HSBC Holdings Regulatory News (HSBA)

6 Mar 2006 11:01

HSBC Holdings PLC06 March 2006 HSBC Finance Corporation-------------------------------------------------------------------------------- SEGMENT RESULTS - MANAGED BASIS-------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services andInternational. Our Consumer segment consists of our consumer lending, mortgageservices, retail services and auto finance businesses. Our Credit Card Servicessegment consists of our domestic MasterCard and Visa credit card business. OurInternational segment consists of our foreign operations in the United Kingdom,Canada, the Republic of Ireland Slovakia, the Czech Republic and Hungary. Therehave been no changes in the basis of our segmentation or any changes in themeasurement of segment profit as compared with the presentation in our 2004 Form10-K. The accounting policies of the reportable segments are described in Note 2,"Summary of Significant Accounting Policies," to the accompanying financialstatements. For segment reporting purposes, intersegment transactions have notbeen eliminated. We generally account for transactions between segments as ifthey were with third parties. We have historically monitored our operations and evaluated trends on a managedbasis (a non-GAAP financial measure), which assumes that securitized receivableshave not been sold and are still on our balance sheet. This is because thereceivables that we securitize are subjected to underwriting standardscomparable to our owned portfolio, are serviced by operating personnel withoutregard to ownership and result in a similar credit loss exposure for us. Inaddition, we fund our operations and make decisions about allocating resourcessuch 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. CONSUMER SEGMENT The following table summarizes the managed basis results forour Consumer segment: YEAR ENDED DECEMBER 31, 2005 2004 2003------------------------------------------------------------------------------------------ (IN MILLIONS)Net income.................................................. $ 1,498 $ 1,563 $ 1,061Operating net income........................................ 1,498 1,247 1,061Net interest income......................................... 6,887 7,699 7,333Securitization related revenue.............................. (622) (1,433) 337Fee and other income, excluding gain on the bulk sale of the domestic private label receivable portfolio............... 1,194 638 664Gain on bulk sale of private label receivable portfolio..... - 683 -Intersegment revenues....................................... 108 101 107Provision for credit losses................................. 2,461 2,575 4,275Total costs and expenses, excluding settlement charge and related expenses.......................................... 2,638 2,528 2,358Receivables................................................. 108,345 87,839 87,104Assets...................................................... 109,214 89,809 89,791Net interest margin......................................... 7.09% 8.20% 8.59%Return on average managed assets............................ 1.53 1.64 1.22 Our Consumer Segment reported higher operating net income in 2005 and 2004.Operating net income is a non-GAAP financial measure of net income whichexcludes the gain on the bulk sale of the domestic private label portfolio(excluding retail sales contracts at our consumer lending business) and theimpact of adoption of FFIEC charge-off policies for this domestic private labelportfolio in 2004. In 2005, the increase in operating net income was primarilydue to higher fee and other income, higher securitization related revenue and alower provision for credit losses, partially offset by lower net interest incomeand higher costs and 53 HSBC Finance Corporation-------------------------------------------------------------------------------- expenses. The increase in fee and other income is due to gains on the dailysales of domestic private label receivable originations to HSBC Bank USA andreceipt of servicing revenue for servicing this portfolio, partially offset bylower fee income related to the sold receivables. Securitization related revenuewas higher due to lower amortization of prior period gains as a result ofreduced securitization levels. Costs and expenses were higher due to highersalary expense and higher support services from affiliates, partially offset bylower REO expenses as well as a lower estimate of exposure relating to accruedfinance charges associated with certain loan restructures. Net interest income and net interest margin decreased in 2005 primarily due to ashift in mix to lower yielding real estate secured receivables resulting fromsignificantly lower levels of private label receivables resulting from theprivate label portfolio sale in December 2004 as well as organic growth of realestate secured receivables. Also contributing to the decrease were lower yieldson real estate secured and auto finance receivables as a result of competitivepressure on pricing and product expansion into near-prime consumer segments, aswell as the run-off of higher yielding real estate secured receivables,including second lien loans, largely due to refinance activity. Our auto financebusiness experienced lower yields as we have targeted higher credit qualitycustomers. Although higher credit quality receivables generate lower yields,such receivables are expected to result in lower operating costs, delinquencyratios and charge-off. The decreases in yield for our consumer segmentreceivable portfolio discussed above were partially offset by higher pricing onour variable rate products. A higher cost of funds due to a rising interest rateenvironment also contributed to the decrease in net interest income and margin. Our managed basis provision for credit losses, which includes both provision forowned basis receivables and over-the-life provision for receivables servicedwith limited recourse, decreased during 2005 due to lower net charge-off levelsas a result of improved credit quality and the impact of the sale of thedomestic private label receivable portfolio in December 2004, as well as lowersecuritization levels. We have experienced lower dollars of net charge-offs inour owned portfolio during 2005 due to the sale of $12.2 billion of owneddomestic private label receivables in December 2004 and as a result of improvedcredit quality. These factors more than offset the increased provisionrequirements associated with receivable growth, the impact from Katrina and thenew bankruptcy legislation in the United States which, as discussed more fullybelow, have resulted in a decrease to our owned provision for credit losses.Over-the-life provision for credit losses for securitized receivables recordedin any given period reflects the level and product mix of securitizations inthat period. Subsequent charge-offs of securitized receivables result in adecrease in the over-the-life reserves without any corresponding increase tomanaged loss provision. In 2005, we increased managed loss reserves as netcharge-offs were less than the provision for credit losses by $57 million. For2004, we decreased managed loss reserves as net charge-offs were greater thanthe provision for credit losses by $1,229 million. Our managed basis provision for credit losses also reflects an estimate ofincremental credit loss exposure relating to Katrina. The incremental provisionfor credit losses for Katrina in the Consumer Segment in 2005 was $130 millionand represents our best estimate of Katrina's impact on our loan portfolio. Asadditional information becomes available relating to the financial condition ofour affected customers, the physical condition of the collateral for loans whichare secured by real estate and the resultant impact on customer paymentpatterns, we will continue to review our estimate of credit loss exposurerelating to Katrina and any adjustments will be reported in earnings when theybecome known. In an effort to assist our customers affected by the disaster, weinitiated various programs including extended payment arrangements for up to 90days or more depending upon customer circumstances. These interest and feewaivers were not material to the Consumer Segment's 2005 results. As previously discussed, the United States enacted new bankruptcy legislationwhich resulted in a spike in bankruptcy filings prior to the October 2005effective date. We had been maintaining credit loss reserves in anticipation ofthe impact this new legislation would have on net charge-offs. However, themagnitude of the spike in bankruptcies experienced immediately before the newlegislation became effective was larger than anticipated. Our fourth quarterresults include an increase of approximately $113 million in our owned provisionfor credit losses due to the spike in bankruptcy filings prior to the effectivedate. While the 54 HSBC Finance Corporation-------------------------------------------------------------------------------- Consumer Segment experienced an increase in the bankruptcy filings related tothis new legislation, the associated accounts have not yet migrated tocharge-off in accordance with our charge-off policy for real estate secured andpersonal non-credit card receivables. 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.As expected, the number of bankruptcy filings subsequent to the enactment ofthis new legislation has decreased dramatically. We believe that a portion ofthis increase is an acceleration of charge-offs that would have otherwise beenexperienced in future periods. Compared to net income in 2003, the increase in operating net income in 2004 wasdue to increases in net interest income and decreases in provision for creditlosses which were partially offset by higher operating expenses andsubstantially lower securitization related revenue. Net interest incomeincreased primarily due to higher receivable levels. Net interest margin,however, decreased primarily due to faster growth in lower yielding real estatesecured lending, lower yields on real estate secured, auto finance and personalnon-credit card receivables as a result of competitive pressure on pricing, aswell as the run off of higher yielding real estate secured receivables,including second lien loans largely due to refinance activity. Our auto financebusiness experienced lower yields as we have targeted lower yielding but highercredit quality customers. These decreases were partially offset by lower cost offunds. Securitization related revenue decreased in 2004 as a result of asignificant decline in receivables securitized, including the impact of higherrun-off due to shorter expected lives as a result of our decision to structureall new collateralized funding transactions as secured financings beginning inthe third quarter of 2004. Securitization levels were also lower in 2004 as weused funding from HSBC, including proceeds from sales of receivables, to assistin the funding of our operations. Operating expenses increased in 2004 as theresult of additional operating costs to support the increased receivable levels,including higher salaries and sales incentives. In December 2004, we adoptedFFIEC charge-off policies for our domestic private label credit card portfolio(excluding retail sales contracts at our consumer lending business) whichresulted in a reduction to net income of $120 million and subsequently sold theportfolio to HSBC Bank USA. We recorded a pre-tax gain of $663 million on thesale. See "Credit Quality" and Note 4, "Sale of Domestic Private LabelReceivable Portfolio and Adoption of FFIEC Policies," to the accompanyingconsolidated financial statements for further discussion of the adoption ofFFIEC charge-off policies and the portfolio sale. Managed receivables increased 23 percent to $108.3 billion at December 31, 2005as compared to $87.8 billion at December 31, 2004. We experienced strong growthin 2005 in our real estate secured portfolio in both our correspondent andbranch-based consumer lending businesses. We have continued to focus on juniorlien loans through portfolio acquisitions and have expanded our sources forpurchasing newly originated loans from flow correspondents. Real estate securedreceivable levels at December 31, 2005 do not include $1.5 billion ofcorrespondent receivables purchased directly by HSBC Bank USA, a portion ofwhich we otherwise would have purchased. Growth in real estate securedreceivables was also supplemented by purchases from a single correspondentrelationship which totaled $1.1 billion in 2005. Also contributing to theincrease were purchases of $1.7 billion in 2005 from a portfolio acquisitionprogram. Our auto finance portfolio also reported growth due to strong organicgrowth, principally in the near-prime portfolios. This came from newlyoriginated loans acquired from our dealer network, growth in the consumer directloan program and expanded distribution through alliance channels. Personalnon-credit card receivables increased from the prior year as we began toincrease the availability of this product in the second half of 2004 as a resultof an improving U.S. economy as well as the success of several large direct mailcampaigns that occurred in 2005. Managed receivables increased 1 percent to $87.8 billion at December 31, 2004compared to $87.1 billion at December 31, 2003. The rate of increase in managedreceivables was impacted by the sale of $15.6 billion in domestic private labelreceivables to HSBC Bank USA in December of 2004. Had this sale not taken place,managed receivables would have increased by $16.3 billion or 19 percent in 2004.We experienced strong growth in 2004 in our real estate secured receivables inboth our correspondent and branch-based consumer lending businesses, which waspartially offset by $2.8 billion of correspondent receivables purchased directlyby HSBC Bank USA, a portion of which we otherwise would have purchased. Growthin our correspondent 55 HSBC Finance Corporation-------------------------------------------------------------------------------- business was supplemented by purchases from a single correspondent relationshipwhich totaled $2.6 billion in 2004. We also experienced growth in auto financereceivables though our dealer network and increased direct mail solicitations.Personal non-credit card receivables also experienced growth in 2004 as we beganto increase availability of this product in the second half of the year as aresult of an improving economy. Prior to the sale of the domestic portfolio inDecember 2004, our private label receivables increased due to organic growththrough existing merchants and a $.5 billion portfolio acquisition. Return on average managed assets ("ROMA") was 1.53 percent in 2005, 1.64 percentin 2004 and 1.22 percent in 2003. On an operating basis, ROMA was 1.53 percentin 2005, 1.32 percent in 2004 and 1.22 percent in 2003. The increase in theoperating ratio in 2005 and 2004 is due to the increase in net income discussedabove which grew faster than average managed assets. In accordance with Federal Financial Institutions Examination Council ("FFIEC")guidance, the required minimum monthly payment amounts for domestic privatelabel credit card accounts has changed. The implementation of these newrequirements began in the fourth quarter of 2005 and will be completed in thefirst quarter of 2006. As previously discussed, we sell new domestic privatelabel receivable originations (excluding retail sales contracts) to HSBC BankUSA on a daily basis. Estimates of the potential impact to the business arebased on numerous assumptions and take into account a number of factors whichare difficult to predict, such as changes in customer behavior, which will notbe fully known or understood until the changes are implemented. Based on currentestimates, we anticipate that these changes will reduce the premium associatedwith these daily sales in 2006. It is not expected this reduction will have amaterial impact on either the results of the Consumer Segment or ourconsolidated results. CREDIT CARD SERVICES SEGMENT The following table summarizes the managed basisresults for our Credit Card Services segment. YEAR ENDED DECEMBER 31, 2005 2004 2003----------------------------------------------------------------------------------------- (IN MILLIONS)Net income.................................................. $ 661 $ 380 $ 500Operating net income........................................ 661 381 500Net interest income......................................... 2,150 2,070 1,954Securitization related revenue.............................. (192) (338) (6)Fee and other income........................................ 2,016 1,731 1,537Intersegment revenues....................................... 21 25 30Provision for credit losses................................. 1,564 1,625 1,598Total costs and expenses.................................... 1,370 1,238 1,099Receivables................................................. 26,181 19,670 19,552Assets...................................................... 27,109 20,049 22,505Net interest margin......................................... 10.38% 10.00% 9.87%Return on average managed assets............................ 3.34 1.82 2.44 In December 2005, our Credit Card Services Segment acquired Metris in anall-cash transaction for $1.6 billion. This acquisition will expand our presencein the near-prime credit card market and will strengthen our capabilities toserve the full spectrum of credit card customers. This acquisition increased ourMasterCard/Visa receivables by $5.3 billion. Net income for the Credit CardServices Segment includes the results of Metris from December 1, 2005 forwardand did not have a significant impact to the results of the Credit Card Servicessegment in 2005. Our Credit Card Services Segment reported higher net income in 2005. Theincrease in net income was primarily due to higher fee and other income, highernet interest income, higher securitization related revenue and lower provisionfor credit losses partially offset by higher costs and expenses. Increases infee and other income resulted from portfolio growth and improved interchangerates, as well as increased gains from the 56 HSBC Finance Corporation-------------------------------------------------------------------------------- daily sales of new volume related to the MasterCard/Visa account relationshipspurchased from HSBC Bank USA in July 2004. Net interest income increased as aresult of higher average receivables and growth in non-prime receivables. Theincrease in net interest income from our receivables reflects increased pricingon variable yield products and higher receivable balances. Net interest marginincreased in 2005 primarily due to increases in non-prime receivable levels,higher pricing on variable rate products as well as other repricing initiatives.Lower average interest earning assets due to lower levels of low yieldinginvestment securities and the impact of lower amortization from receivableorigination costs resulting from changes in the contractual marketingresponsibilities in July 2004 associated with the GM co-branded credit card alsocontributed to the increase. These increases were partially offset by higherinterest expense. Although our non-prime receivables tend to have smallerbalances, they generate higher returns both in terms of net interest margin andfee income. Higher costs and expenses were to support receivable growth andincreases in marketing expenses. The increase in marketing expenses was due tohigher non-prime marketing expense, investments in new marketing initiatives andchanges in contractual marketing responsibilities in July 2004 associated withthe domestic GM co-branded credit card. The managed basis provision for credit losses decreased in 2005 due to improvedcredit quality, partially offset by receivable growth as well as the increasedcredit loss provision relating to the impact of Katrina and the increasedbankruptcy filings resulting from the new bankruptcy legislation in the UnitedStates. Excluding the impact of Katrina and the increased bankruptcy filings,provision for credit losses on an owned basis also decreased in 2005. We haveexperienced higher dollars of net charge-offs in our owned portfolio due tohigher receivable levels as well as the increased credit card charge-offs in thefourth quarter of 2005 which