HSBC Holdings Regulatory News (HSBA)

6 Mar 2006 11:00

HSBC Holdings PLC06 March 2006 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.-------------------------------------------------------------------------------- Not applicable 20 HSBC Finance Corporation-------------------------------------------------------------------------------- ITEM 6. SELECTED FINANCIAL DATA.-------------------------------------------------------------------------------- On March 28, 2003, HSBC Holdings plc ("HSBC") acquired HSBC Finance Corporation(formerly Household International, Inc.). This resulted in a new basis ofaccounting reflecting the fair market value of our assets and liabilities forthe "successor" periods beginning March 29, 2003. Information for all"predecessor" periods prior to the merger is presented using our historicalbasis of accounting, which impacts comparability to our "successor" periods. Toassist in the comparability of our financial results, the "predecessor period"(January 1 to March 28, 2003) has been combined with the "successor period"(March 29 to December 31, 2003) to present "combined" results for the year endedDecember 31, 2003. MAR. 29 JAN. 1 YEAR ENDED YEAR ENDED YEAR ENDED THROUGH THROUGH YEAR ENDED DECEMBER 31, DEC. 31, DEC. 31, DEC. 31, DEC. 31 MAR. 28, ----------------------- 2005 2004 2003 2003 2003 2002 2001------------------------------------------------------------------------------------------------------------------------ (SUCCESSOR) (SUCCESSOR) (COMBINED) (SUCCESSOR)(PREDECESSOR)(PREDECESSOR)(PREDECESSOR) (IN MILLIONS)OWNED BASIS STATEMENT OF INCOME DATANet interest income and other revenues-operating basis(1).............. $13,215 $12,364 $11,633 $8,849 $2,784 $11,178 $9,606Gain on bulk sale of private label receivables(3)........ - 663 - - - - -Loss on disposition of Thrift assets and deposits.............. - - - - - 378 -Provision for credit losses on owned receivables-operating basis(1).............. 4,543 4,296 3,967 2,991 976 3,732 2,913Total costs and expenses, excluding nonrecurring expense items(1).............. 6,009 5,601 4,993 3,811 1,182 4,290 3,875HSBC acquisition related costs incurred by HSBC Finance Corporation... - - 198 - 198 - -Settlement charge and related expenses...... - - - - - 525 -Adoption of FFIEC charge-off policies for domestic private label and MasterCard/Visa portfolios(1),(8)..... - 190 - - - - -Income taxes............ 891 1,000 872 690 182 695 970 ------- ------- ------- ------ ------ ------- ------Net income(1)........... $ 1,772 $ 1,940 $ 1,603 $1,357 $ 246 $ 1,558 $1,848 ======= ======= ======= ====== ====== ======= ====== YEAR ENDED DECEMBER 31, 2005 2004 2003 2002 2001--------------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (COMBINED) (PREDECESSOR) (PREDECESSOR)OWNED BASIS SELECTED FINANCIAL RATIOSReturn on average owned assets(1)............ 1.27 1.57% 1.46% 1.62% 2.26%Return on average common shareholder's(s') equity(1).................................. 9.97 10.99 10.89 17.30 24.14Net interest margin.......................... 6.73 7.33 7.75 7.57 7.85Efficiency ratio(1).......................... 43.52 41.64 42.77 42.63 38.40Consumer net charge-off ratio(1)............. 3.03 4.00 4.06 3.81 3.32Reserves as a percent of net charge-offs(9)............................. 123.8 89.9 105.7 106.5 110.5MANAGED BASIS SELECTED FINANCIAL RATIOS(2)Return on average managed assets(1).......... 1.19 1.33% 1.19% 1.31% 1.82%Net interest margin.......................... 6.94 7.97 8.60 8.47 8.44Efficiency ratio(1).......................... 43.16 41.02 35.58 35.99 34.33Consumer net charge-off ratio(1)............. 3.36 4.61 4.67 4.28 3.73Reserves as a percent of net charge-offs(9)............................. 108.6 79.6 117.4 113.8 110.7 21 HSBC Finance Corporation-------------------------------------------------------------------------------- AT DECEMBER 31, 2005 2004 2003 2002 2001------------------------------------------------------------------------------------------------------------------------ (SUCCESSOR) (SUCCESSOR) (COMBINED) (PREDECESSOR) (PREDECESSOR) (DOLLARS ARE IN MILLIONS)OWNED BASIS BALANCE SHEET DATATotal assets......................................... $156,669 $130,190 $119,052 $ 97,860 $ 88,911Receivables:(3) Domestic: Real estate secured.............................. $ 79,792 $ 61,946 $ 49,026 $ 44,140 $ 42,474 Auto finance..................................... 10,434 7,490 4,138 2,024 2,369 MasterCard/Visa.................................. 23,963 12,371 9,577 7,628 6,967 Private label.................................... 356 341 9,732 9,365 9,853 Personal non-credit card......................... 15,900 12,049 9,624 11,685 11,737 Commercial and other............................. 208 315 399 461 505 -------- -------- -------- -------- -------- Total domestic..................................... $130,653 $ 94,512 $ 82,496 $ 75,303 $ 73,905 -------- -------- -------- -------- -------- Foreign: Real estate secured.............................. $ 3,034 $ 2,874 $ 2,195 $ 1,679 $ 1,383 Auto finance..................................... 270 54 - - - MasterCard/Visa.................................. 147 2,264 1,605 1,319 1,174 Private label.................................... 2,164 3,070 2,872 1,974 1,811 Personal non-credit card......................... 3,645 4,079 3,208 2,285 1,600 Commercial and other............................. - 2 2 2 2 -------- -------- -------- -------- -------- Total foreign...................................... $ 9,260 $ 12,343 $ 9,882 $ 7,259 $ 5,970 -------- -------- -------- -------- -------- Total owned receivables: Real estate secured.............................. $ 82,826 $ 64,820 $ 51,221 $ 45,819 $ 43,857 Auto finance..................................... 10,704 7,544 4,138 2,024 2,369 MasterCard/Visa.................................. 24,110 14,635 11,182 8,947 8,141 Private label.................................... 2,520 3,411 12,604 11,339 11,664 Personal non-credit card......................... 19,545 16,128 12,832 13,970 13,337 Commercial and other............................. 208 317 401 463 507 -------- -------- -------- -------- -------- Total owned receivables............................ $139,913 $106,855 $ 92,378 $ 82,562 $ 79,875 ======== ======== ======== ======== ========Deposits............................................. $ 37 $ 47 $ 232 $ 821 $ 6,562Commercial paper, bank and other borrowings.......... 11,417 9,013 9,122 6,128 12,024Due to affiliates(4)................................. 15,534 13,789 7,589 - -Long term debt....................................... 105,163 85,378 79,632 75,751 57,799Preferred stock(5)................................... 575 1,100 1,100 1,193 456Common shareholder's(s') equity(5),(6)............... 18,904 15,841 16,391 9,222 7,843 -------- -------- -------- -------- --------OWNED BASIS SELECTED FINANCIAL RATIOSCommon and preferred equity to owned assets.......... 12.43% 13.01% 14.69% 10.64% 9.33%Consumer two-month-and-over contractual delinquency........................................ 3.84 4.07 5.36 5.34 4.43Reserves as a percent of receivables................. 3.23 3.39 4.11 4.04 3.33Reserves as a percent of nonperforming loans......... 108.8 103.0 93.7 94.5 92.7 -------- -------- -------- -------- --------MANAGED BASIS BALANCE SHEET DATA AND SELECTED FINANCIAL RATIOS(2)Total assets......................................... $160,743 $144,415 $145,253 $122,794 $109,859Managed receivables:(3) Real estate secured................................ $ 82,826 $ 64,901 $ 51,415 $ 46,275 $ 44,719 Auto finance....................................... 11,896 10,223 8,813 7,442 6,395 MasterCard/Visa.................................... 25,985 22,218 21,149 18,953 17,395 Private label...................................... 2,520 3,411 17,865 14,917 13,814 Personal non-credit card........................... 20,552 20,010 18,936 19,446 17,993 Commercial and other............................... 208 317 401 463 507 -------- -------- -------- -------- --------Total managed receivables............................ $143,987 $121,080 $118,579 $107,496 $100,823 ======== ======== ======== ======== ========Tangible shareholder's(s') equity to tangible managed assets ("TETMA")(7)................................ 7.56% 6.27% 6.64% 9.08% 7.57%Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves")(7)...................................... 10.55 9.04 9.50 11.87 10.03Tangible common equity to tangible managed assets(7).......................................... 6.07 4.67 5.04 6.83 6.24Excluding HSBC acquisition purchase accounting adjustments: TETMA.............................................. 8.52 7.97 8.55 9.08 7.57 TETMA + Owned Reserves............................. 11.51 10.75 11.42 11.87 10.03 Tangible common equity to tangible managed assets........................................... 7.02 6.38 6.98 6.83 6.24Risk adjusted revenue................................ 7.18 6.96 6.98 7.18 7.64Consumer two-month-and-over contractual delinquency........................................ 3.89 4.24 5.39 5.24 4.46Reserves as a percent of receivables................. 3.29 3.73 5.20 4.74 3.78Reserves as a percent of nonperforming loans......... 108.8 108.4 118.0 112.6 105.0 -------- -------- -------- -------- -------- --------------- (1) The following table, which contains non-GAAP financial information is provided for comparison of our operating trends only and should be read in conjunction with our owned basis GAAP financial information. For 2004, the operating trends, percentages and 22 HSBC Finance Corporation-------------------------------------------------------------------------------- ratios presented below exclude the $121 million decrease in net income relating to the adoption of Federal Financial Institutions Examination Council ("FFIEC") charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard/Visa receivables and the $423 million (after-tax) gain on the bulk sale of domestic private label receivables (excluding retail sales contracts at our consumer lending business) to an affiliate, HSBC Bank USA, National Association ("HSBC Bank USA"). For 2003, the operating results, percentages and ratios exclude $167 million (after-tax) of HSBC acquisition related costs and other merger related items and for 2002, exclude a $333 million (after-tax) settlement charge and related expenses and a $240 million (after-tax) loss on disposition of Thrift assets and deposits. See "Basis of Reporting" and "Reconciliations to GAAP Financial Measures" in Management's Discussion and Analysis for additional discussion and quantitative reconciliations to the equivalent GAAP basis financial measure. YEAR ENDED DECEMBER 31, 2005 2004 2003 2002 2001 -------------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (COMBINED)(PREDECESSOR) (PREDECESSOR) (DOLLARS ARE IN MILLIONS) Operating net income.............................. $1,772 $1,638 $1,770 $2,131 $1,848 Return on average owned assets.................... 1.27% 1.32% 1.61% 2.21% 2.26% Return on average common shareholder's(s') equity.......................................... 9.97 9.21 12.08 23.94 24.14 Owned basis consumer net charge-off ratio......... 3.03 3.84 4.06 3.81 3.32 Managed basis consumer net charge-off ratio....... 3.36 4.44 4.67 4.28 3.73 Owned basis efficiency ratio...................... 43.52 43.42 41.01 36.28 38.40 Return on average managed assets.................. 1.19 1.12 1.32 1.80 1.82 Managed basis efficiency ratio.................... 43.16 42.90 34.11 30.80 34.33 (2) We have historically monitored our operations and evaluated trends on both an owned basis as shown in our financial statements and on a managed basis. Managed basis reporting (a non-GAAP financial measure) assumes that securitized receivables have not been sold and are still on our balance sheet. Managed basis information is intended to supplement, and should not be considered a substitute for, owned basis reporting and should be read in conjunction with reported owned basis results. See "Basis of Reporting" and "Reconciliations to GAAP Financial Measures" for additional discussion and quantitative reconciliations to the equivalent GAAP basis financial measure. (3) In 2005, we sold our U.K. credit card business, which included receivables of $2.5 billion ($3.1 billion on a managed basis), to HSBC Bank plc. and acquired $5.3 billion in MasterCard/Visa receivables in conjunction with our acquisition of Metris Companies, Inc. ("Metris"). In 2004, we sold $.9 billion of higher quality non-conforming real estate secured receivables and sold our domestic private label receivable portfolio (excluding retail sales contracts at our consumer lending business) of $12.2 billion ($15.6 billion on a managed basis) to HSBC Bank USA. In 2003, we sold $2.8 billion of higher quality non-conforming real estate secured receivables to HSBC Bank USA and acquired owned basis private label portfolios totaling $1.2 billion ($1.6 billion on a managed basis) and MasterCard and Visa portfolios totaling $.9 billion. In 2002, we sold $6.3 billion of real estate secured whole loans from our consumer lending and mortgage services businesses and purchased a $.5 billion private label portfolio. In 2001, we sold approximately $1 billion of MasterCard and Visa receivables as a result of discontinuing our participation in the Goldfish credit card program and purchased a $.7 billion private label portfolio. (4) We had received $44.1 billion, $35.7 billion and $14.7 billion in HSBC related funding as of December 31, 2005, 2004 and 2003, respectively. See Liquidity and Capital Resources for the components of this funding. (5) In conjunction with the acquisition by HSBC, our 7.625%, 7.60%, 7.50% and 8.25% preferred stock was converted into the right to receive cash which totaled approximately $1.1 billion. In consideration of HSBC transferring sufficient funds to make these payments, we issued $1.1 billion Series A preferred stock to HSBC on March 28, 2003. Also on March 28, 2003, we called for redemption of our $4.30, $4.50 and 5.00% preferred stock. In September 2004, HSBC North America Holdings Inc. ("HNAH") issued a new series of preferred stock to HSBC in exchange for our Series A preferred stock. In October 2004, HSBC Investments (North America) Inc. ("HINO") issued a new series of preferred stock to HNAH in exchange for our Series A preferred stock. Our Series A preferred stock was exchanged by HINO for $1.1 billion of additional common equity in December 2005. (6) In 2005, we received a capital contribution of $1.2 billion from HINO to fund a portion of the purchase in conjunction with our acquisition of Metris. Common shareholder's equity at December 31, 2005, 2004 and 2003 reflects push-down accounting adjustments resulting from the HSBC merger. (7) TETMA, TETMA + Owned Reserves and tangible common equity to tangible managed assets are non-GAAP financial ratios that are used by HSBC Finance Corporation management or certain rating agencies as a measure 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-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. (8) In December 2004, we adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard and Visa portfolios. The adoption of the FFIEC charge-off policies resulted in a reduction to net income of $121 million in the fourth quarter of 2004. See "Credit Quality" in Management's Discussion and Analysis and Note 4, "Sale of Domestic Private Label Receivable Portfolio and Adoption of FFIEC Policies," in the accompanying consolidated financial statements for further discussion of these policy changes. (9) The acquisition of Metris in December 2005 has positively impacted this ratio. Reserves as a percentage of net charge-offs excluding Metris at December 31, 2005 was 118.2 percent on an owned basis and 103.9 percent on a managed basis. Additionally, the adoption of FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard and Visa portfolios and subsequent sale of the domestic private label portfolio (excluding retail sales contracts at our consumer lending business) in December 2004 have negatively impacted these ratios. Reserves as a percentage of net charge-offs excluding net charge-offs associated with the domestic private label portfolio sold in 2004 and the impact of adopting FFIEC charge-off policies for these portfolios was 109.2 percent on an owned basis and 96.0 percent on a managed basis. 23 HSBC Finance Corporation-------------------------------------------------------------------------------- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS.-------------------------------------------------------------------------------- EXECUTIVE OVERVIEW-------------------------------------------------------------------------------- ORGANIZATION AND BASIS OF REPORTING HSBC Finance Corporation (formerly Household International, Inc.) andsubsidiaries is an indirect wholly owned subsidiary of HSBC North AmericaHoldings Inc. ("HNAH") which is a wholly owned subsidiary of HSBC Holdings plc("HSBC"). HSBC Finance Corporation may also be referred to in Management'sDiscussion and Analysis of Financial Condition and Results of Operations("MD&A") as "we", "us", or "our". HSBC Finance Corporation provides middle-market consumers with real estatesecured loans, auto finance loans, MasterCard* and Visa* credit card loans,private label credit card loans, including retail sales contracts, and personalnon-credit card loans in the United States, the United Kingdom, Canada, theRepublic of Ireland, Slovakia, the Czech Republic and Hungary. We also initiatetax refund anticipation loans in the United States and offer credit andspecialty insurance products in the United States, the United Kingdom andCanada. We generate cash to fund our businesses primarily by collectingreceivable balances; issuing commercial paper, medium and long term debt;borrowing from HSBC subsidiaries and customers; securitizing and sellingconsumer receivables and borrowing under secured financing facilities. We usethe cash generated to invest in and support receivable growth, to service ourdebt obligations and to pay dividends to our parent. The acquisition by HSBC on March 28, 2003 resulted in a new basis of accountingreflecting the fair market value of our assets and liabilities for the"successor" periods beginning March 29, 2003. Information for all "predecessor"periods prior to the merger is presented using our historical basis ofaccounting, which impacts comparability to our "successor" periods beginningMarch 29, 2003. During 2003, the "predecessor" period contributed $246 millionof net income and the "successor" period contributed $1.4 billion of net income.To assist in the comparability of our financial results and to make it easier todiscuss and understand our results of operations, Management's Discussion andAnalysis combines the "predecessor period" (January 1 to March 28, 2003) withthe "successor period" (March 29 to December 31, 2003) to present "combined"results for the year ended December 31, 2003. In addition to owned basis reporting, we have historically monitored ouroperations and evaluated trends on a managed basis (a non-GAAP financialmeasure), which assumes that securitized receivables have not been sold and arestill on our balance sheet. See "Basis of Reporting" for further discussion ofthe reasons we use this non-GAAP financial measure. PERFORMANCE, DEVELOPMENTS AND TRENDS Our net income was $1.8 billion in 2005, $1.9 billion in 2004 and $1.6 billionin 2003. In measuring our results, management's primary focus is on receivablegrowth and operating net income (a non-GAAP financial measure which excludescertain nonrecurring items). See "Basis of Reporting" for further discussion ofoperating net income. Operating net income was $1.8 billion in 2005 compared to$1.6 billion in 2004 and $1.8 billion in 2003. Operating net income increased in2005 primarily due to higher other revenues and higher net interest income,partially offset by a higher provision for credit losses as well as higher costsand expenses. Other revenues on an operating basis increased primarily due tohigher fee and other income as well as higher gains on affiliate receivablesales and higher affiliate servicing fees, partially offset by lower derivativeincome and lower securitization related revenue. The higher gains on affiliatereceivable sales and higher affiliate servicing revenue were largely driven bythe gains on daily sales of domestic private label receivable originations andfees earned for servicing the domestic private label receivable portfolio soldto HSBC Bank USA, National Association ("HSBC Bank USA") in December 2004. Feeincome was higher as a result of higher credit card fees due to higher volume inour MasterCard/Visa portfolios. Other income was higher --------------- * MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of Visa USA, Inc. 24 HSBC Finance Corporation-------------------------------------------------------------------------------- primarily due to higher ancillary credit card revenue and higher gains on assetsales, including the partial sale of a real estate investment. The increaseswere partially offset by lower securitization related revenue due to reducedsecuritization activity and lower derivative income. The decrease in derivativeincome was primarily due to an upward shift in the forward yield curve whichdecreased the value of our pay variable interest rate swaps which do not qualifyfor hedge accounting under SFAS No. 133 and to the reduction in the portfolio ofreceive variable interest rate swaps which do not qualify for hedge accounting.The increase in net interest income was due to growth in average receivables andan improvement in the overall yield on the portfolio, partly offset by a highercost of funds. As discussed in more detail below, the higher provision forcredit losses reflects receivable growth, increased credit loss exposure fromHurricane Katrina and higher charge-off due to significantly higher bankruptcyfilings as a result of new bankruptcy legislation in the United States,partially offset by otherwise improved credit quality. Costs and expensesincreased to support receivables growth as well as due to increases in marketingexpenses, partially offset by lower other servicing and administrative expenses.Amortization of purchase accounting fair value adjustments increased net incomeby $102 million in 2005, which included $1 million relating to Metris, comparedto $152 million in 2004. Operating net income declined in 2004 compared to 2003 primarily due to highercosts and expenses and higher provision for credit losses due to receivablesgrowth, partially offset by higher net interest income and higher otherrevenues. Costs and expenses increased due to receivables growth, increases inmarketing expenses and higher amortization of intangibles which were establishedin connection with our acquisition by HSBC. Other revenues increased due tohigher derivative income and higher fee and other income, partially offset bylower securitization related revenue due to reduced securitization activity. Theincrease in net interest income was due to higher average receivable balances,partially offset by lower yields on our receivables, particularly in real estatesecured, auto finance and personal non-credit card receivables and by higherinterest expense. Interest expense was higher in 2004 resulting from a largerbalance sheet, partially offset by a lower cost of funds. Amortization ofpurchase accounting fair value adjustments increased net income by $152 millionin 2004 compared to $91 million in 2003. Our owned net interest margin was 6.73 percent in 2005 compared to 7.33 percentin 2004 and 7.75 percent in 2003. The decrease in 2005 was due to higher fundingcosts, partially offset by improvements in the overall yield on the portfolio.The higher yields in 2005 are due to increases in our rates on variable rateproducts which were in line with market movements and various other repricinginitiatives. In addition, there was a net increase in yields due to a change inreceivables mix in the owned balance sheet. Increased levels of higher yieldingMasterCard/Visa and personal non-credit card receivables were held on thebalance sheet due to lower securitization activity, but the effect of this onyields was partially offset by growth in lower yielding real estate secured andauto finance receivables as well as higher levels of near-prime receivables anda significant decline in the level of private label receivables as discussedabove. The decrease in net interest margin in 2004 was due to lower overallyields on our receivables, partially offset by lower funding costs. The loweryields in 2004 reflect a change in mix with higher levels of near-primereceivables, competitive pressure on pricing and the run-off of higher yieldingreal estate secured receivables, including second lien loans, largely due torefinancing activity. In August 2005, Hurricane Katrina ("Katrina") caused destruction and loss toindividuals, businesses and public infrastructure. As of December 31, 2005, wehad $1.3 billion, or 1.0 percent ($1.3 billion or 1.0 percent on a managedbasis) of consumer receivables outstanding with customers living in the KatrinaFederal Emergency Management Agency ("FEMA") designated Individual Assistancedisaster areas(1) with approximately $835 million of these receivables securedby real estate. Assessment of the impact of Katrina on the collectibility ofthese receivables has been complicated by the number of customers that weredisplaced from their primary residence. Estimates of loss take into account anumber of factors, such as: - how the current and long-term financial impact of the disaster on our customers will affect future loan payments; --------------- (1) Customers in the Individual Assistance Counties, as defined by FEMA on the list last updated and published on September 9, 2005. 25 HSBC Finance Corporation-------------------------------------------------------------------------------- - the condition and value of any collateral supporting the amounts outstanding; and - the availability of insurance to cover losses on the underlying collateral. In an effort to assist our customers affected by the disaster, we initiatedvarious programs including extended payment arrangements and interest and feewaivers for up to 90 days or more for certain products depending on customercircumstances. These interest and fee waivers totaled $14 million during 2005.We recorded an incremental provision for credit losses for Katrina of $185million in 2005, which represents our best estimate of Katrina's impact on ourloan portfolio. Because our estimate is influenced by factors outside of ourcontrol, there is uncertainty inherent in the estimate, making it reasonablypossible that it could change. As additional information becomes availablerelating to the financial condition of our affected customers, the physicalcondition of the collateral for loans which are secured by real estate and theresultant impact on customer payment patterns, we will continue to review ourestimate of credit loss exposure relating to Katrina and any adjustments will bereported in earnings when they become known. During the fourth quarter of 2005,$11 million of loan accounts outstanding to affected customers was charged-offin accordance with our charge-off policies. During 2005, we experienced higher bankruptcy filings, in particular during theperiod leading up to the October 17, 2005 effective date of new bankruptcylegislation in the United States. We had been maintaining credit loss reservesin anticipation of the impact this new legislation would have on netcharge-offs. However, the magnitude of the spike in bankruptcies experiencedimmediately before the new legislation became effective was larger thananticipated which resulted in an additional $100 million credit loss provisionbeing recorded during the third quarter of 2005. Our fourth quarter resultsinclude an estimated $125 million in incremental charge-offs of principal,interest and fees and $113 million in provision expense attributable tobankruptcy reform. The incremental charge-offs in the fourth quarter of 2005 areprimarily related to our MasterCard/Visa portfolio where bankrupt accountscharge-off sooner than in our secured and personal non-credit card portfolios inaccordance with our charge-off policies for these products. This provisionexpense included in our fourth quarter results relating to bankruptcies in oursecured and personal non-credit card portfolios will not begin to migrate tocharge-off until 2006 in accordance with their respective charge-off policies.As expected, the number of bankruptcy filings subsequent to the enactment ofthis new legislation have decreased dramatically. We believe that a portion ofthe increase in net charge-offs resulting from the higher bankruptcy filings isan acceleration of net charge-offs that would otherwise have been experienced infuture periods. Owned receivables increased to $139.9 billion at December 31, 2005, a 30.9percent increase from December 31, 2004. With the exception of our private labelportfolio, we experienced growth in all our receivable products with real estatesecured receivables being the primary contributor of the growth. Real estatesecured receivable levels reflect sales to HSBC Bank USA in 2004 and 2003 andpurchases of correspondent receivables directly by HSBC Bank USA of $1.5 billionand $2.8 billion during 2005 and 2004, a portion of which we otherwise wouldhave purchased. Purchases of real estate secured receivables from ourcorrespondents by HSBC Bank USA were discontinued effective September 1, 2005.Additionally, as discussed in more detail below, our owned receivable balancesincreased in 2005 by $5.3 billion as a result of our acquisition of MetrisCompanies, Inc. and decreased by $2.5 billion as a result of the sale of ourU.K. credit card business. Lower securitization levels also contributed to theincrease in owned receivables in 2005. We previously reported that as part of ongoing integration efforts with HSBC wehave been working with HSBC to determine if management efficiencies could beachieved by transferring all or a portion of our U.K. and other Europeanoperations to HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, and/orone or more unrelated third parties. In December 2005, we sold our U.K. creditcard business, including $2.5 billion of receivables ($3.1 billion on a managedbasis), the associated cardholder relationships and the related retainedinterests in securitized credit card receivables to HBEU for an aggregatepurchase price of $3.0 billion. The purchase price, which was determined basedon a comparative analysis of sales of other credit card portfolios, was paid ina combination of cash and $261 million of preferred stock issued by a subsidiaryof HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In additionto the assets referred to above, 26 HSBC Finance Corporation-------------------------------------------------------------------------------- the sale also included the account origination platform, including the marketingand credit employees associated with this function, as well as the leaseassociated with the credit card call center and the related leaseholds and callcenter employees to provide customer continuity after the transfer, as well asto allow HBEU direct ownership and control of origination and customer service.We have retained the collection operations related to the credit card operationsand have entered into a service level agreement for a period of not less thantwo years to provide collection services and other support services, includingcomponents of the compliance, financial reporting and human resource functions,for the sold credit card operations to HBEU for a fee. Additionally, themanagement teams of HBEU and our remaining U.K. operations will be jointlyinvolved in decision making involving card marketing to ensure that growthobjectives are met for both businesses. Because the sale of this business isbetween affiliates under common control, the premium received in excess of thebook value of the assets transferred of $182 million, including the goodwillassigned to this business, has been recorded as an increase to additional paidin capital and has not been included in earnings. In future periods, the netinterest income, fee income and provision for credit losses related to the U.K.credit card business will be reduced, while other income will be increased bythe receipt of servicing and support services revenue from HBEU. We do notanticipate that the net effect of this sale will result in a material reductionof our consolidated net income. We continue to evaluate strategic alternativeswith respect to our other U.K. and European operations. Additionally, in a separate transaction in December 2005, we transferred ourinformation technology services employees in the U.K. to a subsidiary of HBEU.Subsequent to the transfer, operating expenses relating to informationtechnology, which have previously been reported as salaries and fringe benefitsor other servicing and administrative expenses, are now billed to us by HBEU andreported as support services from HSBC affiliates. During the first quarter of2006, we anticipate that the information technology equipment in the U.K. willbe sold to HBEU for a purchase price equal to the book value of these assets. Our return on average common shareholder's(s') equity ("ROE") was 9.97 percentin 2005 compared to 10.99 percent in 2004, and 10.89 percent in 2003. Our returnon average owned assets ("ROA") was 1.27 percent in 2005 compared to 1.57percent in 2004 and 1.46 percent in 2003. On an operating basis, ROE was 9.97percent in 2005 compared to 9.21 percent in 2004 and 12.08 percent in 2003, andROA was 1.27 percent in 2005 compared to 1.32 percent in 2004 and 1.61 percentin 2003. The increase in our operating basis ROE in 2005 reflects higher netincome, as discussed above, while average common shareholder's equity remainedflat. Operating basis ROA decreased during 2005 and 2004 as average owned assetsincrease at a faster pace than operating net income primarily due to lower netinterest margin, lower securitization revenue and, in 2005, lower derivativeincome. Our owned basis efficiency ratio was 43.52 percent in 2005 compared to 41.64percent in 2004 and 42.77 percent in 2003. Our owned basis efficiency ratio onan operating basis was 43.52 percent in 2005 compared to 43.42 percent in 2004and 41.01 percent in 2003. These ratios have been significantly impacted by theresults of the domestic private label portfolio which was sold in December 2004.Excluding the results of this domestic private label portfolio from bothperiods, our 2005 efficiency ratio improved 259 basis points as compared to2004. This improvement is primarily a result of higher net interest income andother revenues due to higher levels of owned receivables as discussed above,partially offset by the increase in total costs and expenses to supportreceivable growth. In 2004, the deterioration in the efficiency ratio on anoperating basis reflects higher operating expenses including higher intangibleamortization, lower securitization related revenue and lower overall yields onour receivables, partially offset by higher derivative income. On December 1, 2005, we acquired Metris Companies Inc. ("Metris") for $1.6billion in cash. In order to support this acquisition, we received a $1.2billion capital contribution from our parent, HSBC Investments (North America)Inc. ("HINO"). This acquisition will expand our presence in the near-primecredit card market and will strengthen our capabilities to serve the fullspectrum of credit card customers This acquisition resulted in an increase inour MasterCard/Visa credit card receivable portfolio of $5.3 billion. See Note3, "Acquisitions," to our accompanying consolidated financial statements foradditional information on the acquisition of Metris. 