,123 73
------- ------
Total ............................................................... $13,998 $4,063
======= ======
Capital
- --------------------------------------------------------------------------------
The following table presents the capital ratios of the Company and the Bank
calculated in accordance with banking regulations. To be categorized as
"well-capitalized" under the Federal Reserve Board and Federal Deposit Insurance
Corporation guidelines, a banking institution must have the minimum ratios
reflected in the table, and must not be subject to a directive, order, or
written agreement to meet and maintain specific capital levels.
- -----------------------------------------------------------------------------------------------------------------
"Well-Capitalized" June 30, December 31,
Minimum 2004 2003
- -----------------------------------------------------------------------------------------------------------------
Total capital (to risk weighted assets)
Company .................................................. 10.00% 12.07% 12.42%
Bank.. ................................................... 10.00 11.90 11.82
Tier 1 capital (to risk weighted assets)
Company .................................................. 6.00 7.83 8.53
Bank ..................................................... 6.00 8.38 8.99
Tier 1 capital (to average assets)
Company .................................................. 3.00 5.83 5.87
Bank ..................................................... 5.00 6.27 6.22
Tangible common equity (to risk weighted assets)
Company .................................................. 6.08 6.39
Bank ..................................................... 8.43 9.07
Although still well above "well-capitalized" minimums, capital ratios have
generally declined during 2004, due to increased consumer loan balances and
increased off-balance sheet commitments. In light of the balance sheet growth
that has already taken place, and in preparation for continued growth expected
for 2004 and future periods, management is considering various options for
raising capital and improving the capital ratios.
42
Risk Management
- --------------------------------------------------------------------------------
Liquidity Management
The approach to address liquidity risk and to meet funding requirements is
summarized on pages 51-53 of the 2003 Form 10-K. During the second quarter of
2004, there were no significant changes in the approach towards liquidity
management.
In July 2004, Moody's Investors Service (Moody's) raised the long-term deposits
rating for the Bank from Aa3 to Aa2. Moody's also placed the Company on review
for a possible upgrade from its current short-term debt rating of A1. The
long-term and short-term debt ratings from the other major credit rating
agencies for the Company and the Bank are unchanged from December 31, 2003.
As a component of its overall funding strategy, the Company and the Bank
periodically issue debt instruments to fund balance sheet growth, to meet cash
and capital needs, or to fund investments in subsidiaries. See Note 7 to the
financial statements on page 12 of this Form 10-Q for an analysis of 2004
long-term debt activity.
In June 2004, the Bank completed a $10 billion Global Bank Note Program for the
issuance of subordinated and senior global notes. Through June 30, 2004,
approximately $589 million of debt has been issued from this program. In July,
an additional $1 billion was issued under this program. Also in July, the Global
Bank Note Program was expanded to $20 billion to allow for further opportunity
to access the market for longer term funding of anticipated balance sheet
growth.
It was previously reported that subject to receipt of regulatory and other
approvals the Company expected to purchase approximately $18 billion of credit
card receivables and approximately $9 billion of residual interests in
securitized credit card receivables pools from Household during 2004. It was
also reported that subsequent to the initial transfer, additional credit card
receivables would be purchased from Household on a daily basis and that various
methods of funding these transfers were being explored. Given recent growth and
funding needs, the Company now expects to apply for regulatory approval to
purchase only Household's private label credit card portfolio in 2004. Potential
assignment will be considered for some of Household's MasterCard and Visa
receivables in the future based upon continuing evaluations of capital and
liquidity at each entity.
Subject to regulatory and other approvals, the private label receivables
expected to be purchased from Household by year-end will have a principal
balance of approximately $11 billion. Residual interests in securitized private
label credit card receivables pools of approximately $4 billion will also be
acquired. These increases in credit card receivables will have significant
impact on net interest income and the provision and allowance for credit losses
in future periods. However, the impact on future period results cannot currently
be estimated due to the uncertainty as to the timing of the purchases.
Additional information on the financial impact of the proposed transfer will be
reported as the regulatory and other approval processes progress and the amounts
become quantifiable.
