HSBC Holdings Regulatory News (HSBA)

5 Mar 2007 12:18

HSBC Holdings PLC05 March 2007 The increase in restructured loans compared to the prior year was primarilyattributable to higher levels of real estate secured restructures due toportfolio growth and seasoning, including higher restructure levels at ourMortgage Services business as we continue to work with our customers who, in ourjudgment, evidence continued payment probability. Additionally, beginning in thefourth quarter of 2006, we expanded the use of account modification at ourMortgage Services business to modify the rate and/or payment on a number ofqualifying loans and restructured certain of those accounts after receipt of onemodified payment and if certain other criteria were met. Such accounts areincluded in the above restructure statistics beginning in 2006. See "CreditQuality Statistics" for further information regarding owned basis and managedbasis delinquency, charge-offs and nonperforming loans. In addition to our restructuring policies and practices, we employ othercustomer account management techniques that are similarly designed to managecustomer relationships, maximize collection opportunities and avoid foreclosureor repossession if reasonably possible. These additional customer accountmanagement techniques include, at our discretion, actions such as extendedpayment arrangements, approved external debt management plans, forbearance,modifications, loan rewrites and/or deferment pending a change in circumstances.We typically use these customer account management techniques with individualborrowers in transitional situations, usually involving borrower hardshipcircumstances or temporary setbacks that are expected to affect the borrower'sability to pay the contractually specified amount for some period of time. Forexample, under a forbearance agreement, we may agree not to take certaincollection or credit agency reporting actions with respect to missed payments,often in return for the borrower's agreeing to pay us an additional amount withfuture required payments. In some cases, these additional customer accountmanagement techniques may involve us agreeing to lower the contractual paymentamount and/or reduce the periodic interest rate. In most cases, the delinquencystatus of an account is considered to be current if the borrower immediatelybegins payment under the new account terms. We are actively using loanmodifications followed by an account restructure if the borrower makes one ormore modified payments in response to increased volumes within our delinquentMortgage Services portfolio. This account management practice is designed toassist borrowers who may have purchased a home with an expectation of continuedreal estate appreciation or income that has proven unfounded. The amount of domestic and foreign managed receivables in forbearance,modification, credit card services approved consumer credit counselingaccommodations, rewrites, modifications (excluding Mortgage Services in 2006) orother customer account management techniques for which we have reset delinquencyand that is not included in the restructured or delinquency statistics wasapproximately $.3 billion or .2 percent of managed receivables at December 31,2006 compared with $.4 billion or .3 percent of managed receivables at December31, 2005. When we use a customer account management technique, we may treat the account asbeing contractually current and will not reflect it as a delinquent account inour delinquency statistics. However, if the account subsequently experiencespayment defaults, it will again become contractually delinquent. We generallyconsider loan rewrites to involve an extension of a new loan, and such new loansare not reflected in our delinquency or restructuring statistics. Our accountmanagement actions vary by product and are under continual review and assessmentto determine that they meet the goals outlined above. GEOGRAPHIC CONCENTRATIONS The state of California accounts for 13 percent of ourdomestic portfolio. We also have significant concentrations of domestic consumerreceivables in Florida (7%), New York (6%), Texas (5%), Ohio (5%), andPennsylvania (5%). Because of our centralized underwriting, collections andprocessing functions, we can quickly change our credit standards and intensifycollection efforts in specific locations. We believe this lowers risks resultingfrom such geographic concentrations. Our foreign consumer operations located in the United Kingdom and the Republicof Ireland accounted for 3 percent of consumer receivables and Canada accountedfor 2 percent of consumer receivables at December 31, 2006. 78 HSBC Finance Corporation-------------------------------------------------------------------------------- LIQUIDITY AND CAPITAL RESOURCES-------------------------------------------------------------------------------- While the funding synergies resulting from our acquisition by HSBC have allowedus to reduce our reliance on traditional sources to fund our growth, ourcontinued success and prospects for growth are dependent upon access to theglobal capital markets. Numerous factors, internal and external, may impact ouraccess to and the costs associated with issuing debt in these markets. Thesefactors may include our debt ratings, overall capital markets volatility and theimpact of overall economic conditions on our business. We continue to focus onbalancing our use of affiliate and third-party funding sources to minimizefunding expense while maximizing liquidity. As discussed below, we supplementedunsecured debt issuance during 2006 and 2005 with proceeds from the continuingsale of newly originated domestic private label receivables (excluding retailsales contracts) to HSBC Bank USA following the bulk sale of this portfolio inDecember 2004, debt issued to affiliates, the issuance of Series B preferredstock, the issuance of additional common equity to HINO in both 2006 and 2005and the sale of our U.K. credit card business to HBEU in December 2005. Because we are a subsidiary of HSBC, our credit ratings have improved and ourcredit spreads relative to Treasury Bonds have tightened compared to those weexperienced during the months leading up to the announcement of our acquisitionby HSBC. Primarily as a result of tightened credit spreads and improved fundingavailability, we recognized cash funding expense savings of approximately $940million during 2006, $600 million in 2005 and $350 million in 2004 compared tothe funding costs we would have incurred using average spreads and funding mixfrom the first half of 2002. These tightened credit spreads in combination withthe issuance of HSBC Finance Corporation debt and other funding synergiesincluding asset transfers and debt underwriting fees paid to HSBC affiliateshave enabled HSBC to realize a pre-tax cash funding expense savings in excess of$1.0 billion for the year ended December 31, 2006. Amortization of purchaseaccounting fair value adjustments to our external debt obligations, reducedinterest expense by $542 million in 2006, including $62 million relating toMetris and $656 million in 2005, including $1 million relating to Metris and$946 million in 2004. 79 HSBC Finance Corporation-------------------------------------------------------------------------------- Debt due to affiliates and other HSBC related funding are summarized in thefollowing table: DECEMBER 31, 2006 2005--------------------------------------------------------------------------- (IN BILLIONS) Debt outstanding to HSBC subsidiaries: Drawings on bank lines in the U.K. and Europe............. $ 4.3 $ 4.2 Term debt................................................. 10.6 11.0 Preferred securities issued by Household Capital Trust VIII to HSBC........................................... .3 .3 ----- ----- Total debt outstanding to HSBC subsidiaries............... 15.2 15.5 ----- -----Debt outstanding to HSBC clients: Euro commercial paper..................................... 3.0 3.2 Term debt................................................. 1.2 1.3 ----- ----- Total debt outstanding to HSBC clients.................... 4.2 4.5Cash received on bulk and subsequent sale of domestic private label credit card receivables to HSBC Bank USA, net (cumulative).......................................... 17.9 15.7Real estate secured receivable activity with HSBC Bank USA: Cash received on sales (cumulative)....................... 3.7 3.7 Direct purchases from correspondents (cumulative)......... 4.2 4.2 Reductions in real estate secured receivables sold to HSBC Bank USA............................................... (4.7) (3.3) ----- -----Total real estate secured receivable activity with HSBC Bank USA....................................................... 3.2 4.6Cash received from sale of European Operations to HBEU affiliate................................................. -(2) -Cash received from sale of U.K. credit card business to HBEU...................................................... 2.7 2.6Capital contribution by HINO................................ 1.4(1) 1.2(1) ----- -----Total HSBC related funding.................................. $44.6 $44.1 ===== ===== --------------- (1) This capital contribution was made in connection with our acquisition of Champion Mortgage in November 2006 and our acquisition of Metris in December 2005. (2) Less than $100 million. At December 31, 2006, funding from HSBC, including debt issuances to HSBCsubsidiaries and clients, represented 13 percent of our total debt and preferredstock funding. At December 31, 2005, funding from HSBC, including debt issuancesto HSBC subsidiaries and clients, represented 15 percent of our total debt andpreferred stock funding. Cash proceeds of $46 million from the November 2006 sale of the EuropeanOperations and the December 2005 sale of our U.K. credit card receivables toHBEU of $2.7 billion in cash were used to partially pay down drawings on banklines from HBEU for the U.K. and fund operations. Proceeds received from thebulk sale and subsequent daily sales of domestic private label credit cardreceivables to HSBC Bank USA of $17.9 billion were used to pay down short-termdomestic borrowings, including outstanding commercial paper balances, and tofund operations. At December 31, 2006, we had a commercial paper back stop credit facility of$2.5 billion from HSBC supporting domestic issuances and a revolving creditfacility of $5.7 billion from HBEU to fund our operations in the U.K. AtDecember 31, 2005, we had a commercial paper back stop credit facility of $2.5billion from HSBC supporting domestic issuances and a revolving credit facilityof $5.3 billion from HBEU to fund our operations in the U.K. At December 31,2006, $4.3 billion was outstanding under the HBEU lines for the U.K. and nobalances were outstanding under the domestic lines. At December 31, 2005, $4.2billion was outstanding under HBEU lines for the U.K. and no balances wereoutstanding under the domestic lines. We had derivative contracts with anotional value of $87.4 billion, or approximately 93 percent of total derivativecontracts, outstanding with HSBC affiliates at December 31, 2006. At December31, 2005, we had derivative 80 HSBC Finance Corporation-------------------------------------------------------------------------------- contracts with a notional value of $72.2 billion, or approximately 87 percent oftotal derivative contracts, outstanding with HSBC affiliates SECURITIES AND OTHER SHORT-TERM INVESTMENTS Securities totaled $4.7 billion atDecember 31, 2006 and $4.1 billion at December 31, 2005 as a result of anincrease in money market funds restricted for paying down secured financings atthe established payment date. Securities purchased under agreements to reselltotaled $171 million at December 31, 2006 and $78 million at December 31, 2005.Interest bearing deposits with banks totaled $424 million at December 31, 2006and $384 million at December 31, 2005. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS totaled $11.1 billion at December31, 2006 and $11.4 billion at December 31, 2005. The levels at December 31, 2006reflect our decision to carry lower commercial paper balances. This fundingstrategy also requires that bank credit facilities will at all times exceed 85%of outstanding commercial paper and that the combination of bank creditfacilities and undrawn committed conduit facilities will, at all times, exceed115% of outstanding commercial paper. This plan, which was reviewed with therelevant rating agencies, resulted in an increase in our maximum outstandingcommercial paper balance. Included in this total was outstanding Euro commercialpaper sold to customers of HSBC of $3.0 billion at December 31, 2006 and $3.2billion at December 31, 2005. LONG TERM DEBT (with original maturities over one year) increased to $127.6billion at December 31, 2006 from $105.2 billion at December 31, 2005. As partof our overall liquidity management strategy, we continue to extend the maturityof our liability profile. Significant issuances during 2006 included thefollowing: - $7.3 billion of domestic and foreign medium-term notes - $7.9 billion of foreign currency-denominated bonds - $1.8 billion of InterNotes(SM) (retail-oriented medium-term notes) - $9.3 billion of global debt - $14.9 billion of securities backed by real estate secured, auto finance, credit card and personal non-credit card receivables. For accounting purposes, these transactions were structured as secured financings. In the first quarter of 2006, we redeemed the junior subordinated notes, issuedto Household Capital Trust VI with an outstanding principal balance of $206million. In the fourth quarter of 2006 we redeemed the junior subordinatednotes, issued to Household Capital Trust VII with an outstanding principalbalance of $206 million. In November 2005, we issued $1.0 billion of preferred securities of HouseholdCapital Trust IX. The interest rate on these securities is 5.911% from the dateof issuance through November 30, 2015 and is payable semiannually beginning May30, 2006. After November 30, 2015, the rate changes to the three-month LIBORrate, plus 1.926% and is payable quarterly beginning on February 28, 2016. InJune 2005, we redeemed the junior subordinated notes issued to Household CapitalTrust V with an outstanding principal balance of $309 million. PREFERRED SHARES In June 2005, we issued 575,000 shares of Series B PreferredStock for $575 million. Dividends on the Series B Preferred Stock arenon-cumulative and payable quarterly at a rate of 6.36 percent commencingSeptember 15, 2005. The Series B Preferred Stock may be redeemed at our optionafter June 23, 2010. In 2006 and 2005, we paid dividends totaling $37 millionand $17 million, respectively on the Series B Preferred Stock. COMMON EQUITY In 2006, in connection with our purchase of the Championportfolio, HINO made a capital contribution of $163 million. In 2005, we issuedfour shares of common equity to HINO in December 2005 in exchange for the $1.1billion Series A Preferred Stock plus all accrued and unpaid dividends.Additionally, in connection with our acquisition of Metris, HINO made a capitalcontribution of $1.2 billion in exchange for one share of common stock. SELECTED CAPITAL RATIOS In managing capital, we develop targets for tangibleshareholder's(s') equity to tangible managed assets ("TETMA"), tangibleshareholder's(s') equity plus owned loss reserves to tangible 81 HSBC Finance Corporation-------------------------------------------------------------------------------- managed assets ("TETMA + Owned Reserves") and tangible common equity to tangiblemanaged assets. These ratio targets are based on discussions with HSBC andrating agencies, risks inherent in the portfolio, the projected operatingenvironment and related risks, and any acquisition objectives. Our targets maychange from time to time to accommodate changes in the operating environment orother considerations such as those listed above. In 2006, Standard & Poor's Corporation raised the senior debt rating for HSBCFinance Corporation from A to AA-, raised the senior subordinated debt ratingfrom A- to A+, raised the commercial paper rating from A-1 to A-1+, and raisedthe Series B preferred stock rating from BBB+ to A-2. Also, during the fourthquarter of 2006 Standard and Poor's Corporations changed our total outlook onour issuer default rating to "positive outlook". During 2006, Moody's InvestorsService raised the rating for all of our debt with the Senior Debt Rating forHSBC Finance Corporation raised from A1 to Aa3 and the Series B preferred stockrating for HSBC Finance Corporation from A3 to A2. Our short-term rating wasalso affirmed at Prime-1. In the third quarter of 2006, Fitch changed the totaloutlook on our issuer default rating to "positive outlook" from "stableoutlook." Selected capital ratios are summarized in the following table: DECEMBER 31, 2006 2005--------------------------------------------------------------------------- TETMA(1),).................................................. 7.20% 7.56%TETMA + Owned Reserves(1),)................................. 11.08 10.55Tangible common equity to tangible managed assets(1)........ 6.11 6.07Common and preferred equity to owned assets................. 11.19 12.43Excluding HSBC acquisition purchase accounting adjustments: TETMA(1),)................................................ 7.85% 8.52% TETMA + Owned Reserves(1),)............................... 11.73 11.51 Tangible common equity to tangible managed assets(1)...... 