27 HSBC Finance Corporation-------------------------------------------------------------------------------- CREDIT QUALITY Our owned basis two-months-and-over contractual delinquency ratio decreased to3.84 percent at December 31, 2005 from 4.07 percent at December 31, 2004. Thedecrease is consistent with the improvements in the delinquency trends weexperienced beginning in 2004 as a result of portfolio growth including higherlevels of real estate secured receivables, improvements in the economy, betterunderwriting standards and improved credit quality of originations. Thesedecreases were partially offset by higher bankruptcy delinquency in our securedand personal non-credit card receivable portfolios resulting from the spike inbankruptcy filings in the United States discussed above, which will not begin tomigrate to charge-off until 2006. In addition, our delinquency ratio waspositively impacted by the charge-off in the fourth quarter of 2005 of asignificant number of accounts in our domestic MasterCard/Visa portfolio as aresult of the spike in bankruptcy filings in the United States discussed above.Dollars of delinquency at December 31, 2005 increased compared to December 31,2004 due to higher levels of owned receivables in 2005 resulting from a declinein securitized levels and receivable growth as well as the higher delinquencylevels from higher bankruptcy filings in our real estate secured, auto financeand personal non-credit card receivable portfolios discussed above. Net charge-offs as a percentage of average consumer receivables for 2005decreased 97 basis points from 2004 (or 81 basis points excluding the impact ofthe adoption of FFIEC charge-off policies in December 2004 for our domesticprivate label (excluding retail sales contracts at our consumer lendingbusiness) and MasterCard/Visa portfolios) primarily as a result of portfoliogrowth, the positive impact from the lower delinquency levels we experiencedthroughout 2005 as a result of a strong economy as well as improved creditquality of originations. This was partially offset by an increase in charge-offsin the fourth quarter of 2005 for our MasterCard/Visa receivable portfolioresulting from the spike in bankruptcy filings prior to the effective date ofnew bankruptcy legislation in the United States. While our real estate secured,auto finance and personal non-credit card receivables also experienced a spikein bankruptcy filings prior to the effective date of the new legislation, theseaccounts have not yet migrated to charge-off in accordance with our charge-offpolicies for these receivable products. Also contributing to the decrease in2005 was a shift in mix to higher levels of higher credit quality receivables,particularly real estate secured and auto finance receivables, partially as aresult of the sale of our domestic private label receivable portfolio inDecember 2004 as discuss above. During 2005, our credit loss reserves increased as a result of higher levels ofowned receivables, including lower securitization levels which results in anincrease in our interest in the receivables of certain securitization trusts,additional reserves resulting from the Metris acquisition, higher dollars ofdelinquency driven by growth, increases in bankruptcy filings in both ourdomestic and foreign operations and higher credit loss exposure resulting fromKatrina and changes in the required minimum monthly payment for credit cardaccounts. These increases were partially offset by the impact of improved creditquality, and a shift in mix to higher levels of secured receivables and therelease of credit loss reserves of $104 million from the sale of our U.K. creditcard business in December 2005. FUNDING AND CAPITAL During 2005, we supplemented unsecured debt issuances with proceeds from thecontinuing sale of newly originated domestic private label receivables to HSBCBank USA following the bulk sale of this portfolio in December 2004, debt issuedto affiliates, increased levels of secured financings and higher levels ofcommercial paper compared to December 31, 2004. Because we are now a subsidiaryof HSBC, our credit ratings have improved and our credit spreads relative toTreasuries have tightened compared to those we experienced during the monthsleading up to the announcement of our acquisition by HSBC. Primarily as a resultof tightened credit spreads, we recognized cash funding expense savings inexcess of approximately $600 million during 2005, $350 million in 2004 and $125million in 2003 compared to the funding costs we would have incurred usingaverage spreads and funding mix from the first half of 2002. It is anticipatedthat these tightened credit spreads in combination with the issuance of HSBCFinance Corporation debt and other funding synergies including asset transfersand external fee savings will enable HSBC to realize annual cash 28 HSBC Finance Corporation-------------------------------------------------------------------------------- funding expense savings in excess of $1 billion per year which is anticipated tobe achieved in 2006. In 2005, the cash funding expense savings realized by HSBCtotaled approximately $865 million. Securitization of consumer receivables has been a source of funding andliquidity for us. In order to align our accounting treatment with that of HSBCinitially under U.K. GAAP and now under International Financial ReportingStandards ("IFRS"), starting in the third quarter of 2004 we began to structureall new collateralized funding transactions as secured financings. However,because existing public MasterCard and Visa credit card transactions werestructured 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 2008. Private label trusts that publicly issuedsecurities are now replenished by HSBC Bank USA as a result of the daily sale ofnew domestic private label credit card originations to HSBC Bank USA. We willcontinue to replenish at reduced levels certain non-public personal non-creditcard securities issued to conduits and record the resulting replenishment gainsfor a period of time in order to manage liquidity. Since our securitizedreceivables have varying lives, it will take time for these receivables topay-off and the related interest-only strip receivables to be reduced to zero.The termination of sale treatment on new collateralized funding activity reducedour reported net income under U.S. GAAP. There is no impact, however, on cashreceived from operations. In 2005, our net interest-only strip receivables,excluding the mark-to-market adjustment recorded in accumulated othercomprehensive income and the U.K. credit card portion purchased by HBEU,decreased $253 million. In 2004, our net interest-only strip receivables,excluding both the mark-to-market adjustment recorded in accumulated othercomprehensive income and the private label portion purchased by HSBC Bank USA,decreased $466 million. Tangible shareholder's(s') equity to tangible managed assets ("TETMA") was 7.56percent at December 31, 2005, and 6.27 percent at December 31, 2004. TETMA +Owned Reserves was 10.55 percent at December 31, 2005 and 9.04 percent atDecember 31, 2004. Tangible common equity to tangible managed assets was 6.07percent at December 31, 2005 and 4.67 percent at December 31, 2004. Beginning inthe third quarter of 2005, and with the agreement of applicable rating agencies,we have refined our definition of TETMA and TETMA + Owned Reserves to excludethe Adjustable Conversion-Rate Equity Security Units for all periods subsequentto our acquisition by HSBC as this more accurately reflects the impact of theseitems on our equity. All periods subsequent to our acquisition by HSBC have beenrevised to reflect the current period presentation. Our capital levels atDecember 31, 2005 reflect a capital contribution of $1.2 billion from HINO.Capital levels also reflect common stock dividends of $980 million and $2.6billion paid to our parent in 2005 and 2004, respectively. Tangible commonequity at December 31, 2005 reflects the exchange of our Series A PreferredStock of $1.1 billion plus accrued and unpaid interest for common equity inDecember 2005. These ratios represent non-GAAP financial ratios that are used byHSBC Finance Corporation management and certain rating agencies to evaluatecapital adequacy and may be different from similarly named measures presented byother companies. See "Reconciliations to GAAP Financial Measures" for additionaldiscussion and quantitative reconciliation to the equivalent GAAP basisfinancial measure. FUTURE PROSPECTS Our continued success and prospects for growth are dependent upon access to theglobal capital markets. Numerous factors, both internal and external, may impactour access to, and the costs associated with, these markets. These factors mayinclude our debt ratings, overall economic conditions, overall capital marketsvolatility, the counterparty credit limits of investors to the HSBC Group andthe effectiveness of our management of credit risks inherent in our customerbase. Our acquisition by HSBC has improved our access to the capital markets. Italso has given us the ability to use HSBC's liquidity to partially fund ouroperations and reduce our overall reliance on the debt markets. Our affiliationwith HSBC has also expanded our access to a worldwide pool of potentialinvestors. Our results are also impacted by general economic conditions, primarilyunemployment, underemployment and interest rates, which are largely out of ourcontrol. Because we generally lend to customers who have limited credithistories, modest incomes and high debt-to-income ratios or who have experiencedprior credit 29 HSBC Finance Corporation-------------------------------------------------------------------------------- problems, our customers are generally more susceptible to economic slowdownsthan other consumers. When unemployment and underemployment increase, a higherpercentage of our customers default on their loans and our charge-offs increase.Changes in interest rates generally affect both the rates that we charge to ourcustomers and the rates that we must pay on our borrowings. In 2005, theinterest rates that we paid on our debt increased. While our receivableportfolio in 2005 consisted of a higher mix of near-prime receivables and realestate secured receivables which in general carry lower yields than other typesof receivables we offer, we have experienced higher yields on our receivables in2005 as a result of increased pricing on variable rate products in line withmarket movements as well as other repricing initiatives. Our ability to adjustour pricing on some of our products reduces our exposure to an increase ininterest rates. The primary risks and opportunities to achieving our businessgoals in 2006, which are largely dependent upon economic conditions, couldresult in changes to loan volume, charge-offs and net interest income. BASIS OF REPORTING-------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States ("U.S. GAAP"). Unless noted,the discussion of our financial condition and results of operations included inMD&A are presented on an owned basis of reporting. HSBC Finance Corporation's acquisition by HSBC on March 28, 2003 resulted in anew basis of accounting reflecting the fair value of our assets and liabilitiesfor the "successor" periods beginning March 29, 2003. Information for all"predecessor" periods prior to the merger are presented using our historicalbasis of accounting, which impacts comparability with the "successor" periodbeginning March 29, 2003. To assist in the comparability of our financialresults and to make it easier to discuss and understand our results ofoperations, MD&A combines the "predecessor" period (January 1 through March 28,2003) with the "successor" period (March 29 through December 31, 2003) topresent "combined" results for the year ended December 31, 2003. In addition to the GAAP financial results reported in our consolidated financialstatements, MD&A includes reference to the following information which ispresented on a non-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-GAAP financial measure. "Operating net income" is net incomeexcluding certain nonrecurring items shown in the following table: 2005 2004 2003-------------------------------------------------------------------------------------- (IN MILLIONS)Net income.................................................. $1,772 $1,940 $1,603Gain on bulk sale of private label receivables, after tax... - (423) -Adoption of FFIEC charge-off policies for domestic private label and MasterCard and Visa portfolios, after tax....... - 121 -HSBC acquisition related costs and other merger related items, after tax.......................................... - - 167 ------ ------ ------Operating net income........................................ $1,772 $1,638 $1,770 ====== ====== ====== We believe that excluding these nonrecurring items helps readers of ourfinancial statements to better understand the results and trends of ourunderlying business. While we continue to make daily sales of new private labelreceivable originations to HSBC Bank USA, we consider the initial gain on bulksale of the receivable portfolio including the retained interests associatedwith securitized private label receivables as nonrecurring because our resultsof operations for 2004 also include the net interest income, fee income, creditlosses and securitization related revenue generated by the portfolio and therelated retained securitization interests through the date of sale on December29, 2004. As a result of this transaction, our net interest income, fee income,provision for credit losses and securitization related revenue from thisportfolio has been substantially reduced while other revenues has substantiallyincreased as reduced securitization related 30 HSBC Finance Corporation-------------------------------------------------------------------------------- revenue associated with private label receivables has been more than offset bygains from daily sales of newly originated private label receivables andservicing revenue on the portfolio received from HSBC Bank USA. MANAGED BASIS REPORTING We have historically monitored our operations andevaluated trends on a managed basis (a non-GAAP financial measure), whichassumes that securitized receivables have not been sold and remain on ourbalance sheet. This is because the receivables that we securitize are subjectedto underwriting standards comparable to our owned portfolio, are serviced byoperating personnel without regard to ownership and result in a similar creditloss exposure for us. In addition, we fund our operations and make decisionsabout allocating resources such as capital on a managed basis. When reporting on a managed basis, net interest income, provision for creditlosses and fee income related to receivables securitized are reclassified fromsecuritization related revenue in our owned statement of income into theappropriate caption. Additionally, charge-off and delinquency associated withthese receivables are included in our managed basis credit quality statistics. Debt analysts, rating agencies and fixed income investors have also historicallyevaluated our operations on a managed basis for the reasons discussed above andhave historically requested managed basis information from us. We believe thatmanaged basis information enables such investors and other interested parties tobetter understand the performance and quality of our entire loan portfolio andis important to understanding the quality of originations and the related creditrisk inherent in our owned and securitized portfolios. As the level of oursecuritized receivables falls over time, managed basis and owned basis resultswill eventually converge. We have begun reporting "Management Basis" results (anon-GAAP financial measure) in Reports on Form 8-K with our quarterly results.Management Basis reporting, in addition to managed basis adjustments, assumesthe private label and real estate secured receivables transferred to HSBC BankUSA have not been sold and remain on balance sheet. We have begun reporting"Management Basis" results (a non-GAAP financial measure) in Reports on Form 8-Kwith our quarterly results. Management Basis reporting, in addition to managedbasis adjustments, assumes the private label and real estate receivablestransferred to HSBC Bank USA have not been sold and remain on balance sheet. Aswe continue to manage and service receivables sold to HSBC Bank USA, we makedecisions about allocating certain resources, such as employees, on a ManagementBasis. EQUITY RATIOS Tangible shareholder's equity to tangible managed assets("TETMA"), tangible shareholder's equity plus owned loss reserves to tangiblemanaged assets ("TETMA + Owned Reserves") and tangible common equity to tangiblemanaged assets are non-GAAP financial measures that are used by HSBC FinanceCorporation management and certain rating agencies to evaluate capital adequacy.These ratios may differ from similarly named measures presented by othercompanies. The most directly comparable GAAP financial measure is common andpreferred equity to owned assets. We and certain rating agencies also monitor our equity ratios excluding theimpact of the HSBC acquisition purchase accounting adjustments. We do so becausewe believe 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 for all periods subsequent to our acquisition by HSBC as thismore accurately reflects the impact of these items on our equity. All periodssubsequent to our acquisition by HSBC have been revised to reflect the currentperiod presentation. 31 HSBC Finance Corporation-------------------------------------------------------------------------------- INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results inaccordance with IFRS and IFRS results are used in measuring and rewardingperformance of employees, our management also separately monitors net incomeunder IFRS (a non-U.S. GAAP financial measure). The following table reconcilesour net income on a U.S. GAAP basis to net income on an IFRS basis: YEAR ENDED 2005--------------------------------------------------------------------------- (IN MILLIONS)Net income - U.S. GAAP basis................................ $1,772Adjustments, net of tax: Securitizations........................................... 155 Derivatives and hedge accounting (including fair value adjustments)........................................... (83) Intangible assets......................................... 174 HSBC acquisition purchase accounting adjustments.......... 292 Loan origination.......................................... (39) Changes in tax estimates and exposures.................... 66 Gain on sale of U.K. credit card business to HBEU......... 176 Other..................................................... 47 ------Net income - IFRS basis..................................... $2,560 ====== Differences between U.S. GAAP and IFRS are as follows: SECURITIZATIONS IFRS - The recognition of securitized assets is governed by a three-step process. The process may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows arising from securitized assets have been transferred to a third party, the assets concerned are derecognized. - If the rights to the cash flows are retained by HSBC but there is a contractual obligation to pay them to another party, the securitized assets concerned are derecognized if certain conditions are met such as, for example, when there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If some significant risks and rewards of ownership have been transferred, but some have also been retained, it must be determined whether or not control has been retained. If control has been retained, HSBC continues to recognize the asset to the extent of its continuing involvement; if not, the asset is derecognized. - The impact from securitizations resulting in higher net income under IFRS is due to the recognition of income on securitized receivables under US GAAP in prior periods. US GAAP - SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets. - Control is surrendered over transferred assets if, and only if, all of the following conditions are met: - The transferred assets are put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. 32 HSBC Finance Corporation-------------------------------------------------------------------------------- - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. - When HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the special purpose entity ("SPE"), HSBC recognizes this interest at fair value on sale of the assets to the SPE. DERIVATIVES AND HEDGE ACCOUNTING IFRS - Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter ("OTC") derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models. - In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (i.e. the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (i.e. without modification or repackaging) or will be based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading profit or loss on inception of the derivative. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out. - Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value through profit and loss. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. - Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net basis. - The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. Hedge Accounting: - It is HSBC's policy to document, at the inception of a hedge, the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking the hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives that are used in hedging transactions are highly effective 33 HSBC Finance Corporation-------------------------------------------------------------------------------- in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. Interest on designated qualifying hedges is included in "Net interest income". Fair value hedge: - Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair values of the assets or liabilities or groups thereof that are attributable to the hedged risks. - If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item is amortized to the income statement based on a recalculated effective interest rate over the residual period to maturity, unless the hedged item has been derecognized whereby it is released to the income statement immediately. Cash flow hedge: - The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement. - Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect profit or loss. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability. - When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. Net investment hedge: - Hedges of net investments in foreign operations are accounted for in a similar manner to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation. Hedge effectiveness testing: - IAS 39 requires that at inception and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness) to qualify for hedge accounting. Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis. - The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. - For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For retrospective effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective. Derivatives that do not qualify for hedge accounting: - All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement. These gains and losses are reported in "Trading income", except where derivatives are managed in conjunction with financial instruments designated at fair value, in which case gains and losses are reported in "Net income from financial instruments designated at fair value," other than interest settlements or derivatives used to hedge issues of our debt which are reported in "Interest payable." 34 HSBC Finance Corporation-------------------------------------------------------------------------------- US GAAP - The accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39, which HSBC has followed in its IFRS reporting from January 1, 2005, as described above. However, specific assumptions regarding hedge effectiveness under US GAAP are not permitted by IAS 39. - The requirements of SFAS No. 133 have been effective from January 1, 2001. - The US GAAP 'shortcut method' permits an assumption of zero ineffectiveness in hedges of interest rate risk with an interest rate swap provided specific criteria have been met. IAS 39 does not permit such an assumption, requiring a measurement of actual ineffectiveness at each designated effectiveness testing date. - In addition, IFRS allows greater flexibility in the designation of the hedged item. Under US GAAP, all contractual cash flows must form part of the designated relationship, whereas IAS 39 permits the designation of identifiable benchmark interest cash flows only. - Certain issued structured notes are classified as trading liabilities under IFRS, but not under US GAAP. Under IFRS, these notes will be held at fair value, with changes in fair value reflected in the profit and loss account. Under US GAAP, if the embedded derivative is not "clearly and closely related" to the host contract, the embedded derivative will be bifurcated and held at fair value, the host contract will be marked at amortized cost, and changes in both will be reflected in the profit and loss account. If the embedded derivative is "clearly and closely related" to the host contract, the issued note will be held at amortized cost in its entirety, with changes in the amortized cost reflected in the profit and loss account. - Under US GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. These contracts do not meet the requirements for set off under IAS 32 and hence are presented gross on the balance sheet for IFRS. DESIGNATION OF FINANCIAL ASSETS AND LIABILITIES AT FAIR VALUE THROUGH PROFIT ANDLOSS IFRS - Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to key management personnel; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. - Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it is made. Financial assets and financial liabilities are recognized using trade date accounting. - Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends, within "Net income from financial instruments designated at fair value". 35 HSBC Finance Corporation-------------------------------------------------------------------------------- US GAAP - There are no provisions in US GAAP to make an election similar to that in IAS 39. - Generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they must meet the definition of trading securities in SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities are generally reported at amortized cost under US GAAP. GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES IFRS - Prior to 1998, goodwill under UK GAAP was written off against equity. HSBC did not elect to reinstate this goodwill on its balance sheet upon transition to IFRS. From January 1, 1998 to December 31, 2003 goodwill was capitalized and amortized over its useful life. The book value of goodwill existing at December 31, 2003 under UK GAAP was carried forward under IFRS from January 1, 2004, subject to certain adjustments. - IFRS 3 "Business Combinations" requires that goodwill should not be amortized but should be tested for impairment at least annually at the reporting unit level by applying a test based on recoverable amounts. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their market price on the date the transaction is completed. US GAAP - Up to June 30, 2001, goodwill acquired was capitalized and amortized over its useful life which could not exceed 25 years. The amortization of previously acquired goodwill ceased with effect from December 31, 2001. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their average market price over a reasonable period before and after the date on which the terms of the acquisition are agreed and announced. - Changes in tax estimates of the basis in assets and liabilities or other tax estimates recorded at the date of acquisition by HSBC are adjusted against goodwill. LOAN ORIGINATION IFRS - Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. US GAAP - Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the profit and loss account over the life of the loan as an adjustment to interest income (SFAS No. 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) LOAN IMPAIRMENT IFRS - When statistical models, using historic loss rates adjusted for economic conditions, provide evidence of impairment in portfolios of loans, their values are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate. The calculations include a reasonable estimate of recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. 