resulted from the spike in bankruptcy filings priorto the October 2005 effective date of the new bankruptcy legislation. We hadbeen maintaining 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 attributable to bankruptcy reformwhich was offset by a release of our owned credit loss reserves of $125 million.As expected, the number of bankruptcy filings subsequent to the enactment ofthis new legislation has decreased dramatically. We believe that a portion ofthe increase in charge-offs resulting from the higher bankruptcy filings is anacceleration of charge-offs that would otherwise have been experienced in futureperiods. For the year, we have increased our managed loss reserves by recordingloss provision greater than net charge-offs of $120 million in 2005. Our managed basis provision for credit losses also reflects an estimate ofincremental credit loss exposure relating to Katrina. The incremental provisionfor credit losses for Katrina in the Credit Card Services Segment in 2005 was$55 million and represents our best estimate of Katrina's impact on our loanportfolio. As additional information becomes available relating to the financialcondition of our affected customers and the resultant impact on customer paymentpatterns, we will continue to review our estimate of credit loss exposurerelating to Katrina and any adjustments will be reported in earnings when theybecome known. In an effort to assist our customers affected by the disaster, weinitiated various programs including extended payment arrangements and interestand fee waivers for up to 90 days or more depending upon customer circumstances.These interest and fee waivers were not material to the Credit Card ServicesSegment's 2005 results. Our Credit Card Services Segment reported lower net income and operating netincome in 2004. The decrease in net income was due to lower securitizationlevels and higher operating expenses, particularly marketing expenses, partiallyoffset by increases in net interest income as well as fee and other income.Increases in net interest income as well as fee and other income in 2004resulted from higher non-prime receivable levels. Net interest margin increasedcompared to 2003 due to higher non-prime receivable levels and lower fundingcosts. Securitization related revenue declined as a result of a decline inreceivables securitized, including higher run-off due to higher principalrepayment rates. Our provision for credit losses was essentially flat in 2004 asreductions due to improving credit quality and changes in securitization levelswere offset by higher levels of 57 HSBC Finance Corporation-------------------------------------------------------------------------------- non-prime receivables which carry a higher reserve requirement and a corporateadjustment to increase owned reserve levels. We increased managed loss reservesby recording loss provision greater than net charge-offs of $123 million in2004. As previously discussed, in December 2004, we adopted FFIEC charge-offpolicies for the remainder of our domestic MasterCard and Visa portfolio, whichresulted in an immaterial reduction to net income. See "Credit Quality" forfurther discussion of the FFIEC policies and the impact of their adoption. Managed basis receivables increased 33 percent to $26.2 billion at December 31,2005 compared to $19.7 billion at December 31, 2004. As discussed above, theincrease was primarily due to the acquisition of Metris in December 2005 whichincreased our managed basis receivables by $5.3 billion. Organic growth in ourHSBC branded prime, Union Privilege and non-prime portfolios, partially offsetby the continued decline in certain older acquired portfolios, also contributedto the increase. Managed basis receivables at December 31, 2004 were flatcompared to $19.6 billion at December 31, 2003. In 2004, increases in our AFL-CIO Union Plus portfolios, non-prime and prime portfolios were substantiallyoffset by the continued decline in certain older acquired portfolios. The increase in ROMA in 2005 is primarily due to the higher net income discussedabove as well as the impact of lower average managed assets. The decrease inaverage managed assets is due to lower investment securities during 2005 as aresult of the elimination of investments dedicated to our credit card bank in2003 resulting from our acquisition by HSBC. ROMA decreased in 2004 compared to2003 reflecting the lower net income as discussed above. In accordance with FFIEC guidance, our credit card services business adopted aplan to phase in changes to the required minimum monthly payment amount andlimit certain fee billings for non-prime credit card accounts. Theimplementation of these new requirements began in July 2005 with therequirements fully phased in by December 31, 2005. Estimates of the potentialimpact to the business are based on numerous assumptions and take into account anumber of factors which are difficult to predict, such as changes in customerbehavior and impact of other issuers implementing requirements, which will notbe fully known or understood until the changes have been in place for a periodof time. It is anticipated that the changes will result in decreased non-primecredit card fee income and fluctuations in the provision for credit losses ascredit loss provisions for prime accounts will increase as a result of higherrequired monthly payments while the non-prime provision decreases due to lowerlevels of fees incurred by customers. Although we do not expect this will have amaterial impact on our consolidated results, the impact to the Credit CardServices Segment in 2006 will be material. INTERNATIONAL SEGMENT The following table summarizes the managed basis resultsfor our International segment: YEAR ENDED DECEMBER 31, 2005 2004 2003----------------------------------------------------------------------------------------- (IN MILLIONS)Net (loss) income........................................... $ (5) $ 95 $ 170Net interest income......................................... 907 797 753Securitization related revenue.............................. 20 (88) 17Fee and other income........................................ 563 503 380Intersegment revenues....................................... 17 15 12Provision for credit losses................................. 642 336 359Total costs and expenses.................................... 847 726 530Receivables................................................. 9,260 13,263 11,003Assets...................................................... 10,109 14,236 11,923Net interest margin......................................... 7.16% 6.83% 7.44%Return on average managed assets............................ (.04) .76 1.57 58 HSBC Finance Corporation-------------------------------------------------------------------------------- Our International Segment reported lower net income in 2005 and 2004 driven by asignificant decline in earnings at our U.K. subsidiary. Overall, the decrease innet income reflects higher operating expenses, and in 2005, higher provision forcredit losses, partially offset by increased fee and other income, and highernet interest income. Applying constant currency rates, which uses the averagerate of exchange for the 2004 period to translate current period net income, netloss would have been higher by $4 million in 2005. Applying constant currencyrates for the 2003 period to translate 2004 income, net income for 2004 wouldhave been lower by $6 million. Net interest income increased in 2005 and 2004 primarily due to higher averageinterest earning assets. Net interest margin increased in 2005 due to increasedyields on credit cards due to repricing initiatives and interest-free balancesnot being promoted as strongly in 2005 as in the past, partially offset byrun-off of higher yielding receivables, competitive pricing pressures holdingdown yields on our personal loans in the U.K. and increased cost of funds. Netinterest margin decreased in 2004 as the run-off of higher yielding receivables,competitive pricing pressures and higher cost of funds discussed above werepartially offset by increased yields on credit cards due to less promotion ofinterest-free balances. Securitization related revenue increased in 2005 due tolower amortization of prior period gains as a result of reduced securitizationlevels, higher levels of receivable replenishments to support previously issuedsecurities in the U.K. as well as the recognition of residual balancesassociated with certain expired securitization transactions. Securitizationrelated revenue declined in 2004 as a result of lower levels of securitizedreceivables. Fee and other income increased in both years primarily due tohigher insurance revenues. Provision for credit losses increased in 2005 primarily due to higherdelinquency and charge-off levels in the U.K. due to a general increase inconsumer bad debts in the U.K. market, including increased bankruptcies.Provision for credit losses decreased in 2004 due to changes in securitizationlevels, partially offset by a higher provision for credit losses on ownedreceivables due to receivable growth and the higher delinquency and charge-offlevels in the U.K. discussed above. We increased managed loss reserves in 2005by recording loss provision greater than net charge-offs of $145 million. In2004, we decreased managed loss reserves by recording loss provision less thannet charge-offs of $29 million. Total costs and expenses increased in 2005 and2004 due to higher expenses to support receivable growth and collectionactivities, increased costs associated with branch expansions in Canada andhigher policyholder benefits because of increased insurance sales volumes. Totalcosts and expenses in 2004 were also higher due to the full year impact ofoperating costs associated with a 2003 private label portfolio acquisition. 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 HBEU, a U.K. based subsidiary of HSBC, and/or one or moreunrelated third parties. In December 2005, we sold our U.K. credit cardbusiness, 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, the sale also included the account originationplatform, including the marketing and credit employees associated with thisfunction, as well as the lease associated with the credit card call center andthe related leaseholds and call center employees to provide customer continuityafter the transfer as well as to allow HBEU direct ownership and control oforigination and customer service. We have retained the collection operationsrelated to the credit card operations and have entered into a service levelagreement for a period of not less than two years to provide collection servicesand other support services, including components of the compliance, financialreporting and human resource functions, for the sold credit card operations toHBEU for a fee. Additionally, the management teams of HBEU and our remainingU.K. operations will be jointly involved in decision making involving cardmarketing to ensure that growth objectives are met for both businesses. Becausethe sale of this business is between affiliates under common control, thepremium received in excess of the book 59 HSBC Finance Corporation-------------------------------------------------------------------------------- value of the assets transferred of $182 million, including the goodwill assignedto this business, has been recorded as an increase to additional paid in capitaland has not been included in earnings. In future periods, the net interestincome, fee income and provision for credit losses related to the U.K. creditcard business will be reduced, while other income will be increased by thereceipt of servicing and support services revenue from HBEU. While we do notanticipate that the net effect of this sale will result in a material reductionof net income of our consolidated results, the impact will likely be material toour International segment. We continue to evaluate strategic alternatives withrespect 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.As a result, subsequent to the transfer operating expenses relating toinformation technology, which have previously been reported as salaries andfringe benefits or other servicing and administrative expenses, are now billedto us by HBEU and reported as support services from HSBC affiliates. During thefirst quarter of 2006, we anticipate that the information technology equipmentin the U.K. will be sold to HBEU for book value. Managed receivables of $9.3 billion at December 31, 2005 decreased 30 percentcompared to $13.3 billion at December 31, 2004. The decrease was primarily dueto the sale of the U.K. credit card business to HBEU in December 2005, whichincluded managed receivables of $3.1 billion. In addition to the sale of ourcredit card operations in the U.K., our U.K. based unsecured receivable productsdecreased in 2005 due to lower retail sales volume following a slow down inretail consumer spending in the U.K. These decreases were partially offset bygrowth in the receivable portfolio in our Canadian operations. Branch expansionsin Canada in 2005 resulted in strong secured and unsecured receivable growth.Additionally, the Canadian auto finance program, which was introduced in thesecond quarter of 2004, grew to a network of over 1,000 active dealerrelationships at December 31, 2005. Also contributing to the receivable growthin Canada was the successful launch of a MasterCard/Visa credit card program.Receivable growth at December 31, 2005 reflects negative foreign exchangetranslation impacts of $.6 million compared to December 31, 2004 foreignexchange rates. Receivable growth at December 31, 2004 reflects positive foreignexchange translation impacts of $1 billion compared to December 31, 2003 foreignexchange rates. The decrease in ROMA for 2005 and 2004 reflects the lower net income asdiscussed above as well as higher average managed assets primarily due toreceivable growth. RECONCILIATION OF MANAGED BASIS SEGMENT RESULTS As discussed above, we havehistorically monitored our operations on a managed basis. Therefore, anadjustment is required to reconcile the managed financial information to ourreported financial information in our consolidated financial statements. Thisadjustment reclassifies net interest income, fee income and loss provision intosecuritization related revenue. See Note 22, "Business Segments," in theaccompanying consolidated financial statements for a reconciliation of ourmanaged basis segment results to managed basis and owned basis consolidatedtotals. CREDIT QUALITY-------------------------------------------------------------------------------- DELINQUENCY AND CHARGE-OFF POLICIES AND PRACTICES Our delinquency and netcharge-off ratios reflect, among other factors, changes in the mix of loans inour portfolio, the quality of our receivables, the average age of our loans, thesuccess of our collection and customer account management efforts, bankruptcytrends, general economic conditions and significant catastrophic events such asKatrina. The levels of personal bankruptcies also have a direct effect on theasset quality of our overall portfolio and others in our industry. Our credit and portfolio management procedures focus on risk-based pricing andeffective collection and customer account management efforts for each loan. Webelieve our credit and portfolio management process gives us a reasonable basisfor predicting the credit quality of new accounts. This process is based on ourexperience with numerous marketing, credit and risk management tests. We alsobelieve that our frequent and early contact with delinquent customers, as wellas restructuring and other customer account management techniques which aredesigned to optimize account relationships, are helpful in maximizing customer 60 HSBC Finance Corporation-------------------------------------------------------------------------------- collections. See Note 2, "Summary of Significant Accounting Policies," in theaccompanying consolidated financial statements for a description of ourcharge-off and nonaccrual policies by product. Our charge-off policies focus on maximizing the amount of cash collected from acustomer while not incurring excessive collection expenses on a customer whowill likely be ultimately uncollectible. We believe our policies are responsiveto the specific needs of the customer segment we serve. Our real estate and autofinance charge-off policies consider customer behavior in that initiation offoreclosure or repossession activities often prompts repayment of delinquentbalances. Our collection procedures and charge-off periods, however, aredesigned to avoid ultimate foreclosure or repossession whenever it is reasonablyeconomically possible. Our MasterCard/Visa charge-off policy is consistent withindustry practice. Charge-off periods for our personal non-credit card productand, prior to December 2004, our domestic private label credit card product weredesigned to be responsive to our customer needs and may therefore be longer thanbank competitors who serve a different market. Our policies have generally beenconsistently applied in all material respects. Our loss reserve estimatesconsider our charge-off policies to ensure appropriate reserves exist forproducts with longer charge-off lives. We believe our current charge-offpolicies are appropriate and result in proper loss recognition. DELINQUENCY - OWNED BASIS Our policies and practices for the collection of consumer receivables, includingour customer account management policies and practices, permit us to reset thecontractual delinquency status of an account to current, based on indicia orcriteria which, in our judgment, evidence continued payment probability. When weuse a customer account management technique, we may treat the account as beingcontractually current and will not reflect it as a delinquent account in ourdelinquency statistics. However, if the account subsequently experiences paymentdefaults and becomes at least two months contractually delinquent, it will bereported in our delinquency ratios. See "Customer Account Management Policiesand Practices" for further detail of our practices. The following table summarizes two-months-and-over contractual delinquency (as apercent of consumer receivables): 2005 2004 --------------------------------------- --------------------------------------- DEC. 31 SEPT. 30 JUNE 30 MARCH 31 DEC. 31 SEPT. 30 JUNE 30 MARCH 31----------------------------------------------------------------------------------------------------------Real estate secured.... 2.72% 2.51% 2.56% 2.62% 2.96% 3.27% 3.39% 3.87%Auto finance........... 2.34 2.09 2.08 1.65 2.07 1.81 2.12 1.68MasterCard/Visa(1)..... 3.66 4.46 4.14 4.60 4.88 5.84 5.83 5.90Private label.......... 5.43 5.22 4.91 4.71 4.13 4.72 5.00 5.38Personal non-credit card................. 9.40 9.18 8.84 8.63 8.69 8.83 8.92 9.64 ---- ---- ---- ---- ---- ---- ---- ----Total consumer(1)...... 