6.76 7.02 --------------- (1) TETMA, TETMA + Owned Reserves and tangible common equity to tangible managed assets represent non-U.S. GAAP financial ratios that are used by HSBC Finance Corporation management and applicable rating agencies to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See "Basis of Reporting" for additional discussion on the use of non-U.S. GAAP financial measures and "Reconciliations to U.S. GAAP Financial Measures" for quantitative reconciliations to the equivalent U.S. GAAP basis financial measure. HSBC FINANCE CORPORATION. HSBC Finance Corporation is an indirect wholly ownedsubsidiary of HSBC Holdings plc. On March 28, 2003, HSBC acquired HouseholdInternational, Inc. by way of merger in a purchase business combination.Effective January 1, 2004, HSBC transferred its ownership interest in Householdto a wholly owned subsidiary, HSBC North America Holdings Inc., whichsubsequently contributed Household to its wholly owned subsidiary, HINO. OnDecember 15, 2004, Household merged with its wholly owned subsidiary, HouseholdFinance Corporation, with Household as the surviving entity. At the time of themerger, Household changed its name to "HSBC Finance Corporation." HSBC Finance Corporation is the parent company that owns the outstanding commonstock of its subsidiaries. Our main source of funds is cash received fromoperations and subsidiaries in the form of dividends. In addition, we receivecash from third parties and affiliates by issuing preferred stock and debt. HSBC Finance Corporation received cash dividends from its subsidiaries of $74million in 2006 and $514 million in 2005. In conjunction with the acquisition by HSBC, we issued a series of 6.50 percentcumulative preferred stock in the amount of $1.1 billion ("Series A PreferredStock") to HSBC on March 28, 2003. In September 2004, HSBC North America issueda new series of preferred stock totaling $1.1 billion to HSBC in exchange forour Series A Preferred Stock. In October 2004, our immediate parent, HINO,issued a new series of preferred stock to HSBC North America in exchange for ourSeries A Preferred Stock. We paid dividends on our 82 HSBC Finance Corporation-------------------------------------------------------------------------------- Series A Preferred Stock of $66 million in October 2005 and $108 million inOctober 2004. On December 15, 2005, we issued 4 shares of common stock to HINOin exchange for the $1.1 billion Series A Preferred Stock plus the accrued andunpaid dividends and the Series A Preferred Stock was retired. In November 2005, we issued $1.0 billion of preferred securities of HouseholdCapital Trust IX. The interest rate on these securities is 5.911% from the dateof issuance through November 30, 2015 and is payable semiannually beginning May30, 2006. After November 30, 2015, the rate changes to the three-month LIBORrate, plus 1.926% and is payable quarterly beginning on February 28, 2016. InJune 2005, we redeemed the junior subordinated notes issued to the HouseholdCapital Trust V with an outstanding principal balance of $309 million. In June 2005, we issued 575,000 shares of Series B Preferred Stock for $575million. Dividends on the Series B Preferred Stock are non-cumulative andpayable quarterly at a rate of 6.36 percent commencing September 15, 2005. TheSeries B Preferred Stock may be redeemed at our option after June 23, 2010. In2006 and 2005, we paid dividends totaling $37 million and $17 million,respectively, on the Series B Preferred Stock. HSBC Finance Corporation has a number of obligations to meet with its availablecash. It must be able to service its debt and meet the capital needs of itssubsidiaries. It also must pay dividends on its preferred stock and may paydividends on its common stock. Dividends of $809 million were paid to HINO, ourimmediate parent company, on our common stock in 2006 and $980 million were paidin 2005. We anticipate paying future dividends to HINO, but will maintain ourcapital at levels necessary to maintain current ratings either by limiting thedividends to or through capital contributions from our parent. At various times, we will make capital contributions to our subsidiaries tocomply with regulatory guidance, support receivable growth, maintain acceptableinvestment grade ratings at the subsidiary level, or provide funding forlong-term facilities and technology improvements. HSBC Finance Corporation madecapital contributions to certain subsidiaries of $1.5 billion in 2006 and $2.2billion in 2005. SUBSIDIARIES At December 31, 2006, HSBC Finance Corporation had one majorsubsidiary, Household Global Funding ("Global Funding"), and manages alldomestic operations. Prior to December 15, 2004, we had two major subsidiaries:Household Finance Corporation ("HFC"), which managed all domestic operations,and Global Funding. On December 15, 2004, HFC merged with and into HouseholdInternational which changed its name to HSBC Finance Corporation. DOMESTIC OPERATIONS HSBC Finance Corporation's domestic operations are fundedthrough the collection of receivable balances; issuing commercial paper,medium-term debt and long-term debt; borrowing under secured financingfacilities and selling consumer receivables. Domestically, HSBC FinanceCorporation markets its commercial paper primarily through an in-house salesforce. The vast majority of our domestic medium-term notes and long-term debt isnow marketed through subsidiaries of HSBC. Domestic medium-term notes may alsobe marketed through our in-house sales force. Intermediate and long-term debtmay also be marketed through unaffiliated investment banks. At December 31, 2006, advances from subsidiaries of HSBC for our domesticoperations totaled $10.6 billion. At December 31, 2005, advances fromsubsidiaries of HSBC for our domestic operations totaled $11.0 billion. Theinterest rates on funding from HSBC subsidiaries are market-based and comparableto those available from unaffiliated parties. Outstanding commercial paper related to our domestic operations totaled $10.8billion at December 31, 2006 and $10.9 billion at December 31, 2005. Following our acquisition by HSBC, we established a new Euro commercial paperprogram, largely targeted towards HSBC clients, which expanded our Europeaninvestor base. Under the Euro commercial paper program, commercial paperdenominated in Euros, British pounds and U.S. dollars is sold to foreigninvestors. Outstanding Euro commercial paper sold to customers of HSBC totaled$3.0 billion at December 31, 2006 83 HSBC Finance Corporation-------------------------------------------------------------------------------- and $3.2 billion at December 31, 2005. We actively manage the level ofcommercial paper outstanding to ensure availability to core investors whilemaintaining excess capacity within our internally-established targets ascommunicated with the rating agencies. The following table shows various debt issuances by HSBC Finance Corporation andits domestic subsidiaries during 2006 and 2005. 2006 2005--------------------------------------------------------------------------- (IN BILLIONS) Medium term notes, excluding issuances to HSBC customers and subsidiaries of HSBC...................................... $6.0 $9.5Medium term notes issued to HSBC customers.................. - .2Medium term notes issued to subsidiaries of HSBC............ .8 5.0Foreign currency-denominated bonds, excluding issuances to HSBC customers and subsidiaries of HSBC................... 7.9 5.8Junior subordinated notes issued to the Household Capital Trust IX.................................................. - 1.0Foreign currency-denominated bonds issued to HSBC customers................................................. - .2Foreign currency-denominated bonds issued to subsidiaries of HSBC...................................................... - -Global debt................................................. 9.3 11.2InterNotes(SM) (retail-oriented medium-term notes).......... 1.8 1.8Securities backed by home equity, auto finance and credit card and personal non-credit card receivables structured as secured financings..................................... 14.9 9.7 Additionally, in 2005 as part of the Metris acquisition we assumed $4.6 billionof securities backed by credit card receivables which we restructured to failsale treatment and are now accounted for as secured financings. In order to eliminate future foreign exchange risk, currency swaps were used atthe time of issuance to fix in U.S. dollars substantially allforeign-denominated notes in 2006 and 2005. HSBC Finance Corporation issued securities backed by dedicated receivables of$14.9 billion in 2006 and $9.7 billion in 2005. For accounting purposes, thesetransactions were structured as secured financings, therefore, the receivablesand the related debt remain on our balance sheet. At December 31, 2006,closed-end real estate secured, auto finance and credit card and personalnon-credit card receivables totaling $28.1 billion secured $21.8 billion ofoutstanding debt. At December 31, 2005, closed-end real estate secured and autofinance and credit card receivables totaling $19.7 billion secured $15.1 billionof outstanding debt. HSBC Finance Corporation had committed back-up lines of credit totaling $11.7billion at December 31, 2006 for its domestic operations. Included in theDecember 31, 2006 total are $2.5 billion of revolving credit facilities withHSBC. None of these back-up lines were drawn upon in 2006. The back-up linesexpire on various dates through 2009. The most restrictive financial covenantcontained in the back-up line agreements that could restrict availability is anobligation to maintain minimum shareholder's equity of $11.0 billion which issubstantially below our December 31, 2006 common and preferred shareholder'sequity balance of $20.1 billion. At December 31, 2006, we had facilities with commercial and investment banksunder which our domestic operations may issue securities backed with receivablesup to $19.0 billion of receivables, including up to $15.0 billion of autofinance, credit card and personal non-credit card and $4.0 billion of realestate secured receivables. We increased our total conduit capacity by $3.6billion in 2006. Conduit capacity for real estate secured receivables wasincreased $1.2 billion and capacity for other products was increased $2.4billion. The facilities are renewable at the banks' option. At December 31,2006, $9.1 billion of auto finance, credit card, personal non-credit card andreal estate secured receivables were used in collateralized funding transactionsstructured either as securitizations or secured financings under these fundingprograms. In addition, we have available a $4.0 billion single seller mortgagefacility (none of which was outstanding at December 31, 2006). The amountavailable under the facilities will vary based on the timing and volume ofpublic securitization 84 HSBC Finance Corporation-------------------------------------------------------------------------------- transactions. Through existing term bank financing and new debt issuances, webelieve we will continue to have adequate sources of funds. GLOBAL FUNDING Global Funding includes our foreign subsidiaries in the UnitedKingdom, the Republic of Ireland and Canada. Global Funding's assets were $10.9billion at December 31, 2006 and $10.7 billion at December 31, 2005. At December31, 2005, Global Funding's assets included the assets of our European Operationswhich, as previously discussed, were sold to HBEU in November 2006. Consolidatedshareholder's(s') equity includes the effect of translating our foreignsubsidiaries' assets, liabilities and operating results from their localcurrency into U.S. dollars. Each foreign subsidiary conducts its operations using its local currency. Whileeach foreign subsidiary usually borrows funds in its local currency, both ourUnited Kingdom and Canadian subsidiaries have historically borrowed funds inforeign currencies. This allowed the subsidiaries to achieve a lower cost offunds than that available at that time in their local markets. These borrowingswere converted from foreign currencies to their local currencies using currencyswaps at the time of issuance. UNITED KINGDOM Our United Kingdom operation is funded with HBEU debt andpreviously issued long-term debt. The following table summarizes the funding ofour United Kingdom operation: 2006 2005--------------------------------------------------------------------------- (IN BILLIONS) Due to HSBC affiliates...................................... $4.3 $4.2Long term debt.............................................. .2 .9 At December 31, 2006, $.2 billion of long term debt was guaranteed by HSBCFinance Corporation. HSBC Finance Corporation receives a fee for providing theguarantee. In 2006 and 2005, our United Kingdom subsidiary primarily receivedits funding directly from HSBC. As previously discussed, in November 2006, our U.K. operations sold its EuropeanOperations to a subsidiary of HBEU for total consideration of $46 million andused the proceeds to partially pay down amounts due to HBEU on bank lines in theU.K. Additionally, in December 2005, our U.K. operations sold its credit cardoperations to HBEU for total consideration of $3.0 billion, including $261million in preferred stock of a subsidiary of HBEU, and used the proceeds topartially pay down amounts due to HBEU on bank lines in the U.K. and to pay acash dividend of $489 million to HSBC Finance Corporation. Our U.K. operationsalso provided a dividend to HSBC Finance Corporation of $41 million of thepreferred stock received in the transaction. CANADA Our Canadian operation is funded with commercial paper, intermediate debtand long-term debt. Outstanding commercial paper totaled $223 million atDecember 31, 2006 compared to $442 million at December 31, 2005. Intermediateand long-term debt totaled $3.4 billion at December 31, 2006 compared to $2.5billion at December 31, 2005. At December 31, 2006, $3.6 billion of the Canadiansubsidiary's debt was guaranteed by HSBC Finance Corporation for which itreceives a fee for providing the guarantee. Committed back-up lines of creditfor Canada were approximately $86 million at December 31, 2006. All of theseback-up lines are guaranteed by HSBC Finance Corporation and none were used in2006. In 2006, our Canadian operations paid a dividend of $26 million to HSBCFinance Corporation. 85 HSBC Finance Corporation-------------------------------------------------------------------------------- 2007 FUNDING STRATEGY As discussed previously, the acquisition by HSBC hasimproved our access to the capital markets as well as expanded our access to aworldwide pool of potential investors. Our current estimated domestic fundingneeds and sources for 2007 are summarized in the table that follows. (IN BILLIONS)---------------------------------------------------------------------------- FUNDING NEEDS: Net asset growth.......................................... $(10) - 0 Commercial paper, term debt and securitization maturities............................................. 30 - 36 Other..................................................... 1 - 3 ----------Total funding needs......................................... $21 - 39 ==========FUNDING SOURCES: External funding, including commercial paper.............. $20 - 36 HSBC and HSBC subsidiaries................................ 1 - 3 ----------Total funding sources....................................... $21 - 39 ========== As previously discussed, we have experienced deterioration in the performance ofmortgage loan originations in our Mortgage Services business. Numerous riskmitigation efforts are underway in this business and we have slowed growth bytightening underwriting criteria. These actions, combined with normal portfolioattrition, will result in negative growth in 2007. Additionally during 2007, wewill continue to analyze the mortgage acquisition strategy. If we continue toobserve risk in specific portfolios we may choose to constrain growth in certainportfolios. In addition, as opportunities arise we may also choose to sellselected portfolios. Both activities could result in negative year over yeargrowth in the balance sheet. Commercial paper outstanding in 2007 is expected tobe in line with the December 31, 2006 balances, except during the first threemonths of 2007 when commercial paper balances will be temporarily high due tothe seasonal activity of our TFS business. Approximately two-thirds ofoutstanding commercial paper is expected to be domestic commercial paper soldboth directly and through dealer programs. Euro commercial paper is expected toaccount for approximately one-third of outstanding commercial paper and will bemarketed predominately to HSBC clients. Term debt issuances are expected to utilize several ongoing programs to achievethe desired funding. Approximately 78 percent of term debt funding is expectedto be achieved through transactions including U.S. dollar global and Eurotransactions and large medium-term note ("MTN") offerings. Domestic retail noteprograms are expected to account for approximately 12 percent of term debtissuances. The remaining term debt issuances are expected to consist of smallerdomestic and foreign currency MTN offerings. As a result of our decision in 2004 to fund all new collateralized fundingtransactions as secured financings, we anticipate securitization levels willcontinue to decline in 2007. Because existing public credit card transactionswere structured as sales to revolving trusts that require replenishments ofreceivables to support previously issued securities, receivables will continueto be sold to these trusts until the revolving periods end, the last of which iscurrently projected to occur in the fourth quarter of 2007. In addition, we willcontinue to replenish at reduced levels, certain non-public personal non-creditcard securities issued to conduits for a period of time in order to manageliquidity. The termination of sale treatment on new collateralized fundingactivity reduced our reported net income under U.S. GAAP. There was no impact,however, on cash received from operations or on IFRS reported results. Becausewe believe the market for securities backed by receivables is a reliable,efficient and cost-effective source of funds, we will continue to use securedfinancings of consumer receivables as a source of our funding and liquidity. Weanticipate that secured financings in 2007 should increase significantly overthe 2006 levels. HSBC received regulatory approval in 2003 to provide the direct funding requiredby our United Kingdom operations. Accordingly, in 2004 we eliminated all back-uplines of credit which had previously supported our United Kingdom subsidiary.All new funding for our United Kingdom subsidiary is now provided directly byHSBC. Our Canadian operation will continue to fund itself independently throughtraditional third-party 86 HSBC Finance Corporation-------------------------------------------------------------------------------- funding sources such as commercial paper and medium term-notes. Funding needs in2007 are not expected to be significant for Canada. CAPITAL EXPENDITURES We made capital expenditures of $148 million in 2006 whichincluded costs related to the new office building in the Village of Mettawa,Illinois and the Solstice acquisition. Capital expenditures in 2005 were $78million. COMMITMENTS We also enter into commitments to meet the financing needs of ourcustomers. In most cases, we have the ability to reduce or eliminate these openlines of credit. As a result, the amounts below do not necessarily representfuture cash requirements at December 31, 2006: (IN BILLIONS)---------------------------------------------------------------------------- Private label, and credit cards............................. $186Other consumer lines of credit.............................. 7 ----Open lines of credit(1)..................................... $193 ==== --------------- (1) Includes an estimate for acceptance of credit offers mailed to potential customers prior to December 31, 2006. At December 31, 2006, our Mortgage Services business had commitments withnumerous correspondents to purchase up to $104 million of real estate securedreceivables at fair market value, subject to availability based on currentunderwriting guidelines specified by our Mortgage Services business and atprices indexed to general market rates. These commitments have terms of up toone year and can be renewed upon mutual agreement. Also at December 31, 2006,our Mortgage Services business had outstanding forward sales commitmentsrelating to real estate secured loans totaling $607 million and unusedcommitments to extend credit relating to real estate secured loans to customers(as long as certain conditions are met), totaling $1.4 billion. At December 31, 2006, we also had a commitment to lend up to $3.0 billion to H&RBlock to fund its acquisition of a participation interest in refund anticipationloans during the 2007 tax season. CONTRACTUAL CASH OBLIGATIONS The following table summarizes our long-termcontractual cash obligations at December 31, 2006 by period due: 2007 2008 2009 2010 2011 THEREAFTER TOTAL----------------------------------------------------------------------------------------------------------------- (IN MILLIONS) PRINCIPAL BALANCE OF DEBT: Due to affiliates..................... $ 4,909 $ 26 $ 2,005 $ 1,433 $ 191 $ 6,608 $ 15,172 Long term debt (including secured financings)......................... 