36 HSBC Finance Corporation-------------------------------------------------------------------------------- US GAAP - Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery, the loans are written off in full, or to recoverable value where collateral exists. Delinquency depends on the number of days payment is overdue. The delinquency status is applied consistently across similar loan products in accordance with HSBC's credit guidelines. When local regulators mandate the delinquency status at which write-off must occur for different retail loan products and these regulations reasonably reflect estimable recoveries on individual loans, this basis of measuring loan impairment is reflected in US GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. GAIN ON SALE OF U.K. CREDIT CARD BUSINESS TO HBEU IFRS - IFRS requires that all items of income and expense recognized in a period to be included in profit and loss unless another standard or an interpretation requires otherwise. US GAAP - US GAAP requires that transfers of assets including non-financial assets between affiliates under common control be treated as capital transactions. QUANTITATIVE RECONCILIATIONS OF NON-GAAP FINANCIAL MEASURES TO GAAP FINANCIALMEASURES For a reconciliation of managed basis net interest income, fee incomeand provision for credit losses to the comparable owned basis amounts, see Note22, "Business Segments," to the accompanying consolidated financial statements.For a reconciliation of our owned loan portfolio by product to our managed loanportfolio, see Note 6, "Receivables," to the accompanying consolidated financialstatements. For additional quantitative reconciliations of non-GAAP financialmeasures presented herein to the equivalent GAAP basis financial measures, see"Reconciliations to GAAP Financial Measures." CRITICAL ACCOUNTING POLICIES-------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States. We believe our policies areappropriate and fairly present the financial position of HSBC FinanceCorporation. The significant accounting policies used in the preparation of our financialstatements are more fully described in Note 2, "Summary of SignificantAccounting Policies," to the accompanying consolidated financial statements.Certain critical accounting policies, which affect the reported amounts ofassets, liabilities, revenues and expenses, are complex and involve significantjudgment by our management, including the use of estimates and assumptions. Werecognize the different inherent loss characteristics in each of our loanproducts as well as the impact of operational policies such as customer accountmanagement policies and practices and risk management/collection practices. As aresult, changes in estimates, assumptions or operational policies couldsignificantly affect our financial position or our results of operations. Webase and establish our accounting estimates on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities. Actual results may differ fromthese estimates under different assumptions, customer account managementpolicies and practices, risk management/collection practices, or otherconditions as discussed below. We believe that of the significant accounting policies used in the preparationof our consolidated financial statements, the items discussed below involvecritical accounting estimates and a high degree of judgment and complexity. Ourmanagement has discussed the development and selection of these criticalaccounting policies with our external auditors and the audit committee of ourBoard of Directors, including the underlying 37 HSBC Finance Corporation-------------------------------------------------------------------------------- estimates and assumptions, and the audit committee has reviewed our disclosurerelating to these accounting policies and practices in this MD&A. CREDIT LOSS RESERVES Because we lend money to others, we are exposed to the riskthat borrowers may not repay amounts owed to us when they become contractuallydue. Consequently, we maintain credit loss reserves at a level that we consideradequate, but not excessive, to cover our estimate of probable losses ofprincipal, interest and fees, including late, overlimit and annual fees, in theexisting portfolio. Loss reserve estimates are reviewed periodically, andadjustments are reflected through the provision for credit losses in the periodwhen they become known. We believe the accounting estimate relating to thereserve for credit losses is a "critical accounting estimate" for the followingreasons: - The provision for credit losses totaled $4.5 billion in 2005, $4.3 billion in 2004 and $4.0 billion in 2003 and changes in the provision can materially affect net income. As a percentage of average owned receivables, the provision was 3.76 percent in 2005 compared to 4.28 percent in 2004 and 4.45 percent in 2003. - Estimates related to the reserve for credit losses require us to consider future delinquency and charge-off trends which are uncertain and require a high degree of judgment. - The reserve for credit losses is influenced by factors outside of our control such as customer payment patterns, economic conditions, bankruptcy trends and changes in laws and regulations. Because our loss reserve estimate involves judgment and is influenced by factorsoutside of our control, it is reasonably possible such estimates could change.Our estimate of probable net credit losses is inherently uncertain because it ishighly sensitive to changes in economic conditions which influence growth,portfolio seasoning, bankruptcy trends, delinquency rates and the flow of loansthrough the various stages of delinquency, or buckets, the realizable value ofany collateral and actual loss exposure. Changes in such estimates couldsignificantly impact our credit loss reserves and our provision for creditlosses. For example, a 10% change in our projection of probable net creditlosses on owned receivables could have resulted in a change of approximately$454 million in our credit loss reserve for owned receivables at December 31,2005. The reserve for credit losses is a critical accounting estimate for allthree of our reportable segments. Credit loss reserves are based on a range of estimates and are intended to beadequate but not excessive. We estimate probable losses for consumer receivablesusing a roll rate migration analysis that estimates the likelihood that a loanwill progress through the various stages of delinquency, or buckets, andultimately charge off. This analysis considers delinquency status, lossexperience and severity and takes into account whether loans are in bankruptcy,have been restructured or rewritten, or are subject to forbearance, an externaldebt management plan, hardship, modification, extension or deferment. Inaddition, our loss reserves on consumer receivables are maintained to reflectour judgment of portfolio risk factors that may not be fully reflected in thestatistical roll rate calculation. Risk factors considered in establishing lossreserves on consumer receivables include recent growth, product mix, bankruptcytrends, geographic concentrations, economic conditions, portfolio seasoning,account management policies and practices, current levels of charge-offs anddelinquencies and other items which can affect consumer payment patters onoutstanding receivables, such as the impact of Katrina. 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 the appropriate reserves exist for products with longer charge-offperiods. We also consider key ratios such as reserves to nonperforming loans andreserves as a percentage of net charge-offs in developing our loss reserveestimate. In addition to the above procedures for the establishment of ourcredit loss reserves, our Retail Credit Risk Management Department independentlyevaluates the adequacy of our loss reserve levels. 38 HSBC Finance Corporation-------------------------------------------------------------------------------- We periodically re-evaluate our estimate of probable losses for consumerreceivables. Changes in our estimate are recognized in our statement of incomeas provision for credit losses in the period that the estimate is changed. Ourcredit loss reserves for owned receivables increased $896 million from December31, 2004 to $4.5 billion at December 31, 2005 as a direct result of growth inour loan portfolio, including lower securitization levels, additional reservesresulting from the Metris acquisition and higher delinquency levels driven bygrowth, increases in the level of bankruptcy filings in both our domestic andforeign operations, higher credit loss exposure resulting from Katrina andchanges in the required minimum monthly payment for credit card accounts. Theseincreases were partially offset by the impact of improved credit quality, ashift in mix to higher levels of secured receivables and the release of $104million of credit loss reserves associated with the sale of our UK credit cardoperations. Our reserves as a percentage of receivables were 3.23 percent atDecember 31, 2005, 3.39 percent at December 31, 2004 and 4.11 percent atDecember 31, 2003. The decrease in reserves as a percentage of receivables forthese periods was primarily due to a continuing trend of improved credit qualityas well as a shift in mix to higher levels of higher credit quality receivables,particularly real estate secured and auto finance receivables, partially as aresult of the bulk sale of domestic private label receivables in December 2004. For more information about our charge-off and customer account managementpolicies and practices, see "Credit Quality - Delinquency and Charge-offs" and"Credit Quality - Customer Account Management Policies and Practices." RECEIVABLES SOLD AND SERVICED WITH LIMITED RECOURSE AND SECURITIZATION RELATEDREVENUE We have historically used a variety of sources to fund our operations.These sources include the use of collateralized funding transactions which areeither structured as securitizations, which receive sale treatment, or assecured financings, which do not receive sale treatment. For securitizations,the receivables are removed from the balance sheet and a gain on sale andinterest-only strip receivable are recognized. Determination of both the gain onsale and the interest-only strip receivable include estimates of future cashflows to be received over the lives of the sold receivables. We believe theaccounting estimates relating to gains on sale and the value of theinterest-only strip receivable are "critical accounting estimates" for thefollowing reasons: - Changes in the estimates of future cash flows used to determine gains on sale and the value of interest-only strip receivables may materially affect net income. - The value of our interest-only strip receivable totaled $23 million at December 31, 2005 and $323 million at December 31, 2004. This value may be influenced by factors outside of our control such as consumer payment patterns and economic conditions which impact charge-off and delinquency. - Estimates relating to the gain on sale and the value of our interest-only strip receivable require us to forecast cash flows which are uncertain and require a high degree of judgment. The lives of our securitized receivables are relatively short. Recording gainson sales for receivables with shorter lives reduces the period of time for whichcash flows must be forecasted and, therefore, reduces the potential volatilityof these projections. Because our securitization accounting involves judgmentand is influenced by factors outside of our control, it is reasonably possiblesuch forecasts and estimates could change. Changes in such estimates or in thelevel or mix of receivables securitized could significantly impact the gains onsale we record and the value of our interest-only strip receivables.Determination of both the gain on sale and the interest-only strip receivableare critical accounting estimates for our Consumer and Credit Card Servicessegment. Prior to the sale of the U.K. credit card business in December 2005,determination of both the gain on sale and the interest-only strip receivablewas also a critical accounting estimate for our International segment. We have not structured any real estate secured receivable collateralized fundingtransactions to receive sale treatment since 1997. As a result, the real estatesecured receivables, which generally have longer lives than our otherreceivables, and related debt remain on our balance sheet. In the third quarterof 2004, we decided to structure all new collateralized funding transactions assecured financings. However, because existing public MasterCard/Visatransactions were structured as sales to revolving trusts that requirereplenishments of 39 HSBC Finance Corporation-------------------------------------------------------------------------------- receivables 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 2008. Private label trusts that publicly issuedsecurities will now be replenished by HSBC Bank USA as a result of the dailysale of new domestic private label credit card originations to HSBC Bank USA. Wewill continue to replenish, at reduced levels, certain non-public personalnon-credit card securities issued to conduits and record the resultingreplenishment gains for a period of time in order to manage liquidity. See "OffBalance Sheet Arrangements and Secured Financings" for further discussion of ourdecision to fund all new collateralized funding transactions as securedfinancings. For securitizations, a gain on sale is recognized for the difference between thecarrying value of the receivables securitized and the adjusted sales proceeds.The adjusted sales proceeds include cash received and the present value estimateof future cash flows to be received over the lives of the sold receivables.Future cash flows are based on estimates of prepayments, the impact of interestrate movements on yields of receivables and securities issued, delinquency ofreceivables sold, servicing fees and estimated probable losses under therecourse provisions based on historical experience and estimates of expectedfuture performance. Gains on sale net of recourse provisions, servicing incomeand excess spread relating to securitized receivables are reported assecuritization related revenue in our consolidated statements of income. Securitizations also involve the recording of an interest-only strip receivablewhich represents our contractual right to receive interest and other cash flowsfrom the securitization trust. Our interest-only strip receivables are reportedat fair value using discounted cash flow estimates as a separate component ofreceivables, net of our estimate of probable losses under the recourseprovisions. Cash flow estimates include estimates of prepayments, the impact ofinterest rate movements on yields of receivables and securities issued,delinquency of receivables sold, servicing fees and estimated probable lossesunder the recourse provisions. Unrealized gains and losses are recorded asadjustments to common shareholder's(s') equity in accumulated othercomprehensive income, net of income taxes. Our interest-only strip receivablesare reviewed for impairment quarterly or earlier if events indicate that thecarrying value may not be recovered. Any decline in the value of ourinterest-only strip receivable which is deemed to be other than temporary ischarged against current earnings. Assumptions used in estimating gains on sales of receivables are evaluated witheach securitization transaction. Assumptions used in valuing interest-only stripreceivables are re-evaluated each quarter based on experience and expectationsof future performances. During 2005, we experienced higher interest rates onmost of the receivables sold and the securities issued and generally experiencedlower delinquency and charge-offs on the underlying receivables sold. During2004, we experienced lower interest rates on both the receivables sold andsecurities issued and generally experienced lower delinquency and charge-offs onthe underlying receivables sold. These factors impact both the gains recordedand the values of our interest-only strip receivables. Securitization gains aredependent upon the level and mix of receivables securitized in any particularyear. We have not had any initial securitization of receivables since the secondquarter of 2004 as a result of the decision to structure all new collateralizedfunding transactions as secured financings as discussed above. The sensitivityof our interest-only strip receivable to various adverse changes in assumptionsand the amount of gain recorded and initial receivables securitized in eachperiod is disclosed in Note 8, "Asset Securitizations," to the accompanyingconsolidated financial statements. Due to our decision to structure all new collateralized funding as securedfinancings, we do not anticipate any new initial securitization transactions in2006. GOODWILL AND INTANGIBLE ASSETS Goodwill and intangible assets with indefinitelives are not subject to amortization. Intangible assets with finite lives areamortized over their estimated useful lives. Goodwill and intangible assets arereviewed annually on July 1 for impairment using discounted cash flows, butimpairment is reviewed earlier if circumstances indicate that the carryingamount may not be recoverable. We consider significant and long-term changes inindustry and economic conditions to be our primary indicator of potentialimpairment. 