3.84% 3.78% 3.73% 3.78% 4.07% 4.43% 4.57% 5.01% ==== ==== ==== ==== ==== ==== ==== ==== --------------- (1) In December 2005, we completed the acquisition of Metris which included receivables of $5.3 billion. This event had a significant impact on this ratio. Excluding the receivables from the Metris acquisition from this calculation, our consumer delinquency ratio for our MasterCard/Visa portfolio was 4.01% and total consumer delinquency was 3.89%. Compared to September 30, 2005, our total consumer delinquency increased 6 basispoints at December 31, 2005. The increase was due to higher delinquency levelsat December 31, 2005 for our real estate secured and personal non-credit cardreceivable portfolios resulting from portfolio seasoning. The spike inbankruptcy filings in the period leading up to the effective date of newbankruptcy legislation in the United States, which will not begin to migrate tocharge-off until 2006 in accordance with our charge-off policies also has led toincreased delinquency. These increases were partially offset by the continuingstrong economy in the United States, better underwriting and improved quality oforiginations. The increase in delinquency in our real estate secured portfolioreflects maturation of recent receivable growth and, as discussed above, theimpact of the spike in bankruptcy filings, partially offset by the strong levelof recent originations, the recent trend of better 61 HSBC Finance Corporation-------------------------------------------------------------------------------- quality new originations and a continuing strong economy. The increase in autofinance delinquency is due to seasonal increases in delinquency during thefourth quarter. Excluding the impact of the receivables acquired from Metris andthe sale of our U.K. credit card business in December 2005, our MasterCard/Visareceivable delinquency ratio decreased 49 basis points as compared to theSeptember 2005 delinquency ratio. This decrease is a result of lower migrationto two-months-and over contractual delinquency as a result of the spike inbankruptcy filings experienced in the period leading up to the effective date ofthe new bankruptcy legislation as well as changes in receivable mix resultingfrom lower securitization levels and the benefit of seasonal receivable growth.The increase in private label delinquency (which primarily consists of ourforeign private label portfolio that was not sold to HSBC Bank USA in December2004) reflects increased bankruptcy filings in the U.K. Personal non-credit carddelinquencies increased as a result of higher bankruptcy filings in both theUnited States and the U.K., partially offset by improved collection efforts andstrong economic conditions in the U.S. Compared to December 31, 2004, our total consumer delinquency ratio decreased 23basis points generally as a result of better underwriting standards, improvedcredit quality of originations and improvements in the economy in addition tothe impact of the factors discussed above. See "Credit Quality Statistics - Managed Basis" for additional informationregarding our managed basis credit quality. See "Customer Account ManagementPolicies and Practices" regarding the treatment of restructured accounts andaccounts subject to forbearance and other customer account management tools. SeeNote 2, "Summary of Significant Accounting Policies," for a detail of ourcharge-off policy by product. NET CHARGE-OFFS OF CONSUMER RECEIVABLES - OWNED BASIS The following table summarizes net charge-off of consumer receivables as apercent of average consumer receivables: 2005 2004 --------------------------------------------- --------------------------------------------- QUARTER ENDED (ANNUALIZED) QUARTER ENDED (ANNUALIZED) 2003(1) FULL -------------------------------------- FULL --------------------------------- FULL YEAR DEC. 31 SEPT. 30 JUNE 30 MAR. 31 YEAR DEC. 31 SEPT. 30 JUNE 30 MAR. 31 YEAR------------------------------------------------------------------------------------------------------------------------Real estate secured....... .76% .66% .75% .78% .87% 1.10% 1.04% 1.19% 1.04% 1.15% .99%Auto finance.............. 3.27 3.42 3.25 2.61 3.80 3.43 2.73 3.66 3.05 4.65 4.91MasterCard/Visa(2)........ 7.12 7.99 6.24 6.93 7.17 8.85 8.44 8.50 9.91 8.66 9.18Private label(2).......... 4.83 5.60 5.35 4.36 4.18 6.17 9.16 4.79 5.06 5.29 5.75Personal non-credit card.................... 7.88 7.59 8.01 7.77 8.18 9.75 8.06 9.50 10.59 11.17 9.89 ---- ---- ---- ---- ---- ---- ---- ---- ----- ----- ----Total consumer............ 3.03% 3.10% 2.93% 2.93% 3.15% 4.00% 4.04% 3.77% 4.02% 4.17% 4.06% ==== ==== ==== ==== ==== ==== ==== ==== ===== ===== ====Real estate charge-offs and REO expense as a percent of average real estate secured receivables............. .87% .78% .88% .84% 1.01% 1.38% 1.17% 1.31% 1.47% 1.63% 1.42% ==== ==== ==== ==== ==== ==== ==== ==== ===== ===== ==== --------------- (1) We adopted FSP 144-1 in November 2003. The adoption increased real estate charge-offs by $9.1 million and auto finance charge-offs by $1.2 million for the quarter ended December 31, 2003. The adoption increased real estate charge-offs by 7 basis points for the quarter ended December 31, 2003 and 1 basis point for the full year 2003, auto finance charge-offs by 12 basis points for the quarter ended December 31, 2003 and 4 basis points for the full year 2003, and total consumer charge-offs by 4 basis points for the quarter ended December 31, 2003 and 1 basis point for the full year 2003. The impact on prior periods was not material. (2) The adoption of FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard/Visa portfolios in December 2004 increased private label net charge-offs by $155 million (432 basis points), MasterCard/Visa net charge-offs by $3 million (9 basis points) and total consumer net charge-off by $158 million (57 basis points) for the quarter ended December 31, 2004. Full year, the adoption increased private label net charge-offs by 119 basis points, MasterCard/Visa net charge-offs by 2 basis points and total consumer net charge-offs by 16 basis points. Net charge-offs as a percentage of average consumer receivables decreased 97basis points for the full year of 2005 as compared to the full year of 2004. Thenet charge-off ratio for full year 2004 was impacted by the adoption of FFIECcharge-off policies for our domestic private label (excluding retail salescontracts at our consumer lending business) and MasterCard/Visa portfolios.Excluding the additional charge-offs in 2004 62 HSBC Finance Corporation-------------------------------------------------------------------------------- resulting from the adoption of these FFIEC policies, net charge-offs for thefull year 2005 decreased 81 basis points compared to 2004 as a result ofreceivable growth, the positive impact from the lower delinquency levels we haveexperienced as a result of a strong economy as well as improved credit qualityof originations. This was partially offset by the increased charge-offs in thefourth quarter of 2005 for our MasterCard/Visa receivable portfolio resultingfrom the spike in bankruptcy filings prior to the effective date of newbankruptcy legislation in the United States. Our real estate secured portfolioexperienced a decrease in net charge-offs for full year 2005 reflectingreceivables growth, the recent trend of better quality in new originations andcontinuing strong economic conditions. The decrease in the auto finance ratiofor the full year 2005 reflects receivable growth with improved credit qualityof originations, improved collections and better underwriting standards. Thedecrease in the MasterCard/Visa and personal non-credit card receivable netcharge-off ratios reflects the positive impact of changes in receivable mixresulting from lower securitization levels and continued improved creditquality. As discussed above, the decrease in the MasterCard/Visa ratio waspartially offset by increased net charge-offs resulting from higherbankruptcies. The net charge-off ratio for the private label portfolio for thefull year 2004 includes the domestic private label portfolio sold to HSBC BankUSA which contributed 242 basis points to the ratio. The net charge-off ratiofor our private label receivables for the full year 2005 consists primarily ofour foreign private label portfolio which deteriorated in 2005 as a result of ageneral increase in consumer bad debts in the U.K. markets, including increasedbankruptcies. We experienced a decrease in overall net charge-off dollars in 2005. This wasprimarily due to lower delinquency levels we have experienced as a result of thestrong economy as well as improved credit quality of originations. Theseimprovements were partially offset by higher receivable levels in 2005 as wellas higher net charge-offs in the fourth quarter of 2005 of an estimated $125million for our MasterCard/Visa receivable portfolio resulting from theincreased bankruptcy filings as discussed above. While our real estate secured,auto finance and personal non-credit card receivable portfolios also experiencedhigher bankruptcy filings in the period leading up to the effective date of thenew bankruptcy legislation in the United States, these accounts will not beginto migrate to charge-off until 2006 in accordance with our charge-off policy forthese receivable products. As expected, the number of bankruptcy filingssubsequent to the enactment of this new legislation have decreased dramatically.We believe that a portion of the increase in charge-offs resulting from thehigher bankruptcy filings is an acceleration of charge-offs that would otherwisehave been experienced in future periods. The decrease in real estate charge-offs and REO expense as a percent of averagereal estate secured receivables in 2005 from the 2004 ratio was primarily due tostrong receivable growth which will not season for a period of time, thecontinuing strong economy and better credit quality of recent originations. Asdiscussed above, the 2005 ratio was not negatively impacted by the increasedfilings associated with the new bankruptcy legislation in the United States dueto the timing of the bankruptcy filings and our charge-off policy for realestate secured receivables. Net charge-offs as a percentage of average consumer receivables decreased forthe full year of 2004 as compared to full year 2003 as the lower delinquencylevels we experienced due to an improving economy had an impact on charge-offs.Average receivable growth also positively impacted the ratios. The decrease inour net charge-off percentage was reduced by the adoption of FFIEC charge-offpolicies for our domestic private label (excluding consumer lending retail salescontracts) and MasterCard/Visa portfolios. Excluding the additional charge-offsresulting from the adoption of these FFIEC policies, net charge-offs for thefull year 2004 decreased 22 basis points compared to 2003. Our real estatesecured portfolio experienced increases in net charge-offs reflecting lowerestimates of net realizable value as a result of process changes in 2004 tobetter estimate property values at the time of foreclosure. The decrease in theauto finance ratio reflects receivable growth with improved credit quality oforiginations, improved collections and better underwriting standards. Thedecrease in the MasterCard/Visa ratio reflects changes in receivable mix andimproved credit quality of originations. The decrease in net charge-offs in thepersonal non-credit card portfolio is a result of improved credit quality andreceivable growth as well as improved economic conditions. 63 HSBC Finance Corporation-------------------------------------------------------------------------------- While net consumer charge-offs as a percentage of average receivables decreasedduring 2004, we experienced an increase in overall net charge-off dollars in2004. This is due to higher delinquencies due to adverse economic conditionswhich existed in 2003 migrating to charge-off in 2004 as well as to higherreceivable levels in 2004. The decrease in real estate charge-offs and REO expense as a percent of averagereal estate secured receivables in 2004 over the 2003 ratio was the result ofthe improved economy, better credit quality of recent originations and fewerbankruptcy filings in 2004. See "Credit Quality Statistics - Managed Basis" for additional informationregarding our managed basis credit quality. OWNED NONPERFORMING ASSETS AT DECEMBER 31, 2005 2004 2003-------------------------------------------------------------------------------------- (IN MILLIONS)Nonaccrual receivables...................................... $3,533 $3,012 $3,144Accruing consumer receivables 90 or more days delinquent.... 621 507 904Renegotiated commercial loans............................... - 2 2 ------ ------ ------Total nonperforming receivables............................. 4,154 3,521 4,050Real estate owned........................................... 510 587 631 ------ ------ ------Total nonperforming assets.................................. $4,664 $4,108 $4,681 ====== ====== ====== The increase in total nonperforming assets is primarily due to the receivablegrowth we have experienced in 2005 as well as the impact of the increasedbankruptcy filings on our secured and personal non-credit card receivableportfolios. Total nonperforming assets at December 31, 2004 decreased due toimproved credit quality and collection efforts as well as the bulk sale ofdomestic private label receivables to HSBC Bank USA in December 2004, partiallyoffset by growth. Consistent with industry practice, accruing consumerreceivables 90 or more days delinquent includes domestic MasterCard/Visareceivables and, for December 31, 2003, our domestic private label credit cardreceivables. CREDIT LOSS RESERVES We maintain credit loss reserves to cover probable lossesof principal, interest and fees, including late, overlimit and annual fees.Credit loss reserves are based on a range of estimates and are intended to beadequate but not excessive. We estimate probable losses for owned consumerreceivables using a roll rate migration analysis that estimates the likelihoodthat a loan will progress through the various stages of delinquency, or buckets,and ultimately charge-off. This analysis considers delinquency status, lossexperience and severity and takes into account whether loans are in bankruptcy,have been restructured or rewritten, or are subject to forbearance, an externaldebt management plan, hardship, modification, extension or deferment. Our creditloss reserves also take into consideration the loss severity expected based onthe underlying collateral, if any, for the loan in the event of default.Delinquency status may be affected by customer account management policies andpractices, such as the restructure of accounts, forbearance agreements, extendedpayment plans, modification arrangements, external debt management programs,loan rewrites and deferments. If customer account management policies, orchanges thereto, shift loans from a "higher" delinquency bucket to a "lower"delinquency bucket, this will be reflected in our roll rate statistics. To theextent that restructured accounts have a greater propensity to roll to higherdelinquency buckets, this will be captured in the roll rates. Since the lossreserve is computed based on the composite of all of these calculations, thisincrease in roll rate will be applied to receivables in all respectivedelinquency buckets, which will increase the overall reserve level. In addition,loss reserves on consumer receivables are maintained to reflect our judgment ofportfolio risk factors that may not be fully reflected in the statistical rollrate calculation. Risk factors considered in establishing loss reserves onconsumer receivables include recent growth, product mix, bankruptcy trends,geographic concentrations, economic conditions, portfolio seasoning, accountmanagement policies and practices, current levels of charge-offs anddelinquencies, changes in laws 64 HSBC Finance Corporation-------------------------------------------------------------------------------- and regulations and other items which can affect consumer payment patterns 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. Loss reserve estimates are reviewed periodically and adjustments arereported in earnings when they become known. As these estimates are influencedby factors outside of our control, such as consumer payment patterns andeconomic conditions, there is uncertainty inherent in these estimates, making itreasonably possible that they could change. The following table sets forth owned basis credit loss reserves for the periodsindicated: AT DECEMBER 31, ------------------------------------------ 2005 2004 2003 2002 2001---------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Owned credit loss reserves........................ $4,521 $3,625 $3,793 $3,333 $2,663Reserves as a percent of receivables.............. 3.23% 3.39% 4.11% 4.04% 3.33%Reserves as a percent of net charge-offs.......... 123.8(2) 89.9(1) 105.7 106.5 110.5Reserves as a percent of nonperforming loans...... 108.8 103.0 93.7 94.5 92.7 --------------- (1) In December 2004, we adopted FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard/Visa portfolios and subsequently sold this domestic private label receivable portfolio. These events had a significant impact on this ratio. Reserves as a percentage of net charge-offs excluding net charge-offs associated with the sold domestic private label portfolio and charge-off relating to the adoption of FFIEC was 109.2% at December 31, 2004. (2) The acquisition of Metris in December 2005 has positively impacted this ratio. Reserves as a percentage of net charge-offs excluding Metris was 118.2 percent. Owned credit loss reserve levels at December 31, 2005, reflect the additionalreserve requirements resulting from higher levels of owned receivables,including lower securitization levels, higher delinquency levels in ourportfolios driven by growth, the impact of Katrina and minimum monthly paymentchanges, additional reserves resulting from the Metris acquisition and thehigher levels of personal bankruptcy filings in both the United States and theU.K., partially offset by improved asset quality. Credit loss reserves atDecember 31, 2005 also reflect the sale of our U.K. credit card business inDecember 2005 which decreased credit loss reserves by $104 million. In 2005, werecorded owned loss provision greater than net charge-offs of $890 million.Owned credit loss reserve levels at December 31, 2004 reflect the sale of ourdomestic private label portfolio (excluding retail sales contracts at ourconsumer lending business) which had decreased credit loss reserves by $505million. Excluding this sale, owned credit loss reserves would have increasedduring 2004 reflecting growth in our loan portfolio partially offset by improvedasset quality. In 2004, we recorded owned loss provision greater than netcharge-offs of $301 million. Excluding the impact of adopting FFIEC charge-offpolicies for owned domestic private label (excluding retail sales contracts atour consumer lending business) and MasterCard/Visa portfolios, we recorded ownedloss provision $421 million greater than net charge-offs in 2004. Beginning in 2004 and continuing in 2005, we have experienced a shift in ourloan portfolio to higher credit quality and lower yielding receivables,particularly real estate secured and auto finance receivables. Reserves as apercentage of receivables at December 31, 2005 and 2004 were lower than atDecember 31, 2003 as a result of portfolio growth and improved credit quality,partially offset in 2005 by the impact of additional credit loss reservesresulting from the impact of Katrina, minimum monthly payment changes andincreased bankruptcy filings. Reserves as a percentage of receivables atDecember 31, 2003 were higher than at December 31, 2002 as a result of the saleof $2.8 billion of higher quality real estate secured loans to HSBC 65 HSBC Finance Corporation-------------------------------------------------------------------------------- Bank USA in December 2003. Had this sale not occurred, reserves as a percentageof receivables at December 2003 would have been lower than 2002 as a result ofimproving credit quality in the latter half of 2003 as delinquency ratesstabilized and charge-off levels began to improve. The trends in the reserveratios for 2003 and 2002 reflect the impact of the weak economy, higherdelinquency levels, and uncertainty as to the ultimate impact the weakenedeconomy would have on delinquency and charge-off levels. Reserves as a percentage of nonperforming loans increased in 2005. Whilenonperforming loans increased in 2005 as discussed above, reserve levels in 2005increased at a more rapid pace due to receivable growth, the additional reserverequirements related to Katrina and impact of increased bankruptcy filings onour secured receivable and personal non-credit card receivable portfolios, whichwill not begin to migrate to charge-off until 2006. Reserves as a percentage ofnonperforming loans increased in 2004 as nonperforming loans declined due toimproved credit quality and the private label receivable sale while loss reservelevels declined at a slower pace due to receivable growth. Reserves as a percentage of net charge-offs also increased in 2005. As discussedabove, the 2005 ratio was significantly impacted by the acquisition of Metrisand the 2004 ratio was significantly impacted by both the sale of our domesticprivate label receivable portfolio (excluding retail sales contracts) inDecember 2004 as well as the adoption of FFEIC charge-off policies for ourdomestic private label (excluding retail sales contracts) and MasterCard/Visaportfolios. Excluding these items, reserves as a percentage of net charge-offsincreased 900 basis points. While both our reserve levels at December 31, 2005and net charge-offs in 2005 were higher than 2004, our reserve levels grew forthe reasons discussed above more rapidly than our net charge-offs. For securitized receivables, we also record a provision for estimated probablelosses that we expect to incur under the recourse provisions. The followingtable sets forth managed credit loss reserves for the periods indicated: AT DECEMBER 31, 2005 2004 2003 2002 2001---------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONSManaged credit loss reserves...................... $4,736 $4,515 $6,167 $5,092 $3,811Reserves as a percent of receivables.............. 