26,149 21,734 16,815 12,572 13,718 34,330 125,318 ------- ------- ------- ------- ------- ------- -------- Total debt............................ 31,058 21,760 18,820 14,005 13,909 40,938 140,490 ------- ------- ------- ------- ------- ------- --------OPERATING LEASES: Minimum rental payments............... 182 144 121 80 42 127 696 Minimum sublease income............... 58 36 34 15 - - 143 ------- ------- ------- ------- ------- ------- -------- Total operating leases................ 124 108 87 65 42 127 553 ------- ------- ------- ------- ------- ------- --------OBLIGATIONS UNDER MERCHANT AND AFFINITY PROGRAMS.............................. 141 137 90 84 80 334 866NON-QUALIFIED PENSION AND POSTRETIREMENT BENEFIT LIABILITIES(1)................ 20 23 24 26 27 847 967 ------- ------- ------- ------- ------- ------- --------TOTAL CONTRACTUAL CASH OBLIGATIONS...... $31,343 $22,028 $19,021 $14,180 $14,058 $42,246 $142,876 ======= ======= ======= ======= ======= ======= ======== --------------- (1) Expected benefit payments calculated include future service component. These cash obligations could be funded primarily through cash collections onreceivables, from the issuance of new unsecured debt or through securedfinancings of receivables. Our receivables and other liquid assets generallyhave shorter lives than the liabilities used to fund them. 87 HSBC Finance Corporation-------------------------------------------------------------------------------- In January 2006, we entered into a lease for a building in the Village ofMettawa, Illinois. The new facility will consolidate our Prospect Heights, MountProspect and Deerfield offices. Construction of the building began in the springof 2006 and the relocation is planned for the first and second quarters of 2008.The future lease payments for this building are currently estimated as follows: (IN MILLIONS)---------------------------------------------------------------------------- 2008........................................................ $ 52009........................................................ 112010........................................................ 112011........................................................ 11Thereafter.................................................. 115 ---- $153 ==== Our purchase obligations for goods and services at December 31, 2006 were notsignificant. OFF BALANCE SHEET ARRANGEMENTS AND SECURED FINANCINGS-------------------------------------------------------------------------------- SECURITIZATIONS AND SECURED FINANCINGS Securitizations (collateralized fundingtransactions structured to receive sale treatment under Statement of FinancialAccounting Standards No. 140, "Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities, a Replacement of FASBStatement No. 125," ("SFAS No. 140")) and secured financings (collateralizedfunding transactions which do not receive sale treatment under SFAS No. 140) ofconsumer receivables have been a source of funding and liquidity for us.Securitizations and secured financings have been used to limit our reliance onthe unsecured debt markets and often are more cost-effective than alternativefunding sources. In a securitization, a designated pool of non-real estate consumer receivablesis removed from the balance sheet and transferred through a limited purposefinancing subsidiary to an unaffiliated trust. This unaffiliated trust is aqualifying special purpose entity ("QSPE") as defined by SFAS No. 140 and,therefore, is not consolidated. The QSPE funds its receivable purchase throughthe issuance of securities to investors, entitling them to receive specifiedcash flows during the life of the securities. The receivables transferred to theQSPE serve as collateral for the securities. At the time of sale, aninterest-only strip receivable is recorded, representing the present value ofthe cash flows we expect to receive over the life of the securitizedreceivables, net of estimated credit losses and debt service. Under the terms ofthe securitizations, we receive annual servicing fees on the outstanding balanceof the securitized receivables and the rights to future residual cash flows onthe sold receivables after the investors receive their contractual return. Cashflows related to the interest-only strip receivables and servicing thereceivables are collected over the life of the underlying securitizedreceivables. Certain securitization trusts, such as credit cards, are established at fixedlevels and, due to the revolving nature of the underlying receivables, requirethe sale of new receivables into the trust to replace runoff so that theprincipal dollar amount of the investors' interest remains unchanged. We referto such activity as replenishments. Once the revolving period ends, theamortization period begins and the trust distributes principal payments, inaddition to interest, to the investors. When loans are securitized in transactions structured as sales, we receive cashproceeds from investors, net of transaction costs and expenses. These proceedsare generally used to re-pay other debt and corporate obligations and to fundnew loans. The investors' shares of finance charges and fees received from thesecuritized loans are collected each month and are primarily used to payinvestors for interest and credit losses and to pay us for servicing fees. Weretain any excess cash flow remaining after such payments are made to investors. Generally, for each securitization and secured financing we utilize creditenhancement to obtain investment grade ratings on the securities issued by thetrust. To ensure that adequate funds are available to pay investors theircontractual return, we may retain various forms of interests in assets securinga funding transaction, 88 HSBC Finance Corporation-------------------------------------------------------------------------------- whether structured as a securitization or a secured financing, such asover-collateralization, subordinated series, residual interests in thereceivables (in the case of securitizations) or we may fund cash accounts. Over-collateralization is created by transferring receivables to the trust issuingthe securities that exceed the balance of the securities to be issued.Subordinated interests provide additional assurance of payment to investorsholding senior securities. Residual interests are also referred to asinterest-only strip receivables and represent rights to future cash flows fromreceivables in a securitization trust after investors receive their contractualreturn. Cash accounts can be funded by an initial deposit at the time thetransaction is established and/or from interest payments on the receivables thatexceed the investor's contractual return. Our retained securitization interests are not in the form of securities and areincluded in receivables on our consolidated balance sheets. These retainedinterests were comprised of the following at December 31, 2006 and 2005: AT DECEMBER 31, --------------- 2006 2005----------------------------------------------------------------------------- (IN MILLIONS) Overcollateralization....................................... $ 52 $ 214Interest-only strip receivables............................. 6 23Cash spread accounts........................................ 40 150Other subordinated interests................................ 870 2,131 ---- ------Total retained securitization interests..................... $968 $2,518 ==== ====== In a secured financing, a designated pool of receivables are conveyed to awholly owned limited purpose subsidiary which in turn transfers the receivablesto a trust which sells interests to investors. Repayment of the debt issued bythe trust is secured by the receivables transferred. The transactions arestructured as secured financings under SFAS No. 140. Therefore, the receivablesand the underlying debt of the trust remain on our balance sheet. We do notrecognize a gain in a secured financing transaction. Because the receivables andthe debt remain on our balance sheet, revenues and expenses are reportedconsistently with our owned balance sheet portfolio. Using this source offunding results in similar cash flows as issuing debt through alternativefunding sources. Securitizations are treated as secured financings under both IFRS and U.K. GAAP.In order to align our accounting treatment with that of HSBC initially underU.K. GAAP and now under IFRS, we began to structure all new collateralizedfunding transactions as secured financings in the third quarter of 2004.However, because existing public credit card transactions were structured assales to revolving trusts that require replenishments of receivables to supportpreviously issued securities, receivables will continue to be sold to thesetrusts and the resulting replenishment gains recorded until the revolvingperiods end, the last of which is currently projected to occur in the fourthquarter of 2007. We continue to replenish at reduced levels, certain non-publicpersonal non-credit card and credit card securities issued to conduits andrecord the resulting replenishment gains for a period of time in order to manageliquidity. The termination of sale treatment on new collateralized fundingactivity reduced our reported net income under U.S. GAAP. There was no impact,however, on cash received from operations. 89 HSBC Finance Corporation-------------------------------------------------------------------------------- Securitizations and secured financings were as follows: YEAR ENDED DECEMBER 31, -------------------------- 2006 2005 2004---------------------------------------------------------------------------------------- (IN MILLIONS) INITIAL SECURITIZATIONS:Credit card................................................. $ - $ - $ 550Private label............................................... - - 190 ------- ------ -------Total....................................................... $ - $ - $ 740 ======= ====== =======REPLENISHMENT SECURITIZATIONS:Credit card................................................. $ 2,469 $8,620 $20,378Private label............................................... - - 9,104Personal non-credit card.................................... 71 211 828 ------- ------ -------Total....................................................... $ 2,540 $8,831 $30,310 ======= ====== =======SECURED FINANCINGS:Real estate secured......................................... $ 4,767 $4,516 $ 3,299Auto finance................................................ 2,843 3,418 1,790Credit card................................................. 4,745 1,785 -Personal non-credit card.................................... 2,500 - - ------- ------ -------Total....................................................... $14,855 $9,719 $ 5,089 ======= ====== ======= Additionally, as part of the Metris acquisition in 2005, we assumed $4.6 billionof securities backed by credit card receivables which we restructured to failsale treatment and are now accounted for as secured financings. Our securitization levels in 2006 were lower while secured financings werehigher reflecting the decision in the third quarter of 2004 to structure all newcollateralized funding transactions as secured financings and the use ofadditional sources of liquidity provided by HSBC and its subsidiaries. Outstanding securitized receivables consisted of the following: AT DECEMBER 31, --------------- 2006 2005----------------------------------------------------------------------------- (IN MILLIONS) Auto finance................................................ $271 $1,192Credit card................................................. 500 1,875Personal non-credit card.................................... 178 1,007 ---- ------Total....................................................... $949 $4,074 ==== ====== The following table summarizes the expected amortization of our securitizedreceivables at December 31, 2006: 2007 2008 TOTAL--------------------------------------------------------------------------------- (IN MILLIONS) Auto finance................................................ $271 $ - $271Credit card................................................. 250 250 500Personal non-credit card.................................... 178 - 178 ---- ---- ----Total....................................................... $699 $250 $949 ==== ==== ==== At December 31, 2006, the expected weighted-average remaining life of thesetransactions was .25 years. 90 HSBC Finance Corporation-------------------------------------------------------------------------------- The securities issued in connection with collateralized funding transactions maypay off sooner than originally scheduled if certain events occur. For certainauto transactions, early payoff of securities may occur if establisheddelinquency or loss levels are exceeded or if certain other events occur. Forall other transactions, early payoff of the securities begins if the annualizedportfolio yield drops below a base rate or if certain other events occur. We donot presently believe that any early payoff will take place. If early payoffoccurred, our funding requirements would increase. These additional requirementscould be met through issuance of various types of debt or borrowings underexisting back-up lines of credit. We believe we would continue to have adequatesources of funds if an early payoff event occurred. At December 31, 2006, securitizations structured as sales represented 1 percentand secured financings represented 14 percent of the funding associated with ourmanaged funding portfolio. At December 31, 2005, securitizations structured assales represented 3 percent and secured financings represented 11 percent of thefunding associated with our managed funding portfolio. We continue to believe the market for securities backed by receivables is areliable, efficient and cost-effective source of funds, and we will continue touse secured financings of consumer receivables as a source of our funding andliquidity. However, if the market for securities backed by receivables were tochange, we may be unable to enter into new secured financings or to do so atfavorable pricing levels. Factors affecting our ability to structurecollateralized funding transactions as secured financings or to do so atcost-effective rates include the overall credit quality of our securitizedloans, the stability of the securitization markets, the securitization market'sview of our desirability as an investment, and the legal, regulatory, accountingand tax environments governing collateralized funding transactions. At December 31, 2006, we had domestic facilities with commercial and investmentbanks under which we may use up to $19.0 billion of our receivables incollateralized funding transactions structured either as securitizations orsecured financings. The facilities are renewable at the banks' option. AtDecember 31, 2006, $9.1 billion of auto finance, credit card, personalnon-credit card and real estate secured receivables were used in collateralizedfunding transactions structured either as securitizations or secured financingsunder these funding programs. In addition, we have available a $4.0 billionsingle seller mortgage facility (none of which was outstanding at December 31,2006) structured as a secured financing. As a result of the sale of the U.K.credit card receivables to HBEU in 2005 as previously discussed, we no longerhave any securitized receivables or conduit lines in the U.K. As previouslydiscussed, beginning in the third quarter of 2004, we decided to fund all newcollateralized funding transactions as secured financings to align ouraccounting treatment with that of HSBC initially under U.K. GAAP and now underIFRS. The amount available under the facilities will vary based on the timingand volume of collateralized funding transactions. Through existing term bankfinancing and new debt issuances, we believe we should continue to have adequatesources of funds, which could be impacted from time to time by volatility in thefinancial markets or if one or more of these facilities were unable to berenewed. For additional information related to our securitization activities, includingthe amount of revenues and cash flows resulting from these arrangements, seeNote 8, "Asset Securitizations," to our accompanying consolidated financialstatements. RISK MANAGEMENT-------------------------------------------------------------------------------- Some degree of risk is inherent in virtually all of our activities. Accordingly,we have comprehensive risk management policies and practices in place to addresspotential financial risks, which include credit, liquidity, market (whichincludes interest rate and foreign currency exchange risks), reputational andoperational risk (which includes compliance and technology risks). Our riskmanagement policies are designed to identify and analyze these risks, to setappropriate limits and controls, and to monitor the risks and limits continuallyby means of reliable and up-to-date administrative and information systems. Wecontinually modify and enhance our risk management policies and systems toreflect changes in markets and products and to better overall risk managementprocesses. Training, individual responsibility and accountability, together witha disciplined, conservative and constructive culture of control, lie at theheart of our management of risk. 91 HSBC Finance Corporation-------------------------------------------------------------------------------- Our risk management policies are primarily carried out in accordance withpractice and limits set by the HSBC Group Management Board which consists ofsenior executives throughout the HSBC organization. In addition, due to theincreasingly complex business environment and the evolution of improved riskmanagement tools and standards, HSBC Finance Corporation has significantlyupgraded, and continues to upgrade, its risk management function. New practicesand techniques have been implemented to enhance data analysis, modeling, stresstesting, management information systems, risk self-assessment, and independentoversight. A Chief Risk Officer is in place whose role is to establish, oversee,and direct the various non-credit risk-related functions. The Chief Risk Officerhas dedicated senior risk leaders that independently ensure risks areappropriately identified, measured, managed, controlled and reported. Risk management oversight begins with the HSBC Finance Corporation Board ofDirectors and its various committees, principally the Audit Committee.Management oversight is provided by corporate and business unit risk managementcommittees with the participation of the Chief Risk Officer or his staff. AnHSBC Finance Corporation Risk Management