Interest Rate Risk Management
Various techniques are utilized to quantify and monitor risks associated with
the repricing characteristics of the Company's assets, liabilities, and
derivative contracts. The approach toward managing interest rate risk is
summarized on pages 53-56 of the 2003 Form 10-K. During the first six months of
2004, there were no significant changes in policies or approach for managing
interest rate risk.
Static "gap" measurement of interest rate risk is not used as a primary
management tool. In the course of managing interest rate risk, Present Value of
a Basis Point (PVBP) analysis is utilized in conjunction with a combination of
other risk assessment techniques, including capital at risk, dynamic simulation
modeling, capital risk and Value at Risk (VAR) analyses. The combination of
these tools enables management to identify and assess the potential impact of
interest rate movements and take appropriate action.
43
Institutional movement limits are established at the beginning of each fiscal
year for each of the assessment techniques discussed below. These limits act as
a guide for managing interest rate risk associated with balance sheet
composition and off-balance sheet hedging strategy (the risk position).
Calculated values within movement limit ranges reflect an acceptable risk
position, although an unfavorable trend may prompt consideration to adjust on or
off-balance sheet exposure. Calculated values outside of movement limit ranges
will result in consideration of adjustment of the risk position, or
consideration of temporary dispensation from making adjustments.
PVBP Analysis
For assets and liabilities whose cash flows are subject to change due to
movements in interest rates, such as the sensitivity of mortgage loans to
prepayments, data is reported based on the earlier of expected repricing or
maturity and reflects anticipated prepayments based on the current rate
environment. The resulting "gaps" are reviewed to assess the potential
sensitivity to earnings with respect to the direction, magnitude and timing of
changes in market interest rates.
Certain limits and benchmarks that serve as guidelines in determining the
appropriate levels of interest rate risk for the institution have been
established. One such limit is expressed in terms of the PVBP, which is the
change in value of the balance sheet for a one basis point upward movement in
all interest rates.
The following table reflects PVBP position at June 30, 2004.
- ------------------------------------------------------------------------------------------------------------------------
June 30, 2004 Values
- ------------------------------------------------------------------------------------------------------------------------
(in millions)
Institutional PVBP movement limit .................................................................... +/- $5.0
PVBP position at period end .......................................................................... (.7)
Capital at Risk
The Company also monitors capital at risk, which is the change in base case
valuation of the balance sheet for either a 200 basis point gradual rate
increase or a 100 basis point gradual rate decrease.
The following table reflects our capital at risk position at June 30, 2004.
- ------------------------------------------------------------------------------------------------------------------------
June 30, 2004 Values
- ------------------------------------------------------------------------------------------------------------------------
Institutional capital at risk movement limit ......................................................... +/- 10.0%
Projected change in value resulting from a gradual 200 basis point increase in interest rates ........ (9.9)
Projected change in value resulting from a gradual 100 basis point decrease in interest rates ........ (2.3)
The projected drop in value for a 100 basis point gradual decrease in rates is
primarily related to the anticipated acceleration of prepayments for the held
mortgage and mortgage backed securities portfolios in this lower rate
environment. This assumes that no management actions are taken to manage
exposures to the changing interest rate environment.
44
Dynamic Simulation Modeling
In addition to the above mentioned limits, the Asset and Liability Policy
Committee (ALCO) uses various modeling techniques 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 of 200 basis points, as well as scenarios in which rates rise or fall
by 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.
- ----------------------------------------------------------------------------------------------------------------------------------
June 30, 2004 Values
---------------------------
Amount %
- ----------------------------------------------------------------------------------------------------------------------------------
(in millions)
Projected change in net interest income (reflects projected rate movements on July 1, 2004):
Institutional base earnings movement limit ....................................................... +/- 10
Change resulting from a gradual 200 basis point increase in the yield curve ...................... $(30) (1)
Change resulting from a gradual 200 basis point decrease in the yield curve ...................... 281 10
Other significant scenarios monitored (reflects projected rate movements on July 1, 2004):
Change resulting from an immediate 100 basis point increase in the yield curve ................... (26)
Change resulting from an immediate 100 basis point decrease in the yield curve ................... 74
Change resulting from an immediate 200 basis point increase in the yield curve ................... (138)
Change resulting from an immediate 200 basis point decrease in the yield curve ................... (134)
Change resulting from an immediate 100 basis point decrease in long term
rates, and a decrease of 50-75 basis points in short term rates ................................. 24
Change resulting from an immediate 100 basis point increase in short term rates .................. (87)
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.