3.29% 3.73% 5.20% 4.74% 3.78%Reserves as a percent of net charge-offs.......... 108.6(2) 79.6(1) 117.4 113.8 110.7Reserves as a percent of nonperforming loans...... 108.8 108.4 118.0 112.6 105.0 --------------- (1) In December 2004 we adopted FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard/Visa portfolios and subsequently sold this domestic private label receivable portfolio. These events had a significant impact on this ratio. Reserves as a percentage of net charge-offs excluding net charge-offs associated with the sold domestic private label portfolio and charge-off relating to the adoption of FFIEC policies was 96.0% on a managed basis at December 31, 2004. (2) The acquisition of Metris in December 2005 has positively impacted this ratio. Reserves as a percentage of net charge-offs excluding Metris was 103.9 percent. Managed credit loss reserves at December 31, 2005 also increased as theincreases in our owned credit loss reserves as discussed above were offset bylower reserves on securitized receivables due to run-off and the decision in thethird quarter of 2004 to structure new collateralized funding transactions assecured financings and the December 2004 domestic private label receivable sale.Securitized receivables of $4.1 billion at December 31, 2005 decreased $10.1billion from December 31, 2004. See the "Analysis of Credit Loss Reserves Activity," "Reconciliations to GAAPFinancial Measures" and Note 7, "Credit Loss Reserves," to the accompanyingconsolidated financial statements for additional information regarding our ownedbasis and managed basis loss reserves. CUSTOMER ACCOUNT MANAGEMENT POLICIES AND PRACTICES Our policies and practicesfor the collection of consumer receivables, including our customer accountmanagement policies and practices, permit us to reset the contractualdelinquency status of an account to current, based on indicia or criteria which,in our 66 HSBC Finance Corporation-------------------------------------------------------------------------------- judgment, evidence continued payment probability. Such policies and practicesvary by product and are designed to manage customer relationships, maximizecollection opportunities and avoid foreclosure or repossession if reasonablypossible. If the account subsequently experiences payment defaults, it willagain become contractually delinquent. In the third quarter of 2003, we implemented certain changes to ourrestructuring policies. These changes were intended to eliminate and/orstreamline exception provisions to our existing policies and were generallyeffective for receivables originated or acquired after January 1, 2003.Receivables originated or acquired prior to January 1, 2003 generally are notsubject to the revised restructure and customer account management policies.However, for ease of administration, in the third quarter of 2003, our MortgageServices business elected to adopt uniform policies for all products regardlessof the date an account was originated or acquired. Implementation of the uniformpolicy by Mortgage Services had the effect of only counting restructuresoccurring on or after January 1, 2003 in assessing restructure eligibility forpurposes of the limitation that no account may be restructured more than fourtimes in a rolling sixty-month period. Other business units may also elect toadopt uniform policies. The changes adopted in the third quarter of 2003 havenot had a significant impact on our business model or on our results ofoperations as these changes have generally been phased in as new receivableswere originated or acquired. As discussed in more detail below, we also revisedcertain policies for our domestic private label credit card and MasterCard andVisa portfolios in December 2004. As discussed previously and described more fully in the table below, we adoptedFFIEC account management policies regarding restructuring of past due accountsfor our domestic private label credit card and MasterCard/Visa portfolios inDecember 2004. These changes have not had a significant impact on our businessmodel or on our results of operations. Approximately two-thirds of all restructured receivables are secured products,which in general have less loss severity exposure because of the underlyingcollateral. Credit loss reserves take into account whether loans have beenrestructured, rewritten or are subject to forbearance, an external debtmanagement plan, modification, extension or deferment. Our credit loss reservesalso take into consideration the loss severity expected based on the underlyingcollateral, if any, for the loan. Our restructuring policies and practices vary by product and are described inthe table that follows and reflect the revisions from the adoption of FFIECcharge-off and account management policies for our domestic private label(excluding retail sales contracts at our consumer lending business) andMasterCard/Visa receivables in December 2004. The fact that the restructuringcriteria may be met for a particular account does not require us to restructurethat account, and the extent to which we restructure accounts that are eligibleunder the criteria will vary depending upon our view of prevailing economicconditions and other factors which may change from period to period. Inaddition, for some products, accounts may be restructured without receipt of apayment in certain special circumstances (e.g. upon reaffirmation of a debtowed to us in connection with a Chapter 7 bankruptcy proceeding). We use accountrestructuring as an account and customer management tool in an effort toincrease the value of our account relationships, and accordingly, theapplication of this tool is subject to complexities, variations and changes fromtime to time. These policies and practices are continually under review andassessment to assure that they meet the goals outlined above, and accordingly,we modify or permit exceptions to these general policies and practices from timeto time. In addition, exceptions to these policies and practices may be made inspecific situations in response to legal or regulatory agreements or orders. In the policies summarized below, "hardship restructures" and "workoutrestructures" refer to situations in which the payment and/or interest rate maybe modified on a temporary or permanent basis. In each case, the contractualdelinquency status is reset to current. "External debt management plans" refersto situations in which consumers receive assistance in negotiating or schedulingdebt repayment through public or private agencies. 67 HSBC Finance Corporation-------------------------------------------------------------------------------- RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING POLICIES FOLLOWING CHANGES IMPLEMENTED AND PRACTICES(1),(2),(3) IN THE THIRD QUARTER 2003 AND IN DECEMBER 2004(1),(2),(3)---------------------------------------------------------------------------------------------------------REAL ESTATE SECURED REAL ESTATE SECURED Real Estate - Overall Real Estate - Overall - An account may be restructured if we - Accounts may be restructured upon receipt of two receive two qualifying payments within qualifying payments within the 60 days preceding the the 60 days preceding the restructure; restructure we may restructure accounts in hardship, - Accounts generally are not eligible for restructure disaster or strike situations with one until nine months after origination qualifying payment or no payments - Accounts will be limited to four collection - Accounts that have filed for Chapter 7 restructures in a rolling sixty-month period bankruptcy protection may be - Accounts whose borrowers have filed for Chapter 7 restructured upon receipt of a signed bankruptcy protection may be restructured upon reaffirmation agreement receipt of a signed reaffirmation agreement - Accounts subject to a Chapter 13 plan - Accounts whose borrowers are subject to a Chapter 13 filed with a bankruptcy court generally plan filed with a bankruptcy court generally may be require one qualifying payment to be restructured upon receipt of one qualifying payment restructured - Except for bankruptcy reaffirmation and filed Chapter - Except for bankruptcy reaffirmation and 13 plans, accounts will generally not be filed Chapter 13 plans, agreed automatic restructured more than once in a twelve-month period payment withdrawal or - Accounts whose borrowers agree to pay by automatic hardship/disaster/strike, accounts are withdrawal are generally restructured upon receipt generally limited to one restructure of one qualifying payment after initial every twelve-months authorization for automatic withdrawal(4) - Accounts generally are not eligible for restructure until they are on the books for at least six months Real Estate - Consumer Lending Real Estate - Mortgage Services(5) - Accounts whose borrowers agree to pay by - Accounts will generally not be eligible for automatic withdrawal are generally restructure until nine months after origination and restructured upon receipt of one six months after acquisition qualifying payment after initial authorization for automatic withdrawalAUTO FINANCE AUTO FINANCE - Accounts may be extended if we receive - Accounts may generally be extended upon receipt of one qualifying payment within the 60 two qualifying payments within the 60 days preceding days preceding the extension the extension - Accounts may be extended no more than - Accounts may be extended by no more than three months three months at a time and by no more at a time than three months in any twelve-month - Accounts will be limited to four extensions in a period rolling sixty-month period, but in no case will an - Extensions are limited to six months over account be extended more than a total of six months the contractual life over the life of the account - Accounts that have filed for Chapter 7 - Accounts will be limited to one extension every six bankruptcy protection may be months restructured upon receipt of a signed - Accounts will not be eligible for extension until reaffirmation agreement 68 HSBC Finance Corporation-------------------------------------------------------------------------------- RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING POLICIES FOLLOWING CHANGES IMPLEMENTED AND PRACTICES(1),(2),(3) IN THE THIRD QUARTER 2003 AND IN DECEMBER 2004(1),(2),(3)--------------------------------------------------------------------------------------------------------- - Accounts whose borrowers are subject to a they are on the books for at least six months Chapter 13 plan may be restructured upon - Accounts whose borrowers have filed for Chapter 7 filing of the plan with a bankruptcy bankruptcy protection may be restructured upon court receipt of a signed reaffirmation agreement - Accounts whose borrowers are subject to a Chapter 13 plan may be restructured upon filing of the plan with the bankruptcy court.MASTERCARD AND VISA MASTERCARD AND VISA - Typically, accounts qualify for Accounts originated between January 2003 - December restructuring if we receive two or three 2004 qualifying payments prior to the - Accounts typically qualified for restructuring if we restructure, but accounts in approved received two or three qualifying payments prior to external debt management programs may the restructure, but accounts in approved external generally be restructured upon receipt debt management programs could generally be of one qualifying payment restructured upon receipt of one qualifying payment. - Generally, accounts may be restructured - Generally, accounts could have been restructured once once every six months every six months. Beginning in December 2004, all accounts regardless of origination date - Domestic accounts qualify for restructuring if we receive three consecutive minimum monthly payments or a lump sum equivalent. - Domestic accounts qualify for restructuring if the account has been in existence for a minimum of nine months and the account has not been restructured in the prior twelve months and not more than once in the prior five years. - Domestic accounts entering third party debt counseling programs are limited to one restructure in a five-year period in addition to the general limits of one restructure in a twelve-month period and two restructures in a five-year period.PRIVATE LABEL(6) PRIVATE LABEL(6) Private Label - Overall Private Label - Overall - An account may generally be restructured Prior to December 2004 for accounts originated after if we receive one or more qualifying October 2002 payments, depending upon the merchant. - For certain merchants, receipt of two or three - Restructuring is limited to once every qualifying payments was required, except accounts in six months (or longer, depending upon an approved external debt management program could the merchant) for revolving accounts and be restructured upon receipt of one qualifying once every twelve-months for closed-end payment. accounts 69 HSBC Finance Corporation-------------------------------------------------------------------------------- RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING POLICIES FOLLOWING CHANGES IMPLEMENTED AND PRACTICES(1),(2),(3) IN THE THIRD QUARTER 2003 AND IN DECEMBER 2004(1),(2),(3)--------------------------------------------------------------------------------------------------------- - Accounts must have been on the books for at least nine months to be restructured and a minimum of two qualifying payments were received within the 60 days preceding the restructure. - Accounts were not eligible for subsequent restructure until twelve months after a prior restructure and upon receipt of three qualifying payments within the 90 days preceding the restructure. Beginning in December 2004, all accounts regardless of origination date - Domestic accounts qualify for restructuring if we receive three consecutive minimum monthly payments or a lump sum equivalent. - Domestic accounts qualify for restructuring if the account has been in existence for a minimum of nine months and the account has not been restructured in the prior twelve months and not more than once in the prior five years. - Domestic accounts entering a workout program, including internal and third party debt counseling programs, are limited to one restructure in a five-year period in addition to the general limits of one restructure in a twelve-month period and two restructures in a five-year period. Private Label - Consumer Lending RetailSales Contracts Private Label - Consumer Lending Retail Sales Contracts - Accounts may be restructured if we - Accounts may be restructured upon receipt of two receive one qualifying payment within qualifying payments within the 60 days preceding the the 60 days preceding the restructure; restructure may restructure accounts in a - Accounts will be limited to one restructure every six hardship/disaster/strike situation with months one qualifying payment or no payments - Accounts will be limited to four collection - If an account is never more than 90 days restructures in a rolling sixty-month period delinquent, it may generally be - Accounts will not be eligible for restructure until restructured up to three times per year six months after origination - If an account is ever more than 90 days delinquent, generally it may be restructured with one qualifying payment no more than four times over its life; however, generally the account may thereafter be restructured if two qualifying payments are received - Accounts subject to programs for hardship or strike may require only the receipt of reduced 70 HSBC Finance Corporation-------------------------------------------------------------------------------- RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING POLICIES FOLLOWING CHANGES IMPLEMENTED AND PRACTICES(1),(2),(3) IN THE THIRD QUARTER 2003 AND IN DECEMBER 2004(1),(2),(3)--------------------------------------------------------------------------------------------------------- payments in order to be restructured; disaster may be restructured with no paymentsPERSONAL NON-CREDIT CARD PERSONAL NON-CREDIT CARD - Accounts may be restructured if we - Accounts may be restructured upon receipt of two receive one qualifying payment within qualifying payments within the 60 days preceding the the 60 days preceding the restructure; restructure may restructure accounts in a - Accounts will be limited to one restructure every six hardship/disaster/strike situation with months one qualifying payment or no payments - Accounts will be limited to four collection - If an account is never more than 90 days restructures in a rolling sixty-month period delinquent, it may generally be - Accounts will not be eligible for restructure until restructured up to three times per year six months after origination - If an account is ever more than 90 days delinquent, generally it may be restructured with one qualifying payment no more than four times over its life; however, generally the account may thereafter be restructured if two qualifying payments are received - Accounts subject to programs for hardship or strike may require only the receipt of reduced payments in order to be restructured; disaster may be restructured with no payments --------------- (1) We employ account restructuring and other customer account management policies and practices as flexible customer account management tools as criteria may vary by product line. In addition to variances in criteria by product, criteria may also vary within a product line. Also, we continually review our product lines and assess restructuring criteria and they are subject to modification or exceptions from time to time. Accordingly, the description of our account restructuring policies or practices provided in this table should be taken only as general guidance to the restructuring approach taken within each product line, and not as assurance that accounts not meeting these criteria will never be restructured, that every account meeting these criteria will in fact be restructured or that these criteria will not change or that exceptions will not be made in individual cases. In addition, in an effort to determine optimal customer account management strategies, management may run more conservative tests on some or all accounts in a product line for fixed periods of time in order to evaluate the impact of alternative policies and practices. (2) For our United Kingdom business, all portfolios have a consistent account restructure policy. An account may be restructured if we receive two or more qualifying payments within two calendar months, limited to one restructure every 12 months, with a lifetime limit of three times. In hardship situations an account may be restructured if a customer makes three consecutive qualifying monthly payments within the last three calendar months. Only one hardship restructure is permitted in the life of a loan. There were no changes to the restructure policies of our United Kingdom business in 2005 or 2004. (3) Historically, policy changes are not applied to the entire portfolio on the date of implementation but are applied to new, or recently originated or acquired accounts. However, the policies adopted in the third quarter of 2003 for the mortgage services business and the fourth quarter of 2004 for the domestic private label (excluding retail sales contracts) and MasterCard/Visa credit card portfolios were applied more broadly. The policy changes for the mortgage services business which occurred in the third quarter of 2003, unless otherwise noted, were generally applied to accounts originated or acquired after January 1, 2003 and the historical restructuring policies and practices are effective for all accounts originated or acquired prior to January 1, 2003. Implementation of this uniform policy had the effect of only counting restructures occurring on or after January 1, 2003 in assessing restructure eligibility for the purpose of the limitation that no account may be restructured more than four times in a rolling 60 month period. These policy changes adopted in the third quarter of 2003 did not have a significant impact on our business model or results of operations as the changes are, in effect, phased in as receivables were originated or acquired. For the adoption of FFIEC policies which occurred in the fourth quarter of 2004, the policies were effective immediately for all receivables in the domestic private label credit card and the MasterCard and Visa portfolios. Other business units may also elect to adopt uniform policies in future periods. (4) Our mortgage services business implemented this policy for all accounts effective March 1, 2004. (5) Prior to January 1, 2003, accounts that had made at least six qualifying payments during the life of the loan and that agreed to pay by automatic withdrawal were generally restructured with one qualifying payment. 