40 HSBC Finance Corporation-------------------------------------------------------------------------------- We believe the impairment testing of our goodwill and intangibles is a criticalaccounting estimate due to the level of goodwill ($7.0 billion) and intangibleassets ($2.5 billion) recorded at December 31, 2005 and the significant judgmentrequired in the use of discounted cash flow models to determine fair value.Discounted cash flow models include such variables as revenue growth rates,expense trends, interest rates and terminal values. Based on an evaluation ofkey data and market factors, management's judgment is required to select thespecific variables to be incorporated into the models. Additionally, theestimated fair value can be significantly impacted by the cost of capital usedto discount future cash flows. The cost of capital percentage is generallyderived from an appropriate capital asset pricing model, which itself depends ona number of financial and economic variables which are established on the basisof management's judgment. When management's judgment is that the anticipatedcash flows have decreased and/or the cost of capital has increased, the effectwill be a lower estimate of fair value. If the fair value is determined to belower than the carrying value, an impairment charge will be recorded and netincome will be negatively impacted. Impairment testing of goodwill requires that the fair value of each reportingunit be compared to its carrying amount. A reporting unit is defined as anydistinct, separately identifiable component of an operating segment for whichcomplete, discrete financial information is available that management regularlyreviews. For purposes of the annual goodwill impairment test, we assigned ourgoodwill to our reporting units. At July 1, 2005, the estimated fair value ofeach reporting unit exceeded its carrying value, resulting in none of ourgoodwill being impaired. Impairment testing of intangible assets requires that the fair value of theasset be compared to its carrying amount. As a result of our impairment testingat July 1, 2005, we recorded an impairment charge related to a tradename in theU.K. For all other intangible assets, we determined that the estimated fairvalue of each intangible asset exceeded its carrying value and, as such, none ofour remaining intangible assets were impaired. As a result of the sale of our U.K. credit card business in December 2005, wewrote off $218 million of goodwill attributable to this business. Subsequent tothe sale, we performed an interim goodwill impairment test for our remainingU.K. and European operations as required by SFAS No. 142, "Goodwill and OtherIntangible Assets". As the estimated fair value of our remaining U.K. andEuropean operations exceeded our carrying value subsequent to the sale, weconcluded that the remaining goodwill assigned to this reporting unit was notimpaired. VALUATION OF DERIVATIVE INSTRUMENTS AND DERIVATIVE INCOME We regularly usederivative instruments as part of our risk management strategy to protect thevalue of certain assets and liabilities and future cash flows against adverseinterest rate and foreign exchange rate movements. All derivatives arerecognized on the balance sheet at fair value. As of December 31, 2005, therecorded fair values of derivative assets and liabilities were $234 million and$383 million, respectively. We believe the valuation of derivative instrumentsis a critical accounting estimate because certain instruments are valued usingdiscounted cash flow modeling techniques in lieu of market value quotes. Theseflow modeling techniques require the use of estimates regarding the amount andtiming of future cash flows, which are susceptible to significant change infuture periods based on changes in market rates. The assumptions used in thecash flow projection models are based on forward yield curves which aresusceptible to changes as market conditions change. We utilize HSBC Bank USA todetermine the fair value of substantially all of our derivatives using thesemodeling techniques. We regularly review the results of these valuations forreasonableness by comparing to an internal determination of fair value or thirdparty quotes. Significant changes in the fair value can result in equity andearnings volatility as follows: - Changes in the fair value of a derivative that has been designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability (including losses or gains on firm commitments), are recorded in current period earnings. - Changes in the fair value of a derivative that has been designated and qualifies as a cash flow hedge are recorded in other comprehensive income to the extent of its effectiveness, until earnings are impacted by the variability of cash flows from the hedged item. 41 HSBC Finance Corporation-------------------------------------------------------------------------------- - Changes in the fair value of a derivative that has not been designated as an effective hedge is reported in current period earnings. This volatility may be mitigated to the extent such derivatives are designatedas effective hedges. If a derivative designated as an effective hedge will betested for effectiveness under the long-haul method (which at December 31, 2005comprises 91 percent of our hedge portfolio based on notional amounts eligiblefor hedge accounting), we formally assess, both at the inception of the hedgeand on a quarterly basis, whether the derivative used in a hedging transactionhas been and is expected to continue to be highly effective in offsettingchanges in fair values or cash flows of the hedged item. This assessment isconducted using statistical regression analysis. If it is determined as result of this assessment that a derivative is notexpected to be a highly effective hedge or that it has ceased to be a highlyeffective hedge, we discontinue hedge accounting as of the beginning of thequarter in which such determination was made. We also believe the assessment ofthe effectiveness of the derivatives used in hedging transactions is a criticalaccounting estimate due to the use of statistical regression analysis in makingthis determination. Similar to discounted cash flow modeling techniques,statistical regression analysis also requires the use of estimates regarding theamount and timing of future cash flows, which are susceptible to significantchange in future periods based on changes in market rates. However, statisticalregression analysis also involves the use of additional assumptions includingthe determination of the period over which the analysis should occur as well asselecting a convention for the treatment of credit spreads in the analysis. Thestatistical regression analysis for our derivative instruments is performed byeither HSBC Bank USA or an independent third party. The outcome of the statistical regression analysis serves as the foundation fordetermining whether or not the derivative is highly effective as a hedginginstrument. This can result in earnings volatility as the mark-to-market onderivatives which do not qualify as effective hedges and the ineffectivenessassociated with qualifying hedges are recorded in current period earnings. Themark-to market on derivatives which do not qualify as effective hedges was $156million in 2005, $442 million in 2004 and $230 million in 2003. Theineffectiveness associated with qualifying hedges was $41 million in 2005, $1million in 2004 and $2 million in 2003. See "Results of Operations" inManagement's Discussion and Analysis of Financial Condition and Results ofOperations for a discussion of the yearly trends. For more information about our policies regarding the use of derivativeinstruments, see Note 2, "Summary of Significant Accounting Policies," and Note15, "Derivative Financial Instruments," to the accompanying consolidatedfinancial statements. CONTINGENT LIABILITIES Both we and certain of our subsidiaries are parties tovarious legal proceedings resulting from ordinary business activities relatingto our current and/or former operations which affect all three of our reportablesegments. Certain of these activities are or purport to be class actions seekingdamages in significant amounts. These actions include assertions concerningviolations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certainthat we will ultimately prevail in each instance. Also, as the ultimateresolution of these proceedings is influenced by factors that are outside of ourcontrol, it is reasonably possible our estimated liability under theseproceedings may change. However, based upon our current knowledge, our defensesto these actions have merit and any adverse decision should not materiallyaffect our consolidated financial condition, results of operations or cashflows. 42 HSBC Finance Corporation-------------------------------------------------------------------------------- RECEIVABLES REVIEW-------------------------------------------------------------------------------- The following table summarizes owned receivables at December 31, 2005 andincreases (decreases) over prior periods: INCREASES (DECREASES) FROM ----------------------------------- DECEMBER 31, DECEMBER 31, 2004 2003 DECEMBER 31, ---------------- ---------------- 2005 $ % $ %---------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Real estate secured.......................... $ 82,826 $18,006 27.8% $ 31,605 61.7%Auto finance................................. 10,704 3,160 41.9 6,566 100+MasterCard/Visa.............................. 24,110 9,475 64.7 12,928 100+Private label................................ 2,520 (891) (26.1) (10,084) (80.0)Personal non-credit card..................... 19,545 3,417 21.2 6,713 52.3Commercial and other......................... 208 (109) (34.4) (193) (48.1) -------- ------- ----- -------- -----Total owned receivables...................... $139,913 $33,058 30.9% $ 47,535 51.5% ======== ======= ===== ======== ===== REAL ESTATE SECURED RECEIVABLES Driven by growth in our correspondent and branchbusinesses, real estate secured receivables increased significantly over theyear-ago period. Growth in real estate secured receivables was also supplementedby purchases from a single correspondent relationship which totaled $1.1 billionin 2005 and $2.6 billion in 2004. Real estate secured receivable levels in ourbranch-based consumer lending business improved because of higher sales volumesthan in the prior year as we continue to emphasize real estate secured loans,including a near-prime mortgage product we first introduced in 2003. Alsocontributing to the increase in our domestic branch operations was $1.7 billionin 2005 and $900 million in 2004 of acquisitions from a portfolio acquisitionprogram. We have continued to focus on junior lien loans through portfolioacquisitions and have expanded our sources for purchasing newly originated loansfrom flow correspondents. Additionally, we have expanded our Canadian branchoperations in 2005 which has also resulted in strong real estate securedreceivable growth. The increases in the real estate secured receivable levelshave been partially offset by run-off of higher yielding real estate securedreceivables largely due to refinance activity. Real estate secured receivablelevels reflect sales to HSBC Bank USA of $.9 billion on March 31, 2004 and $2.8billion on December 31, 2003, as well as HSBC Bank USA's purchase of receivablesdirectly from correspondents totaling $1.5 billion and $2.8 billion in 2005 and2004, a portion of which we otherwise would have purchased. Purchases of realestate secured receivables from our correspondents by HSBC Bank USA werediscontinued effective September 1, 2005. AUTO FINANCE RECEIVABLES Auto finance receivables increased over the year-agoperiod due to organic growth principally in the near-prime portfolio. This camefrom newly originated loans acquired from our dealer network, growth in theconsumer direct loan program, expanded distribution through alliance channelsand lower securitization levels. Additionally in 2005, we experienced continuedgrowth from the expansion of an auto finance program introduced in Canada in thesecond quarter of 2004 which at December 31, 2005, has grown to a network ofover 1,000 active dealer relationships. MASTERCARD AND VISA RECEIVABLES MasterCard and Visa receivables reflect the $5.3billion of receivables acquired as part of our acquisition of Metris in December2005 as well as strong domestic organic growth especially in our HSBC brandedprime, Union Privilege and non-prime portfolios. Also contributing to the growthwas the successful launch of a MasterCard/Visa credit card program in Canada.These increases were offset by the sale of our U.K. credit card business whichincluded $2.2 billion of MasterCard/Visa receivables. Lower securitizationlevels also contributed to the increase at December 31, 2005. PRIVATE LABEL RECEIVABLES Private label receivables decreased in 2005 as aresult of lower retail sales volumes in the U.K., the sale of our U.K. creditcard business in December 2005, which included $300 million of private 43 HSBC Finance Corporation-------------------------------------------------------------------------------- label receivables and changes in the foreign exchange rates since December 31,2004. The decrease in 2004 reflects the sale of $12.2 billion of domesticprivate label receivables to HSBC Bank USA in December 2004 and our continuingsale of all new domestic private label receivables (excluding retail salescontracts) to HSBC Bank USA. PERSONAL NON-CREDIT CARD RECEIVABLES Personal non-credit card receivables arecomprised of the following: INCREASES (DECREASES) FROM ------------------------------- DECEMBER 31, DECEMBER 31, 2004 2003 DECEMBER 31, -------------- -------------- 2005 $ % $ %------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS)Domestic personal non-credit card............... $11,394 $3,513 44.6% $5,786 100+%Union Plus personal non-credit card............. 333 (141) (29.7) (381) (53.4)Personal homeowner loans........................ 4,173 480 13.0 871 26.4Foreign personal non-credit card................ 3,645 (435) (10.7) 437 13.6 ------- ------ ----- ------ -----Total personal non-credit card receivables...... $19,545 $3,417 21.2% $6,713 52.3% ======= ====== ===== ====== ===== Personal non-credit card receivables increased during 2005 as a result of lowersecuritization levels and increased marketing, including several large directmail campaigns. In the second half of 2004, we began to increase theavailability of this product as a result of the improving U.S. economy. Domestic and foreign personal non-credit card loans (cash loans with nosecurity) are made to customers who may not qualify for either a real estatesecured or personal homeowner loan ("PHL"). The average personal non-credit cardloan is approximately $7,300 and 52 percent of the personal non-credit cardportfolio is closed-end with terms ranging from 12 to 60 months. The Union Pluspersonal non-credit card loans are part of our affinity relationship with theAFL-CIO and are underwritten similar to other personal non-credit card loans. PHL's typically have terms of 120 to 240 months and are subordinate lien, homeequity loans with high (100 percent or more) combined loan-to-value ratios whichwe underwrite, price and manage like unsecured loans. The average PHL isapproximately $19,000. Because recovery upon foreclosure is unlikely aftersatisfying senior liens and paying the expenses of foreclosure, we do notconsider the collateral as a source for repayment in our underwriting.Historically, these loans have performed better from a credit loss perspectivethan traditional unsecured loans as consumers are more likely to pay securedloans than unsecured loans in times of financial distress. DISTRIBUTION AND SALES We reach our customers through many differentdistribution channels and our growth strategies vary across product lines. Theconsumer lending business originates real estate and personal non-credit cardproducts through its retail branch network, direct mail, telemarketing,strategic alliances and Internet applications and purchases loans as part of aportfolio acquisition program. The mortgage services business originates realestate secured receivables through brokers and purchases real estate securedreceivables primarily through correspondents. Private label receivables aregenerated through merchant promotions, application displays, Internetapplications, direct mail and telemarketing. Auto finance receivables aregenerated primarily through dealer relationships from which installmentcontracts are purchased. Additional auto finance receivables are generatedthrough direct lending which includes alliance partner referrals, Internetapplications and direct mail as well as in our consumer lending branches.MasterCard and Visa receivables are generated primarily through direct mail,telemarketing, Internet applications, application displays including in ourconsumer lending retail branch network, promotional activity associated with ourco-branding and affinity relationships, mass media advertisements and merchantrelationships sourced through our retail services business. We also supplementinternally-generated receivable growth with portfolio acquisitions. 44 HSBC Finance Corporation-------------------------------------------------------------------------------- Our acquisition by HSBC has allowed us to enlarge our customer base throughcross-selling products to HSBC customers as well as generating new business withvarious major corporations. The rebranding of the majority of our U.S. andCanadian businesses to the HSBC brand has positively impacted these efforts. AConsumer Finance team, which was established in 2004, has worked throughout 2005on a consultative basis to extend consumer finance offerings in select emergingmarkets across the HSBC Group. Based on certain criteria, we offer personal non-credit card customers who meetour current underwriting standards the opportunity to convert their loans intoreal estate secured loans. This enables our customers to have access toadditional credit at lower interest rates. This also reduces our potential lossexposure and improves our portfolio performance as previously unsecured loansbecome secured. We converted approximately $652 million of personal non-creditcard loans into real estate secured loans in 2005 and $520 million in 2004. Itis not our practice to rewrite or reclassify delinquent secured loans (realestate or auto) into personal non-credit card loans. RESULTS OF OPERATIONS-------------------------------------------------------------------------------- Unless noted otherwise, the following discusses amounts reported in our ownedbasis statement of income. NET INTEREST INCOME The following table summarizes net interest income: YEAR ENDED DECEMBER 31, 2005 (1) 2004 (1) 2003 (1)----------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Finance and other interest income......... $13,216 10.61% $10,945 10.28% $10,242 10.85%Interest expense.......................... 