Capital Risk
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 credited on a tax effective basis through other comprehensive
income in the consolidated statement of shareholders' equity. This valuation
mark is excluded from Tier 1 and Tier 2 capital ratios but it would be 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
June 30, 2004, the Company had an available for sale securities portfolio of
approximately $14 billion with a net negative mark to market of $269 million
included in tangible common equity of $5 billion. An increase of 25 basis points
in interest rates of all maturities would further lower the mark to market by
approximately $93 million to a net loss of $362 million with the following
results on the tangible capital ratios.
- ----------------------------------------------------------------------------------------------------------------------------------
Proforma - Reflecting
25 Basis Points
June 30, 2004 Actual Increase in Rates
- ----------------------------------------------------------------------------------------------------------------------------------
Tangible common equity to tangible assets ............................................. 4.25% 4.20%
Tangible common equity to risk weighted assets ........................................ 6.08 6.00
Value at Risk
VAR analysis is also used to measure interest rate risk and to calculate the
economic capital required to cover potential losses due to interest risk. VAR
looks at a two year historical observation period and shows, based upon that,
the potential loss from unfavorable market conditions during a "given period"
with a certain confidence level (99%). A one-day "given period" or "holding
period" is used for setting limits and measuring results. Thus, at a 99%
confidence level for 500 business days (about two calendar years), the fifth
worst loss performance in the last 500 business days is set as the limit. For
purposes of determining economic capital, a six month "given period" is used, a
conservative time to allow for adjustments of our interest rate risk profile.
45
The predominant VAR methodology used by the Company, "historical simulation",
has a number of limitations including the use of historical data as a proxy for
the future, the assumption that position adjustments can be made within the
holding period specified, and the use of a 99% confidence level, which does not
take into account potential losses that might occur beyond that level of
confidence.
Trading Activities
Trading portfolios reside primarily in the Treasury and mortgage banking areas
and include foreign exchange, derivatives, precious metals (gold, silver,
platinum), commodities, equities, money market instruments including "repos" 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 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.
Trading Activities - Treasury
Value at Risk
Value at Risk (VAR) analysis is relied upon as a basis for quantifying and
managing risks associated with the Treasury trading portfolios. The VAR
methodology employed is summarized on pages 56-57 of the 2003 Form 10-K.
The following table summarizes trading VAR for 2004, assuming a 99% confidence
level for 500 business days and a 10 day "holding period".
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended June 30, 2004
June 30, ------------------------------------ December 31,
2004 Minimum Maximum Average 2003
- ------------------------------------------------------------------------------------------------------------------------------------
(in millions)
Total trading ............................................. $ 30 $18 $47 $30 $23
Commodities ............................................... 4 1 11 4 --
Credit derivatives ........................................ 3 1 6 2 4
Equities .................................................. -- -- 1 -- 1
Foreign exchange .......................................... 5 2 23 8 11
Interest rate ............................................. 23 15 28 22 16
Trading Volatility
The following tables summarize the frequency distribution of daily market
risk-related revenues for Treasury trading activities during 2004. Market
risk-related Treasury trading revenues include realized and unrealized gains
(losses) related to Treasury trading activities, but excludes the related net
interest income. Analysis of the second quarter of 2004 gain (loss) data shows
that the largest daily gain was $7 million and the largest daily loss was $2
million. Analysis of the first six months of 2004 gain (loss) data shows that
the largest daily gain was $12 million and the largest daily loss was $9
million.
- ------------------------------------------------------------------------------------------------------------------------------------
Three months ended June 30, 2004
- ------------------------------------------------------------------------------------------------------------------------------------
Ranges of daily Treasury trading revenue
earned from market risk-related activities
Below $(2) to $0 to $2 to $4 to Over
(in millions) $ (2) $ 0 $ 2 $ 4 $ 6 $6
Number of trading days market risk-related
revenue was within the stated range .................... 1 19 24 12 5 1
46
- ------------------------------------------------------------------------------------------------------------------------------------
Six months ended June 30, 2004
- ------------------------------------------------------------------------------------------------------------------------------------
Ranges of daily Treasury trading revenue
earned from market risk-related activities
Below $(2) to $0 to $2 to $4 to Over
(in millions) $(2) $0 $2 $4 $6 $6
Number of trading days market risk-related
revenue was within the stated range ..................... 2 30 43 29 13 7
Trading Activities - Mortgage Banking
Mortgage servicing rights (MSRs) are assets that represent the net present value
of net servicing income (servicing fees, ancillary income, and float, net of
servicing costs). MSRs are recognized upon the sale of the underlying loans.