71 HSBC Finance Corporation-------------------------------------------------------------------------------- (6) For our Canadian business, private label accounts are limited to one restructure every four months and if originated or acquired after January 1, 2003, two qualifying payments must be received, the account must be on the books for at least six months, at least six months must have elapsed since the last restructure, and there may be no more than four restructures in a rolling 60 month period. In addition to our restructuring policies and practices, we employ othercustomer account management techniques, which we typically use on a more limitedbasis, that are similarly designed to manage customer relationships, maximizecollection opportunities and avoid foreclosure or repossession if reasonablypossible. These additional customer account management techniques include, atour discretion, actions such as extended payment arrangements, approved externaldebt management plans, forbearance, modifications, loan rewrites and/ordeferment pending a change in circumstances. We typically use these customeraccount management techniques with individual borrowers in transitionalsituations, usually involving borrower hardship circumstances or temporarysetbacks that are expected to affect the borrower's ability to pay thecontractually specified amount for some period of time. For example, under aforbearance agreement, we may agree not to take certain collection or creditagency reporting actions with respect to missed payments, often in return forthe borrower's agreeing to pay us an additional amount with future requiredpayments. In some cases, these additional customer account management techniquesmay involve us agreeing to lower the contractual payment amount and/or reducethe periodic interest rate. In most cases, the delinquency status of an accountis considered to be current if the borrower immediately begins payment under thenew account terms. When we use a customer account management technique, we maytreat the account as being contractually current and will not reflect it as adelinquent account in our delinquency statistics. However, if the accountsubsequently experiences payment defaults, it will again become contractuallydelinquent. We generally consider loan rewrites to involve an extension of a newloan, and such new loans are not reflected in our delinquency or restructuringstatistics. Our account management actions vary by product and are undercontinual review and assessment to determine that they meet the goals outlinedabove. The tables below summarize approximate restructuring statistics in our managedbasis domestic portfolio. We report our restructuring statistics on a managedbasis only because the receivables that we securitize are subject tounderwriting standards comparable to our owned portfolio, are generally servicedand collected without regard to ownership and result in a similar credit lossexposure for us. As previously reported, in prior periods we used certainassumptions and estimates to compile our restructure statistics. The systemiccounters used to compile the information presented below exclude from thereported statistics loans that have been reported as contractually delinquentbut have been reset to a current status because we have determined that theloans should not have been considered delinquent (e.g., payment applicationprocessing errors). We continue to enhance our ability to capture and segmentrestructure data across all business units. When comparing restructuringstatistics from different periods, the fact that our restructure policies andpractices will change over time, that exceptions are made to those policies andpractices, and that our data capture methodologies have been enhanced, should betaken into account. TOTAL RESTRUCTURED BY RESTRUCTURE PERIOD - DOMESTIC PORTFOLIO(1)(MANAGED BASIS) AT DECEMBER 31, 2005 2004---------------------------------------------------------------------------Never restructured.......................................... 89.5% 86.7%Restructured: Restructured in the last 6 months......................... 4.0 5.1 Restructured in the last 7-12 months...................... 2.4 3.2 Previously restructured beyond 12 months.................. 4.1 5.0 ----- ----- Total ever restructured(2)................................ 10.5 13.3 ----- -----Total....................................................... 100.0% 100.0% ===== ===== 72 HSBC Finance Corporation-------------------------------------------------------------------------------- TOTAL RESTRUCTURED BY PRODUCT - DOMESTIC PORTFOLIO(1)(MANAGED BASIS) AT DECEMBER 31, 2005 2004--------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONSReal estate secured......................................... $ 8,334 10.4% $ 8,572 13.8% Auto finance................................................ 1,688 14.5 1,545 15.2 MasterCard/Visa............................................. 774 3.0 619 3.2 Private label(3)............................................ 26 7.3 21 6.1 Personal non-credit card.................................... 3,369 19.9 3,541 22.4 ------- ---- ------- ----Total(2).................................................... $14,191 10.5% $14,298 13.3% ======= ==== ======= ==== --------------- (1) Excludes foreign businesses, commercial and other. (2) Total including foreign businesses was 10.3 percent at December 31, 2005 and 12.3 percent at December 31, 2004. (3) Only reflects consumer lending retail sales contracts which have historically been classified as private label. All other domestic private label receivables were sold to HSBC Bank USA in December 2004. See "Credit Quality Statistics" for further information regarding owned basisand managed basis delinquency, charge-offs and nonperforming loans. The amount of domestic and foreign managed receivables in forbearance,modification, credit card services approved consumer credit counselingaccommodations, rewrites or other customer account management techniques forwhich we have reset delinquency and that is not included in the restructured ordelinquency statistics was approximately $.4 billion or .3 percent of managedreceivables at December 31, 2005 compared with $.4 billion or .4 percent ofmanaged receivables at December 31, 2004 In addition to the above, we granted an initial 30 or 60 day payment deferral(based on product) to customers living in the Katrina FEMA designated IndividualAssistance disaster areas. This deferral was extended for a period of up to 90days or longer in certain cases based on a customer's specific circumstances,consistent with our natural disaster policies. In certain cases thesearrangements have resulted in a customer's delinquency status being reset by 30days. These extended payment arrangements totaled $1.1 billion or .8 percent ofmanaged receivables at December 31, 2005 and are not reflected as restructuresin the table above or included in the other customer account managementtechniques described in the paragraph above. ADOPTION OF FFIEC CHARGE-OFF AND ACCOUNT MANAGEMENT POLICIES Upon receipt ofregulatory approval for the sale of our domestic private label portfolio(excluding retail sales contracts at our consumer lending business) to HSBC BankUSA in December 2004, we adopted charge-off and account management guidelines inaccordance with the Uniform Retail Credit Classification and Account ManagementPolicy issued by the Federal Financial Institutions Examination Council for ourdomestic private label (excluding retail sales contracts at our consumer lendingbusiness) and our MasterCard and Visa portfolios. The adoption of FFIECcharge-off policies for our domestic private label and MasterCard/Visareceivables resulted in a reduction to our net income in December 2004 ofapproximately $121 million. GEOGRAPHIC CONCENTRATIONS The state of California accounts for 12 percent ofboth our domestic owned and managed portfolios. No other state accounts for morethan 10 percent of either our domestic owned or managed portfolio. Because ofour centralized underwriting, collections and processing functions, we canquickly change our credit standards and intensify collection efforts in specificlocations. We believe this lowers risks resulting from such geographicconcentrations. Our foreign consumer operations located in the United Kingdom and the rest ofEurope accounted for 4 percent of owned consumer receivables and Canadaaccounted for 2 percent of owned consumer receivables at December 31, 2005. 73 HSBC Finance Corporation-------------------------------------------------------------------------------- LIQUIDITY AND CAPITAL RESOURCES-------------------------------------------------------------------------------- While the funding synergies resulting from our acquisition by HSBC have allowedus to reduce our reliance on traditional sources to fund our growth, ourcontinued success and prospects for growth are dependent upon access to theglobal capital markets. Numerous factors, internal and external, may impact ouraccess to and the costs associated with issuing debt in these markets. Thesefactors may include our debt ratings, overall capital markets volatility and theimpact of overall economic conditions on our business. We continue to focus onbalancing our use of affiliate and third-party funding sources to minimizefunding expense while maximizing liquidity. As discussed below, we supplementedunsecured debt issuance during 2005 with proceeds from the continuing sale ofnewly originated domestic private label receivables (excluding retail salescontracts) to HSBC Bank USA following the bulk sale of this portfolio inDecember 2004, debt issued to affiliates, the issuance of Series B preferredstock, the issuance of additional common equity to HINO and the sale of our U.K.credit card business to HBEU in December 2005. Because we are now a subsidiary of HSBC, 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 these tightened credit spreads, we recognized cash funding expense savings ofapproximately $600 million in 2005, $350 million in 2004 and $125 million in2003 compared to the funding costs we would have incurred using average spreadsfrom the first half of 2002. It is anticipated that these tightened creditspreads in combination with the issuance of new HSBC Finance Corporation debtand other funding synergies including asset transfers and external fee savingswill enable HSBC to realize annual cash funding expense savings in excess of $1billion per year as our existing term debt matures which is anticipated to beachieved in 2006. In 2005, the cash funding expense savings realized by HSBCtotaled approximately $865 million. The portion of these savings to be realizedby HSBC Finance Corporation will depend in large part upon the amount and timingof various initiatives between HSBC Finance Corporation and other HSBCsubsidiaries. Amortization of purchase accounting fair value adjustments to ourexternal debt obligations, reduced interest expense by $656 million in 2005,including $1 million relating to Metris, $946 million in 2004 and $773 millionin 2003. 74 HSBC Finance Corporation-------------------------------------------------------------------------------- Debt due to affiliates and other HSBC related funding are summarized in thefollowing table: DECEMBER 31, 2005 2004--------------------------------------------------------------------------- (IN BILLIONS)Debt outstanding to HSBC subsidiaries: Drawings on bank lines in the U.K. and Europe............. $ 4.2 $ 7.5 Term debt................................................. 11.0 6.0 Preferred securities issued by Household Capital Trust VIII to HSBC........................................... .3 .3 ----- ----- Total debt outstanding to HSBC subsidiaries............... 15.5 13.8 ----- -----Debt outstanding to HSBC clients: Euro commercial paper..................................... 3.2 2.6 Term debt................................................. 1.3 .8 ----- ----- Total debt outstanding to HSBC clients.................... 4.5 3.4Series A preferred stock issued to HINO..................... - 1.1(1)Cash received on bulk and subsequent sale of domestic private label credit card receivables to HSBC Bank USA, net (cumulative).......................................... 15.7 12.4Real estate secured receivable activity with HSBC Bank USA: Cash received on sales (cumulative)....................... 3.7 3.7 Direct purchases from correspondents (cumulative)......... 4.2 2.8 Reductions in real estate secured receivables sold to HSBC Bank USA............................................... (3.3) (1.5) ----- -----Total real estate secured receivable activity with HSBC Bank USA....................................................... 4.6 5.0Cash received from sale of U.K. credit card business to HBEU...................................................... 2.6 -Capital contribution by HINO................................ 1.2(2) - ----- -----Total HSBC related funding.................................. $44.1 $35.7 ===== ===== --------------- (1) In December 2005, the $1.1 billion Series A preferred stock plus all accrued and unpaid dividends was exchanged for a like amount of common equity and the Series A preferred stock was retired. We issued 4 shares of common equity to HINO as part of the exchange. (2) This capital contribution was made in connection with our acquisition of Metris. At December 31, 2005, funding from HSBC, including debt issuances to HSBCsubsidiaries and clients, represented 15 percent of our total managed debt andpreferred stock funding. At December 31, 2004, funding from HSBC, including debtissuances to HSBC subsidiaries and clients and preferred stock held by HINO,represented 15 percent of our total managed debt and preferred stock funding. Cash proceeds from the December 2005 sale of our managed basis U.K. credit cardreceivables to HBEU of $2.6 billion in cash were used to partially pay downdrawings on bank lines from HBEU for the U.K. and fund operations. Proceeds fromthe December 2004 domestic private label receivable sale to HSBC Bank USA of$12.4 billion were used to pay down short-term domestic borrowings, includingoutstanding commercial paper balances, and to fund operations. Excess liquidityfrom the sale was used to temporarily fund available for sale investments.Proceeds from the March 2004 real estate secured receivable sale were used topay-down commercial paper balances which had been used as temporary funding inthe first quarter of 2004 and to fund various debt maturities. At December 31, 2005, we had commercial paper back stop credit facility of $2.5billion from HSBC domestically and a revolving credit facility of $5.3 billionfrom HSBC in the U.K. At December 31, 2004, we had commercial paper back stopcredit facility of $2.5 billion from HSBC domestically and a revolving creditfacility of $7.5 billion from HSBC in the U.K. At December 31, 2005, $4.2billion was outstanding under the HBEU lines for the U.K. and no balances wereoutstanding under the domestic lines. At December 31, 2004, $7.5 billion wasoutstanding under HBEU lines for the U.K. and no balances were outstanding underthe 75 HSBC Finance Corporation-------------------------------------------------------------------------------- domestic lines. A $4.0 billion revolving credit facility with HSBC Private Bank(Suisse) SA, which was in place during a portion of 2004 to allow temporaryincreases in commercial paper issuances in anticipation of the sale of theprivate label receivables to HSBC Bank USA, expired on December 30, 2004. We hadderivative contracts with a notional value of $72.2 billion, or approximately 95percent of total derivative contracts, outstanding with HSBC affiliates atDecember 31, 2005. At December 31, 2004, we had derivative contracts with anotional value of $62.6 billion, or approximately 87 percent of total derivativecontracts, outstanding with HSBC affiliates. SECURITIES AND OTHER SHORT-TERM INVESTMENTS Securities totaled $4.1 billion atDecember 31, 2005 and $3.6 billion at December 31, 2004. Securities purchasedunder agreements to resell totaled $78 million at December 31, 2005 and $2.7billion at December 31, 2004. Interest bearing deposits with banks totaled $384million at December 31, 2005 and $603 million at December 31, 2004. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS totaled $11.4 billion at December31, 2005 and $9.0 billion at December 31, 2004. The increase at December 31,2005 was primarily a result of a plan to increase our commercial paper issuancesas a result of lowering the coverage ratio of bank credit facilities tooutstanding commercial paper from 100% to 80%. This plan also requires that thecombination of bank credit facilities and undrawn committed conduit facilitieswill, at all times, exceed 115% of outstanding commercial paper. This plan,which was reviewed with the relevant rating agencies, resulted in an increase inour maximum outstanding commercial paper balance to in excess of $12.0 billion.At December 31, 2004, we were carrying lower levels of commercial paper as theproceeds from the bulk sale of domestic private label receivables to HSBC BankUSA were used to reduce the outstanding balances. Included in this total wasoutstanding Euro commercial paper sold to customers of HSBC of $3.2 billion atDecember 31, 2005 and $2.6 billion at December 31, 2004. LONG TERM DEBT (with original maturities over one year) increased to $105.2billion at December 31, 2005 from $85.4 billion at December 31, 2004. As part ofour overall liquidity management strategy, we continue to extend the maturity ofour liability profile. Significant issuances during 2005 included the following: - $10.5 billion of domestic and foreign medium-term notes - $6.0 billion of foreign currency-denominated bonds (including $227 million which was issued to customers of HSBC) - $1.8 billion of InterNotes(SM) (retail-oriented medium-term notes) - $11.2 billion of global debt - $1.0 billion of junior subordinated notes issued to Household Capital Trust IX. - $9.7 billion of securities backed by real estate secured, auto finance and MasterCard/Visa receivables. For accounting purposes, these transactions were structured as secured financings. Additionally, as part of the Metris acquisition we assumed $4.6 billion ofsecurities backed by MasterCard/ Visa receivables which we restructured to failsale treatment and are now accounted for as secured financings. In January 2006, we redeemed the junior subordinated notes issued to HouseholdCapital Trust VI with an outstanding principal balance of $206 million. InNovember 2005, we issued $1.0 billion of preferred securities of HouseholdCapital Trust IX. The interest rate on these securities is 5.911% from the dateof issuance through November 30, 2015 and is payable semiannually beginning May30, 2006. After November 30, 2015, the rate changes to the three-month LIBORrate, plus 1.926% and is payable quarterly beginning on February 28, 2016. InJune 2005, we redeemed the junior subordinated notes issued to Household CapitalTrust V with an outstanding principal balance of $309 million. PREFERRED SHARES In June 2005, we issued 575,000 shares of Series B PreferredStock for $575 million. Dividends on the Series B Preferred Stock arenon-cumulative and payable quarterly at a rate of 6.36 percent commencingSeptember 15, 2005. The Series B Preferred Stock may be redeemed at our optionafter June 23, 2010. In 2005, we paid dividends totaling $17 million on theSeries B Preferred Stock. 