4,832 3.88 3,143 2.95 2,928 3.10 ------- ----- ------- ----- ------- -----Net interest income....................... $ 8,384 6.73% $ 7,802 7.33% $ 7,314 7.75% ======= ===== ======= ===== ======= ===== --------------- (1) % Columns: comparison to average owned interest-earning assets. The increase in net interest income during 2005 was due to higher averagereceivables and a higher overall yield, partially offset by higher interestexpense. Overall yields increased as our rates on variable rate productsincreased in line with market movements and other repricing initiatives morethan offset a decline in real estate secured and auto finance yields. Changes inreceivable mix also contributed to the increase in yield as the impact ofincreased levels of higher yielding MasterCard/Visa and personal non-credit cardreceivables due to lower securitization levels was partially offset by growth inlower yielding real estate secured receivables. Receivable mix was alsosignificantly impacted by lower levels of private label receivables as a resultof the sale of our domestic private label portfolio (excluding retail salescontracts at our consumer lending business) in December 2004. The lower realestate and auto finance yields during 2005 reflect strong receivable andrefinancing growth on receivables originated during an economic cycle withhistorically low market rates, high liquidation of older, higher yielding loans,product expansion into near-prime customer segments and competitive pricingpressures due to excess market capacity. Yields also benefited from reducedlevels of lower yielding investment securities in 2005. The higher interestexpense, which contributed to lower net interest margin, was due to a largerbalance sheet and a significantly higher cost of funds due to a rising interestrate environment. In addition, as part of our overall liquidity managementstrategy, we continue to extend the maturity of our liability profile whichresults in higher interest expense. Our purchase accounting fair valueadjustments include both amortization of fair value adjustments to our externaldebt obligations and receivables. Amortization of purchase accounting fair valueadjustments increased net interest income by $520 million in 2005, whichincluded $4 million relating to Metris, and $743 million in 2004. The increase in net interest income during 2004 was due to higher averagereceivables partially offset by lower yields on our receivables, particularlyreal estate secured, auto finance and personal non-credit card receivables andhigher interest expense. The lower yields in 2004 reflect strong receivable andrefinancing growth which has occurred in an economic cycle with historically lowmarket rates, high liquidation of older, higher yielding loans, productexpansion into near-prime customer segments and competitive pricing pressuresdue to excess 45 HSBC Finance Corporation-------------------------------------------------------------------------------- market capacity. All of these factors contributed to a decrease in overall loanyields. The higher interest expense experienced in 2004 was due to a largerbalance sheet partially offset by a lower cost of funds. Amortization ofpurchase accounting fair value adjustments increased net interest income by $743million in 2004 and $598 million in 2003. Net interest margin was 6.73 percent in 2005, 7.33 percent in 2004 and 7.75percent in 2003. Net interest margin decreased in 2005 as the improvement in theoverall yield on our receivable portfolio, as discussed above, was more thanoffset by the higher funding costs. The decrease in 2004 was driven by loweryields on certain products, partially offset by lower funding costs on our debt.The following table shows the impact of these items on owned basis net interestmargin: 2005 2004-------------------------------------------------------------------------Net interest margin - December 31, 2004 and 2003, respectively.............................................. 7.33% 7.75%Impact to net interest margin resulting from: Bulk sale of domestic private label portfolio in December 2004................................................... (.24) - Receivable pricing........................................ .11 (.34) Receivable mix............................................ .12 (.31) Metris acquisition in December 2005....................... .03 - Cost of funds change...................................... (.79) .18 Investment securities mix................................. .06 .03 Sale of real estate secured receivables in December 2003................................................... - .11 Other..................................................... .11 (.09) ---- ----Net interest margin - December 31, 2005 and 2004, respectively.............................................. 6.73% 7.33% ==== ==== Our net interest income on a managed basis includes finance income earned on ourowned receivables as well as on our securitized receivables. This finance incomeis offset by interest expense on the debt recorded on our balance sheet as wellas the contractual rate of return on the instruments issued to investors whenthe receivables were securitized. Managed basis net interest income was $9.3billion in 2005, $10.3 billion in 2004 and $10.2 billion in 2003. Managed basisnet interest margin was 6.94 percent in 2005 compared to 7.97 percent in 2004and 8.60 percent in 2003. The decrease in 2005 was primarily due to higherfunding costs. The decrease in net interest margin in 2004 was due to loweryields on our receivables, partially offset by lower funding costs on our debtas discussed above. Net interest margin is greater than on an owned basisbecause the managed basis portfolio includes more unsecured loans which havehigher yields. The following table shows the impact of these items on managedbasis net interest margin: 2005 2004-------------------------------------------------------------------------Net interest margin - December 31, 2004 and 2003, respectively.............................................. 7.97% 8.60%Impact to net interest margin resulting from: Bulk sale of domestic private label portfolio in December 2004................................................... (.16) - Receivable pricing........................................ .10 (.46) Receivable mix............................................ (.24) (.36) Metris acquisition in December 2005....................... .03 - Cost of funds change...................................... (.92) .12 Investment securities mix................................. .06 .02 Sale of real estate secured receivables in December 2003................................................... - .11 Other..................................................... .10 (.06) ---- ----Net interest margin - December 31, 2005 and 2004, respectively.............................................. 6.94% 7.97% ==== ==== 46 HSBC Finance Corporation-------------------------------------------------------------------------------- Our interest earning assets expose us to interest rate risk. We try to managethis risk by borrowing money with similar interest rate and maturity profiles;however, there are instances when this cannot be achieved. When the variousrisks inherent in both the asset and the debt to do not meet our desired riskprofile, we use derivative financial instruments to manage these risks toacceptable interest rate risk levels. See "Risk Management" for additionalinformation regarding interest rate risk and derivative financial instruments. See the "Net Interest Margin" tables and "Reconciliation to GAAP FinancialMeasures" for additional information regarding our owned basis and managed basisnet interest income. PROVISION FOR CREDIT LOSSES The provision for credit losses includes currentperiod net credit losses and an amount which we believe is sufficient tomaintain reserves for losses of principal, interest and fees, including late,overlimit and annual fees, at a level that reflects known and inherent losses inthe portfolio. Growth in receivables and portfolio seasoning ultimately resultin higher provision for credit losses. The provision for credit losses may alsovary from year to year depending on a variety of additional factors includingproduct mix and the credit quality of the loans in our portfolio including,historical delinquency roll rates, customer account management policies andpractices, risk management/collection policies and practices related to our loanproducts, economic conditions, changes in laws and regulations and our productvintage analysis. The following table summarizes provision for owned credit losses: YEAR ENDED DECEMBER 31, 2005 2004 2003-------------------------------------------------------------------------------------- (IN MILLIONS)Provision for credit losses................................. $4,543 $4,334 $3,967 Our provision for credit losses increased during 2005 primarily due to increasedcredit loss exposure as a result of Katrina and higher bankruptcy losses due tohigher bankruptcy filings resulting from new bankruptcy legislation in theUnited States. Excluding the increased credit loss provision related to Katrinaand the impact from the increased bankruptcy filings in 2005, our provision forcredit losses declined in 2005 as improved credit quality and a shift inportfolio mix to higher levels of secured receivables, primarily as a result ofthe sale of our domestic private label portfolio (excluding retail salescontracts at our consumer lending business) in December 2004, were partiallyoffset by increased requirements due to receivable growth, including lowersecuritization levels and higher credit loss exposure in the U.K. Net charge-offdollars for 2005 decreased $380 million compared to 2004 ($538 million excludingFFIEC in 2004) primarily due to the lower delinquency levels we have experiencedas a result of the strong economy as well as improved credit quality oforiginations. These improvements were partially offset by receivable growth aswell as higher bankruptcy related charge-offs in the fourth quarter of 2005resulting from the new bankruptcy legislation in the United States. We had beenmaintaining credit loss reserves in anticipation of the impact this newlegislation would have on net charge-offs. However, the magnitude of the spikein bankruptcies experienced immediately before the new legislation becameeffective was larger than anticipated which resulted in an additional $100million credit loss provision being recorded during the third quarter of 2005.Our fourth quarter results include an estimated $125 million in incrementalcharge-offs of principal, interest and fees and $113 million in provisionexpense attributable to bankruptcy reform. The incremental charge-off isprimarily related to our MasterCard/Visa portfolio where bankrupt accountscharge-off sooner in accordance with FFIEC policies than in our secured andpersonal non-credit card portfolios. This provision expense included in ourfourth quarter results relating to bankruptcies in our secured and personalnon-credit card portfolios will not begin to migrate to charge-off until 2006 inaccordance with their respective charge-off policies. As expected, the number ofbankruptcy filings subsequent to the enactment of this new legislation havedecreased dramatically. We believe that a portion of the increase in charge-offsresulting from the higher bankruptcy filings is an acceleration of charge-offsthat would otherwise have been experience in future periods. Our provision for credit losses increased in 2004 compared to 2003 partially asa result of the adoption of FFIEC charge-off policies for our domestic privatelabel (excluding retail sales contracts at our consumer lending business) andMasterCard/Visa portfolios. The adoption of the FFIEC charge-off policiesresulted in a $38 million increase to loss provision in the fourth quarter of2004 as the incremental charge-off of 47 HSBC Finance Corporation-------------------------------------------------------------------------------- $158 million associated with these products was partially offset by the releaseof $120 million in existing credit loss reserves. Excluding the impact of theadoption of FFIEC charge-off policies in 2004, our credit loss provisionincreased in 2004 compared to 2003 due to receivable growth, including lowersecuritization levels, partially offset by improving asset quality. Netcharge-off dollars for 2004 increased $446 million ($288 million excludingFFIEC) compared to 2003 as higher delinquencies due to adverse economicconditions which existed in 2003 migrated to charge-off in 2004, partiallyoffset by an overall improvement in asset quality during 2004. We increased our credit loss reserves in both 2005 and 2004 as the provision forowned credit losses was $890 million greater than net charge-offs in 2005 and$301 million in 2004. The provision as a percent of average owned receivableswas 3.76 percent in 2005, 4.28 percent in 2004 and 4.45 percent in 2003. Thedecrease in 2005 reflects receivable growth, better underwriting standards and ashift in portfolio mix to higher levels of secured receivables, partially offsetby the impact of Katrina and the higher provision resulting from the increasedbankruptcy filings resulting from the new bankruptcy legislation in the UnitedStates. The decrease in 2004 reflects receivable growth and better underwritingstandards. See "Critical Accounting Policies," "Credit Quality," "Analysis of Credit LossReserves Activity" and "Reconciliations to GAAP Financial Measures" foradditional information regarding our owned basis and managed basis loss reservesand the adoption of FFIEC policies. See Note 7, "Credit Loss Reserves" in theaccompanying consolidated financial statements for additional analysis of theowned basis and managed basis loss reserves. OTHER REVENUES The following table summarizes other revenues: YEAR ENDED DECEMBER 31, 2005 2004 2003-------------------------------------------------------------------------------------- (IN MILLIONS)Securitization related revenue.............................. $ 211 $1,008 $1,461Insurance revenue........................................... 918 839 746Investment income........................................... 134 137 196Derivative income........................................... 249 511 286Fee income.................................................. 1,568 1,091 1,064Taxpayer financial services revenue......................... 277 217 185Gain on bulk sale of private label receivables.............. - 663 -Gain on receivable sales to HSBC affiliates................. 413 39 16Servicing fees from HSBC affiliates......................... 409 24 -Other income................................................ 652 544 365 ------ ------ ------Total other revenues........................................ $4,831 $5,073 $4,319 ====== ====== ====== Securitization related revenue is the result of the securitization of ourreceivables and includes the following: YEAR ENDED DECEMBER 31, 2005 2004 2003------------------------------------------------------------------------------------ (IN MILLIONS)Net initial gains(1)........................................ $ - $ 25 $ 176Net replenishment gains(2).................................. 154 414 548Servicing revenue and excess spread......................... 57 569 737 ---- ------ ------Total....................................................... $211 $1,008 $1,461 ==== ====== ====== --------------- (1) Net initial gains reflect inherent recourse provisions of $47 million in 2004 and $963 million in 2003. (2) Net replenishment gains reflect inherent recourse provisions of $252 million in 2005, $850 million in 2004 and $849 million in 2003. 48 HSBC Finance Corporation-------------------------------------------------------------------------------- The decline in securitization related revenue in 2005 and 2004 was due todecreases in the level and product mix of securitized receivables and higher runoff due to shorter expected lives of securitization trusts as a result of ourdecision in the third quarter of 2004 to structure all new collateralizedfunding transactions as secured financings. Excess spread in 2004 and 2003 wasalso negatively impacted by higher recourse estimates at auto finance as aresult of certain vintages performing worse than expected which reduced excessspread by $91 million in 2004 and $200 million in 2003. Because existing publicMasterCard and Visa credit card transactions were structured as sales torevolving trusts that require replenishments of receivables to supportpreviously issued securities, receivables will continue to be sold to thesetrusts until the revolving periods end, the last of which is currently projectedto occur in 2008. Private label trusts that publicly issued securities will nowbe replenished by HSBC Bank USA as a result of the daily sales of new domesticprivate label originations (excluding retail sales contracts) to HSBC Bank USA.We will continue to replenish at reduced levels, certain non-public personalnon-credit card securities issued to conduits and record the resultingreplenishment gains for a period of time in order to manage liquidity. Since oursecuritized receivables have varying lives, it will take time for thesereceivables to pay-off and the related interest-only strip receivables to bereduced to zero. While the termination of sale treatment on new collateralizedfunding activity and the reduction of sales under replenishment agreementsreduced our reported net income under U.S. GAAP, there is no impact on cashreceived from operations. In 2005, our net interest-only strip receivables, excluding the mark-to-marketadjustment recorded in accumulated other comprehensive income and the U.K.credit card portion purchased by HBEU, decreased $253 million. In 2004, our netinterest-only strip receivables, excluding both the mark-to-market adjustmentrecorded in accumulated other comprehensive income and the private label portionpurchased by HSBC Bank USA, decreased $466 million as securitized receivablescontinue to decline. See Note 2, "Summary of Significant Accounting Policies," and Note 8, "AssetSecuritizations," to the accompanying consolidated financial statements, and"Critical Accounting Policies" and "Off Balance Sheet Arrangements and SecuredFinancings" for further information on asset securitizations. Insurance revenue increased in 2005 as we have experienced higher sales volumesfor many of our insurance products in both our U.K. and domestic operations. Theincrease in 2004 was due to increased sales in our U.K. business partiallyoffset by slightly lower revenue from our domestic operations due to thecontinued run off of insurance products discontinued in prior years. Investment income, which includes income on securities available for sale in ourinsurance business and realized gains and losses from the sale of securities,was essentially flat in 2005 as the lower average investment balances and lowergains from security sales were largely offset by higher yields on ourinvestments. The decrease in 2004 was a result of decreases in income due tolower yields on lower average balances, lower gains from security sales andreduced amortization of purchase accounting fair value adjustments. Derivative income, which includes realized and unrealized gains and losses onderivatives which do not qualify as effective hedges under SFAS No. 133 as wellas the ineffectiveness on derivatives associated with our qualifying hedges issummarized in the table below: 2005 2004 2003-------------------------------------------------------------------------------- (IN MILLIONS)Net realized gains (losses)................................. $ 52 $ 68 $ 54Mark-to-market on derivatives which do not qualify as effective hedges.......................................... 156 442 230Ineffectiveness............................................. 41 1 2 ---- ---- ----Total....................................................... $249 $511 $286 ==== ==== ==== Derivative income decreased in 2005 primarily due to an upward shift in theforward yield curve which decreased the value of our pay variable interest rateswaps which do not qualify for hedge accounting under 49 HSBC Finance Corporation-------------------------------------------------------------------------------- SFAS No. 133 and to the reduction in the portfolio of non-qualifying receivevariable interest rate swaps. The income from ineffectiveness in 2005 resultedfrom this designation of a significant number of our non-hedging derivativeportfolio, which had previously not qualified for hedge accounting under SFASNo. 133, as effective hedges under the long-haul method of accounting during2005. Redesignation of swaps as effective hedges reduces the overall volatilityof reported income. For certain new hedging relationships, however, we continuedto experience income volatility during the period before hedging documentationwas put in place. We are working to improve this process and reduce the delaybetween executing the swap and establishing hedge accounting. Additionally, 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. Derivative income increased in 2004 due to an increasinginterest rate environment which caused our pay fixed interest rate swaps, whichdo not qualify for hedge accounting under SFAS No. 133, to increase in value.These derivatives were economic hedges of the underlying debt instruments. Net income volatility, whether based on changes in interest rates for swapswhich do not qualify for hedge accounting or ineffectiveness recorded on ourqualifying hedges under the long haul method of accounting, impacts thecomparability of our reported results between periods. Accordingly, derivativeincome for the year ended December 31, 2005 should not be considered indicativeof the results for any future periods. Fee income, which includes revenues from fee-based products such as creditcards, increased in 2005 and 2004 due to higher credit card fees, particularlyrelating to our non-prime credit card portfolio, due to higher levels ofMasterCard/Visa credit card receivables and, in 2005, improved interchangerates. In 2005, these increases were partially offset by lower private labelcredit card fees and higher rewards program expenses. The lower private labelcredit card fees were the result of the bulk sale of domestic private labelreceivables to HSBC Bank USA in December 2004. For 2004, the higher credit cardfees were partially offset by higher payments to merchant partners as a resultof portfolio acquisitions in our retail services business. See Note 22,"Business Segments," to the accompanying consolidated financial statements foradditional information on fee income on a managed basis. Taxpayer financial services ("TFS") revenue increased in 2005 due to increasedloan volume during the 2005 tax season and revenue on the sale of certain baddebt recovery rights to third parties in 2005. The increase in 2004 wasprimarily due to lower funding costs as a result of our acquisition by HSBC. Gain on bulk sale of private label receivables resulted from the sale of $12.2billion of domestic private label receivables ($15.6 billion on a managed basis)including the retained interests associated with securitized private labelreceivables to HSBC Bank USA in December 2004. See Note 4, "Sale of DomesticPrivate Label Receivable Portfolio and Adoption of FFIEC Policies," to theaccompanying consolidated financial statements for further information. Gains on receivable sales to HSBC affiliates in 2005 includes the daily sales ofdomestic private label receivable originations (excluding retail salescontracts) and certain MasterCard/Visa account originations to HSBC Bank USA. In2004, gains on receivable sales to HSBC affiliates includes the bulk sale ofreal estate secured receivables in March 2004 as well as certain MasterCard/Visaaccount originations to HSBC Bank USA. See Note 4, "Sale of Domestic PrivateLabel Receivable Portfolio and Adoption of FFIEC Policies," to the accompanyingconsolidated financial statements for further information. Servicing fees from HSBC affiliates represents revenue received under servicelevel agreements under which we service MasterCard/Visa credit card and domesticprivate label receivables as well as real estate secured and auto financereceivables for HSBC affiliates. The increases primarily relate to the servicingfees we receive from HSBC Bank USA for servicing the domestic private labelreceivables beginning in December 2004. Other income increased in 2005 and 2004. The increase in 2005 and 2004 wasprimarily due to higher ancillary credit card revenue and higher gains onmiscellaneous asset sales, including the partial sale of a real estateinvestment. 50 HSBC Finance Corporation-------------------------------------------------------------------------------- COSTS AND EXPENSES Effective January 1, 2004, our domestic technology servicesemployees were transferred to HSBC Technology and Services (USA) Inc. ("HTSU").As a result, operating expenses relating to information technology as well ascertain item processing and statement processing activities, which havepreviously been reported as salaries and fringe benefits, occupancy andequipment expenses, or other servicing and administrative expenses, are nowbilled to us by HTSU and reported as support services from HSBC affiliates.Support services from HSBC affiliates also include banking services and othermiscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. The following table summarizes total costs and expenses: YEAR ENDED DECEMBER 31, 2005 2004 2003-------------------------------------------------------------------------------------- (IN MILLIONS)Salaries and employee benefits.............................. $2,072 $1,886 $1,998Sales incentives............................................ 397 363 263Occupancy and equipment expenses............................ 334 323 400Other marketing expenses.................................... 731 636 548Other servicing and administrative expenses................. 785 868 1,149Support services from HSBC affiliates....................... 889 750 -Amortization of intangibles................................. 345 363 258Policyholders' benefits..................................... 456 412 377HSBC acquisition related costs incurred by HSBC Finance Corporation............................................... - - 198 ------ ------ ------Total costs and expenses.................................... $6,009 $5,601 $5,191 ====== ====== ====== Salaries and employee benefits increased in 2005 as a result of additionalstaffing, primarily in our consumer lending, mortgage services and Canadianoperations as well as in our corporate functions to support growth. Salaries andemployee benefits decreased in 2004 primarily due to the transfer of ourtechnology personnel to HTSU. Excluding this change, salaries and fringebenefits increased $126 million in 2004 as a result of additional staffing tosupport growth, primarily in our consumer lending, mortgage services andinternational business units and in our compliance functions. Sales incentives increased in 2005 and 2004 due to higher volumes in ourconsumer lending branches and mortgage services business. Occupancy and equipment expenses increased in 2005 as higher occupancy expenseand higher repairs and maintenance costs were partially offset by lowerdepreciation. The decrease in 2004 was primarily due to the formation of HTSU asdiscussed above. Other marketing expenses includes payments for advertising, direct mail programsand other marketing expenditures. The increase in 2005 was primarily due toincreased domestic credit card marketing expenses due to higher non-primemarketing expense and investments in new marketing initiatives. Changes incontractual marketing responsibilities in July 2004 associated with the GeneralMotors ("GM") co-branded credit card also resulted in increased expenses in both2005 and 2004. Other servicing and administrative expenses decreased in 2005 due to lower REOexpenses and a lower estimate of exposure relating to accrued finance chargesassociated with certain loan restructures which were partially offset by highersystems costs. The decrease in 2004 was primarily due to the transfer of certainitem processing and statement processing services to HTSU. This decrease waspartially offset by higher systems and credit bureau costs due to growth, higherinsurance commissions and costs associated with the rebranding. Effective December 20, 2005, our U.K. based technology services employees weretransferred to HBEU. As a result, operating expenses relating to informationtechnology, which have previously been reported as salaries and fringe benefits,are now billed to us by HBEU and reported as support services from HSBCaffiliates. 51 HSBC Finance Corporation-------------------------------------------------------------------------------- Support services from HSBC affiliates, which includes technology and otherservices charged to us by HTSU since January 1, 2004 and by HBEU since December20, 2005, increased in 2005 primarily due to growth. Amortization of intangibles decreased in 2005 as lower intangible amortizationrelated to our purchased credit card relationships due to a contractrenegotiation with one of our co-branded credit card partners and loweramortization associated with an individual contractual relationship waspartially offset by amortization associated with the Metris cardholderrelationships and a write-off related to a trade name in the U.K. The increasein 2004 was due to the higher amortization of intangibles established inconjunction with the HSBC acquisition on March 28, 2003. Due to the timing ofthe merger, there were nine months of amortization expense in 2003 compared witha full year of amortization expense in 2004. Policyholders' benefits increased in 2005 due to a continuing increase ininsurance sales volumes in both our U.K. and domestic operations, partiallyoffset by lower amortization of fair value adjustments relating to our insurancebusiness. The increase in 2004 was due to higher sales in our U.K. business andhigher amortization of fair value adjustments relating to our insurancebusiness, partially offset by lower expenses in our domestic business. HSBC acquisition related costs incurred by HSBC Finance Corporation in the firstquarter of 2003 include payments to executives under existing employmentcontracts and investment banking, legal and other costs relating to ouracquisition by HSBC. The following table summarizes our owned basis efficiency ratio: YEAR ENDED DECEMBER 31, 2005 2004 2003-----------------------------------------------------------------------------------GAAP basis efficiency ratio................................. 43.52% 41.64% 42.77%Operating basis efficiency ratio(1)......................... 43.52 43.42 41.01 --------------- (1) Represents a non-GAAP financial measure. See "Basis of Reporting" for additional discussion on the use of this non-GAAP financial measure and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations of our operating efficiency ratio to our owned basis GAAP efficiency ratio. Our owned basis efficiency ratio has been significantly impacted by the resultsof the domestic private label receivable portfolio which was sold in December2004. Excluding the results of this domestic private label portfolio from bothperiods, our 2005 efficiency ratio improved 259 basis points as compared to2004. This improvement is primarily a result of higher net interest income andother revenues due to higher levels of owned receivables, partially offset bythe increase in total costs and expenses to support receivable growth. Thedeterioration in the efficiency ratio on an operating basis for 2004 wasprimarily attributable to an increase in operating expenses, including higherintangible amortization and lower securitization related revenue partiallyoffset by higher net interest income and derivative income. INCOME TAXES Our effective tax rates were as follows: Year ended December 31, 2005 (successor).................... 33.5%Year ended December 31, 2004 (successor).................... 34.0March 29 through December 31, 2003 (successor).............. 33.7January 1 through March 28, 2003 (predecessor).............. 42.5 The decrease in the effective tax rate in 2005 is attributable to lower statetax rates and lower pretax income with low income housing tax credits remainingconstant. The effective tax rate for January 1 through March 28, 2003 wasadversely impacted by the non-deductibility of certain HSBC acquisition relatedcosts. The effective tax rate differs from the statutory Federal income tax rateprimarily because of the effects of state and local taxes and tax credits. 52 This information is provided by RNS The company news service from the London Stock Exchange