Committee, chaired by the ChiefExecutive Officer, focuses on credit and operational risk management strategies.In addition, the HSBC Finance Corporation Asset Liability Committee ("ALCO")meets regularly to review risks and approve appropriate risk managementstrategies within the limits established by the HSBC Group Management Board. CREDIT RISK MANAGEMENT Credit risk is the risk that financial loss arises fromthe failure of a customer or counterparty to meet its obligations under acontract. Our credit risk arises primarily from lending and treasury activities. Day-to-day management of credit risk is decentralized and administered by ChiefCredit Officers in each business line. Independent oversight is provided by acorporate Chief Retail Credit Officer who reports directly to our ChiefExecutive Officer and indirectly to the Group General Manager, Head of Creditand Risk for HSBC. We have established detailed policies to address the creditrisk that arises from our lending activities. Our credit and portfoliomanagement procedures focus on risk-based pricing and effective collection andcustomer account management efforts for each loan. Our lending guidelines, whichdelineate the credit risk we are willing to take and the related terms, arespecific not only for each product, but also take into consideration variousother factors including borrower characteristics. We also have specific policiesto ensure the establishment of appropriate credit loss reserves on a timelybasis to cover probable losses of principal, interest and fees. See "CreditQuality" for a detailed description of our policies regarding the establishmentof credit loss reserves, our delinquency and charge-off policies and practicesand our customer account management policies and practices. Also see Note 2,"Summary of Significant Accounting Policies," to our consolidated financialstatements for further discussion of our policies surrounding credit lossreserves. While we develop our own policies and procedures for all of ourlending activities, they are consistent with HSBC standards and are regularlyreviewed and updated both on an HSBC Finance Corporation and HSBC level. Counterparty credit risk is our primary exposure on our interest rate swapportfolio. Counterparty credit risk is the risk that the counterparty to atransaction fails to perform according to the terms of the contract. We controlcounterparty credit risk in derivative instruments through established creditapprovals, risk control limits, collateral, and ongoing monitoring procedures.Counterparty limits have been set and are closely monitored as part of theoverall risk management process and control structure. During the third quarterof 2003 and continuing through 2006, we utilize an affiliate, HSBC Bank USA, asthe primary provider of new domestic derivative products. We have never suffereda loss due to counterparty failure. Currently the majority of our existing derivative contracts are with HSBCsubsidiaries, making them our primary counterparty in derivative transactions.Most swap agreements, both with unaffiliated and affiliated third parties,require that payments be made to, or received from, the counterparty when thefair value of the agreement reaches a certain level. Generally, third-party swapcounterparties provide collateral in the form of cash which is recorded in ourbalance sheet as other assets or derivative related liabilities and totaled $158million at December 31, 2006 and $91 million at December 31, 2005 forthird-party counterparties. Beginning in the second quarter of 2006, when thefair value of our agreements with affiliate counterparties require the postingof collateral by the affiliate, it is provided in the form of cash and recordedon the balance 92 HSBC Finance Corporation-------------------------------------------------------------------------------- sheet, consistent with third party arrangements. Previously, the posting ofcollateral by affiliates was provided in the form of securities, which were notrecorded on our balance sheet. Also during 2006, we lowered the level of thefair value of our agreements with affiliate counterparties above whichcollateral is required to be posted to $75 million. At December 31, 2006, thefair value of our agreements with affiliate counter parties required theaffiliate to provide cash collateral of $1.0 billion, which is recorded in ourbalance sheet as a component of derivative related liabilities. At December 31,2005, the fair value of our agreements with affiliate counterparties was belowthe level requiring posting of collateral. As such, at December 31, 2005, wewere not holding any swap collateral from HSBC affiliates in the form ofsecurities. See Note 14, "Derivative Financial Instruments," to the accompanyingconsolidated financial statements for additional information related to interestrate risk management and Note 23, "Fair Value of Financial Instruments," forinformation regarding the fair value of certain financial instruments. LIQUIDITY RISK The management of liquidity risk is addressed in HSBC FinanceCorporation's funding management policies and practices. HSBC FinanceCorporation funds itself principally through unsecured term funding in themarkets, through secured financings and securitization transactions and throughborrowings from HSBC and HSBC clients. Generally, the lives of our assets areshorter than the lives of the liabilities used to fund them. This initiallyreduces liquidity risk by ensuring that funds are received prior to liabilitiesbecoming due. Our ability to ensure continuous access to the capital markets and maintain adiversified funding base is important in meeting our funding needs. To managethis liquidity risk, we offer a broad line of debt products designed to meet theneeds of both institutional and retail investors. We maintain investor diversityby placing debt directly with customers, through selected dealer programs and bytargeted issuance of large liquid transactions. Through collateralized fundingtransactions, we are able to access an alternative investor base and furtherdiversify our funding strategies. We also maintain a comprehensive, directmarketing program to ensure our investors receive consistent and timelyinformation regarding our financial performance. The measurement and management of liquidity risk is a primary focus. Threestandard analyses are utilized to accomplish this goal. First, a rolling 60 dayfunding plan is updated daily to quantify near-term needs and develop theappropriate strategies to fund those needs. As part of this process, debtmaturity profiles (daily, monthly, annually) are generated to assist in planningand limiting any potential rollover risk (which is the risk that we will beunable to pay our debt or borrow additional funds as it becomes due). Second,comprehensive plans identifying monthly funding requirements for the next twelvemonths are updated at least weekly and monthly funding plans for the next twoyears are maintained. These plans focus on funding projected asset growth anddrive both the timing and size of debt issuances. These plans are shared on aregular basis with HSBC. And third, a Maximum Cumulative Outflow (MCO) analysisis updated regularly to measure liquidity risk. Cumulative comprehensive cashinflows are subtracted from outflows to generate a net exposure that is trackedboth monthly over the next 12 month period and annually for 5 years. Net outflowlimits are reviewed by HSBC Finance Corporation's ALCO and HSBC. We recognize the importance of being prepared for constrained fundingenvironments. While the potential scenarios driving this analysis have changeddue to our affiliation with HSBC, contingency funding plans are still maintainedas part of the liquidity management process. Alternative funding strategies areupdated regularly for a rolling 12 months and assume limited access to unsecuredfunding and continued access to the collateralized funding markets. Thesealternative strategies are designed to enable us to achieve monthly fundinggoals through controlled growth, sales of receivables and access to committedsources of contingent liquidity including bank lines and undrawn securitizationconduits. Although our overall liquidity situation has improved significantlysince our acquisition by HSBC, the strategies and analyses utilized in the pastto successfully manage liquidity remain in place today. The combination of thisprocess with the funding provided by HSBC subsidiaries and clients should ensureour access to diverse markets, investor bases and adequate funding for theforeseeable future. See "Liquidity and Capital Resources" for further discussion of our liquidityposition. 93 HSBC Finance Corporation-------------------------------------------------------------------------------- MARKET RISK The objective of our market risk management process is to manage andcontrol market risk exposures in order to optimize return on risk whilemaintaining a market profile as a provider of financial products and services.Market risk is the risk that movements in market risk factors, includinginterest rates and foreign currency exchange rates, will reduce our income orthe value of our portfolios. Future net interest income is affected by movements in interest rates. Althoughour main operations are in the U.S., we also have operations in Canada and theU.K. which prepare their financial statements in their local currency.Accordingly, our financial statements are affected by movements in exchangerates between the functional currencies of these subsidiaries and the U.S.dollar. We maintain an overall risk management strategy that uses a variety ofinterest rate and currency derivative financial instruments to mitigate ourexposure to fluctuations caused by changes in interest rates and currencyexchange rates. We manage our exposure to interest rate risk primarily throughthe use of interest rate swaps, but also use forwards, futures, options, andother risk management instruments. We manage our exposure to foreign currencyexchange risk primarily through the use of currency swaps, options and forwards.We do not use leveraged derivative financial instruments for interest rate riskmanagement. Since our acquisition by HSBC, we have not entered into foreignexchange contracts to hedge our investment in foreign subsidiaries. Prior to the acquisition by HSBC, the majority of our fair value and cash flowhedges were effective hedges which qualified for the shortcut method ofaccounting. Under the Financial Accounting Standards Board's interpretations ofSFAS No. 133, the shortcut method of accounting was no longer allowed forinterest rate swaps which were outstanding at the time of our acquisition byHSBC. As a result of the acquisition, we were required to reestablish andformally document the hedging relationship associated with all of our fair valueand cash flow hedging instruments and assess the effectiveness of each hedgingrelationship, both at the date of the acquisition and on an ongoing basis. As aresult of deficiencies in our contemporaneous hedge documentation at the time ofacquisition, we lost the ability to apply hedge accounting to our entire cashflow and fair value hedging portfolio that existed at the time of acquisition byHSBC. Substantially all derivative financial instruments entered into subsequentto the acquisition qualify as effective hedges under SFAS No. 133 and beginningin 2005 are being accounted for under the long-haul method of accounting. Interest rate risk is defined as the impact of changes in market interest rateson our earnings. We use simulation models to measure the impact of changes ininterest rates on net interest income. The key assumptions used in these modelsinclude expected loan payoff rates, loan volumes and pricing, cash flows fromderivative financial instruments and changes in market conditions. Theseassumptions are based on our best estimates of actual conditions. The modelscannot precisely predict the actual impact of changes in interest rates on ourearnings because these assumptions are highly uncertain. At December 31, 2006,our interest rate risk levels were below those allowed by our existing policy. Customer demand for our receivable products shifts between fixed rate andfloating rate products, based on market conditions and preferences. These shiftsin loan products produce different interest rate risk exposures. We usederivative financial instruments, principally interest rate swaps, to managethese exposures. Interest rate futures, interest rate forwards and purchasedoptions are also used on a limited basis to reduce interest rate risk. We monitor the impact that an immediate hypothetical increase or decrease ininterest rates of 25 basis points applied at the beginning of each quarter overa 12 month period would have on our net interest income assuming a growingbalance sheet and the current interest rate risk profile. The following tablesummarizes such estimated impact: AT DECEMBER 31, ---------------- 2006 2005------------------------------------------------------------------------------ (IN MILLIONS) Decrease in net interest income following a hypothetical 25 basis points rise in interest rates applied at the beginning of each quarter over the next 12 months......... $180 $213Increase in net interest income following a hypothetical 25 basis points fall in interest rates applied at the beginning of each quarter over the next 12 months......... $ 54 $120 94 HSBC Finance Corporation-------------------------------------------------------------------------------- These estimates include both the net interest income impact of the derivativepositions we have entered into which are considered to be effective hedges underSFAS No. 133 and the impact of economic hedges of certain underlying debtinstruments which do not qualify for hedge accounting as previously discussed,as if they were effective hedges under SFAS No. 133. These estimates also assumewe would not take any corrective actions in response to interest rate movementsand, therefore, exceed what most likely would occur if rates were to change bythe amount indicated. As part of our overall risk management strategy to reduce earnings volatility,in 2005 a significant number of our pay fixed/receive variable interest rateswaps which had not previously qualified for hedge accounting under SFAS No.133, have been designated as effective hedges using the long-haul method ofaccounting, and certain other interest rate swaps were terminated. This willsignificantly reduce the volatility of the mark-to-market on the previouslynon-qualifying derivatives which have been designated as effective hedges goingforward, but will result in the recording of ineffectiveness under the long-haulmethod of accounting under SFAS No. 133. In order to further reduce earningsvolatility that would otherwise result from changes in interest rates, wecontinue to evaluate the steps required to regain hedge accounting treatmentunder SFAS No. 133 for the remaining swaps which do not currently qualify forhedge accounting. These derivatives remain economic hedges of the underlyingdebt instruments. Use of interest rate swaps which qualify as effective hedgesunder SFAS No. 133 decreased our net interest income by 4 basis points in 2006,increased our net interest income by 24 basis points in 2005 and 49 basis pointsin 2004. We will continue to manage our total interest rate risk on a basisconsistent with the risk management process employed since the acquisition. HSBC also has certain limits and benchmarks that serve as guidelines indetermining the appropriate levels of interest rate risk. One such limit isexpressed in terms of the Present Value of a Basis Point ("PVBP"), whichreflects the change in value of the balance sheet for a one basis point movementin all interest rates. Our PVBP limit as of December 31, 2006 was $2 million,which includes the risk associated with hedging instruments. Thus, for a onebasis point change in interest rates, the policy dictates that the value of thebalance sheet shall not increase or decrease by more than $2 million. As ofDecember 31, 2006, we had a PVBP position of $1.1 million reflecting the impactof a one basis point increase in interest rates. While the total PVBP position will not change as a result of the loss of hedgeaccounting following our acquisition by HSBC, the following table shows thecomponents of PVBP: 2006 2005--------------------------------------------------------------------------- (IN MILLIONS) Risk related to our portfolio of ineffective hedges......... $(1.8) $(1.4)Risk for all other remaining assets and liabilities......... 