76 HSBC Finance Corporation-------------------------------------------------------------------------------- COMMON EQUITY We issued four shares of common equity to HINO in December 2005 inexchange for the $1.1 billion Series A Preferred Stock plus all accrued andunpaid dividends. Additionally, in connection with our acquisition of Metris,HINO made a capital contribution of $1.2 billion in exchange for one share ofcommon stock. SELECTED CAPITAL RATIOS In managing capital, we develop targets for tangibleshareholder's(s') equity to tangible managed assets ("TETMA"), tangibleshareholder's(s') equity plus owned loss reserves to tangible managed assets("TETMA + Owned Reserves") and tangible common equity to tangible managedassets. These ratio targets are based on discussions with HSBC and ratingagencies, risks inherent in the portfolio, the projected operating environmentand related risks, and any acquisition objectives. Our targets may change fromtime to time to accommodate changes in the operating environment or otherconsiderations such as those listed above. We are committed to maintaining atleast a mid-single "A" rating and as part of that effort will continue to reviewappropriate capital levels with our rating agencies. On January 30, 2006, Moody's Investor Service raised the Senior Debt Rating forHSBC Finance Corporation from A1 to Aa3 with positive outlook. Our short-termrating was also affirmed at Prime-1. Selected capital ratios are summarized in the following table: DECEMBER 31, 2005 2004---------------------------------------------------------------------------TETMA(1),(2)................................................ 7.56% 6.27%TETMA + Owned Reserves(1),(2)............................... 10.55 9.04Tangible common equity to tangible managed assets(1)........ 6.07 4.67Common and preferred equity to owned assets................. 12.43 13.01Excluding HSBC acquisition purchase accounting adjustments: TETMA(1),(2).............................................. 8.52% 7.97% TETMA + Owned Reserves(1),(2)............................. 11.51 10.75 Tangible common equity to tangible managed assets(1)...... 7.02 6.38 --------------- (1) TETMA, TETMA + Owned Reserves and tangible common equity to tangible managed assets represent non-GAAP financial ratios that are used by HSBC Finance Corporation management and applicable rating agencies to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. (2) Beginning in the third quarter of 2005, and with the agreement of applicable rating agencies, we have refined our definition of TETMA and TETMA + Owned Reserves to exclude the Adjustable Conversion-Rate Equity Security Units for all periods subsequent to our acquisition by HSBC as this more accurately reflects the impact of these items on our equity. Prior period amounts have been revised to reflect the current period presentation. HSBC FINANCE CORPORATION. HSBC Finance Corporation is an indirect wholly ownedsubsidiary of HSBC Holdings plc. On March 28, 2003, HSBC acquired HouseholdInternational, Inc. by way of merger in a purchase business combination.Effective January 1, 2004, HSBC transferred its ownership interest in Householdto a wholly owned subsidiary, HSBC North America Holdings Inc., whichsubsequently contributed Household to its wholly owned subsidiary, HSBCInvestments (North America) Inc. ("HINO"). On December 15, 2004, Householdmerged with its wholly owned subsidiary, Household Finance Corporation, withHousehold as the surviving entity. At the time of the merger, Household changedits name to "HSBC Finance Corporation." HSBC Finance Corporation is the parent company that owns the outstanding commonstock of its subsidiaries. Our main source of funds is cash received fromoperations and subsidiaries in the form of dividends. In addition, we receivecash from third parties or affiliates by issuing preferred stock and debt. HSBC Finance Corporation received cash dividends from its subsidiaries of $514million in 2005 and $120 million in 2004. 77 HSBC Finance Corporation-------------------------------------------------------------------------------- In conjunction with the acquisition by HSBC, we issued a series of 6.50 percentcumulative preferred stock in the amount of $1.1 billion ("Series A PreferredStock") to HSBC on March 28, 2003. In September 2004, HNAH issued a new seriesof preferred stock totaling $1.1 billion to HSBC in exchange for our Series APreferred Stock. In October 2004, our immediate parent, HINO, issued a newseries of preferred stock to HNAH in exchange for our Series A Preferred Stock.We paid dividends on our Series A Preferred Stock of $66 million in October 2005and $108 million in October 2004. On December 15, 2005, we issued 4 shares ofcommon stock to HINO in exchange for the $1.1 billion Series A Preferred Stockplus the accrued and unpaid dividends and the Series A Preferred Stock wasretired. In November 2005, we issued $1.0 billion of preferred securities of HouseholdCapital Trust IX. The interest rate on these securities is 5.911% from the dateof issuance through November 30, 2015 and is payable semiannually beginning May30, 2006. After November 30, 2015, the rate changes to the three-month LIBORrate, plus 1.926% and is payable quarterly beginning on February 28, 2016. InJune 2005, we redeemed the junior subordinated notes issued to the HouseholdCapital Trust V with an outstanding principal balance of $309 million. In June 2005, we issued 575,000 shares of Series B Preferred Stock for $575million. Dividends on the Series B Preferred Stock are non-cumulative andpayable quarterly at a rate of 6.36 percent commencing September 15, 2005. TheSeries B Preferred Stock may be redeemed at our option after June 23, 2010. In2005, we paid dividends totaling $17 million on the Series B Preferred Stock. HSBC Finance Corporation has a number of obligations to meet with its availablecash. It must be able to service its debt and meet the capital needs of itssubsidiaries. It also must pay dividends on its preferred stock and may paydividends on its common stock. Dividends of $980 million were paid to HINO, ourimmediate parent company, on our common stock in 2005 and $2.6 billion were paidin 2004. We anticipate paying future dividends to HINO, but will maintain ourcapital at levels necessary to maintain at least a mid-single "A" rating eitherby limiting the dividends to or through capital contributions from our parent. At various times, we will make capital contributions to our subsidiaries tocomply with regulatory guidance, support receivable growth, maintain acceptableinvestment grade ratings at the subsidiary level, or provide funding forlong-term facilities and technology improvements. HSBC Finance Corporation madecapital contributions to certain subsidiaries of $2.2 billion in 2005 and $1.1billion in 2004. SUBSIDIARIES At December 31, 2005, HSBC Finance Corporation had one majorsubsidiary, Household Global Funding ("Global"), and manages all domesticoperations. Prior to December 15, 2004, we had two major subsidiaries: HouseholdFinance Corporation ("HFC"), which managed all domestic operations, and Global.On December 15, 2004, HFC merged with and into Household International whichchanged its name to HSBC Finance Corporation. DOMESTIC OPERATIONS HSBC Finance Corporation's domestic operations are fundedthrough the collection of receivable balances; issuing commercial paper,medium-term debt and long-term debt; securitizing and borrowing under securedfinancing facilities and selling consumer receivables. Domestically, HSBCFinance Corporation markets its commercial paper primarily through an in-housesales force. The vast majority of our domestic medium-term notes and long-termdebt is now marketed through subsidiaries of HSBC. Domestic medium-term notesmay also be marketed through our in-house sales force and investment banks.Long-term debt may also be marketed through unaffiliated investment banks. At December 31, 2005, advances from subsidiaries of HSBC for our domesticoperations totaled $11.0 billion. At December 31, 2004, advances fromsubsidiaries of HSBC for our domestic operations totaled $6.0 billion. Theinterest rates on funding from HSBC subsidiaries are market-based and comparableto those available from unaffiliated parties. Outstanding commercial paper related to our domestic operations totaled $10.9billion at December 31, 2005 and $8.7 billion at December 31, 2004. As discussedabove, the outstanding domestic commercial paper balance increased significantlyin 2005 as a result of the plan to increase our commercial paper issuances as a 78 HSBC Finance Corporation-------------------------------------------------------------------------------- result of lowering the coverage ratio of bank credit facilities to outstandingcommercial paper from 100% to 80%. This plan also requires that the combinationof bank credit facilities and undrawn committed conduit facilities will, at alltimes, exceed 115% of outstanding commercial paper. Following our acquisition by HSBC, we established a new Euro commercial paperprogram, largely targeted towards HSBC clients, which expanded our Europeaninvestor base. Under the Euro commercial paper program, commercial paperdenominated in Euros, British pounds and U.S. dollars is sold to foreigninvestors. Outstanding Euro commercial paper sold to customers of HSBC totaled$3.2 billion at December 31, 2005 and $2.6 billion at December 31, 2004. Weactively manage the level of commercial paper outstanding to ensure availabilityto core investors while maintaining excess capacity within ourinternally-established targets as communicated with the rating agencies. The following table shows various debt issuances by HSBC Finance Corporation andits domestic subsidiaries during 2005 and 2004. 2005 2004---------------------------------------------------------------------------- (IN BILLIONS)Medium term notes, excluding issuances to HSBC customers and subsidiaries of HSBC...................................... $ 9.5 $6.4Medium term notes issued to HSBC customers.................. .2 .3Medium term notes issued to subsidiaries of HSBC............ 5.0 4.6Foreign currency-denominated bonds, excluding issuances to HSBC customers and subsidiaries of HSBC................... 5.8 1.0Junior subordinated notes issued to the Household Capital Trust IX.................................................. 1.0 -Foreign currency-denominated bonds issued to HSBC customers................................................. .2 .2Foreign currency-denominated bonds issued to subsidiaries of HSBC...................................................... - .6Global debt................................................. 11.2 4.5InterNotes(SM) (retail-oriented medium-term notes).......... 1.8 1.4Securities backed by home equity, auto finance and MasterCard/Visa receivables structured as secured financings................................................ 9.7 5.1 Additionally, as part of the Metris acquisition we assumed $4.6 billion ofsecurities backed by MasterCard/ Visa receivables which we restructured to failsale treatment and are now accounted for as secured financings. In order to eliminate future foreign exchange risk, currency swaps were used atthe time of issuance to fix in U.S. dollars substantially allforeign-denominated notes in 2005 and 2004. HSBC Finance Corporation issued securities backed by dedicated receivables of$9.7 billion in 2005 and $5.1 billion in 2004. For accounting purposes, thesetransactions were structured as secured financings, therefore, the receivablesand the related debt remain on our balance sheet. At December 31, 2005,closed-end real estate secured, auto finance and MasterCard/Visa receivablestotaling $21.8 billion secured $15.1 billion of outstanding debt. At December31, 2004, closed-end real estate secured and auto finance receivables totaling$10.3 billion secured $7.3 billion of outstanding debt. HSBC Finance Corporation had committed back-up lines of credit totaling $10.6billion at December 31, 2005 for its domestic operations. Included in theDecember 31, 2005 total are $2.5 billion of revolving credit facilities withHSBC. None of these back-up lines were drawn upon in 2005. The back-up linesexpire on various dates through 2008. The most restrictive financial covenantcontained in the back-up line agreements that could restrict availability is anobligation to maintain minimum shareholder's equity of $10.0 billion which issubstantially below our December 31, 2005 common and preferred shareholder'sequity balance of $19.5 billion. At December 31, 2005, we had facilities with commercial and investment banksunder which our domestic operations may issue securities backed with receivablesup to $15 billion of receivables, including up to 79 HSBC Finance Corporation-------------------------------------------------------------------------------- $12.7 billion of auto finance, MasterCard, Visa, and personal non-credit cardand $2.3 billion of real estate secured receivables. We have increased our totalconduit capacity by $2.2 billion in 2005. Conduit capacity for real estatesecured receivables was decreased $.2 billion and capacity for other productswas increased $2.4 billion. The facilities are renewable at the banks' option.At December 31, 2005, $5.6 billion of auto finance, MasterCard/Visa, personalnon-credit card and real estate secured receivables were used in collateralizedfunding transactions structured either as securitizations or secured financingsunder these funding programs and unsecured debt funding. In addition, we haveavailable a $4 billion single seller mortgage facility (none of which wasoutstanding at December 31, 2005). The amount available under the facilitieswill vary based on the timing and volume of public securitization transactions.Through existing term bank financing and new debt issuances, we believe we willcontinue to have adequate sources of funds. GLOBAL Global includes our foreign subsidiaries in the United Kingdom, the restof Europe and Canada. Global's assets were $10.7 billion at December 31, 2005and $14.3 billion at December 31, 2004. Consolidated shareholder's(s') equityincludes the effect of translating our foreign subsidiaries' assets, liabilitiesand operating results from their local currency into U.S. dollars. Each foreign subsidiary conducts its operations using its local currency. Whileeach foreign subsidiary usually borrows funds in its local currency, both ourUnited Kingdom and Canadian subsidiaries have historically borrowed funds inforeign currencies. This allowed the subsidiaries to achieve a lower cost offunds than that available at that time in their local markets. These borrowingswere converted from foreign currencies to their local currencies using currencyswaps at the time of issuance. UNITED KINGDOM Our United Kingdom operation is funded with HBEU debt andpreviously issued long-term debt. Prior to 2004, at various times we have alsoutilized securitizations of receivables, wholesale deposits, commercial paperand short-term and intermediate term bank lines of credit to fund our U.K.operations. The following table summarizes the funding of our United Kingdomoperation: 2005 2004--------------------------------------------------------------------------- (IN BILLIONS)Due to HSBC affiliates...................................... $4.2 $7.5Long term debt.............................................. .9 1.0 At December 31, 2005, $.9 billion of long term debt was guaranteed by HSBCFinance Corporation. HSBC Finance Corporation receives a fee for providing theguarantee. In 2005 and 2004, our United Kingdom subsidiary primarily receivedits funding directly from HSBC. As previously discussed, in December 2005, our U.K. operations sold its creditcard operations to HBEU for total consideration of $3.0 billion, including $261million in preferred stock of a subsidiary of HBEU, and used the proceeds topartially pay down amounts due to HBEU on bank lines in the U.K. and to pay acash dividend of $489 million to HSBC Finance Corporation. Our U.K. operationsalso provided a dividend to HSBC Finance Corporation of $41 million of thepreferred stock received in the transaction. CANADA Our Canadian operation is funded with commercial paper, intermediate debtand long-term debt. Outstanding commercial paper totaled $442 million atDecember 31, 2005 compared to $248 million at December 31, 2004. Intermediateand long-term debt totaled $2.5 billion at December 31, 2005 compared to $1.9billion at December 31, 2004. At December 31, 2005, $2.9 billion of the Canadiansubsidiary's debt was guaranteed by HSBC Finance Corporation for which itreceives a fee for providing the guarantee. Committed back-up lines of creditfor Canada were approximately $86 million at December 31, 2005. All of theseback-up lines are guaranteed by HSBC Finance Corporation and none were used in2005. In 2005, our Canadian operations paid a dividend of $25 million to HSBCFinance Corporation. 80 HSBC Finance Corporation-------------------------------------------------------------------------------- 2006 FUNDING STRATEGY As discussed previously, the acquisition by HSBC hasimproved our access to the capital markets as well as expanded our access to aworldwide pool of potential investors. Our current estimated domestic fundingneeds and sources for 2006 are summarized in the table that follows. (IN BILLIONS)----------------------------------------------------------------------------FUNDING NEEDS: Net asset growth.......................................... $15 - 25 Commercial paper, term debt and securitization maturities............................................. 30 - 36 Other..................................................... 1 - 3 --------Total funding needs......................................... $46 - 64 ========FUNDING SOURCES: External funding, including commercial paper.............. $45 - 59 HSBC and HSBC subsidiaries................................ 1 - 5 --------Total funding sources....................................... $46 - 64 ======== Commercial paper outstanding in 2006 is expected to be in line with the December31, 2005 balances, except during the first three months of 2006 when commercialpaper balances will be temporarily high due to the seasonal activity of our TFSbusiness. Approximately two-thirds of outstanding commercial paper is expectedto be domestic commercial paper sold both directly and through dealer programs.Euro commercial paper is expected to account for approximately one-third ofoutstanding commercial paper and will be marketed predominately to HSBC clients. Term debt issuances are expected to utilize several ongoing programs to achievethe desired funding. Approximately 70 percent of term debt funding is expectedto be achieved through transactions including U.S. dollar global and Eurotransactions and large medium-term note ("MTN") offerings. Domestic and foreignretail note programs are expected to account for approximately 20 percent ofterm debt issuances. The remaining term debt issuances are expected to consistof smaller domestic and foreign currency MTN offerings. As a result of our decision in 2004 to fund all new collateralized fundingtransactions as secured financings, we anticipate securitization levels willcontinue to decline in 2006. Because existing public MasterCard and Visa creditcard transactions were structured as sales to revolving trusts that requirereplenishments of receivables to support previously issued securities,receivables will continue to be sold to these trusts until the revolving periodsend, the last of which is currently projected to occur in 2008. In addition, wewill continue to replenish at reduced levels, certain non-public personalnon-credit card securities issued to conduits for a period of time in order tomanage liquidity. Since our securitized receivables have varying lives, it willtake time for these receivables to pay-off and the related interest-only stripreceivables to be reduced to zero. The termination of sale treatment on newcollateralized funding activity reduced our reported net income under U.S. GAAP.There was no impact, however, on cash received from operations or on IFRSreported results. Because we believe the market for securities backed byreceivables is a reliable, efficient and cost-effective source of funds, we willcontinue to use secured financings of consumer receivables as a source of ourfunding and liquidity. We anticipate that secured financings in 2006 shouldincrease significantly over the 2005 levels. HSBC received regulatory approval in 2003 to provide the direct funding requiredby our United Kingdom operations. Accordingly, in 2004 we eliminated all back-uplines of credit which had previously supported our United Kingdom subsidiary.All new funding for our United Kingdom subsidiary is now provided directly byHSBC. Our Canadian operation will continue to fund itself independently throughtraditional third-party funding sources such as commercial paper and mediumterm-notes. Funding needs in 2006 are not expected to be significant for Canada. CAPITAL EXPENDITURES We made capital expenditures of $78 million in 2005 and $96million in 2004. 