MSRs are subject to interest rate risk, in that the value of MSRs will decline
(as a result of actual and expected acceleration of prepayment of the underlying
loans) in a falling interest rate environment.
Interest rate risk is mitigated through an active hedging program that uses
available for sale (AFS) 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.
A review of the Company's MSRs hedging program was conducted in light of the
unprecedented market conditions of 2003. This was to ensure that a program is in
place to support anticipated business growth while at the same time limiting
volatility in the mortgage banking results. Existing risk limits were tightened
and additional risk limits were established for hedging of economic losses.
Rate Shock Analysis
Modeling techniques are used to monitor certain interest rate scenarios for
their impact on the value of MSRs, as reflected in the following table.
- ------------------------------------------------------------------------------------------------------------------------
June 30, 2004 Values
--------------------------
Amount %
- ------------------------------------------------------------------------------------------------------------------------
(in millions)
Projected change in net market value of hedged MSRs portfolio (reflects projected rate
movements on July 1, 2004):
Value of hedged MSRs portfolio ......................................................... $436
Change resulting from an immediate 50 bp decrease in the yield curve:
Change limit .................................................................... <- 4
Calculated change in net market value ........................................... (5) - 1
Change resulting from an immediate 50 bp increase in the yield curve:
Change limit .................................................................... <- 2
Calculated change in net market value ........................................... 9 + 2
Change resulting from a gradual 100 bp increase in the yield curve:
Change limit .................................................................... <- 3
Calculated change in net market value ........................................... 17 + 4
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.
47
Hedge Volatility
During 2004, there was volatility in the trading positions in derivative
instruments used to protect the economic value of the MSRs portfolio. The
following tables summarize the frequency distribution of weekly market
risk-related revenues during 2004 associated with mortgage trading positions.
- --------------------------------------------------------------------------------------------------------------------------
Three months ended June 30, 2004
- --------------------------------------------------------------------------------------------------------------------------
Ranges of mortgage trading revenue earned
from market risk-related activities
Below $(5) to $0 to $5 to Over
(in millions) $(5) $0 $5 $10 $10
Number of trading weeks market risk-related
revenue was within the stated range ............... 6 3 5 -- --
- --------------------------------------------------------------------------------------------------------------------------
Six months ended June 30, 2004
- --------------------------------------------------------------------------------------------------------------------------
Ranges of mortgage trading revenue earned
from market risk-related activities
Below $(5) to $0 to $5 to Over
(in millions) $(5) $0 $5 $10 $10
Number of trading weeks market risk-related
revenue was within the stated range ............... 8 7 8 3 2
48
Item 3. Quantitative and Qualitative Disclosures About Market Risk
- --------------------------------------------------------------------------------
Refer to the disclosure in Item 2 of the Management's Discussion and Analysis of
Financial Condition and Results of Operations under the captions "Interest Rate
Risk Management" and "Trading Activities".
Item 4. Controls and Procedures
- --------------------------------------------------------------------------------
Under the direction of the Company's Chief Executive Officer (CEO) and Chief
Financial Officer (CFO), the Company has reviewed its "disclosure controls and
procedures". That term means controls and other procedures designed to ensure
that information required to be disclosed in the Company's reports filed with
the United States Securities and Exchange Commission (SEC) is recorded,
processed, summarized and reported by the due dates specified by the SEC's
rules. Such controls and procedures must be designed to ensure that information
required to be disclosed in reports filed with the SEC, is accumulated and
communicated to the Company's management personnel to allow timely decisions
regarding required disclosure. Also, this process directly supports the CEO and
CFO certifications included as exhibits to this report.