2.9 2.3 ----- -----Total PVBP risk............................................. $ 1.1 $ .9 ===== ===== Foreign currency exchange risk refers to the potential changes in current andfuture earnings or capital arising from movements in foreign exchange rates. Weenter into foreign exchange rate forward contracts and currency swaps tominimize currency risk associated with changes in the value offoreign-denominated liabilities. Currency swaps convert principal and interestpayments on debt issued from one currency to another. For example, we may issueEuro-denominated debt and then execute a currency swap to convert the obligationto U.S. dollars. Prior to the acquisition, we had periodically entered intoforeign exchange contracts to hedge portions of our investments in our UnitedKingdom and Canada subsidiaries. We estimate that a 10 percent adverse change inthe British pound/U.S. dollar and Canadian dollar/U.S. dollar exchange ratewould result in a decrease in common shareholder's(s') equity of $159 million atDecember 31, 2006 and $162 million at December 31, 2005 and would not have amaterial impact on net income. We have issued debt in a variety of currencies and simultaneously executedcurrency swaps to hedge the future interest and principal payments. As a resultof the loss of hedge accounting on currency swaps outstanding at the time of ouracquisition, the recognition of the change in the currency risk on these swapsis recorded differently than the corresponding risk on the underlying foreigndenominated debt. Currency risk on the swap is now recognized immediately on thenet present value of all future swap payments. On the 95 HSBC Finance Corporation-------------------------------------------------------------------------------- corresponding debt, currency risk is recognized on the principal outstandingwhich is converted at the period end spot translation rate and on the interestaccrual which is converted at the average spot rate for the reporting period. OPERATIONAL RISK Operational risk is the risk of loss arising through fraud,unauthorized activities, error, omission, inefficiency, systems failure or fromexternal events. It is inherent in every business organization and covers a widespectrum of issues. HSBC Finance Corporation has established an independent Operational RiskManagement function, headed by a Corporate Operational Risk Coordinatorreporting directly to the Chief Risk Officer and indirectly to the Head ofOperational Risk for HSBC. The Operational Risk Coordinator provides independentfunctional oversight by managing the following activities: - maintaining a network of business line Operational Risk Coordinators; - developing scoring and risk assessment tools and databases; - providing training and developing awareness; and - independently reviewing and reporting the assessments of operational risks. An Operational Risk Management Committee, chaired by the Operational RiskCoordinator and Chief Risk Officer, is responsible for oversight of theoperational risks being taken, the analytic tools used to monitor those risks,and reporting. Business unit line management is responsible for managing andcontrolling all risks and for communicating and implementing all controlstandards. This is supported by an independent program of periodic reviewsundertaken by Internal Audit. We also monitor external operations risk eventswhich take place to ensure that we remain in line with best practice and takeaccount of lessons learned from publicized operational failures within thefinancial services industry. We also maintain and test emergency policies andprocedures to support operations and our personnel in the event of disasters. COMPLIANCE RISK Compliance Risk is the risk arising from failure to comply withrelevant laws, regulations, and regulatory requirements governing the conduct ofspecific businesses. It is a composite risk that can result in regulatorysanctions, financial penalties, litigation exposure and loss of reputation.Compliance risk is inherent throughout the HSBC Finance Corporationorganization. Consistent with HSBC's commitment to ensure adherence with applicable regulatoryrequirements for all of its world-wide affiliates, HSBC Finance Corporation hasimplemented a multi-faceted Compliance Risk Management Program. This programaddresses the following priorities, among other issues: - anti-money laundering (AML) regulations; - fair lending and consumer protection laws; - dealings with affiliates; - permissible activities; and - conflicts of interest. The independent Corporate Compliance function is headed by a Chief ComplianceOfficer who reports directly to the Chief Compliance Officer of HSBC NorthAmerica, who in turn reports to the Chief Risk Officer and the Head ofCompliance for HSBC. The Corporate Compliance function is supported by variouscompliance teams assigned to individual business units. The Corporate Compliancefunction is responsible for the following activities: - advising management on compliance matters; - providing independent assessment and monitoring; and - reporting compliance issues to HSBC Finance Corporation senior management and Board of Directors, as well as to HSBC Compliance. The overall Corporate Compliance program elements include identification,assessment, monitoring, control and mitigation of the risk and timely resolutionof the results of risk events. These functions are generally performed bybusiness line management, with oversight provided by Corporate Compliance.Controls for mitigating compliance risk are incorporated into business operatingpolicies and procedures. Processes are in place to ensure controls areappropriately updated to reflect changes in regulatory requirements as well as 96 HSBC Finance Corporation-------------------------------------------------------------------------------- changes in business practices, including new or revised products, services andmarketing programs. A wide range of compliance training is provided to relevantstaff, including mandated programs for such areas as anti-money laundering, fairlending and privacy. A separate Corporate Compliance Control Unit, along withInternal Audit, tests the effectiveness of the overall Compliance RiskManagement Program through continuous monitoring and periodic target audits. REPUTATIONAL RISK The safeguarding of our reputation is of paramount importanceto our continued prosperity and is the responsibility of every member of ourstaff. Reputational risk can arise from social, ethical or environmental issues,or as a consequence of operations risk events. Our good reputation depends uponthe way in which we conduct our business, but can also be affected by the way inwhich customers, to whom we provide financial services, conduct themselves. Reputational risk is considered and assessed by the HSBC Group Management Board,our Board of Directors and senior management during the establishment ofstandards for all major aspects of business and the formulation of policy. Thesepolicies, which are an integral part of the internal control systems, arecommunicated through manuals and statements of policy, internal communicationand training. The policies set out operational procedures in all areas ofreputational risk, including money laundering deterrence, environmental impact,anti-corruption measures and employee relations. We have established a strong internal control structure to minimize the risk ofoperational and financial failure and to ensure that a full appraisal ofreputational risk is made before strategic decisions are taken. The HSBCinternal audit function monitors compliance with our policies and standards. 97 HSBC Finance Corporation-------------------------------------------------------------------------------- GLOSSARY OF TERMS Affinity Credit Card - A MasterCard or Visa account jointly sponsored by theissuer of the card and an organization whose members share a common interest(e.g., the AFL-CIO Union Plus(R) credit card program). Auto Finance Loans - Closed-end loans secured by a first lien on a vehicle. Basis point - A unit that is commonly used to calculate changes in interestrates. The relationship between percentage changes and basis points can besummarized as a 1 percent change equals a 100 basis point change or .01 percentequals 1 basis point. Co-Branded Credit Card - A MasterCard, Visa or American Express account that isjointly sponsored by the issuer of the card and another corporation (e.g., theGM Card(R)). The account holder typically receives some form of added benefitfor using the card. Consumer Net Charge-off Ratio - Net charge-offs of consumer receivables dividedby average consumer receivables outstanding. Contractual Delinquency - A method of determining aging of past due accountsbased on the status of payments under the loan. Delinquency status may beaffected by customer account management policies and practices such as therestructure of accounts, forbearance agreements, extended payment plans,modification arrangements, external debt management plans, loan rewrites anddeferments. Efficiency Ratio - Ratio of total costs and expenses less policyholders'benefits to net interest income and other revenues less policyholders' benefits. Enhancement Services Income - Ancillary credit card revenue from products suchas Account Secure (debt waiver) and Identity Protection Plan. Fee Income - Income associated with interchange on credit cards and late andother fees from the origination, acquisition or servicing of loans. Foreign Exchange Contract - A contract used to minimize our exposure to changesin foreign currency exchange rates. Futures Contract - An exchange-traded contract to buy or sell a stated amount ofa financial instrument or index at a specified future date and price. HBEU - HSBC Bank plc, a U.K. based subsidiary of HSBC Holdings plc. HINO - HSBC Investments (North America) Inc., which is the immediate parent ofHSBC Finance Corporation. HSBC North America - HSBC North America Holdings Inc. and the immediate parentof HINO. HSBC - HSBC Holdings plc. HSBC Bank USA - HSBC Bank USA, National Association HTSU - HSBC Technology and Services (USA) Inc., which provides informationtechnology services to all subsidiaries of HSBC North America and othersubsidiaries of HSBC. Goodwill - Represents the purchase price over the fair value of identifiableassets acquired less liabilities assumed from business combinations. IFRS Management Basis - A non-U.S. GAAP measure of reporting results inaccordance with IFRSs and assumes the private label and real estate securedreceivables transferred to HSBC Bank USA have not been sold and remain on ourbalance sheet. Intangible Assets - Assets (not including financial assets) that lack physicalsubstance. Our acquired intangibles include purchased credit card relationshipsand related programs, merchant relationships in our retail services business,other loan related relationships, trade names, technology, customer lists andother contracts. 98 HSBC Finance Corporation-------------------------------------------------------------------------------- Interchange Fees - Fees received for processing a credit card transactionthrough the MasterCard, Visa, American Express or Discover network. Interest-only Strip Receivables - Represent our contractual right to receiveinterest and other cash flows from our securitization trusts after the investorsreceive their contractual return. Interest Rate Swap - Contract between two parties to exchange interest paymentson a stated principal amount (notional principal) for a specified period.Typically, one party makes fixed rate payments, while the other party makespayments using a variable rate. LIBOR - London Interbank Offered Rate. A widely quoted market rate which isfrequently the index used to determine the rate at which we borrow funds. Liquidity - A measure of how quickly we can convert assets to cash or raiseadditional cash by issuing debt. Managed Receivables - The sum of receivables on our balance sheet and those thatwe service for investors as part of our asset securitization program. MasterCard, Visa, American Express and Discover Receivables - Receivablesgenerated through customer usage of MasterCard , Visa, American Express andDiscover credit cards. Near-prime receivables - A portion of our non-prime receivable portfolio whichis comprised of customers with somewhat stronger credit scores than our othercustomers that are priced at rates generally below the rates offered on ournon-prime products. Net Interest Income - Interest income from receivables and noninsuranceinvestment securities reduced by interest expense. Net Interest Margin - Net interest income as a percentage of averageinterest-earning assets. Nonaccrual Loans - Loans on which we no longer accrue interest because ultimatecollection is unlikely. Non-prime receivables - Receivables which have been priced above the standardinterest rates charged to prime customers due to a higher than average risk fordefault as a result of the customer's credit history and the value ofcollateral, if applicable. Options - A contract giving the owner the right, but not the obligation, to buyor sell a specified item at a fixed price for a specified period. Owned Receivables - Receivables held on our balance sheet. Personal Homeowner Loan ("PHL") - A high loan-to-value real estate loan that hasbeen underwritten and priced as an unsecured loan. These loans are reported aspersonal non-credit card receivables. Personal Non-Credit Card Receivables - Unsecured lines of credit or closed-endloans made to individuals. Portfolio Seasoning - Relates to the aging of origination vintages. Losspatterns emerge slowly over time as new accounts are booked. Private Label Credit Card - A line of credit made available to customers ofretail merchants evidenced by a credit card bearing the merchant's name. Real Estate Secured Loan - Closed-end loans and revolving lines of creditsecured by first or subordinate liens on residential real estate. Receivables Serviced with Limited Recourse - Receivables we have securitized intransactions structured as sales and for which we have some level of potentialloss if defaults occur. Return on Average Common Shareholder's(s') Equity - Net income less dividends onpreferred stock divided by average common shareholder's(s') equity. Return on Average Assets - Net income divided by average owned assets. Secured Financing - The process where interests in a dedicated pool of financialassets are sold to investors. Generally, the receivables are transferred througha limited purpose financing subsidiary to a trust that issues 99 HSBC Finance Corporation-------------------------------------------------------------------------------- interests that are sold to investors. These transactions do not receive saletreatment under SFAS No. 140. The receivables and related debt remain on ourbalance sheet. Securitization - The process where interests in a dedicated pool of financialassets, typically credit card, auto or personal non-credit card receivables, aresold to investors. Generally, the receivables are sold to a trust that issuesinterests that are sold to investors. These transactions are structured toreceive sale treatment under SFAS No. 140. The receivables are then removed fromour balance sheet. Securitization Related Revenue - Includes income associated with current andprior period securitizations structured as sales of receivables with limitedrecourse. Such income includes gains on sales, net of our estimate of probablecredit losses under the recourse provisions, servicing income and excess spreadrelating to those receivables. Stated Income (low documentation) - Loans for which reduced documentation ofincome is accepted during the underwriting process. Tangible Common Equity - Common shareholder's(s') equity (excluding unrealizedgains and losses on investments and cash flow hedging instruments and anyminimum pension liability) less acquired intangibles and goodwill. Tangible Shareholder's(s') Equity - Tangible common equity, preferred stock, andcompany obligated mandatorily redeemable preferred securities of subsidiarytrusts (including amounts due to affiliates) adjusted for HSBC acquisitionpurchase accounting adjustments. Tangible Managed Assets - Total managed assets less acquired intangibles,goodwill and derivative financial assets. Taxpayer Financial Services ("TFS") Revenue - Our taxpayer financial servicesbusiness provides consumer tax refund lending in the United States. This incomeprimarily consists of fees received from the consumer for origination of a shortterm loan which will be repaid from their Federal income tax return refund. Whole Loan Sales - Sales of loans to third parties without recourse. Typically,these sales are made pursuant to our liquidity or capital management plans. 100 HSBC FINANCE CORPORATION AND SUBSIDIARIES CREDIT QUALITY STATISTICS 2006 2005 2004 2003 2002-------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) OWNED TWO-MONTH-AND-OVER CONTRACTUAL DELINQUENCY RATIOSReal estate secured(1)...................................... 3.54% 2.72% 2.96% 4.33% 3.91%Auto finance................................................ 3.18 3.04 3.03 3.39 5.44Credit card(2).............................................. 4.57 3.66 4.88 5.76 5.97Private label............................................... 5.31 5.43 4.13 5.42 6.36Personal non-credit card.................................... 10.17 9.40 8.69 10.01 8.95 ------ ------ ------ ------ ------Total consumer(2)........................................... 4.59% 3.89% 4.13% 5.40% 5.37% ====== ====== ====== ====== ======RATIO OF OWNED NET CHARGE-OFFS TO AVERAGE OWNED RECEIVABLES FOR THE YEARReal estate secured(3)...................................... 1.00% .76% 1.10% .99% .91%Auto finance................................................ 3.67 3.27 3.43 4.91 6.00Credit card(4).............................................. 5.56 7.12 8.85 9.18 9.46Private label(4)............................................ 5.80 4.83 6.17 5.75 6.28Personal non-credit card.................................... 7.89 7.88 9.75 9.89 8.26 ------ ------ ------ ------ ------Total consumer(4)........................................... 2.97 3.03 4.00 4.06 3.81Commercial.................................................. .43 2.60 - .46 (.40) ------ ------ ------ ------ ------Total....................................................... 2.97% 3.03% 3.98% 4.05% 3.79% ====== ====== ====== ====== ======REAL ESTATE CHARGE-OFFS AND REO EXPENSE AS A PERCENT OF AVERAGE REAL ESTATE SECURED RECEIVABLES................... 1.19% .87% 1.38% 1.42% 1.29% ------ ------ ------ ------ ------NONACCRUAL OWNED RECEIVABLESDomestic: Real estate secured(5).................................... $2,461 $1,601 $1,489 $1,777 $1,367 Auto finance.............................................. 389 320 227 140 110 Private label............................................. 31 31 24 43 38 Personal non-credit card.................................. 1,444 1,190 908 898 902Foreign..................................................... 482 463 432 316 264 ------ ------ ------ ------ ------Total consumer.............................................. 4,807 3,605 3,080 3,174 2,681Commercial and other........................................ - 3 4 6 15 ------ ------ ------ ------ ------Total....................................................... $4,807 $3,608 $3,084 $3,180 $2,696 ====== ====== ====== ====== ======ACCRUING CONSUMER OWNED RECEIVABLES 90 OR MORE DAYS DELINQUENTDomestic: Credit card............................................... $ 894 $ 585 $ 469 $ 429 $ 343 Private label............................................. - - - 443 491Foreign..................................................... 35 38 38 32 27 ------ ------ ------ ------ ------Total....................................................... $ 929 $ 623 $ 507 $ 904 $ 861 ====== ====== ====== ====== ======REAL ESTATE OWNEDDomestic.................................................... $ 785 $ 506 $ 583 $ 627 $ 424Foreign..................................................... 9 4 4 4 3 ------ ------ ------ ------ ------Total....................................................... $ 794 $ 510 $ 587 $ 631 $ 427 ====== ====== ====== ====== ======RENEGOTIATED COMMERCIAL LOANS............................... $ 1 $ - $ 2 $ 2 $ 1 ====== ====== ====== ====== ====== --------------- (1) Real estate secured two-months-and-over contractual delinquency (as a percent of consumer receivables) are comprised of the following: 2006 2005 2004 2003 2002 ---------------------------------------------------------------------------------------------- Mortgage Services: First lien.................................................. 4.50% 3.21% 3.26% 5.49% 5.23% Second lien................................................. 5.74 1.94 2.47 4.90 4.23 ---- ---- ---- ---- ---- Total Mortgage Services..................................... 4.75 2.98 3.16 5.40 5.02 Consumer Lending: First lien.................................................. 2.07 2.14 2.69 3.40 3.11 Second lien................................................. 3.06 3.03 3.02 5.07 3.62 ---- ---- ---- ---- ---- Total Consumer Lending...................................... 2.21 2.26 2.73 3.59 3.18 Foreign and all other: First lien.................................................. 1.58 2.11 1.95 3.14 3.29 Second lien................................................. 5.38 5.71 3.94 4.03 5.23 ---- ---- ---- ---- ---- Total Foreign and all other................................. 4.59 5.09 3.66 3.91 4.96 ---- ---- ---- ---- ---- Total real estate secured................................... 