81 HSBC Finance Corporation-------------------------------------------------------------------------------- COMMITMENTS We also enter into commitments to meet the financing needs of ourcustomers. In most cases, we have the ability to reduce or eliminate these openlines of credit. As a result, the amounts below do not necessarily representfuture cash requirements at December 31, 2005: (IN BILLIONS)----------------------------------------------------------------------------Private label, MasterCard and Visa credit cards............. $176.2Other consumer lines of credit.............................. 15.0 ------Open lines of credit(1)..................................... $191.2 ====== --------------- (1) Includes an estimate for acceptance of credit offers mailed to potential customers prior to December 31, 2005. At December 31, 2005, our mortgage services business had commitments withnumerous correspondents to purchase up to $1.6 billion of real estate securedreceivables at fair market value, subject to availability based on underwritingguidelines specified by our mortgage services business and at prices indexed togeneral market rates. These commitments have terms of up to one year and can berenewed upon mutual agreement. CONTRACTUAL CASH OBLIGATIONS The following table summarizes our long-termcontractual cash obligations at December 31, 2005 by period due: 2006 2007 2008 2009 2010 THEREAFTER TOTAL----------------------------------------------------------------------------------------------------------- (IN MILLIONS)PRINCIPAL BALANCE OF DEBT: Time certificates of deposit.... $ - $ 9 $ - $ - $ - $ - $ 9 Due to affiliates............... 5,466 624 - 1,831 1,505 6,108 15,534 Long term debt (including secured financings)........... 19,291 18,805 14,937 11,390 11,357 28,291 104,071 ------- ------- ------- ------- ------- ------- -------- Total debt...................... 24,757 19,438 14,937 13,221 12,862 34,399 119,614 ------- ------- ------- ------- ------- ------- --------OPERATING LEASES: Minimum rental payments......... 197 136 118 96 61 123 731 Minimum sublease income......... 76 28 28 27 16 1 176 ------- ------- ------- ------- ------- ------- -------- Total operating leases.......... 121 108 90 69 45 122 555 ------- ------- ------- ------- ------- ------- --------OBLIGATIONS UNDER MERCHANT AND AFFINITY PROGRAMS............... 127 128 124 124 116 480 1,099NON-QUALIFIED PENSION AND POSTRETIREMENT BENEFIT LIABILITIES(1).................. 24 25 30 27 31 1,102 1,239 ------- ------- ------- ------- ------- ------- --------TOTAL CONTRACTUAL CASH OBLIGATIONS..................... $25,029 $19,699 $15,181 $13,441 $13,054 $36,103 $122,507 ======= ======= ======= ======= ======= ======= ======== --------------- (1) Expected benefit payments calculated include future service component. These cash obligations could be funded primarily through cash collections onreceivables, from the issuance of new unsecured debt or through securedfinancings of receivables. Our receivables and other liquid assets generallyhave shorter lives than the liabilities used to fund them. In January 2006 we entered into a lease for a building in the Village ofMettawa, Illinois. The new facility will consolidate our Prospect Heights, MountProspect and Deerfield offices. Construction of the building will begin in thespring of 2006 with the move planned for first and second quarter 2008. Anestimate of the contractual cash obligation associated with this lease will notbe finalized until later in 2006. Our purchase obligations for goods and services at December 31, 2005 were notsignificant. 82 HSBC Finance Corporation-------------------------------------------------------------------------------- OFF BALANCE SHEET ARRANGEMENTS AND SECURED FINANCINGS-------------------------------------------------------------------------------- SECURITIZATIONS AND SECURED FINANCINGS Securitizations (collateralized fundingtransactions structured to receive sale treatment under Statement of FinancialAccounting Standards No. 140, "Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities, a Replacement of FASBStatement No. 125," ("SFAS No. 140")) and secured financings (collateralizedfunding transactions which do not receive sale treatment under SFAS No. 140) ofconsumer receivables have been a source of funding and liquidity for us.Securitizations and secured financings have been used to limit our reliance onthe unsecured debt markets and often are more cost-effective than alternativefunding sources. In a securitization, a designated pool of non-real estate consumer receivablesis removed from the balance sheet and transferred through a limited purposefinancing subsidiary to an unaffiliated trust. This unaffiliated trust is aqualifying special purpose entity ("QSPE") as defined by SFAS No. 140 and,therefore, is not consolidated. The QSPE funds its receivable purchase throughthe issuance of securities to investors, entitling them to receive specifiedcash flows during the life of the securities. The receivables transferred to theQSPE serve as collateral for the securities. At the time of sale, aninterest-only strip receivable is recorded, representing the present value ofthe cash flows we expect to receive over the life of the securitizedreceivables, net of estimated credit losses and debt service. Under the terms ofthe securitizations, we receive annual servicing fees on the outstanding balanceof the securitized receivables and the rights to future residual cash flows onthe sold receivables after the investors receive their contractual return. Cashflows related to the interest-only strip receivables and servicing thereceivables are collected over the life of the underlying securitizedreceivables. Certain securitization trusts, such as credit cards, are established at fixedlevels and, due to the revolving nature of the underlying receivables, requirethe sale of new receivables into the trust to replace runoff so that theprincipal dollar amount of the investors' interest remains unchanged. We referto such activity as replenishments. Once the revolving period ends, theamortization period begins and the trust distributes principal payments to theinvestors. When loans are securitized in transactions structured as sales, we receive cashproceeds from investors, net of transaction costs and expenses. These proceedsare generally used to re-pay other debt and corporate obligations and to fundnew loans. The investors' shares of finance charges and fees received from thesecuritized loans are collected each month and are primarily used to payinvestors for interest and credit losses and to pay us for servicing fees. Weretain any excess cash flow remaining after such payments are made to investors. Generally, for each securitization and secured financing we utilize creditenhancement to obtain investment grade ratings on the securities issued by thetrust. To ensure that adequate funds are available to pay investors theircontractual return, we may retain various forms of interests in assets securinga funding transaction, whether structured as a securitization or a securedfinancing, such as over-collateralization, subordinated series, residualinterests (in the case of securitizations) in the receivables or we may fundcash accounts. Over-collateralization is created by transferring receivables tothe trust issuing the securities that exceed the balance of the securities to beissued. Subordinated interests provide additional assurance of payment toinvestors holding senior securities. Residual interests are also referred to asinterest-only strip receivables and represent rights to future cash flows fromreceivables in a securitization trust after investors receive their contractualreturn. Cash accounts can be funded by an initial deposit at the time thetransaction is established and/or from interest payments on the receivables thatexceed the investor's contractual return. 83 HSBC Finance Corporation-------------------------------------------------------------------------------- Our retained securitization interests are not in the form of securities and areincluded in receivables on our consolidated balance sheets. These retainedinterests were comprised of the following at December 31, 2005 and 2004: AT DECEMBER 31, --------------- 2005 2004----------------------------------------------------------------------------- (IN MILLIONS)Overcollateralization....................................... $ 295 $ 826Interest-only strip receivables............................. 23 323Cash spread accounts........................................ 150 225Other subordinated interests................................ 2,190 2,809 ------ ------Total retained securitization interests..................... $2,658 $4,183 ====== ====== In a secured financing, a designated pool of receivables are conveyed to awholly owned limited purpose subsidiary which in turn transfers the receivablesto a trust which sells interests to investors. Repayment of the debt issued bythe trust is secured by the receivables transferred. The transactions arestructured as secured financings under SFAS No. 140. Therefore, the receivablesand the underlying debt of the trust remain on our balance sheet. We do notrecognize a gain in a secured financing transaction. Because the receivables andthe debt remain on our balance sheet, revenues and expenses are reportedconsistently with our owned balance sheet portfolio. Using this source offunding results in similar cash flows as issuing debt through alternativefunding sources. Securitizations are treated as secured financings under both IFRS and U.K. GAAP.In order to align our accounting treatment with that of HSBC initially underU.K. GAAP and now under IFRS, we began to structure all new collateralizedfunding transactions as secured financings in the third quarter of 2004.However, because existing public MasterCard and Visa credit card transactionswere structured as sales to revolving trusts that require replenishments ofreceivables to support previously issued securities, receivables will continueto be sold to these trusts and the resulting replenishment gains recorded untilthe revolving periods end, the last of which is currently projected to occur inearly 2008. Private label trusts that publicly issue securities will now bereplenished by HSBC Bank USA as a result of the daily sale of new domesticprivate label credit card originations to HSBC Bank USA. We will continue toreplenish at reduced levels, certain non-public personal non-credit card andMasterCard/ Visa 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. The termination of sale treatment on new collateralized fundingactivity reduced our reported net income under U.S. GAAP. There was no impact,however, on cash received from operations. 84 HSBC Finance Corporation-------------------------------------------------------------------------------- Securitizations and secured financings were as follows: YEAR ENDED DECEMBER 31, --------------------------- 2005 2004 2003----------------------------------------------------------------------------------------- (IN MILLIONS)INITIAL SECURITIZATIONS:Auto finance................................................ $ - $ - $ 1,523MasterCard/Visa............................................. - 550 670Private label............................................... - 190 1,250Personal non-credit card.................................... - - 3,320 ------- ------- -------Total....................................................... $ - $ 740 $ 6,763 ======= ======= =======REPLENISHMENT SECURITIZATIONS:MasterCard/Visa............................................. $ 8,620 $20,378 $23,433Private label............................................... - 9,104 6,767Personal non-credit card.................................... 211 828 675 ------- ------- -------Total....................................................... $ 8,831 $30,310 $30,875 ======= ======= =======SECURED FINANCINGS:Real estate secured......................................... $ 4,516 $ 3,299 $ 3,260Auto finance................................................ 3,418 1,790 -MasterCard/Visa............................................. 1,785 - - ------- ------- -------Total....................................................... $ 9,719 $ 5,089 $ 3,260 ======= ======= ======= Additionally, as part of the Metris acquisition we assumed $4.6 billion ofsecurities backed by MasterCard/Visa receivables which we restructured to failsale treatment and are now accounted for as secured financings. Our securitization levels in 2005 were lower while secured financings werehigher in 2005 reflecting the decision in the third quarter of 2004 to structureall new collateralized funding transactions as secured financings and the use ofadditional sources of liquidity provided by HSBC and its subsidiaries. Outstanding securitized receivables consisted of the following: AT DECEMBER 31, ---------------- 2005 2004------------------------------------------------------------------------------ (IN MILLIONS)Real estate secured......................................... $ - $ 81Auto finance................................................ 1,192 2,679MasterCard/Visa............................................. 1,875 7,583Personal non-credit card.................................... 1,007 3,882 ------ -------Total....................................................... $4,074 $14,225 ====== ======= 85 HSBC Finance Corporation-------------------------------------------------------------------------------- The following table summarizes the expected amortization of our securitizedreceivables at December 31, 2005: 2006 2007 2008 2009 TOTAL-------------------------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured......................................... $ - $ - $ - $- $ -Auto finance................................................ 931 261 - - 1,192MasterCard/Visa............................................. 1,375 167 333 - 1,875Personal non-credit card.................................... 885 122 - - 1,007 ------ ---- ---- -- ------Total....................................................... $3,191 $550 $333 $- $4,074 ====== ==== ==== == ====== At December 31, 2005, the expected weighted-average remaining life of thesetransactions was .76 years. The securities issued in connection with collateralized funding transactions maypay off sooner than originally scheduled if certain events occur. For certainauto transactions, early payoff of securities may occur if establisheddelinquency or loss levels are exceeded or if certain other events occur. Forall other transactions, early payoff of the securities begins if the annualizedportfolio yield drops below a base rate or if certain other events occur. We donot presently believe that any early payoff will take place. If early payoffoccurred, our funding requirements would increase. These additional requirementscould be met through issuance of various types of debt or borrowings underexisting back-up lines of credit. We believe we would continue to have adequatesources of funds if an early payoff event occurred. At December 31, 2005, securitizations structured as sales represented 3 percentand secured financings represented 11 percent of the funding associated with ourmanaged funding portfolio. At December 31, 2004, securitizations structured assales represented 12 percent and secured financings represented 6 percent of thefunding associated with our managed funding portfolio. We continue to believe the market for securities backed by receivables is areliable, efficient and cost-effective source of funds, and we will continue touse secured financings of consumer receivables as a source of our funding andliquidity. However, if the market for securities backed by receivables were tochange, we may be unable to enter into new secured financings or to do so atfavorable pricing levels. Factors affecting our ability to structurecollateralized funding transactions as secured financings or to do so atcost-effective rates include the overall credit quality of our securitizedloans, the stability of the securitization markets, the securitization market'sview of our desirability as an investment, and the legal, regulatory, accountingand tax environments governing collateralized funding transactions. At December 31, 2005, we had domestic facilities with commercial and investmentbanks under which we may use up to $15 billion of our receivables incollateralized funding transactions structured either as securitizations orsecured financings. The facilities are renewable at the banks' option. AtDecember 31, 2005, $5.6 billion of auto finance, MasterCard/Visa, personalnon-credit card and real estate secured receivables were used in collateralizedfunding transactions structured either as securitizations or secured financingsunder these funding programs. In addition, we have available a $4 billion singleseller mortgage facility (none of which was outstanding at December 31, 2005)structured as a secured financing. As a result of the sale of the managed basisU.K. credit card receivables to HBEU as previously discussed, we no longer haveany securitized receivables or conduit lines in the U.K. As previouslydiscussed, beginning in the third quarter of 2004, we decided to fund all newcollateralized funding transactions as secured financings to align ouraccounting treatment with that of HSBC initially under U.K. GAAP and now underIFRS. The amount available under the facilities will vary based on the timingand volume of collateralized funding transactions. Through existing term bankfinancing and new debt issuances, we believe we should continue to have adequatesources of funds, which could be impacted from time to time by volatility in thefinancial markets or if one or more of these facilities were unable to berenewed. 