Since 1993, the CEO and CFO have reported on the Bank's internal controls over
financial reporting pursuant to Federal Deposit Insurance Corporation
Improvement Act (FDICIA) regulations. The Company's independent registered
public accounting firm has annually attested, without qualification, to the
reports. Thus management is well acquainted with the process underlying the
attestation to financial reporting controls. The current review process is built
on the annual review at the Bank in accordance with FDICIA as well as various
other internal control processes and procedures, which management has
established and monitors. The review is conducted quarterly and includes all
subsidiaries of the Company.
To monitor the Company's compliance with the disclosure controls and procedures,
the Company has formed a Disclosure Committee chaired by its CFO. The Disclosure
Committee is composed of key members of senior management, who have knowledge of
significant portions of the Company's internal control system as well as the
business and competitive environment in which the Company operates. The
Disclosure Committee covers all of the Company's significant business and
administrative functions. One of the key responsibilities of each Committee
member is to review the document to be filed with the SEC as it progresses
through the preparation process. Open lines of communication to financial
reporting management exist for Disclosure Committee members to convey comments
and suggestions.
The Disclosure Committee has designated a preparation working group that is
responsible for providing and/or reviewing the detail supporting financial
disclosures. The Disclosure Committee also has designated a business issues
working group that is responsible for the development of forward-looking
disclosures.
The Company's CEO and CFO have concluded that, based on the deliberations of the
Disclosure Committee and input received from senior business and financial
managers, the Company's disclosure controls and procedures were effective as of
June 30, 2004 and that those controls and procedures support the disclosures in
this document. During the six months ended June 30, 2004, there were no material
changes in the Company's internal controls over financial reporting.
49
Part II - OTHER INFORMATION
- --------------------------------------------------------------------------------
Item 1 - Legal Proceedings
The Company is named in and is defending legal actions in various
jurisdictions arising from its normal business. None of these
proceedings is regarded as material litigation. In addition,
there are certain proceedings related to the "Princeton Note
Matter" that are described below.
In relation to the Princeton Note Matter, as disclosed in the
Company's 2003 Annual Report on Form 10-K, two of the noteholders
were not included in the settlement and their civil suits are
continuing. The U.S. Government excluded one of them from the
restitution order (Yakult Honsha Co., Ltd.) because a senior
officer of the noteholder was being criminally prosecuted in
Japan for his conduct relating to its Princeton Notes. The senior
officer in question was convicted during September 2002 of
various criminal charges related to the sale of the Princeton
Notes. The U.S. Government excluded the other noteholder (Maruzen
Company, Limited) because the sum it is likely to recover from
the Princeton Receiver exceeds its losses attributable to its
funds transfers with Republic New York Securities Corporation as
calculated by the U.S. Government. Both of these civil suits seek
compensatory, punitive, and treble damages pursuant to RICO and
assorted fraud and breach of duty claims arising from unpaid
Princeton Notes with face amounts totaling approximately $125
million. No amount of compensatory damages is specified in either
complaint. These two complaints name HSBC USA Inc., the Bank, and
Republic New York Securities Corporation as defendants. HSBC USA
Inc. and the Bank have moved to dismiss both complaints. The
motion is fully briefed and sub judice. Mutual production of
documents took place in 2001, but additional discovery
proceedings have been suspended pending the Court's resolution of
the motions to dismiss.
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits -
3(i) Registrant's Restated Certificate of Incorporation and
Amendments thereto, Exhibit 3(a) to the Company's 1999
Annual Report on Form 10-K incorporated herein by
reference.
(ii) Registrant's By-Laws, as Amended to Date, Exhibit 3 to the
Company's Form 10-Q for the quarter ended June 30, 2002
incorporated herein by reference.
4 Instruments Defining the Rights of Security Holders,
including Indentures, incorporated by reference to
previously filed periodic reports.
31.1 Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.0 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
A current report on Form 8-K was filed June 28, 2004 announcing
approval by the Office of the Comptroller of the Currency for
HSBC USA Inc. to consolidate its banking operations under a
single national charter.
50
SIGNATURE
- --------------------------------------------------------------------------------
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.
HSBC USA Inc.
-------------
(Registrant)
Date: August 2, 2004 /s/ Joseph R. Simpson
--------------------------------------
Joseph R. Simpson
Senior Vice President & Controller
(On behalf of Registrant and
as Chief Accounting Officer)
51