3.54% 2.72% 2.96% 4.33% 3.91% ==== ==== ==== ==== ==== 101 HSBC FINANCE CORPORATION AND SUBSIDIARIES (2) In December 2005, we completed the acquisition of Metris which included receivables of $5.3 billion. This event had a significant impact on this ratio. Excluding the receivables from the Metris acquisition from this calculation, our consumer delinquency ratio for our credit card portfolio was 4.01% and total consumer delinquency was 3.89%. (3) Real estate secured net charge-off of consumer receivables as a percent of average consumer receivables are comprised of the following: 2006 2005 2004 2003 2002 ---------------------------------------------------------------------------------------------- Mortgage Services: First lien.................................................. .77% .68% .81% .54% .69% Second lien................................................. 2.38 1.11 2.64 2.89 2.59 ---- ---- ---- ---- ---- Total Mortgage Services..................................... 1.12 .75 1.05 .94 1.08 Consumer Lending: First lien.................................................. .85 .74 1.03 .89 .66 Second lien................................................. 1.12 1.21 2.77 2.44 1.78 ---- ---- ---- ---- ---- Total Consumer Lending...................................... .89 .80 1.21 1.07 .82 Foreign and all other: First lien.................................................. .54 1.04 .89 1.19 .96 Second lien................................................. .94 .37 .24 .38 .45 ---- ---- ---- ---- ---- Total Foreign and all other................................. .86 .47 .33 .50 .52 ---- ---- ---- ---- ---- Total real estate secured................................... 1.00% .76% 1.10% .99% .91% ==== ==== ==== ==== ==== (4) The adoption of FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios in December 2004 increased private label net charge-offs by $155 million (119 basis points) and credit card net charge-offs by $3 million (2 basis points) and total consumer net charge-offs by $158 million (16 basis points) for the year ended December 31, 2004. (5) Domestic real estate nonaccrual receivables are comprised of the following: 2006 2005 2004 2003 2002 -------------------------------------------------------------------------------------------------------- Real estate secured: Closed-end: First lien................................................. $1,884 $1,359 $1,287 $1,437 $1,111 Second lien................................................ 369 148 105 121 149 Revolving: First lien................................................. 22 31 40 92 44 Second lien................................................ 186 63 57 127 63 ------ ------ ------ ------ ------ Total real estate secured.................................. $2,461 $1,601 $1,489 $1,777 $1,367 ====== ====== ====== ====== ====== 102 HSBC FINANCE CORPORATION AND SUBSIDIARIES ANALYSIS OF CREDIT LOSS RESERVES ACTIVITY 2006 2005 2004 2003 2002------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) TOTAL CREDIT LOSS RESERVES AT JANUARY 1..................... $4,521 $3,625 $3,793 $3,333 $2,663 ------ ------ ------ ------ ------PROVISION FOR CREDIT LOSSES................................. 6,564 4,543 4,334 3,967 3,732 ------ ------ ------ ------ ------CHARGE-OFFSDomestic: Real estate secured(1)..................................... (931) (569) (629) (496) (430) Auto finance............................................... (468) (311) (204) (148) (159) Credit card(2)............................................. (1,665) (1,339) (1,082) (936) (736) Private label(2)........................................... (43) (33) (788) (684) (650) Personal non-credit card................................... (1,455) (1,333) (1,350) (1,354) (1,193)Foreign..................................................... (600) (509) (355) (257) (223) ------ ------ ------ ------ ------Total consumer.............................................. (5,162) (4,094) (4,408) (3,875) (3,391)Commercial and other........................................ (2) (6) (1) (3) (2) ------ ------ ------ ------ ------Total receivables charged off............................... (5,164) (4,100) (4,409) (3,878) (3,393) ------ ------ ------ ------ ------RECOVERIESDomestic: Real estate secured(3)..................................... 33 27 18 10 7 Auto finance............................................... 50 18 6 5 7 Credit card................................................ 274 157 103 87 59 Private label.............................................. 13 6 79 72 48 Personal non-credit card................................... 216 171 120 82 92Foreign..................................................... 59 68 50 34 49 ------ ------ ------ ------ ------Total consumer.............................................. 645 447 376 290 262Commercial and other........................................ - - - 1 2 ------ ------ ------ ------ ------Total recoveries on receivables............................. 645 447 376 291 264OTHER, NET.................................................. 21 6 (469) 80 67 ------ ------ ------ ------ ------CREDIT LOSS RESERVESDomestic: Real estate secured........................................ 2,365 718 645 670 551 Auto finance............................................... 241 222 181 172 126 Credit card................................................ 1,864 1,576 1,205 806 649 Private label.............................................. 38 36 28 519 527 Personal non-credit card................................... 1,732 1,652 1,237 1,348 1,275Foreign..................................................... 346 312 316 247 172 ------ ------ ------ ------ ------Total consumer.............................................. 6,586 4,516 3,612 3,762 3,300Commercial and other........................................ 1 5 13 31 33 ------ ------ ------ ------ ------TOTAL CREDIT LOSS RESERVES AT DECEMBER 31................... $6,587 $4,521 $3,625 $3,793 $3,333 ====== ====== ====== ====== ======RATIO OF CREDIT LOSS RESERVES TO:Net charge-offs............................................. 145.8% 123.8%(4) 89.9%(5) 105.7% 106.5%Receivables: Consumer................................................... 4.07 3.23 3.39 4.09 4.02 Commercial................................................. .60 2.67 8.90 6.80 6.64 ------ ------ ------ ------ ------ Total...................................................... 4.07% 3.23% 3.39% 4.11% 4.04% ====== ====== ====== ====== ======Nonperforming loans: Consumer................................................... 114.8% 106.8% 100.7% 92.2% 93.1% Commercial................................................. 100.0 166.7 260.0 620.0 275.0 ------ ------ ------ ------ ------ Total...................................................... 114.8% 106.9% 100.9% 92.8% 93.7% ====== ====== ====== ====== ====== --------------- (1) Domestic real estate secured charge-offs can be further analyzed as follows: 2006 2005 2004 2003 2002 --------------------------------------------------------------------------------------------------- Closed end: First lien................................................. $(582) $(421) $(418) $(279) $(242) Second lien................................................ (256) (105) (151) (152) (109) Revolving: First lien................................................. (17) (22) (34) (35) (17) Second lien................................................ (76) (21) (26) (30) (62) ----- ----- ----- ----- ----- Total....................................................... $(931) $(569) $(629) $(496) $(430) ===== ===== ===== ===== ===== (2) Includes $3 million of credit card and $155 million of private label charge-off relating to the adoption of FFIEC charge-off policies in December 2004.(3) Domestic recoveries can be further analyzed as follows: 2006 2005 2004 2003 2002 ---------------------------------------------------------------------------------------------- Closed end: First lien................................................. $11 $11 $ 5 $ 3 $1 Second lien................................................ 15 10 8 5 4 Revolving: First lien................................................. 2 2 2 - 1 Second lien................................................ 5 4 3 2 1 --- --- --- --- -- Total....................................................... $33 $27 $18 $10 $7 === === === === == (4) The acquisition of Metris in December 2005 has positively impacted this ratio. Reserves as a percentage of net charge-offs excluding Metris was 118.2 percent.(5) In December 2004 we adopted FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios and subsequently sold this domestic private label receivable portfolio. These events had a significant impact on this ratio. Reserves as a percentage of net charge-offs excluding net charge-offs associated with the sold domestic private label portfolio and charge-off relating to the adoption of FFIEC was 109.2% at December 31, 2004. 103 HSBC FINANCE CORPORATION AND SUBSIDIARIES NET INTEREST MARGIN - 2006 COMPARED TO 2005 FINANCE AND AVERAGE INTEREST INCOME/ INCREASE/ (DECREASE) DUE TO: OUTSTANDING(1) AVERAGE RATE INTEREST EXPENSE ------------------------------------ ------------------- ------------- ----------------- VOLUME RATE 2006 2005 2006 2005 2006 2005 VARIANCE VARIANCE(2) VARIANCE(2)------------------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Receivables: Real estate secured.......... $ 92,318 $73,097 8.6% 8.4% $ 7,912 $ 6,155 $1,757 $1,646 $ 111 Auto finance....... 11,660 9,074 12.0 11.8 1,405 1,067 338 311 27 Credit card........ 25,065 17,823 16.3 13.9 4,086 2,479 1,607 1,129 478 Private label...... 2,492 2,948 9.6 9.4 239 278 (39) (44) 5 Personal non-credit card............. 20,611 17,558 19.0 18.4 3,926 3,226 700 578 122 Commercial and other............ 195 255 2.1 2.4 4 6 (2) (1) (1) Purchase accounting adjustments...... - 134 - - (124) (139) 15 15 - -------- -------- ---- ---- ------- ------- ------ ------ ------Total receivables.... 152,341 120,889 11.5 10.8 17,448 13,072 4,376 3,565 811Noninsurance investments........ 2,958 3,694 3.9 3.9 114 144 (30) (28) (2) -------- -------- ---- ---- ------- ------- ------ ------ ------Total interest-earning assets (excluding insurance investments)....... $155,299 $124,583 11.3% 10.6% $17,562 $13,216 $4,346 $3,437 $ 909Insurance investments........ 3,105 3,159Other assets......... 11,609 12,058 -------- --------TOTAL ASSETS......... $170,013 $139,800 ======== ========Debt: Commercial paper... $ 12,344 $11,877 5.0% 3.4% $ 612 $ 399 $ 213 $ 16 $ 197 Bank and other borrowings....... 494 111 3.3(6) 2.5(6) 16 3 13 12 1 Due to affiliates....... 15,459 16,654 6.0 4.3 929 713 216 (54) 270 Long term debt (with original maturities over one year)........ 115,900 86,207 5.0 4.3 5,817 3,717 2,100 1,430 670 -------- -------- ---- ---- ------- ------- ------ ------ ------Total debt........... $144,197 $114,849 5.1% 4.2% $ 7,374 $ 4,832 $2,542 $1,379 $1,163Other liabilities.... 5,362 6,649 -------- --------Total liabilities.... 149,559 121,498Preferred securities......... 575 1,366Common shareholder's(s') equity............. 19,879 16,936 -------- --------TOTAL LIABILITIES AND SHAREHOLDER'S(S') EQUITY............. $170,013 $139,800 ======== ========NET INTEREST MARGIN(3)(5)....... 6.6% 6.7% $10,188 $ 8,384 $1,804 $2,058 $ (254) ==== ==== ======= ======= ====== ====== ======INTEREST SPREADS(4)......... 6.2% 6.4% ==== ==== --------------- (1) Nonaccrual loans are included in average outstanding balances. (2) Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total interest variance. For total receivables, total interest-earning assets and total debt, the rate and volume variances are calculated based on the relative weighting of the individual components comprising these totals. These totals do not represent an arithmetic sum of the individual components. (3) Represents net interest income as a percent of average interest-earning assets (4) Represents the difference between the yield earned on interest-earning assets and the cost of the debt used to fund the assets (5) The net interest margin analysis includes the following for foreign businesses: 2006 2005 ------------------------------------------------------------------------------- Average interest-earning assets............................. $ 9,657 $12,098 Average interest-bearing liabilities........................ 8,150 10,231 Net interest income......................................... 691 754 Net interest margin......................................... 7.2% 6.2% (6) Average rate does not recompute from the dollar figures presented due to rounding. 104 HSBC FINANCE CORPORATION AND SUBSIDIARIES NET INTEREST MARGIN - 2005 COMPARED TO 2004 FINANCE AND INTEREST AVERAGE AVERAGE INCOME/INTEREST INCREASE/(DECREASE) DUE TO: OUTSTANDING(1) RATE EXPENSE ------------------------------------ ------------------- ----------- --------------------- VOLUME RATE 2005 2004 2005 2004 2005 2004 VARIANCE VARIANCE(2) VARIANCE(2)-------------------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Receivables: Real estate secured... $ 73,097 $ 56,303 8.4% 8.8% $ 6,155 $ 4,974 $1,181 $1,424 $ (243) Auto finance.......... 9,074 5,785 11.8 12.2 1,067 706 361 388 (27) Credit card........... 17,823 11,575 13.9 13.6 2,479 1,572 907 868 39 Private label......... 2,948 13,029 9.4 10.8 278 1,407 (1,129) (970) (159) Personal non-credit card................ 17,558 14,194 18.4 16.7 3,226 2,374 852 602 250 Commercial and other............... 255 354 2.4 2.5 6 9 (3) (2) (1) HSBC acquisition purchase accounting adjustments......... 134 319 - - (139) (201) 62 62 - -------- -------- ---- ---- ------- ------- ------ ------ -------Total receivables....... 120,889 101,559 10.8 10.7 13,072 10,841 2,231 2,089 142Noninsurance investments........... 3,694 4,853 3.9 2.1 144 104 40 (29) 69 -------- -------- ---- ---- ------- ------- ------ ------ -------Total interest-earning assets (excluding insurance investments).......... $124,583 $106,412 10.6% 10.3% $13,216 $10,945 $2,271 $1,940 $ 331Insurance investments... 3,159 3,165Other assets............ 12,058 14,344 -------- --------TOTAL ASSETS............ $139,800 $123,921 ======== ========Debt: Commercial paper...... $ 11,877 $ 11,403 3.4% 1.8% $ 399 $ 210 $ 189 $ 9 $ 180 Bank and other borrowings.......... 111 126 2.5(6) 1.9(6) 3 3 - - - Due to affiliates..... 16,654 8,752 4.3 3.9 713 343 370 336 34 Long term debt (with original maturities over one year)...... 86,207 79,834 4.3 3.3 3,717 2,587 1,130 222 908 -------- -------- ---- ---- ------- ------- ------ ------ -------Total debt.............. $114,849 $100,115 4.2% 3.1% $ 4,832 $ 3,143 $1,689 $ 495 $ 1,194Other liabilities....... 6,649 5,703 -------- --------Total liabilities....... 121,498 105,818Preferred securities.... 1,366 1,100Common shareholder's(s') equity................ 16,936 17,003 -------- --------TOTAL LIABILITIES AND SHAREHOLDER'S(S') EQUITY................ $139,800 $123,921 ======== ========NET INTEREST MARGIN(3)(5).......... 6.7% 7.3% $ 8,384 $ 7,802 $ 582 $1,445 $ (863) ==== ==== ======= ======= ====== ====== =======INTEREST SPREAD - OWNED BASIS(4).............. 6.4% 7.2% ==== ==== --------------- (1) Nonaccrual loans are included in average outstanding balances. (2) Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total interest variance. For total receivables, total interest-earning assets and total debt, the rate and volume variances are calculated based on the relative weighting of the individual components comprising these totals. These totals do not represent an arithmetic sum of the individual components. (3) Represents net interest income as a percent of average interest-earning assets (4) Represents the difference between the yield earned on interest-earning assets and the cost of the debt used to fund the assets (5) The net interest margin analysis includes the following for foreign businesses: 2005 2004 ------------------------------------------------------------------------------- Average interest-earning assets............................. $12,098 $10,728 Average interest-bearing liabilities........................ 10,231 9,127 Net interest income......................................... 754 712 Net interest margin......................................... 6.2% 6.8% (6) Average rate does not recompute from the dollar figures presented due to rounding. 105 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES Our consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States ("U.S. GAAP"). In addition tothe U.S. GAAP financial results reported in our consolidated financialstatements, MD&A includes reference to the following information which ispresented on a non-U.S. GAAP basis: OPERATING RESULTS, PERCENTAGES AND RATIOS Certain percentages and ratios havebeen presented on an operating basis and have been calculated using "operatingnet income", a non-U.S. GAAP financial measure. "Operating net income" is netincome excluding certain nonrecurring items. These nonrecurring items are alsoexcluded in calculating our operating basis efficiency ratios. We believe thatexcluding these items helps readers of our financial statements to understandbetter the results and trends of our underlying business. IFRS MANAGEMENT BASIS A non-U.S. GAAP measure of reporting results in accordancewith IFRSs and assumes the private label and real estate secured receivablestransferred to HSBC Bank USA have not been sold and remain on our balance sheet. EQUITY RATIOS Tangible shareholder's(s') equity to tangible managed assets("TETMA"), tangible shareholder's(s') equity plus owned loss reserves totangible managed assets ("TETMA + Owned Reserves") and tangible common equity totangible managed assets are non-U.S. GAAP financial measures that are used byHSBC Finance Corporation management or applicable rating agencies to evaluatecapital adequacy. Managed assets assume that securitized receivables have notbeen sold and are still on our balance sheet. These ratios may differ fromsimilarly named measures presented by other companies. The most directlycomparable U.S. GAAP financial measure is common and preferred equity to ownedassets. We and certain rating agencies also monitor our equity ratios excluding theimpact of HSBC acquisition purchase accounting adjustments. We do so because webelieve that the HSBC acquisition purchase accounting adjustments representnon-cash transactions which do not affect our business operations, cash flows orability to meet our debt obligations. Preferred securities issued by certain non-consolidated trusts are consideredequity in the TETMA and TETMA + Owned Reserves calculations because of theirlong-term subordinated nature and the ability to defer dividends. Previously,our Adjustable Conversion-Rate Equity Security Units, adjusted for HSBCacquisition purchase accounting adjustments, were also considered equity inthese calculations. Beginning in the third quarter of 2005, and with theagreement of applicable rating agencies, we have refined our definition of TETMAand TETMA + Owned Reserves to exclude the Adjustable Conversion-Rate EquitySecurity Units as this more accurately reflects the impact of these items on ourequity. Prior period amounts have been revised to reflect the current periodpresentation. QUANTITATIVE RECONCILIATIONS OF NON-U.S. GAAP FINANCIAL MEASURES TO U.S. GAAPFINANCIAL MEASURES For a reconciliation of IFRS Management Basis results to thecomparable owned basis amounts, see Note 21, "Business Segments," to theaccompanying consolidated financial statements. Reconciliations of selectedowned basis and operating basis financial ratios and our equity ratios follow. 