86 HSBC Finance Corporation-------------------------------------------------------------------------------- For additional information related to our securitization activities, includingthe amount of revenues and cash flows resulting from these arrangements, seeNote 8, "Asset Securitizations," to our accompanying consolidated financialstatements. RISK MANAGEMENT-------------------------------------------------------------------------------- Our activities involve analysis, evaluation, acceptance and management of somedegree of risk or combination of risks. Accordingly, we have comprehensive riskmanagement policies to address potential financial risks, which include creditrisk, liquidity risk, market risk (which includes interest rate and foreigncurrency exchange risks), reputational risk and operational risk. Our riskmanagement policies are designed to identify and analyze these risks, to setappropriate limits and controls, and to monitor the risks and limits continuallyby means of reliable and up-to-date administrative and information systems. Wecontinually modify and enhance our risk management policies and systems toreflect changes in markets and products and in best practice risk managementprocesses. Training, individual responsibility and accountability, together witha disciplined, conservative and constructive culture of control, lie at theheart of our management of risk. Our risk management policies are primarilycarried out in accordance with practice and limits set by the HSBC GroupManagement Board. The HSBC Finance Corporation Asset Liability Committee("ALCO") meets regularly to review risks and approve appropriate risk managementstrategies within the limits established by the HSBC Group Management Board.Additionally, our Audit Committee receives regular reports on our liquiditypositions in relation to the established limits. CREDIT RISK MANAGEMENT Credit risk is the risk that financial loss arises fromthe failure of a customer or counterparty to meet its obligations under acontract. Our credit risk arises primarily from lending and treasury activities. We have established detailed policies to address the credit risk that arisesfrom our lending activities. Our credit and portfolio management proceduresfocus on risk-based pricing and effective collection and customer accountmanagement efforts for each loan. Our lending guidelines, which delineate thecredit risk we are willing to take and the related terms, are specific not onlyfor each product, but also take into consideration various other factorsincluding borrower characteristics. We also have specific policies to ensure theestablishment of appropriate credit loss reserves on a timely basis to coverprobable losses of principal, interest and fees. See "Credit Quality" for adetailed description of our policies regarding the establishment of credit lossreserves, our delinquency and charge-off policies and practices and our customeraccount management policies and practices. While we develop our own policies andprocedures for all of our lending activities, they are based on standardsestablished by HSBC and are regularly reviewed and updated both on an HSBCFinance Corporation and HSBC level. Counterparty credit risk is our primary exposure on our interest rate swapportfolio. Counterparty credit risk is the risk that the counterparty to atransaction fails to perform according to the terms of the contract. We controlcounterparty credit risk in derivative instruments through established creditapprovals, risk control limits, collateral, and ongoing monitoring procedures.Counterparty limits have been set and are closely monitored as part of theoverall risk management process and control structure. During the third quarterof 2003 and continuing through 2005, we utilize an affiliate, HSBC Bank USA, asthe primary provider of new domestic derivative products. We have never suffereda loss due to counterparty failure. Currently the majority of our existing derivative contracts are with HSBCsubsidiaries, making them our primary counterparty in derivative transactions.Most swap agreements, both with unaffiliated and affiliated third parties,require that payments be made to, or received from, the counterparty when thefair value of the agreement reaches a certain level. Generally, third-party swapcounterparties provide collateral in the form of cash which is recorded in ourbalance sheet as other assets or derivative related liabilities and totaled $91million at December 31, 2005 and $.4 billion at December 31, 2004. Affiliateswap counterparties provide collateral in the form of securities as required,which are not recorded on our balance sheet. At December 31, 2005, the fairvalue of our agreements with affiliate counterparties was below the $1.2 billionlevel requiring posting of collateral. As such, at December 31, 2005, we werenot holding any swap collateral from HSBC 87 HSBC Finance Corporation-------------------------------------------------------------------------------- affiliates in the form of securities. At December 31, 2004, affiliate swapcounterparties had provided collateral in the form of securities, which were notrecorded on our balance sheet, totaling $2.2 billion. At December 31, 2005, wehad derivative contracts with a notional value of approximately $75.9 billion,including $71.3 billion outstanding with HSBC Bank USA. At December 31, 2004, wehad derivative contracts with a notional value of approximately $71.6 billion,including $61.3 billion outstanding with HSBC Bank USA. See Note 15 to the accompanying consolidated financial statements, "DerivativeFinancial Instruments," for additional information related to interest rate riskmanagement and Note 24, "Fair Value of Financial Instruments," for informationregarding the fair value of certain financial instruments. LIQUIDITY RISK The management of liquidity risk is addressed in HSBC FinanceCorporation's funding management policies and practices. HSBC FinanceCorporation funds itself principally through unsecured term funding in themarkets, through secured financings and securitization transactions and throughborrowings from HSBC and HSBC clients. Generally, the lives of our assets areshorter than the lives of the liabilities used to fund them. This initiallyreduces liquidity risk by ensuring that funds are received prior to liabilitiesbecoming due. Our ability to ensure continuous access to the capital markets and maintain adiversified funding base is important in meeting our funding needs. To managethis liquidity risk, we offer a broad line of debt products designed to meet theneeds of both institutional and retail investors. We maintain investor diversityby placing debt directly with customers, through selected dealer programs and bytargeted issuance of large liquid transactions. Through collateralized fundingtransactions, we are able to access an alternative investor base and furtherdiversify our funding strategies. We also maintain a comprehensive, directmarketing program to ensure our investors receive consistent and timelyinformation regarding our financial performance. The measurement and management of liquidity risk is a primary focus. Threestandard analyses are utilized to accomplish this goal. First, a rolling 60 dayfunding plan is updated daily to quantify near-term needs and develop theappropriate strategies to fund those needs. As part of this process, debtmaturity profiles (daily, monthly, annually) are generated to assist in planningand limiting any potential rollover risk (which is the risk that we will beunable to pay our debt or borrow additional funds as it becomes due). Second,comprehensive plans identifying monthly funding requirements for the next twelvemonths are updated at least weekly and monthly funding plans for the next twoyears are maintained. These plans focus on funding projected asset growth anddrive both the timing and size of debt issuances. These plans are shared on aregular basis with HSBC. And third, a Maximum Cumulative Outflow (MCO) analysisis updated regularly to measure liquidity risk. Cumulative comprehensive cashinflows are subtracted from outflows to generate a net exposure that is trackedboth monthly over the next 12 month period and annually for 5 years. Net outflowlimits are reviewed by HSBC Finance Corporation's ALCO and HSBC. We recognize the importance of being prepared for constrained fundingenvironments. While the potential scenarios driving this analysis have changeddue to our affiliation with HSBC, contingency funding plans are still maintainedas part of the liquidity management process. Alternative funding strategies areupdated regularly for a rolling 12 months and assume limited access to unsecuredfunding and continued access to the collateralized funding markets. Thesealternative strategies are designed to enable us to achieve monthly fundinggoals through controlled growth, sales of receivables and access to committedsources of contingent liquidity including bank lines and undrawn securitizationconduits. Although our overall liquidity situation has improved significantlysince our acquisition by HSBC, the strategies and analyses utilized in the pastto successfully manage liquidity remain in place today. The combination of thisprocess with the funding provided by HSBC subsidiaries and clients should ensureour access to diverse markets, investor bases and adequate funding for theforeseeable future. See "Liquidity and Capital Resources" for further discussion of our liquidityposition. MARKET RISK The objective of our market risk management process is to manage andcontrol market risk exposures in order to optimize return on risk whilemaintaining a market profile as a provider of financial products and services.Market risk is the risk that movements in market risk factors, includinginterest rates and foreign currency exchange rates, will reduce our income orthe value of our portfolios. 88 HSBC Finance Corporation-------------------------------------------------------------------------------- Future net interest income is affected by movements in interest rates. Althoughour main operations are in the U.S., we also have operations in Canada and theU.K. which prepare their financial statements in their local currency.Accordingly, our financial statements are affected by movements in exchangerates between the functional currencies of these subsidiaries and the U.S.dollar. We maintain an overall risk management strategy that uses a variety ofinterest rate and currency derivative financial instruments to mitigate ourexposure to fluctuations caused by changes in interest rates and currencyexchange rates. We manage our exposure to interest rate risk primarily throughthe use of interest rate swaps, but also use forwards, futures, options, andother risk management instruments. We manage our exposure to foreign currencyexchange risk primarily through the use of currency swaps, options and forwards.We do not use leveraged derivative financial instruments for interest rate riskmanagement. Since our acquisition by HSBC, we have not entered into foreignexchange contracts to hedge our investment in foreign subsidiaries. Prior to the acquisition by HSBC, the majority of our fair value and cash flowhedges were effective hedges which qualified for the shortcut method ofaccounting. Under the Financial Accounting Standards Board's interpretations ofSFAS No. 133, the shortcut method of accounting was no longer allowed forinterest rate swaps which were outstanding at the time of our acquisition byHSBC. As a result of the acquisition, we were required to reestablish andformally document the hedging relationship associated with all of our fair valueand cash flow hedging instruments and assess the effectiveness of each hedgingrelationship, both at the date of the acquisition and on an ongoing basis. As aresult of deficiencies in our contemporaneous hedge documentation at the time ofacquisition, we lost the ability to apply hedge accounting to our entire cashflow and fair value hedging portfolio that existed at the time of acquisition byHSBC. Substantially all derivative financial instruments entered into subsequentto the acquisition qualify as effective hedges under SFAS No. 133 and beginningin 2005 are being accounted for under the long-haul method of accounting. Interest rate risk is defined as the impact of changes in market interest rateson our earnings. We use simulation models to measure the impact of changes ininterest rates on net interest income. The key assumptions used in these modelsinclude expected loan payoff rates, loan volumes and pricing, cash flows fromderivative financial instruments and changes in market conditions. Theseassumptions are based on our best estimates of actual conditions. The modelscannot precisely predict the actual impact of changes in interest rates on ourearnings because these assumptions are highly uncertain. At December 31, 2005,our interest rate risk levels were below those allowed by our existing policy. We generally fund our assets with liabilities that have similar interest ratefeatures, or are combined at issuance with derivatives to produce liabilitieswith repricing features similar to the assets. This initially reduces interestrate risk. Over time, however, customer demand for our receivable productsshifts between fixed rate and floating rate products, based on market conditionsand preferences. These shifts in loan products produce different interest raterisk exposures. We use derivative financial instruments, principally interestrate swaps, to manage these exposures. Interest rate futures, interest rateforwards and purchased options are also used on a limited basis to reduceinterest rate risk. We monitor the impact that an immediate hypothetical increase or decrease ininterest rates of 25 basis points applied at the beginning of each quarter overa 12 month period would have on our net interest income assuming a growingbalance sheet and the current interest rate risk profile. The following tablesummarizes such estimated impact: AT DECEMBER 31, ------------- 2005 2004--------------------------------------------------------------------------- (IN MILLIONS)Decrease in net interest income following a hypothetical 25 basis points rise in interest rates applied at the beginning of each quarter over the next 12 months......... $213 $176Increase in net interest income following a hypothetical 25 basis points fall in interest rates applied at the beginning of each quarter over the next 12 months......... $120 $169 89 HSBC Finance Corporation-------------------------------------------------------------------------------- These estimates include both the net interest income impact of the derivativepositions we have entered into which are considered to be effective hedges underSFAS No. 133 and the impact of economic hedges of certain underlying debtinstruments which do not qualify for hedge accounting as previously discussed,as if they were effective hedges under SFAS No. 133. These estimates also assumewe would not take any corrective actions in response to interest rate movementsand, therefore, exceed what most likely would occur if rates were to change bythe amount indicated. As part of our overall risk management strategy to reduce earnings volatility,in 2005 a significant number of our pay fixed/receive variable interest rateswaps which had not previously qualified for hedge accounting under SFAS No.133, have been designated as effective hedges using the long-haul method ofaccounting, and certain other interest rate swaps were terminated. This willsignificantly reduce the volatility of the mark-to-market on the previouslynon-qualifying derivatives which have been designated as effective hedges goingforward, but will result in the recording of ineffectiveness under the long-haulmethod of accounting under SFAS No. 133. In order to further reduce earningsvolatility that would otherwise result from changes in interest rates, wecontinue to evaluate the steps required to regain hedge accounting treatmentunder SFAS No. 133 for the remaining swaps which do not currently qualify forhedge accounting. These derivatives remain economic hedges of the underlyingdebt instruments. We will continue to manage our total interest rate risk on abasis consistent with the risk management process employed since theacquisition. HSBC Group also has certain limits and benchmarks that serve as guidelines indetermining the appropriate levels of interest rate risk. One such limit isexpressed in terms of the Present Value of a Basis Point ("PVBP"), whichreflects the change in value of the balance sheet for a one basis point movementin all interest rates. Our PVBP limit as of December 31, 2005 was $2 million,which includes the risk associated with hedging instruments. Thus, for a onebasis point change in interest rates, the policy dictates that the value of thebalance sheet shall not increase or decrease by more than $2 million. As ofDecember 31, 2005, we had a PVBP position of less than $1 million reflecting theimpact of a one basis point increase in interest rates. While the total PVBPposition will not change as a result of the loss of hedge accounting followingour acquisition by HSBC, the following table shows the components of PVBP: 2005 2004--------------------------------------------------------------------------- (IN MILLIONS)Risk related to our portfolio of ineffective hedges......... $(1.4) $(2.7)Risk for all other remaining assets and liabilities......... 2.3 1.9 ----- -----Total PVBP risk............................................. $ .9 $ .8 ===== ===== Foreign currency exchange risk refers to the potential changes in current andfuture earnings or capital arising from movements in foreign exchange rates. Weenter into foreign exchange rate forward contracts and currency swaps tominimize currency risk associated with changes in the value offoreign-denominated liabilities. Currency swaps convert principal and interestpayments on debt issued from one currency to another. For example, we may issueEuro-denominated debt and then execute a currency swap to convert the obligationto U.S. dollars. Prior to the acquisition, we had periodically entered intoforeign exchange contracts to hedge portions of our investments in our UnitedKingdom and Canada subsidiaries. We estimate that a 10 percent adverse change inthe British pound/U.S. dollar and Canadian dollar/U.S. dollar exchange ratewould result in a decrease in common shareholder's(s') equity of $162 million atDecember 31, 2005 and $188 million at December 31, 2004 and would not have amaterial impact on net income. We have issued debt in a variety of currencies and simultaneously executedcurrency swaps to hedge the future interest and principal payments. As a resultof the loss of hedge accounting on currency swaps outstanding at the time of ouracquisition, the recognition of the change in the currency risk on these swapsis recorded differently than the corresponding risk on the underlying foreigndenominated debt. Currency risk on the swap is now recognized immediately on thenet present value of all future swap payments. On the corresponding debt,currency risk is recognized on the principal outstanding which is converted atthe period 90 HSBC Finance Corporation-------------------------------------------------------------------------------- end spot translation rate and on the interest accrual which is converted at theaverage spot rate for the reporting period. OPERATIONAL RISK Operational risk is the risk of loss arising through fraud,unauthorized activities, error, omission, inefficiency, systems failure or fromexternal events. It is inherent in every business organization and covers a widespectrum of issues. We manage this risk through a controls-based environment inwhich processes are documented, authorization is independent and transactionsare reconciled and monitored. This is supported by an independent program ofperiodic reviews undertaken by Internal Audit. We also monitor externaloperations risk events which take place to ensure that we remain in line withbest practice and take account of lessons learned from publicized operationalfailures within the financial services industry. We also maintain and testemergency policies and procedures to support operations and our personnel in theevent of disasters. REPUTATIONAL RISK The safeguarding of our reputation is of paramount importanceto our continued prosperity and is the responsibility of every member of ourstaff. Reputational risk can arise from social, ethical or environmental issues,or as a consequence of operations risk events. Our good reputation depends uponthe way in which we conduct our business, but can also be affected by the way inwhich customers, to whom we provide financial services, conduct themselves. Reputational risk is considered and assessed by the HSBC Group Management Board,our Board of Directors and senior management during the establishment ofstandards for all major aspects of business and the formulation of policy. Thesepolicies, which are an integral part of the internal control systems, arecommunicated through manuals and statements of policy, internal communicationand training. The policies set out operational procedures in all areas ofreputational risk, including money laundering deterrence, environmental impact,anti-corruption measures and employee relations. We have established a strong internal control structure to minimize the risk ofoperational and financial failure and to ensure that a full appraisal ofreputational risk is made before strategic decisions are taken. The HSBCinternal audit function monitors compliance with our policies and standards. 91 This information is provided by RNS The company news service from the London Stock Exchange