106 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES SELECTED FINANCIAL DATA AND STATISTICS 2006 2005 2004 2003 2002------------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) RETURN ON AVERAGE COMMON SHAREHOLDER'S(S') EQUITY:Net income.................................................. $ 1,443 $ 1,772 $ 1,940 $ 1,603 $ 1,558 Dividends on preferred stock.............................. (37) (83) (72) (76) (63) -------- -------- -------- -------- --------Net income available to common shareholders................. $ 1,406 $ 1,689 $ 1,868 $ 1,527 $ 1,495Gain on sale of investment in Kanbay........................ (78) - - - -Gain on bulk sale of private label receivables.............. - - (423) - -Adoption of FFIEC charge-off policies for domestic private label (excluding retail sales contracts) and credit card portfolios................................................ - - 121 - -HSBC acquisition related costs and other merger related items incurred by HSBC Finance Corporation................ - - - 167 -Settlement charge and related expenses...................... - - - - 333Loss on the disposition of Thrift assets and deposits....... - - - - 240 -------- -------- -------- -------- --------Operating net income available to common shareholders....... $ 1,328 $ 1,689 $ 1,566 $ 1,694 $ 2,068 -------- -------- -------- -------- --------Average common shareholder's(s') equity..................... $ 19,879 $ 16,936 $ 17,003 $ 14,022 $ 8,640 -------- -------- -------- -------- --------Return on average common shareholder's(s') equity........... 7.07% 9.97% 10.99% 10.89% 17.30%Return on average common shareholder's(s') equity,operating basis............................................. 6.68 9.97 9.21 12.08 23.94 ======== ======== ======== ======== ========RETURN ON AVERAGE ASSETS:Net income.................................................. $ 1,443 $ 1,772 $ 1,940 $ 1,603 $ 1,558Operating net income........................................ 1,365 1,772 1,638 1,770 2,131 -------- -------- -------- -------- --------Average owned assets........................................ $170,013 $139,800 $123,921 $110,097 $ 96,304 -------- -------- -------- -------- --------Return on average assets.................................... .85% 1.27% 1.57% 1.46% 1.62%Return on average assets, operating basis................... .80 1.27 1.32 1.61 2.21 ======== ======== ======== ======== ========EFFICIENCY RATIO:Total costs and expenses less policyholders' benefits....... $ 6,293 $ 5,685 $ 5,279 $ 4,853 $ 4,473 HSBC acquisition related costs and other merger related items incurred by HSBC Finance Corporation.............. - - - (198) - Settlement charge and related expenses.................... - - - - (525) -------- -------- -------- -------- -------- Total costs and expenses less policyholders' benefits, excluding nonrecurring items............................ $ 6,293 $ 5,685 $ 5,279 $ 4,655 $ 3,948 -------- -------- -------- -------- --------Net interest income and other revenues less policyholders' benefits.................................................. $ 15,144 $ 12,891 $ 12,553 $ 11,295 $ 10,458Nonrecurring items: Gain on sale of investment in Kanbay.................... (123) - - - - Gain on bulk sale of private label receivables.......... - - (663) - - Adoption of FFIEC charge-off policies for domestic private label (excluding retail sales contracts) and credit card portfolios................................ - - 151 - - Loss on the disposition of Thrift assets and deposits... - - - - 378 Net interest income and other revenues less policyholders' benefits, excluding nonrecurring items.................. $ 15,021 $ 12,891 $ 12,041 $ 11,295 $ 10,836Efficiency ratio............................................ 41.55% 44.10% 42.05% 42.97% 42.77%Efficiency ratio, operating basis........................... 41.89 44.10 43.84 41.21 36.43 ======== ======== ======== ======== ======== 107 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES EQUITY RATIOS 2006 2005 2004 2003 2002------------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) TANGIBLE COMMON EQUITY:Common shareholder's(s') equity............................. $ 19,515 $ 18,904 $ 15,841 $ 16,391 $ 9,222Exclude: Unrealized (gains) losses on cash flow hedging instruments............................................. 61 (260) (119) 10 737 Minimum pension liability................................. 1 - 4 - 30 Unrealized gains on investments and interest-only strip receivables............................................. 23 3 (53) (167) (319) Intangibles assets........................................ (2,218) (2,480) (2,705) (2,856) (386) Goodwill.................................................. (7,010) (7,003) (6,856) (6,697) (1,122) -------- -------- -------- -------- --------Tangible common equity...................................... 10,372 9,164 6,112 6,681 8,162Purchase accounting adjustments............................. 1,105 1,441 2,227 2,548 - -------- -------- -------- -------- --------Tangible common equity, excluding HSBC acquisition purchase accounting adjustments.................................... $ 11,477 $ 10,605 $ 8,339 $ 9,229 $ 8,162 ======== ======== ======== ======== ========TANGIBLE SHAREHOLDER'S(S') EQUITY:Tangible common equity...................................... $ 10,372 $ 9,164 $ 6,112 $ 6,681 $ 8,162Preferred stock............................................. 575 575 1,100 1,100 1,193Mandatorily redeemable preferred securities of Household Capital Trusts............................................ 1,275 1,679 994 1,031 975Adjustable Conversion-Rate Equity Security Units............ - - - - 511 -------- -------- -------- -------- --------Tangible shareholder's(s') equity........................... 12,222 11,418 8,206 8,812 10,841HSBC acquisition purchase accounting adjustments............ 1,105 1,438 2,208 2,492 - -------- -------- -------- -------- --------Tangible shareholder's(s') equity, excluding purchase accounting adjustments.................................... $ 13,327 $ 12,856 $ 10,414 $ 11,304 $ 10,841 ======== ======== ======== ======== ========TANGIBLE SHAREHOLDER'S(S') EQUITY PLUS OWNED LOSS RESERVES:Tangible shareholder's(s') equity........................... $ 12,222 $ 11,418 $ 8,206 $ 8,812 $ 10,841Owned loss reserves......................................... 6,587 4,521 3,625 3,793 3,333 -------- -------- -------- -------- --------Tangible shareholder's(s') equity plus owned loss reserves.................................................. 18,809 15,939 11,831 12,605 14,174HSBC acquisition purchase accounting adjustments............ 1,105 1,438 2,208 2,492 - -------- -------- -------- -------- --------Tangible shareholder's(s') equity plus owned loss reserves, excluding purchase accounting adjustments................. $ 19,914 $ 17,377 $ 14,039 $ 15,097 $ 14,174 ======== ======== ======== ======== ========TANGIBLE MANAGED ASSETS:Owned assets................................................ $179,459 $156,669 $130,190 $119,052 $ 97,860Receivables serviced with limited recourse.................. 949 4,074 14,225 26,201 24,934 -------- -------- -------- -------- --------Managed assets.............................................. 180,408 160,743 144,415 145,253 122,794Exclude: Intangible assets......................................... (2,218) (2,480) (2,705) (2,856) (386) Goodwill.................................................. (7,010) (7,003) (6,856) (6,697) (1,122) Derivative financial assets............................... (1,461) (234) (4,049) (3,016) (1,864) -------- -------- -------- -------- --------Tangible managed assets..................................... 169,719 151,026 130,805 132,684 119,422HSBC acquisition purchase accounting adjustments............ 64 (52) (202) (431) - -------- -------- -------- -------- --------Tangible managed assets, excluding purchase accounting adjustments............................................... $169,783 $150,974 $130,603 $132,253 $119,422 ======== ======== ======== ======== ========EQUITY RATIOS:Common and preferred equity to owned assets................. 11.19% 12.43% 13.01% 14.69% 10.64%Tangible common equity to tangible managed assets........... 6.11 6.07 4.67 5.04 6.83Tangible shareholder's(s') equity to tangible managed assets.................................................... 7.20 7.56 6.27 6.64 9.08Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets................................ 11.08 10.55 9.04 9.50 11.87Excluding HSBC acquisition purchase accounting adjustments: Tangible common equity to tangible managed assets......... 6.76 7.02 6.38 6.98 6.83 Tangible shareholder's(s') equity to tangible managed assets.................................................. 7.85 8.52 7.97 8.55 9.08 Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets.............................. 11.73 11.51 10.75 11.42 11.87 ======== ======== ======== ======== ======== 108 HSBC Finance Corporation-------------------------------------------------------------------------------- ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.-------------------------------------------------------------------------------- Information required by this Item is included in sections of Item 7.Management's Discussion and Analysis of Financial Condition and Results ofOperations on the following pages: "Liquidity and Capital Resources", pages79-88, "Off Balance Sheet Arrangements and Secured Financings", pages 88-91 and"Risk Management", pages 91-97. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.-------------------------------------------------------------------------------- Our 2006 Financial Statements meet the requirements of Regulation S-X. The 2006Financial Statements and supplementary financial information specified by Item302 of Regulation S-K are set forth below. 109 HSBC Finance Corporation-------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and ShareholderHSBC Finance Corporation: We have audited the accompanying consolidated balance sheets of HSBC FinanceCorporation (a Delaware corporation), an indirect wholly-owned subsidiary ofHSBC Holdings plc, and subsidiaries as of December 31, 2006 and 2005 and therelated consolidated statements of income, changes in shareholder's equity, andcash flows for each of the years in the three-year period ended December 31,2006. These consolidated financial statements are the responsibility of HSBCFinance Corporation's management. Our responsibility is to express an opinion onthese consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we planand perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes consideration ofinternal control over financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but not for the purpose ofexpressing an opinion on the effectiveness of HSBC Finance Corporation'sinternal control over financial reporting. Accordingly, we express no suchopinion. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion. In our opinion, the aforementioned consolidated financial statements presentfairly, in all material respects, the financial position of HSBC FinanceCorporation and subsidiaries as of December 31, 2006 and 2005, and the resultsof their operations and their cash flows for each of the years in the three-yearperiod ended December 31, 2006, in conformity with U.S. generally acceptedaccounting principles. /s/ KPMG LLPChicago, IllinoisMarch 2, 2007 110 HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME YEAR ENDED DECEMBER 31, 2006 2005 2004---------------------------------------------------------------------------------------------------- (IN MILLIONS) Finance and other interest income....................... $17,562 $13,216 $10,945Interest expense: HSBC affiliates....................................... 929 713 343 Non-affiliates........................................ 6,445 4,119 2,800 ------- ------- -------NET INTEREST INCOME..................................... 10,188 8,384 7,802Provision for credit losses............................. 6,564 4,543 4,334 ------- ------- -------NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES... 3,624 3,841 3,468 ------- ------- -------Other revenues: Securitization revenue................................ 167 211 1,008 Insurance revenue..................................... 1,001 997 882 Investment income..................................... 274 134 137 Derivative income..................................... 190 249 511 Fee income............................................ 1,911 1,568 1,091 Enhancement services revenue.......................... 515 338 251 Taxpayer financial services revenue................... 258 277 217 Gain on bulk sale of private label receivables........ - - 663 Gain on receivable sales to HSBC affiliates........... 422 413 39 Servicing and other fees from HSBC affiliates......... 506 440 57 Other income.......................................... 179 336 307 ------- ------- -------TOTAL OTHER REVENUES.................................... 5,423 4,963 5,163 ------- ------- -------Costs and expenses: Salaries and employee benefits........................ 2,333 2,072 1,886 Sales incentives...................................... 358 397 363 Occupancy and equipment expenses...................... 317 334 323 Other marketing expenses.............................. 814 731 636 Other servicing and administrative expenses........... 1,115 917 958 Support services from HSBC affiliates................. 1,087 889 750 Amortization of intangibles........................... 269 345 363 Policyholders' benefits............................... 467 456 412 ------- ------- -------TOTAL COSTS AND EXPENSES................................ 6,760 6,141 5,691 ------- ------- -------Income before income tax expense........................ 2,287 2,663 2,940Income tax expense...................................... 844 891 1,000 ------- ------- -------NET INCOME.............................................. $ 1,443 $ 1,772 $ 1,940 ======= ======= ======= The accompanying notes are an integral part of the consolidated financialstatements. 111 HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET YEAR ENDED DECEMBER 31, 2006 2005--------------------------------------------------------------------------------- (IN MILLIONS, EXCEPT SHARE DATA) ASSETSCash........................................................ $ 871 $ 903Interest bearing deposits with banks........................ 424 384Securities purchased under agreements to resell............. 171 78Securities.................................................. 4,695 4,051Receivables, net............................................ 157,262 136,989Intangible assets, net...................................... 2,218 2,480Goodwill.................................................... 7,010 7,003Properties and equipment, net............................... 426 458Real estate owned........................................... 794 510Derivative financial assets................................. 1,461 234Other assets................................................ 4,127 3,579 -------- --------TOTAL ASSETS................................................ $179,459 $156,669 ======== ========LIABILITIESDebt: Commercial paper, bank and other borrowings............... $ 11,055 $ 11,454 Due to affiliates......................................... 15,172 15,534 Long term debt (with original maturities over one year)... 127,590 105,163 -------- --------Total debt.................................................. 153,817 132,151 -------- --------Insurance policy and claim reserves......................... 1,319 1,291Derivative related liabilities.............................. 1,222 383Liability for pension benefits.............................. 355 341Other liabilities........................................... 2,656 3,024 -------- --------TOTAL LIABILITIES........................................... 159,369 137,190 -------- --------SHAREHOLDERS' EQUITYRedeemable preferred stock, 1,501,100 shares authorized, Series B, $0.01 par value, 575,000 shares issued.......... 575 575Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized; 55 shares issued.......................................... - - Additional paid-in capital................................ 17,279 17,145 Retained earnings......................................... 1,877 1,280 Accumulated other comprehensive income.................... 359 479 -------- --------TOTAL COMMON SHAREHOLDER'S EQUITY........................... 19,515 18,904 -------- --------TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY.................. $179,459 $156,669 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 112 HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004-------------------------------------------------------------------------------------------------------- (IN MILLIONS) PREFERRED STOCK Balance at beginning of period............................ $ 575 $ 1,100 $ 1,100 Issuance of Series B preferred stock...................... - 575 - Exchange of Series A preferred stock for common stock..... - (1,100) - ------- ------- ------- Balance at end of period.................................. $ 575 $ 575 $ 1,100 ======= ======= =======COMMON SHAREHOLDER'S EQUITY COMMON STOCK Balance at beginning of period.......................... $ - $ - $ - Exchange of common stock for Series A preferred stock... - - - ------- ------- ------- Balance at end of period................................ $ - $ - $ - ------- ------- ------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period.......................... $17,145 $14,627 $14,645 Premium on sale of European Operations to affiliate..... 13 - - Premium on sale of U.K. credit card business to affiliate............................................. - 182 - Exchange of common stock for Series A preferred stock... - 1,112 - Capital contribution from parent company................ 163 1,200 - Return of capital to HSBC............................... (49) (19) (31) Employee benefit plans, including transfers and other... 7 59 13 Issuance costs of Series B preferred stock.............. - (16) - ------- ------- ------- Balance at end of period................................ $17,279 $17,145 $14,627 ------- ------- ------- RETAINED EARNINGS Balance at beginning of period.......................... $ 1,280 $ 571 $ 1,303 Net income.............................................. 1,443 1,772 1,940 Dividends: Preferred stock....................................... (37) (83) (72) Common stock.......................................... (809) (980) (2,600) ------- ------- ------- Balance at end of period................................ $ 1,877 $ 1,280 $ 571 ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period.......................... $ 479 $ 643 $ 443 Net change in unrealized gains (losses) on: Derivatives classified as cash flow hedges.......... (321) 141 130 Securities available for sale and interest-only strip receivables................................. (21) (56) (114) Minimum pension liability............................. - 4 (4) Adjustment to initially apply FASB statement No. 158, net of tax.......................................... (1) - - Foreign currency translation adjustment............... 223 (253) 188 ------- ------- ------- Other comprehensive income, net of tax.................. (120) (164) 200 Balance at end of period................................ $ 359 $ 479 $ 643 ------- ------- -------TOTAL COMMON SHAREHOLDER'S EQUITY........................... $19,515 $18,904 $15,841 ======= ======= =======COMPREHENSIVE INCOMENet income.................................................. $ 1,443 $ 1,772 $ 1,940Other comprehensive (loss) income........................... (120) (164) 200 ------- ------- -------COMPREHENSIVE INCOME........................................ $ 1,323 $ 1,608 $ 2,140 ======= ======= =======PREFERRED STOCK Balance at beginning of period............................ 575 1,100 1,100 Issuance of Series B preferred stock...................... - 575 - Exchange of Series A preferred stock to common stock...... - (1,100) - ------- ------- ------- Balance at end of period.................................. 575 575 1,100 ======= ======= =======COMMON STOCK ISSUED Balance at beginning of period.......................... 55 50 50 Issuance of common stock to parent...................... - 5 - ------- ------- ------- Balance at end of period................................ 55 55 50 ------- ------- ------- The accompanying notes are an integral part of the consolidated financialstatements. 113 HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004-------------------------------------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIESNet income.................................................. $ 1,443 $ 1,772 $ 1,940Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for credit losses................................ 6,564 4,543 4,334 Gain on bulk sale of private label receivables............. - - (663) Gain on receivable sales to HSBC affiliates................ (422) (413) (39) Gain on sale of investment in Kanbay International, Inc. .................................................... (123) - - Insurance policy and claim reserves........................ (240) (222) (170) Depreciation and amortization.............................. 385 457 483 Deferred income tax (benefit) provision.................... (560) (366) 348 Net change in other assets................................. (615) 326 (696) Net change in other liabilities............................ 155 393 23 Net change in loans held for sale.......................... 78 (672) (376) Net change in derivative related assets and liabilities.... 937 (524) (497) Excess tax benefits from share-based compensation arrangements............................................. (16) - - Other, net................................................. 728 434 1,394 -------- ------- --------Net cash provided by (used in) operating activities......... 8,314 5,728 6,081 -------- ------- --------CASH FLOWS FROM INVESTING ACTIVITIESSecurities: Purchased.................................................. (2,071) (852) (1,363) Matured.................................................... 1,847 646 1,375 Sold....................................................... 492 429 854Net change in short-term securities available for sale...... (606) (472) 5,372Net change in securities purchased under agreements to resell..................................................... (93) 2,573 (2,651)Net change in interest bearing deposits with banks.......... (5) 187 466Receivables: Originations, net of collections........................... (23,978) (33,511) (18,742) Purchases and related premiums............................. (3,225) (1,053) (608) Initial securitizations.................................... - - 740 Net change in interest-only strip receivables.............. (5) 253 466Cash received in sale of European Operations................ 46 - -Cash received in sale of U.K. credit card business.......... 90 2,627 -Net cash paid for acquisition of Metris..................... - (1,572) -Net cash paid for acquisition of Solstice................... (50) - -Properties and equipment: Purchases.................................................. (102) (78) (96) Sales...................................................... 26 7 4 -------- ------- --------Net cash provided by (used in) investing activities......... (27,634) (30,816) (14,183) -------- ------- --------CASH FLOWS FROM FINANCING ACTIVITIESDebt: Net change in short-term debt and deposits................. (411) 2,381 (341) Net change in due to affiliates............................ (846) 2,435 5,716 Long term debt issued...................................... 41,138 40,214 19,916 Long term debt retired..................................... (19,663) (20,967) (14,628) Issuance of company obligated mandatorily redeemable preferred securities of subsidiary trusts to HSBC........ -- 1,031 - Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts................ (412) (309) -Insurance: Policyholders' benefits paid............................... (264) (250) (194) Cash received from policyholders........................... 393 380 265Capital contribution from parent............................ 163 1,200Shareholder's(s') dividends................................. (846) (1,063) (2,708)Issuance of preferred stock................................. - 559 -Excess tax benefits from share-based compensation arrangements............................................... 16 - - -------- ------- --------Net cash provided by (used in) financing activities......... 19,268 25,611 8,026 -------- ------- --------Effect of exchange rate changes on cash..................... 20 (12) 5 -------- ------- --------Net change in cash.......................................... (32) 511 (71)Cash at beginning of period................................. 903 392 463 -------- ------- --------CASH AT END OF PERIOD....................................... $ 871 $ 903 $ 392 ======== ======= ========SUPPLEMENTAL CASH FLOW INFORMATION:Interest paid............................................... $ 7,454 $ 5,233 $ 3,468Income taxes paid........................................... 1,406 1,119 842 -------- ------- --------SUPPLEMENTAL NONCASH FINANCING AND CAPITAL ACTIVITIES:Affiliate preferred stock received in sale of U.K. credit card business.............................................. $ - $ 261 $ -Exchange of preferred for common stock...................... - 1,112 - ======== ======= ======== The accompanying notes are an integral part of the consolidated financialstatements. 114 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION-------------------------------------------------------------------------------- HSBC Finance Corporation (formerly Household International, Inc.) and itssubsidiaries were acquired by a wholly owned subsidiary of HSBC Holdings plc("HSBC") on March 28, 2003 in a purchase business combination recorded under the"push-down" method of accounting, which resulted in a new basis of accountingfor the "successor" period beginning March 29, 2003. HSBC Finance Corporation and subsidiaries, is an indirect wholly ownedsubsidiary of HSBC North America Holdings Inc. ("HSBC North America"), which isan indirect wholly-owned subsidiary of HSBC. HSBC Finance Corporation providesmiddle-market consumers with several types of loan products in the UnitedStates, the United Kingdom, Canada, and the Republic of Ireland. HSBC FinanceCorporation may also be referred to in these notes to the consolidated financialstatements as "we," "us" or "our." Our lending products include real estatesecured loans, auto finance loans, MasterCard*, Visa*, American Express* andDiscover* credit card loans ("Credit Card"), private label credit card loans,including retail sales contracts, and personal non-credit card loans. We alsoinitiate tax refund anticipation loans and other related products in the UnitedStates and offer credit and specialty insurance in the United States, the UnitedKingdom and Canada. We have three reportable segments: Consumer, Credit CardServices, and International. Our Consumer segment consists of our branch-basedconsumer lending, mortgage services, retail services, and auto financebusinesses. Our Credit Card Services segment consists of our domestic creditcard business. Our International segment consists of our foreign operations inCanada, the United Kingdom ("U.K."), the Republic of Ireland and prior toNovember 9, 2006 our operations in Slovakia, the Czech Republic and Hungary. During 2004, Household International, Inc. ("Household") rebranded the majorityof its U.S. and Canadian businesses to the HSBC brand. Businesses previouslyoperating under the Household name are now called HSBC. Our consumer lendingbusiness retained the HFC and Beneficial brands in the United States,accompanied by the HSBC Group's endorsement signature, "Member HSBC Group." Thesingle brand has allowed HSBC in North America to better align its businesses,provided a stronger platform to service customers and advanced growth. The HSBCbrand also positions us to expand the products and services offered to ourcustomers. As part of this initiative, Household changed its name to HSBCFinance Corporation in December 2004. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-------------------------------------------------------------------------------- BASIS OF PRESENTATION The consolidated financial statements include the accountsof HSBC Finance Corporation and all subsidiaries including all variable interestentities in which we are the primary beneficiary as defined by FinancialAccounting Standards Board Interpretation No. 46 (Revised). Unaffiliated truststo which we have transferred securitized receivables which are qualifyingspecial purpose entities ("QSPEs") as defined by Statement of FinancialAccounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicingof Financial Assets and Extinguishments of Liabilities," are not consolidated.All significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the amounts reported in the financialstatements and accompanying notes. Actual results could differ from thoseestimates. Certain reclassifications have been made to prior year amounts toconform to the current period presentation. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL Securities purchased underagreements to resell are treated as collateralized financing transactions andare carried at the amounts at which the securities were acquired plus accruedinterest. Interest income earned on these securities is included in net interestincome. --------------- * MasterCard is a registered trademark of MasterCard International, Incorporated; VISA is a registered trademark of Visa USA, Inc; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc. 115 INVESTMENT SECURITIES We maintain investment portfolios (comprised primarily ofdebt securities and money market funds) in both our noninsurance and insuranceoperations. Our entire investment securities portfolio was classified asavailable-for-sale at December 31, 2006 and 2005. Available-for-sale investmentsare intended to be invested for an indefinite period but may be sold in responseto events we expect to occur in the foreseeable future. These investments arecarried at fair value. Unrealized holding gains and losses on available-for-saleinvestments are recorded as adjustments to common shareholder's equity inaccumulated other comprehensive income, net of income taxes. Any decline in thefair value of investments which is deemed to be other than temporary is chargedagainst current earnings. Cost of investment securities sold is determined using the specificidentification method. Interest income earned on the noninsurance investmentportfolio is classified in the statements of income in net interest income.Realized gains and losses from the investment portfolio and investment incomefrom the insurance portfolio are recorded in investment income. Accruedinvestment income is classified with investment securities. RECEIVABLES Finance receivables are carried at amortized cost which representsthe principal amount outstanding, net of any unearned income, charge-offs,unamortized deferred fees and costs on originated loans, purchase accountingfair value adjustments as a result of our acquisition by HSBC and premiums ordiscounts on purchased loans. Finance receivables are further reduced by creditloss reserves and unearned credit insurance premiums and claims reservesapplicable to credit risks on our consumer receivables. Receivables held forsale are carried at the lower of aggregate cost or market value and remainpresented as receivables in the consolidated balance sheet. Finance income isrecognized using the effective yield method. Premiums and discounts, includingpurchase accounting adjustments on receivables, are recognized as adjustments tothe yield of the related receivables. Origination fees, which include points onreal estate secured loans, are deferred and generally amortized to financeincome over the estimated life of the related receivables, except to the extentthey offset directly related lending costs. Net deferred origination fees,excluding credit card, totaled $150 million at December 31, 2006 and $94 millionat December 31, 2005. Credit card annual fees are netted with direct lendingcosts, deferred, and amortized on a straight-line basis over one year. Deferredcredit card annual fees, net of direct lending costs related to thesereceivables, totaled $233 million at December 31, 2006 and $191 million atDecember 31, 2005. Insurance reserves and unearned premiums applicable to credit risks on consumerreceivables are treated as a reduction of receivables in the balance sheet,since payments on such policies generally are used to reduce outstandingreceivables. PROVISION AND CREDIT LOSS RESERVES Provision for credit losses on ownedreceivables is made in an amount sufficient to maintain credit loss reserves ata level considered adequate, but not excessive, to cover probable losses ofprincipal, interest and fees, including late, overlimit and annual fees, in theexisting owned portfolio. We estimate probable losses for owned consumerreceivables using a roll rate migration analysis that estimates the likelihoodthat a loan will progress through the various stages of delinquency, or buckets,and ultimately charge-off. This analysis considers delinquency status, lossexperience and severity and takes into account whether loans are in bankruptcy,have been restructured, rewritten or are subject to forbearance, an externaldebt management plan, hardship, modification, extension or deferment. Our creditloss reserves also take into consideration the loss severity expected based onthe underlying collateral, if any, for the loan in the event of default.Delinquency status may be affected by customer account management policies andpractices, such as the restructure of accounts, forbearance agreements, extendedpayment plans, modification arrangements, loan rewrites and deferments. Whencustomer account management policies or changes thereto, shift loans from a"higher" delinquency bucket to a "lower" delinquency bucket, this will bereflected in our roll rate statistics. To the extent that restructured accountshave a greater propensity to roll to higher delinquency buckets, this will becaptured in the roll rates. Since the loss reserve is computed based on thecomposite of all these calculations, this increase in roll rate will be appliedto receivables in all respective buckets, which will increase the overallreserve level. In addition, loss reserves on consumer receivables are maintainedto reflect our judgment of portfolio risk factors which may not be fullyreflected in the statistical roll rate calculation. Risk factors considered inestablishing loss reserves on consumer receivables include recent growth,product mix, bankruptcy trends, geographic concentrations, loan product featuressuch as adjustable rate loans, 116 economic conditions such as national and local trends in housing markets andinterest rates, portfolio seasoning, account management policies and practicesand current levels of charge-offs and delinquencies, changes in laws andregulations and other items which can affect consumer payment patterns onoutstanding receivables such as natural disasters and global pandemics. Forcommercial loans, probable losses are calculated using estimates of amounts andtiming of future cash flows expected to be received on loans. While our credit loss reserves are available to absorb losses in the entireportfolio, we specifically consider the credit quality and other risk factorsfor each of our products. We recognize the different inherent losscharacteristics in each of our products as well as customer account managementpolicies and practices and risk management/collection practices. Charge-offpolicies are also considered when establishing loss reserve requirements toensure appropriate allowances exist for products with longer charge-off periods.We also consider key ratios such as reserves to nonperforming loans and reservesas a percentage of net charge-offs in developing our loss reserve estimate. Lossreserve estimates are reviewed periodically and adjustments are reported inearnings when they become known. As these estimates are influenced by factorsoutside our control, such as consumer payment patterns and economic conditions,there is uncertainty inherent in these estimates, making it reasonably possiblethat they could change. CHARGE-OFF AND NONACCRUAL POLICIES AND PRACTICES Our consumer charge-off andnonaccrual policies vary by product and are summarized below: PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1)------------------------------------------------------------------------------------------------------- Real estate Secured(2) Carrying values in excess of net Interest income accruals are realizable value are charged-off suspended when principal or interest at or before the time foreclosure payments are more than three months is completed or when settlement contractually past due and resumed is reached with the borrower. If when the receivable becomes less foreclosure is not pursued (which than three months contractually past frequently occurs on loans in the due. second lien position), and there is no reasonable expectation for recovery (insurance claim, title claim, pre-discharge bankrupt account), generally the account will be charged-off by the end of the month in which the account becomes eight months contractually delinquent.Auto finance(3)(6) Carrying values in excess of net Interest income accruals are realizable value are charged off suspended and the portion of at the earlier of the following: previously accrued interest expected to be uncollectible is written off - the collateral has been when principal payments are more repossessed and sold, than two months contractually past due and resumed when the receivable - the collateral has been in our becomes less than two months possession for more than 30 contractually past due days (prior to December 2006, 90 days), or - the loan becomes 150 days contractually delinquent.Credit card(5) Generally charged-off by the end Interest generally accrues until of the month in which the account charge-off. becomes six months contractually delinquent. 117 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange