HSBC Holdings Regulatory News (HSBA)

6 Mar 2006 11:01

HSBC Holdings PLC06 March 2006 HSBC Finance Corporation-------------------------------------------------------------------------------- ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.-------------------------------------------------------------------------------- Information required by this Item is included in sections of Item 7.Management's Discussion and Analysis of Financial Condition and Results ofOperations on the following pages: "Liquidity and Capital Resources", pages74-82, "Off Balance Sheet Arrangements and Secured Financings", pages 83-87 and"Risk Management", pages 87-91. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.-------------------------------------------------------------------------------- Our 2005 Financial Statements meet the requirements of Regulation S-X. The 2005Financial Statements and supplementary financial information specified by Item302 of Regulation S-K are set forth below. 119 HSBC Finance Corporation-------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and ShareholderHSBC Finance Corporation: We have audited the accompanying consolidated balance sheets of HSBC FinanceCorporation (a Delaware corporation), an indirect wholly-owned subsidiary ofHSBC Holdings plc, and subsidiaries as of December 31, 2005 (successor basis)and December 31, 2004 (successor basis) and the related consolidated statementsof income, changes in shareholder's(s') equity, and cash flows for each of theyears in the two-year period ended December 31, 2005 (successor basis), and forthe periods January 1, 2003 through March 28, 2003 (predecessor basis) and March29, 2003 through December 31, 2003 (successor basis). These consolidatedfinancial statements are the responsibility of HSBC Finance Corporation'smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits. We conducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we planand perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes consideration ofinternal control over financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but not for the purpose ofexpressing an opinion on the effectiveness of HSBC Finance Corporation'sinternal control over financial reporting. Accordingly, we express no suchopinion. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion. In our opinion, the aforementioned consolidated financial statements presentfairly, in all material respects, the financial position of HSBC FinanceCorporation and subsidiaries as of December 31, 2005 (successor basis) andDecember 31, 2004 (successor basis), and the results of their operations andtheir cash flows for each of the years in the two-year period ended December 31,2005 (successor basis) and for the period March 29, 2003 through December 31,2003 (successor basis), in conformity with U.S. generally accepted accountingprinciples. Further, in our opinion, the aforementioned consolidated financialstatements present fairly, in all material respects, the results of operationsand cash flows of HSBC Finance Corporation and subsidiaries for the periodJanuary 1, 2003 through March 28, 2003 (predecessor basis), in conformity withU.S. generally accepted accounting principles. As discussed in Note 3 to the consolidated financial statements, effective March28, 2003, HSBC Holdings plc acquired all of the outstanding stock of HouseholdInternational, Inc. (now HSBC Finance Corporation) in a business combinationaccounted for as a purchase. As a result of the acquisition, the consolidatedfinancial information for the period after the acquisition is presented on adifferent cost basis than that for the periods before the acquisition and,therefore, is not comparable. /s/ KPMG LLPChicago, IllinoisMarch 6, 2006 120 HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003---------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (IN MILLIONS)Finance and other interest income....... $13,216 $10,945 $7,773 $2,469Interest expense: HSBC affiliates....................... 713 343 73 - Non-affiliates........................ 4,119 2,800 1,958 897 ------- ------- ------ ------NET INTEREST INCOME..................... 8,384 7,802 5,742 1,572Provision for credit losses............. 4,543 4,334 2,991 976 ------- ------- ------ ------NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES......................... 3,841 3,468 2,751 596 ------- ------- ------ ------Other revenues: Securitization related revenue........ 211 1,008 1,027 434 Insurance revenue..................... 918 839 575 171 Investment income..................... 134 137 116 80 Derivative income..................... 249 511 284 2 Fee income............................ 1,568 1,091 784 280 Taxpayer financial services revenue... 277 217 4 181 Gain on bulk sale of private label receivables........................ - 663 - - Gain on receivable sales to HSBC affiliates......................... 413 39 16 - Servicing fees from HSBC affiliates... 409 24 - Other income.......................... 652 544 301 64 ------- ------- ------ ------TOTAL OTHER REVENUES.................... 4,831 5,073 3,107 1,212 ------- ------- ------ ------Costs and expenses: Salaries and employee benefits........ 2,072 1,886 1,507 491 Sales incentives...................... 397 363 226 37 Occupancy and equipment expenses...... 334 323 302 98 Other marketing expenses.............. 731 636 409 139 Other servicing and administrative expenses........................... 785 868 835 314 Support services from HSBC affiliates......................... 889 750 - - Amortization of intangibles........... 345 363 246 12 Policyholders' benefits............... 456 412 286 91 HSBC acquisition related costs incurred by HSBC Finance Corporation........................ - - - 198 ------- ------- ------ ------TOTAL COSTS AND EXPENSES................ 6,009 5,601 3,811 1,380 ------- ------- ------ ------Income before income tax expense........ 2,663 2,940 2,047 428Income tax expense...................... 891 1,000 690 182 ------- ------- ------ ------NET INCOME.............................. $ 1,772 $ 1,940 $1,357 $ 246 ======= ======= ====== ====== The accompanying notes are an integral part of the consolidated financialstatements. 121 HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET YEAR ENDED DECEMBER 31, 2005 2004--------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (IN MILLIONS, EXCEPT SHARE DATA)ASSETSCash........................................................ $ 903 $ 392Interest bearing deposits with banks........................ 384 603Securities purchased under agreements to resell............. 78 2,651Securities.................................................. 4,051 3,645Receivables, net............................................ 136,989 104,815Intangible assets, net...................................... 2,480 2,705Goodwill.................................................... 7,003 6,856Properties and equipment, net............................... 458 487Real estate owned........................................... 510 587Derivative financial assets................................. 234 4,049Other assets................................................ 3,579 3,400 -------- --------TOTAL ASSETS................................................ $156,669 $130,190 ======== ========LIABILITIESDebt: Deposits.................................................. $ 37 $ 47 Commercial paper, bank and other borrowings............... 11,417 9,013 Due to affiliates......................................... 15,534 13,789 Long term debt (with original maturities over one year)... 105,163 85,378 -------- --------Total debt.................................................. 132,151 108,227 -------- --------Insurance policy and claim reserves......................... 1,291 1,303Derivative related liabilities.............................. 383 432Other liabilities........................................... 3,365 3,287 -------- --------TOTAL LIABILITIES........................................... 137,190 113,249 -------- --------SHAREHOLDER'S(S') EQUITYRedeemable preferred stock, 1,501,100 shares authorized at December 31, 2005 and 1,100 shares authorized at December 31, 2004: Series A, $0.01 par value, 1,100 shares issued at December 31, 2004, held by HSBC Investments (North America) Inc. ........................................ - 1,100 Series B, $0.01 par value, 575,000 shares issued....... 575 -Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized; 55 and 50 shares issued at December 31, 2005 and 2004, respectively.......................................... - - Additional paid-in capital............................. 17,145 14,627 Retained earnings...................................... 1,280 571 Accumulated other comprehensive income................. 479 643 -------- --------TOTAL COMMON SHAREHOLDER'S EQUITY........................... 18,904 15,841 -------- --------TOTAL LIABILITIES AND SHAREHOLDER'S(S') EQUITY.............. $156,669 $130,190 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 122 HSBC Finance Corporation--------------------------------------------------------------------------------CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003------------------------------------------------------------------------------------------------------------------------ (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (IN MILLIONS)PREFERRED STOCK Balance at beginning of period............................. $ 1,100 $ 1,100 $ 1,100 $ 1,193 Reclassification of preferred stock issuance costs......... - - - 21 Issuance of Series B preferred stock....................... 575 - - - Redemption of preferred stock.............................. - - - (114) Exchange of Series A preferred stock for common stock...... (1,100) - - - ------- ------- ------- ------- Balance at end of period................................... $ 575 $ 1,100 $ 1,100 $ 1,100 ======= ======= ======= =======COMMON SHAREHOLDER'S(S') EQUITY COMMON STOCK Balance at beginning of period........................... $ - $ - $ - $ 552 Issuance of common stock in exchange for Series A Preferred Stock........................................ - - - - Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - - (552) ------- ------- ------- ------- Balance at end of period................................. $ - $ - $ - $ - ------- ------- ------- ------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period........................... $14,627 $14,645 $14,661 $ 1,911 Premium on sale of U.K. credit card business to affiliate.............................................. 182 - - - Issuance of common stock in exchange for Series A preferred stock........................................ 1,112 - - - Capital contribution from parent company................. 1,200 - - - Return of capital to HSBC................................ (19) (31) (41) - Employee benefit plans, including transfers and other.... 59 13 25 10 Reclassification of preferred stock issuance costs....... - - - (21) Issuance costs of Series B preferred stock............... (16) - - - Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - - 12,761 ------- ------- ------- ------- Balance at end of period................................. $17,145 $14,627 $14,645 $14,661 ------- ------- ------- ------- RETAINED EARNINGS Balance at beginning of period........................... 571 1,303 $ - $ 9,885 Net income............................................... 1,772 1,940 1,357 246 Dividends: Preferred stock........................................ (83) (72) (54) (22) Common stock........................................... (980) (2,600) - (412) Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - - (9,697) ------- ------- ------- ------- Balance at end of period................................. $ 1,280 $ 571 $ 1,303 $ - ------- ------- ------- ------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period........................... $ 643 $ 443 $ - $ (695) Net change in unrealized gains (losses) on: Derivatives classified as cash flow hedges........... 141 130 (11) 101 Securities available for sale and interest-only strip receivables......................................... (56) (114) 168 (25) Minimum pension liability.............................. 4 (4) - - Foreign currency translation adjustment................ (253) 188 286 (24) ------- ------- ------- ------- Other comprehensive income, net of tax................... (164) 200 443 52 Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - - 643 ------- ------- ------- ------- Balance at end of period................................. $ 479 $ 643 $ 443 $ - ------- ------- ------- ------- COMMON STOCK IN TREASURY Balance at beginning of period........................... - - - $(2,431) Exercise of stock options................................ - - - 12 Issuance of common stock for employee benefit plans...... - - - 12 Purchase of treasury stock............................... - - - (164) Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - - 2,571 ------- ------- ------- ------- Balance at end of period................................. - - - -TOTAL COMMON SHAREHOLDER'S(S') EQUITY....................... $18,904 $15,841 $16,391 $14,661 ======= ======= ======= =======COMPREHENSIVE INCOMENet income.................................................. $ 1,772 $ 1,940 $ 1,357 $ 246Other comprehensive (loss) income........................... (164) 200 443 52 ------- ------- ------- -------COMPREHENSIVE INCOME........................................ $ 1,608 $ 2,140 $ 1,800 $ 298 ======= ======= ======= ======= The accompanying notes are an integral part of the consolidated financialstatements. 123 HSBC Finance Corporation--------------------------------------------------------------------------------CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY (CONTINUED) MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28,SHARES OUTSTANDING 2005 2004 2003 2003------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (PREDECESSOR)PREFERRED STOCK Balance at beginning of period................. 1,100 1,100 1,100 2,448,279 Redemption of preferred stock.................. - - (1,348,279) Conversion of preferred stock to right to receive cash................................. - - - (1,100,000) Issuance of preferred stock.................... 575 - - 1,100 Conversion of Series A preferred stock to common stock................................. (1,100) - - - ------ ----- ----- ------------ Balance at end of period....................... 575 1,100 1,100 1,100 ====== ===== ===== ============COMMON STOCK ISSUED Balance at beginning of period............... 50 50 50 551,811,025 Exercise of stock options.................... - - - 3,557 Cancellation of common stock................. - - - (551,814,582) Issuance of common stock to parent........... 5 - - 50 ------ ----- ----- ------------ Balance at end of period..................... 55 50 50 50 ------ ----- ----- ------------ IN TREASURY Balance at beginning of period............... - - - (77,197,686) Exercise of stock options.................... - - - 435,530 Issuance of common stock for employee benefit plans...................................... - - - 1,464,984 Purchase of treasury stock................... - - - (2,861,400) Issuance of common stock for restricted stock rights which vested upon change in control.................................... - - - 2,342,890 Cancellation of common stock................. - - - 75,815,682 ------ ----- ----- ------------ Balance at end of period..................... - - - - ------ ----- ----- ------------NET COMMON STOCK OUTSTANDING..................... 55 50 50 50 ====== ===== ===== ============ The accompanying notes are an integral part of the consolidated financialstatements. 124 HSBC Finance Corporation--------------------------------------------------------------------------------CONSOLIDATED STATEMENT OF CASH FLOWS CASH FLOWS FROM OPERATING ACTIVITIESNet income.................................................. $ 1,772 $ 1,940 $ 1,357 $ 246Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for credit losses................................ 4,543 4,334 2,991 976 Gain on bulk sale of private label receivables............. - (663) - - Gain on receivable sales to HSBC affiliates................ (413) (39) (16) - Insurance policy and claim reserves........................ (222) (170) (196) 47 Depreciation and amortization.............................. 457 483 344 53 Deferred income tax (benefit) provision.................... (366) 348 (83) 90 Net change in other assets................................. 326 (696) 842 (593) Net change in other liabilities............................ 393 23 (735) 526 Other, net................................................. (762) 521 (108) 78 -------- -------- -------- -------Net cash provided by (used in) operating activities......... 5,728 6,081 4,396 1,423 -------- -------- -------- -------CASH FLOWS FROM INVESTING ACTIVITIESSecurities: Purchased.................................................. (852) (1,363) (4,750) (1,047) Matured.................................................... 646 1,375 3,403 584 Sold....................................................... 429 854 687 768Net change in short-term securities available for sale...... (472) 5,372 (1,832) (391)Net change in securities purchased under agreements to resell..................................................... 2,573 (2,651) - -Net change in interest bearing deposits with banks.......... 187 466 (795) 16Receivables: Originations, net of collections........................... (56,617) (33,021) (16,630) (2,144) Purchases and related premiums............................. (1,053) (608) (2,473) (129) Initial securitizations.................................... - 740 5,568 1,195 Sales to affiliates........................................ 23,106 14,279 2,844 - Net change in interest-only strip receivables.............. 253 466 400 30Cash received in sale of U.K. credit card business.......... 2,627 - - -Net cash paid for acquisition of Metris..................... (1,572) - - -Properties and equipment: Purchases.................................................. (78) (96) (94) (21) Sales...................................................... 7 4 6 - -------- -------- -------- -------Net cash provided by (used in) investing activities......... (30,816) (14,183) (13,666) (1,139) -------- -------- -------- -------CASH FLOWS FROM FINANCING ACTIVITIESDebt: Net change in short-term debt and deposits................. 2,383 (180) 3,284 (514) Net change in time certificates............................ (2) (161) (708) 150 Net change in due to affiliates............................ 2,435 5,716 7,023 - Long term debt issued...................................... 40,214 19,916 15,559 4,361 Long term debt retired..................................... (20,967) (14,628) (15,789) (4,030) Issuance of company obligated mandatorily redeemable preferred securities of subsidiary trusts to HSBC........ 1,031 - 275 - Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts................ (309) - (275) -Insurance: Policyholders' benefits paid............................... (250) (194) (121) (36) Cash received from policyholders........................... 380 265 127 33Capital contribution from parent............................ 1,200Shareholder's(s') dividends................................. (1,063) (2,708) (293) (141)Issuance of preferred stock................................. 559 - - -Redemption of preferred stock............................... - - - (114)Purchase of treasury stock.................................. - - - (164)Issuance of common stock for employee benefit plans......... - - - 62 -------- -------- -------- -------Net cash provided by (used in) financing activities......... 25,611 8,026 9,082 (393) -------- -------- -------- -------Effect of exchange rate changes on cash..................... (12) 5 (23) (15) -------- -------- -------- -------Net change in cash.......................................... 511 (71) (211) (124)Cash at beginning of period................................. 392 463 674 798 -------- -------- -------- -------CASH AT END OF PERIOD....................................... $ 903 $ 392 $ 463 $ 674 ======== ======== ======== =======SUPPLEMENTAL CASH FLOW INFORMATION:Interest paid............................................... $ 5,233 $ 3,468 $ 2,582 $ 897Income taxes paid........................................... 1,119 842 600 40 -------- -------- -------- -------SUPPLEMENTAL NONCASH FINANCING AND CAPITAL ACTIVITIES:Push-down of purchase price by HSBC......................... $ - $ - $ - $14,661Affiliate preferred stock received in sale of U.K. credit card business.............................................. 261 - - -Exchange of preferred for common stock...................... 1,112 - - 1,100 ======== ======== ======== ======= The accompanying notes are an integral part of the consolidated financialstatements. 125 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION-------------------------------------------------------------------------------- HSBC Finance Corporation (formerly Household International, Inc.) and itssubsidiaries were acquired by a wholly owned subsidiary of HSBC Holdings plc("HSBC") on March 28, 2003 in a purchase business combination recorded under the"push-down" method of accounting, which resulted in a new basis of accountingfor the "successor" period beginning March 29, 2003. Information relating to all"predecessor" periods prior to the acquisition is presented using the historicalbasis of accounting. HSBC Finance Corporation and subsidiaries, is an indirect wholly ownedsubsidiary of HSBC North America Holdings Inc. ("HNAH"), which is an indirectwholly-owned subsidiary of HSBC. HSBC Finance Corporation provides middle-marketconsumers with several types of loan products in the United States, the UnitedKingdom, Canada, the Republic of Ireland, the Czech Republic, Slovakia andHungary. HSBC Finance Corporation may also be referred to in these notes to theconsolidated financial statements as "we," "us" or "our." Our lending productsinclude real estate secured loans, auto finance loans, MasterCard* and Visa*credit card loans, private label credit card loans, including retail salescontracts, and personal non-credit card loans. We also initiate tax refundanticipation loans in the United States and offer credit and specialty insurancein the United States, the United Kingdom and Canada. We have three reportablesegments: Consumer, Credit Card Services, and International. Our Consumersegment consists of our branch-based consumer lending, mortgage services, retailservices, and auto finance businesses. Our Credit Card Services segment consistsof our domestic MasterCard and Visa credit card business. Our Internationalsegment consists of our foreign operations in the United Kingdom ("U.K."), theRepublic of Ireland, Slovakia, the Czech Republic, Hungary and Canada. During 2004, Household International, Inc. ("Household") rebranded the majorityof its U.S. and Canadian businesses to the HSBC brand. Businesses previouslyoperating under the Household name are now called HSBC. Our consumer lendingbusiness retained the HFC and Beneficial brands in the United States,accompanied by the HSBC Group's endorsement signature, "Member HSBC Group." Thesingle brand has allowed HSBC in North America to better align its businesses,provided a stronger platform to service customers and advanced growth. The HSBCbrand also positions us to expand the products and services offered to ourcustomers. As part of this initiative, Household changed its name to HSBCFinance Corporation in December 2004. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-------------------------------------------------------------------------------- BASIS OF PRESENTATION The consolidated financial statements include the accountsof HSBC Finance Corporation and all subsidiaries including all variable interestentities in which we are the primary beneficiary as defined by FinancialAccounting Standards Board Interpretation No. 46 (Revised). Unaffiliated truststo which we have transferred securitized receivables which are qualifyingspecial purpose entities ("QSPEs") as defined by Statement of FinancialAccounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicingof Financial Assets and Extinguishments of Liabilities," are not consolidated.All significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the amounts reported in the financialstatements and accompanying notes. Actual results could differ from thoseestimates. Certain reclassifications have been made to prior year amounts toconform to the current period presentation. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL Securities purchased underagreements to resell are treated as collateralized financing transactions andare carried at the amounts at which the securities were acquired plus accruedinterest. Interest income earned on these securities is included in net interestincome. --------------- * MasterCard is a registered trademark of MasterCard International, Incorporated and VISA is a registered trademark of VISA USA, Inc. 126 INVESTMENT SECURITIES We maintain investment portfolios (comprised primarily ofdebt securities and money market funds) in both our noninsurance and insuranceoperations. Our entire investment securities portfolio was classified asavailable-for-sale at December 31, 2005 and 2004. Available-for-sale investmentsare intended to be invested for an indefinite period but may be sold in responseto events we expect to occur in the foreseeable future. These investments arecarried at fair value. Unrealized holding gains and losses on available-for-saleinvestments are recorded as adjustments to common shareholder's equity inaccumulated other comprehensive income, net of income taxes. Any decline in thefair value of investments which is deemed to be other than temporary is chargedagainst current earnings. Cost of investment securities sold is determined using the specificidentification method. Interest income earned on the noninsurance investmentportfolio is classified in the statements of income in net interest income.Realized gains and losses from the investment portfolio and investment incomefrom the insurance portfolio are recorded in investment income. Accruedinvestment income is classified with investment securities. RECEIVABLES Finance receivables are carried at amortized cost which representsthe principal amount outstanding, net of any unearned income, charge-offs,unamortized deferred fees and costs on originated loans, purchase accountingfair value adjustments and premiums or discounts on purchased loans. Financereceivables are further reduced by credit loss reserves and unearned creditinsurance premiums and claims reserves applicable to credit risks on ourconsumer receivables. Receivables held for sale are carried at the lower ofaggregate cost or market value and remain presented as receivables in theconsolidated balance sheet. Finance income is recognized using the effectiveyield method. Premiums and discounts, including purchase accounting adjustmentson receivables, are recognized as adjustments to the yield of the relatedreceivables. Origination fees, which include points on real estate securedloans, are deferred and generally amortized to finance income over the estimatedlife of the related receivables, except to the extent they offset directlyrelated lending costs. Net deferred origination costs (fees), excludingMasterCard and Visa, totaled $26 million at December 31, 2005 and ($43) millionat December 31, 2004. MasterCard and Visa annual fees are netted with directlending costs, deferred, and amortized on a straight-line basis over one year.Deferred MasterCard and Visa annual fees, net of direct lending costs related tothese receivables, totaled $191 million at December 31, 2005 and $107 million atDecember 31, 2004. Beginning in 2005, for loans acquired within the scope of Statement of Position03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer"("SOP 03-3"), the difference between the estimated future cash flows on theloans accrued and the purchase price for the loans is recognized into incomeover the life of the acquired loans on a level yield basis. Credit loss reservesare not recorded at the time of acquisition for these loans in accordance withSOP 03-3. Credit loss reserves are only recorded if there is a deterioration incredit quality subsequent to the acquisition date. Insurance reserves and unearned premiums applicable to credit risks on consumerreceivables are treated as a reduction of receivables in the balance sheet,since payments on such policies generally are used to reduce outstandingreceivables. PROVISION AND CREDIT LOSS RESERVES Provision for credit losses on ownedreceivables is made in an amount sufficient to maintain credit loss reserves ata level considered adequate, but not excessive, to cover probable losses ofprincipal, interest and fees, including late, overlimit and annual fees, in theexisting owned portfolio. We estimate probable losses for owned consumerreceivables using a roll rate migration analysis that estimates the likelihoodthat a loan will progress through the various stages of delinquency, or buckets,and ultimately charge off. This analysis considers delinquency status, lossexperience and severity and takes into account whether loans are in bankruptcy,have been restructured, rewritten or are subject to forbearance, an externaldebt management plan, hardship, modification, extension or deferment. Our creditloss reserves also take into consideration the loss severity expected based onthe underlying collateral, if any, for the loan in the event of default.Delinquency status may be affected by customer account management policies andpractices, such as the restructure of accounts, forbearance agreements, extendedpayment plans, modification arrangements, loan rewrites and deferments. Whencustomer account management policies, or changes thereto, shift loans from a"higher" delinquency bucket to a "lower" delinquency bucket, this will bereflected in our roll rate 127 statistics. To the extent that restructured accounts have a greater propensityto roll to higher delinquency buckets, this will be captured in the roll rates.Since the loss reserve is computed based on the composite of all thesecalculations, this increase in roll rate will be applied to receivables in allrespective buckets, which will increase the overall reserve level. In addition,loss reserves on consumer receivables are maintained to reflect our judgment ofportfolio risk factors which 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 and current levels of charge-offs anddelinquencies. For commercial loans, probable losses are calculated usingestimates of amounts and timing of future cash flows expected to be received onloans. While our credit loss reserves are available to absorb losses in the entireportfolio, we specifically consider the credit quality and other risk factorsfor each of our products. We recognize the different inherent losscharacteristics in each of our products as well as customer account managementpolicies and practices and risk management/collection practices. Charge-offpolicies are also considered when establishing loss reserve requirements toensure appropriate allowances exist for products with longer charge-off periods.We also consider key ratios such as reserves to nonperforming loans and reservesas a percentage of net charge-offs in developing our loss reserve estimate. Lossreserve estimates are reviewed periodically and adjustments are reported inearnings when they become known. As these estimates are influenced by factorsoutside our control, such as consumer payment patterns and economic conditions,there is uncertainty inherent in these estimates, making it reasonably possiblethat they could change. CHARGE-OFF AND NONACCRUAL POLICIES AND PRACTICES Our consumer charge-off andnonaccrual policies vary by product and are summarized below: PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1)-------------------------------------------------------------------------------------------------------Real estate Secured(2,4) Carrying values in excess of net Interest income accruals are realizable value are charged-off suspended when principal or interest at or before the time foreclosure payments are more than three months is completed or when settlement contractually past due and resumed is reached with the borrower. If when the receivable becomes less foreclosure is not pursued, and than three months contractually past there is no reasonable due. expectation for recovery (insurance claim, title claim, pre-discharge bankrupt account), generally the account will be charged-off by the end of the month in which the account becomes nine months contractually delinquent.Auto finance(4, 6) Carrying values in excess of net Interest income accruals are realizable value are charged off suspended and the portion of at the earlier of the following: previously accrued interest expected - the collateral has been to be uncollectible is written off repossessed and sold, when principal payments are more - the collateral has been in our than two months contractually past possession for more than 90 due and resumed when the receivable days, or becomes less than two months - the loan becomes 150 days contractually past due. contractually delinquent. 128 PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1)-------------------------------------------------------------------------------------------------------MasterCard and Visa(5) Generally charged-off by the end Interest generally accrues until of the month in which the account charge-off. becomes six months contractually delinquent. Private label(3, 5) Subsequent to the adoption of Interest generally accrues until FFIEC policies in December 2004, charge-off, except for retail sales domestic receivables (excluding contracts at our consumer lending retail sales contracts at our business. Interest income accruals consumer lending business) are for retail sales contracts are charged-off by the end of the suspended when principal or interest month in which the account payments are more than three months becomes six months contractually contractually delinquent. After delinquent. Our domestic private suspension, interest income is label receivable portfolio generally recorded as collected. (excluding retail sales contracts at our consumer lending business) was sold to HSBC Bank USA on December 29, 2004. Prior to December 2004, receivables were generally charged-off the month following the month in which the account became nine months contractually delinquent. Beginning in the fourth quarter of 2002, receivables originated through new domestic merchant relationships were charged-off by the end of the month in which the account became six months contractually delinquent. Retail sales contracts at our consumer lending business generally charge-off the month following the month in which the account becomes nine months contractually delinquent and no payment received in six months, but in no event to exceed 12 months contractually delinquent. 129 PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1)-------------------------------------------------------------------------------------------------------Personal non-credit card(3) Generally charged-off the month Interest income accruals are following the month in which the suspended when principal or interest account becomes nine months payments are more than three months contractually delinquent and no contractually delinquent. For PHLs, payment received in six months, interest income accruals resume if but in no event to exceed 12 the receivable becomes less than months contractually delinquent three months contractually past due. (except in our United Kingdom For all other personal non- credit business which may be longer). card receivables for which income accruals are suspended, interest income is generally recorded as collected. --------------- (1) For our United Kingdom business, interest income accruals are suspended when principal or interest payments are more than three months contractually delinquent. (2) For our United Kingdom business, real estate secured carrying values in excess of net realizable value are charged-off at time of sale. (3) For our Canada business, the private label and personal non-credit card charge-off policy prior to December 2004 required a charge-off of an account where no payment was received in six months, but in no event was an account to exceed 18 months contractually delinquent. In December 2004, the policy was revised to charge-off accounts when no payment is received in six months but in no event is an account to exceed 12 months contractually delinquent. This policy change was not part of the adoption of FFIEC policies discussed in Note 4 and its impact was not material to our net income. (4) In November 2003, the FASB issued FASB Staff Position Number 144-1, "Determination of Cost Basis for Foreclosed Assets under FASB Statement No. 15, and the Measurement of Cumulative Losses Previously Recognized Under Paragraph 37 of FASB Statement No. 144" ("FSP 144-1"). Under FSP 144-1, sales commissions related to the sale of foreclosed assets are recognized as a charge-off through the provision for credit losses. Previously, we had recognized sales commission expense as a component of other servicing and administrative expenses in our statements of income. We adopted FSP 144-1 in November 2003. The adoption had no significant impact on our net income. (5) For our United Kingdom business, prior to the sale of our U.K. credit card business in December 2005, delinquent MasterCard/Visa accounts were charged-off the month following the month in which the account becomes six months contractually delinquent. Delinquent private label receivables are charged-off the month following the month in which the account becomes nine months contractually delinquent. (6) For our Canada business, the interest income accruals on auto loans are suspended and the portion of previously accrued interest expected to be uncollectible is written off when principal payments are more than three months contractually past due and resumed when the receivables become less than three months contractually past due. In December 2004, upon receipt of regulatory approval for the sale of ourdomestic private label portfolio (excluding retail sales contracts at ourconsumer lending business) to HSBC Bank USA, National Association ("HSBC BankUSA"), we adopted charge-off and account management policies in accordance withthe Uniform Retail Credit Classification and Account Management Policy issued bythe Federal Financial Institutions Examination Council ("FFIEC") for ourdomestic private label (excluding retail sales contracts at our consumer lendingbusiness) and MasterCard/Visa portfolios. See Note 4, "Sale of Domestic PrivateLabel Receivable Portfolio and Adoption of FFIEC Policies." Charge-off involving a bankruptcy for our domestic private label (excludingretail sales contracts at our consumer lending business) and MasterCard and Visareceivables subsequent to the adoption of FFIEC charge-off policies in December2004 occurs by the end of the month 60 days after notification or 180 daysdelinquent, whichever is sooner. For domestic auto finance receivables, bankruptaccounts are charged off no later than the end of the month in which the loanbecomes 210 days contractually delinquent. Charge-off involving a bankruptcy forour real estate secured and personal non-credit card receivables are consistentwith the credit charge-off policy for these products. Prior to December 2004,charge-offs involving a bankruptcy for our domestic private label (excludingretail sales contracts at our consumer lending business) receivables occurred bythe end of the month 90 days after notification. Our domestic private labelreceivable portfolio (excluding retail sales contracts at our consumer lendingbusiness) was sold to HSBC Bank USA on December 29, 2004. RECEIVABLES SOLD AND SERVICED WITH LIMITED RECOURSE AND SECURITIZATION RELATEDREVENUE Certain auto finance, MasterCard and Visa, private label and personalnon-credit card receivables have been securitized 130 and sold to investors with limited recourse. We have retained the servicingrights to these receivables. Recourse is limited to our rights to future cashflow and any subordinated interest that we may retain. Upon sale, thesereceivables are removed from the balance sheet and a gain on sale is recognizedfor the difference between the carrying value of the receivables and theadjusted sales proceeds. The adjusted sales proceeds include cash received andthe present value estimate of future cash flows to be received over the lives ofthe sold receivables. Future cash flows are based on estimates of prepayments,the impact of interest rate movements on yields of receivables and securitiesissued, delinquency of receivables sold, servicing fees and other factors. Theresulting gain is also adjusted by a provision for estimated probable lossesunder the recourse provisions. This provision and the related reserve forreceivables serviced with limited recourse are established at the time of saleto cover all probable credit losses over-the-life of the receivables sold basedon historical experience and estimates of expected future performance. Themethodologies vary depending upon the type of receivable sold, using eitherhistorical monthly net charge-off rates applied to the expected balances to bereceived over the remaining life of the receivable or a historical static poolanalysis. The reserves are reviewed periodically by evaluating the estimatedfuture cash flows of each securitized pool to ensure that there is sufficientremaining cash flow to cover estimated future credit losses. Any changes to theestimates for the reserve for receivables serviced with limited recourse aremade in the period they become known. Gains on sale net of recourse provisions,servicing income and excess spread relating to securitized receivables arereported in the accompanying consolidated statements of income as securitizationrevenue. In connection with these transactions, we record an interest-only stripreceivable, representing our contractual right to receive interest and othercash flows from our securitization trusts. Our interest-only strip receivablesare reported at fair value using discounted cash flow estimates as a separatecomponent of receivables net of our estimate of probable losses under therecourse provisions. Cash flow estimates include estimates of prepayments, theimpact of interest rate movements on yields of receivables and securitiesissued, delinquency of receivables sold, servicing fees and estimated probablelosses under the recourse provisions. Unrealized gains and losses are recordedas adjustments to common shareholder's equity in accumulated other comprehensiveincome, net of income taxes. Our interest-only strip receivables are reviewedfor impairment quarterly or earlier if events indicate that the carrying valuemay not be recovered. Any decline in the fair value of the interest-only stripreceivable which is deemed to be other than temporary is charged against currentearnings. We have also, in certain cases, retained other subordinated interests in thesesecuritizations. Neither the interest-only strip receivables nor the othersubordinated interests are in the form of securities. In order to align our accounting treatment with that of HSBC initially underU.K. GAAP and now under International Financial Reporting Standards ("IFRS"),starting in the third quarter of 2004 we began to structure all newcollateralized funding transactions as secured financings. However, becauseexisting public MasterCard and Visa credit card transactions were structured assales to revolving trusts that require replenishments to support previouslyissued securities, receivables will continue to be sold to these trusts untilthe revolving periods end, the last of which is currently projected to occur in2008. Private label trusts that publicly issued securities are now replenishedby HSBC Bank USA as a result of the daily sale of new domestic private labelcredit card originations to HSBC Bank USA. We will continue to replenish atreduced levels certain non-public personal non-credit card securities issued toconduits and record the resulting replenishment gains for a period of time inorder to manage liquidity. Since our securitized receivables have varying lives,it will take a period of time for these receivables to pay-off and the relatedinterest only strip receivables to be reduced to zero. PROPERTIES AND EQUIPMENT, NET Properties and equipment are recorded at cost, netof accumulated depreciation and amortization. As a result of our acquisition byHSBC, the amortized cost of our properties and equipment was adjusted to fairmarket value and accumulated depreciation and amortization on a "predecessor"basis was eliminated at the time of the acquisition. For financial reportingpurposes, depreciation is provided on a straight-line basis over the estimateduseful lives of the assets which generally range from 3 to 40 years. Leaseholdimprovements are amortized over the lesser of the economic useful life of theimprovement or the term of the lease. Maintenance and repairs are expensed asincurred. 131 REPOSSESSED COLLATERAL Real estate owned is valued at the lower of cost or fairvalue less estimated costs to sell. These values are periodically reviewed andreduced, if necessary. Costs of holding real estate and related gains and losseson disposition are credited or charged to operations as incurred as a componentof operating expense. Repossessed vehicles, net of loss reserves whenapplicable, are recorded at the lower of the estimated fair market value or theoutstanding receivable balance. INSURANCE Insurance revenues on monthly premium insurance policies arerecognized when billed. Insurance revenues on the remaining insurance contractsare recorded as unearned premiums and recognized into income based on the natureand terms of the underlying contracts. Liabilities for credit insurance policiesare based upon estimated settlement amounts for both reported and incurred butnot yet reported losses. Liabilities for future benefits on annuity contractsand specialty and corporate owned life insurance products are based on actuarialassumptions as to investment yields, mortality and withdrawals. INTANGIBLE ASSETS Intangible assets consist of purchased credit cardrelationships and related programs, retail services merchant relationships,other loan related relationships, trade names, technology, customer lists andother contracts. The trade names are not subject to amortization, as we believethey have indefinite lives. The remaining intangible assets are being amortizedover their estimated useful lives either on a straight-line basis or inproportion to the underlying revenues generated. These useful lives range from 5years for retail services merchant relationships to approximately 10 years forcertain loan related relationships. Intangible assets are reviewed forimpairment using discounted cash flows annually, or earlier if events indicatethat the carrying amounts may not be recoverable. We consider significant andlong-term changes in industry and economic conditions to be our primaryindicator of potential impairment. Impairment charges, when required, arecalculated using discounted cash flows. GOODWILL Goodwill represents the purchase price over the fair value ofidentifiable assets acquired less liabilities assumed from businesscombinations. Goodwill is not amortized, but is reviewed for impairment annuallyusing discounted cash flows but impairment may be reviewed earlier ifcircumstances indicate that the carrying amount may not be recoverable. Weconsider significant and long-term changes in industry and economic conditionsto be our primary indicator of potential impairment. TREASURY STOCK Prior to the acquisition by HSBC, repurchases of treasury stockwere accounted for using the cost method with common stock in treasuryclassified in the balance sheet as a reduction of common shareholder's equity.Treasury stock was reissued at average cost. DERIVATIVE FINANCIAL INSTRUMENTS All derivatives are recognized on the balancesheet at their fair value. At the inception of the hedging relationship, wedesignate the derivative as a fair value hedge, a cash flow hedge, a hedge of anet investment in a foreign operation, or a non-hedging derivative. Fair valuehedges include hedges of the fair value of a recognized asset or liability andcertain foreign currency hedges. Cash flow hedges include hedges of thevariability of cash flows to be received or paid related to a recognized assetor liability and certain foreign currency hedges. Changes in the fair value ofderivatives designated as fair value hedges, along with the change in fair valueon the hedged asset or liability that is attributable to the hedged risk, arerecorded in current period earnings. Changes in the fair value of derivatives designated as cash flow hedges, to theextent effective as a hedge, are recorded in accumulated other comprehensiveincome and reclassified into earnings in the period during which the hedged itemaffects earnings. Changes in the fair value of derivatives used to hedge our netinvestment in foreign subsidiaries, to the extent effective as a hedge, arerecorded in common shareholder's(s') equity as a component of the cumulativetranslation adjustment account within accumulated other comprehensive income.Changes in the fair value of derivative instruments not designated as hedginginstruments and ineffective portions of changes in the fair value of hedginginstruments are recognized in other revenue as derivative income in the currentperiod. For derivative instruments designated as hedges, we formally document allrelationships between hedging instruments and hedged items. This documentationincludes our risk management objective and strategy for undertaking varioushedge transactions, as well as how hedge effectiveness and ineffectiveness willbe measured. This process includes linking derivatives to specific assets andliabilities on the balance sheet. We 132 also formally assess, both at the hedge's inception and on a quarterly basis,whether the derivatives that are used in hedging transactions are highlyeffective in offsetting changes in fair values or cash flows of hedged items.This assessment is conducted using statistical regression analysis. For interestrate swaps which meet the shortcut method criteria under SFAS No. 133, noongoing assessment is required. When as a result of the quarterly assessment, itis determined that a derivative has ceased to be a highly effective hedge, wediscontinue hedge accounting as of the beginning of the quarter in which suchdetermination was made. When hedge accounting is discontinued because it is determined that thederivative no longer qualifies as an effective hedge, the derivative willcontinue to be carried on the balance sheet at its fair value, with changes inits fair value recognized in current period earnings. For fair value hedges, theformerly hedged asset or liability will no longer be adjusted for changes infair value and any previously recorded adjustments to the carrying value of thehedged asset or liability will be amortized in the same manner that the hedgeditem affects income. For cash flow hedges, amounts previously recorded inaccumulated other comprehensive income will be reclassified into income in thesame manner that the hedged item affects income. If the hedging instrument is terminated early, the derivative is removed fromthe balance sheet. Accounting for the adjustments to the hedged asset orliability or adjustments to accumulated other comprehensive income are the sameas described above when a derivative no longer qualifies as an effective hedge. If the hedged asset or liability is sold or extinguished, the derivative willcontinue to be carried on the balance sheet at its fair value, with changes inits fair value recognized in current period earnings. The hedged item, includingpreviously recorded mark-to-market adjustments, is derecognized immediately as acomponent of the gain or loss upon disposition. FOREIGN CURRENCY TRANSLATION We have foreign subsidiaries located in the UnitedKingdom and Canada. The functional currency for each foreign subsidiary is itslocal currency. Assets and liabilities of these subsidiaries are translated atthe rate of exchange in effect on the balance sheet date. Translationadjustments resulting from this process are accumulated in commonshareholder's(s') equity as a component of accumulated other comprehensiveincome. Income and expenses are translated at the average rate of exchangeprevailing during the year. Prior to our acquisition by HSBC, we periodically entered into forward exchangecontracts and foreign currency options to hedge our investment in foreignsubsidiaries. After-tax gains and losses on contracts to hedge foreign currencyfluctuations are accumulated in common shareholder's equity as a component ofaccumulated other comprehensive income. Effects of foreign currency translationin the statements of cash flows are offset against the cumulative foreigncurrency adjustment, except for the impact on cash. Foreign currency transactiongains and losses are included in income as they occur. STOCK-BASED COMPENSATION In 2002, we adopted the fair value method of accountingfor our stock option and employee stock purchase plans. We elected to recognizestock compensation cost prospectively for all new awards granted under thoseplans beginning January 1, 2002 as provided under SFAS No. 148, "Accounting forStock-Based Compensation - Transition and Disclosure (an amendment of FASBStatement No. 123") ("SFAS No. 148"). The fair value of these awards grantedbeginning in 2002 is recognized as expense over the vesting period, generallyeither three or four years. As option expense is recognized over the vestingperiod of the awards, compensation expense included in the determination of netincome for the period January 1, 2003 through March 28, 2003 does not reflectthe expense which would have been recognized if the fair value method had beenapplied to all awards since the original effective date of SFAS No. 123. Becauseoptions granted prior to November 2002 vested upon completion of our acquisitionby HSBC on March 29, 2003, all of our stock options are now accounted for usingthe fair value method. In 2004, we began to consider forfeitures for all stockawards granted subsequent to March 28, 2003 as part of our estimate ofcompensation expense rather than adjust compensation expense as forfeituresoccur. The cumulative impact of the change was not material. Compensation expense relating to restricted stock rights ("RSRs") is based uponthe market value of the RSRs on the date of grant and is charged to earningsover the vesting period of the RSRs, generally three or five years. 133 The following table illustrates the effect on net income if the fair valuemethod had been applied to all outstanding and unvested awards in the periodprior to the acquisition: JANUARY 1 THROUGH MARCH 28, 2003---------------------------------------------------------------------------- (PREDECESSOR) (IN MILLIONS)Net income, as reported..................................... $246 Add stock-based employee compensation expense included in reported net income, net of tax: Stock option and employee stock purchase plans............ 7 Restricted stock rights................................... 11 Deduct stock-based employee compensation expense determined under the fair value method, net of tax: Stock option and employee stock purchase plans............ (53) Restricted stock rights................................... (45) ----Pro forma net income........................................ $166 ==== INCOME TAXES HSBC Finance Corporation is included in HNAH's consolidated Federalincome tax return and in various state income tax returns. In addition, HSBCFinance Corporation files some unconsolidated state tax returns. Deferred taxassets and liabilities are determined based on differences between financialreporting and tax bases of assets and liabilities and are measured using theenacted tax rates and laws that will be in effect. Investment tax creditsgenerated by leveraged leases are accounted for using the deferral method.Changes in estimates of the basis in our assets and liabilities or otherestimates recorded at the date of our acquisition by HSBC are adjusted againstgoodwill. TRANSACTIONS WITH RELATED PARTIES In the normal course of business, we enterinto transactions with HSBC and its subsidiaries. These transactions includefunding arrangements, purchases and sales of receivables, servicingarrangements, information technology services, item processing and statementprocessing services, banking and other miscellaneous services. NEW ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued FASB StatementNo. 123 (Revised), "Share-Based Payment," ("SFAS No. 123R"). SFAS No. 123Rrequires public entities to measure the cost of stock-based compensation basedon the grant date fair value of the award as well as other additional disclosurerequirements. On March 28, 2005, the Securities and Exchange Commission issuedStaff Accounting Bulletin No. 107 which amended the compliance date to allowpublic companies to comply with the provisions of SFAS No. 123R at the beginningof their next fiscal year that begins after June 15, 2005, instead of the nextreporting period as originally required by SFAS No. 123R. Because we currentlyapply the fair value method of accounting for all equity based awards, theadoption of SFAS 123R will not have a significant effect on the results of ouroperations or cash flows. In May 2005, the FASB issued FASB Statement No. 154, "Accounting Changes andError Corrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3"("SFAS No. 154") which requires companies to apply voluntary changes inaccounting principles retrospectively whenever it is practicable. Theretrospective application requirement replaces APB 20's requirement to recognizemost voluntary changes in accounting principle by including the cumulativeeffect of the change in net income during the period the change occurs.Retrospective application will be the required transition method for newaccounting pronouncements in the event that a newly-issued pronouncement doesnot specify transition guidance. SFAS No. 154 is effective for accountingchanges made in fiscal years beginning after December 15, 2005 and is notexpected to have a material impact on our financial position or results ofoperations. In November 2005, the Financial Accounting Standards Board (FASB) issued StaffPosition Nos. FAS 115-1 and FAS 124-1 ("FSP 115-1 and FSP 124-1"), "The Meaningof Other-Than-Temporary 134 Impairment and Its Application to Certain Investments," in response to EmergingIssues Task Force 03-1, "The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments." FSP 115-1 and FSP 124-1 provide guidanceregarding the determination as to when an investment is considered impaired,whether that impairment is other-than-temporary, and the measurement of animpairment loss. FSP 115-1 and FSP 124-1 also include accounting considerationssubsequent to the recognition of an other-than-temporary impairment and requirecertain disclosures about unrealized losses that have not been recognized asother-than-temporary impairments. These requirements are effective for annualreporting periods beginning after December 15, 2005. Adoption of the impairmentguidance contained in FSP 115-1 and FSP 124-1 is not expected to have a materialimpact on our financial position or results of operations. In February 2006, the FASB issued FASB Statement No. 155, "Accounting forCertain Hybrid Financial Instruments" ("SFAS No. 155"). SFAS No. 155 permitsfair value measurement for any hybrid financial instrument that contains anembedded derivative that would otherwise require bifurcation. An irrevocableelection may be made to initially and subsequently measure such a hybridfinancial instrument at fair value, with changes in fair value recognizedthrough income. Such election needs to be supported by concurrent documentation.SFAS No. 155 is effective for financial years beginning after September 15,2006, with early adoption permitted. We are currently evaluating the impact thatadoption of SFAS No. 155 will have on our financial position or results ofoperations. 3. ACQUISITIONS AND DIVESTITURES-------------------------------------------------------------------------------- ACQUISITION OF METRIS COMPANIES INC. On December 1, 2005, we acquired theoutstanding capital stock of Metris Companies Inc. ("Metris"), a provider offinancial products and services to middle market consumers throughout the UnitedStates, in an all-cash transaction for $1.6 billion. HSBC Investments (NorthAmerica) Inc. ("HINO") made a capital contribution of $1.2 billion to fund aportion of the purchase price. This acquisition will expand our presence in thenear-prime credit card market and will strengthen our capabilities to serve thefull spectrum of credit card customers. The results of Metris are included inour consolidated financial statements beginning December 1, 2005. The purchase price was allocated to the assets and liabilities acquired based ontheir estimated fair values at the acquisition date. These preliminary fairvalues were estimated, in part, based on third party valuation data. These fairvalue adjustments represent current estimates and are subject to furtheradjustment as our valuation data is finalized. Goodwill associated with theMetris acquisition is not tax deductible. The initial purchase price allocationsmay be adjusted within one year of the purchase date for changes in estimates ofthe 135 fair value of assets acquired and liabilities assumed. The following tablesummarizes the estimated fair values of the owned basis assets acquired andliabilities assumed as a result of the acquisition of Metris: (IN MILLIONS)--------------------------------------------------------------------------------------------ASSETS ACQUIRED:Cash........................................................ $ 22Investment securities....................................... 230 Receivables............................................... $5,333 Credit loss reserves...................................... (151) ------Receivables, net............................................ 5,182Intangible assets........................................... 271Goodwill.................................................... 522Properties and equipment.................................... 20Other assets................................................ 198 ------ Total assets acquired..................................... $6,445 ====== LIABILITIES ASSUMED:Long term debt (with original maturities over one year)..... $4,602Other liabilities........................................... 249 ------ Total liabilities assumed................................. $4,851 ======TOTAL PURCHASE PRICE........................................ $1,594 ====== The intangible assets resulting from this acquisition are purchased credit cardrelationships. The purchased credit card relationships are being amortized overtheir estimated useful life of seven years on a straight-line basis with noresidual value. The following table summarizes pro forma financial information assuming theMetris acquisition had occurred on January 1, 2004. The pro forma informationuses Metris data for the periods presented. This pro forma financial informationdoes not necessarily represent what would have occurred if the transaction hadtaken place on the dates presented and should not be taken as representative ofour future consolidated results of operations or financial position.Additionally, the pro forma financial information shown below does not reflectany costs associated with the integration of Metris into our operations or anyoperating synergies we ultimately expect to realize. 2005 2004 ------------------------------- ------------------------------- HSBC FINANCE PRO HSBC FINANCE PRO CORPORATION METRIS FORMA CORPORATION METRIS FORMA------------------------------------------------------------------------------------------------- (IN MILLIONS)Net interest income and other revenues.................... $13,215 $1,142 $14,357 $12,875 $1,395 $14,270Net income.................... 1,772 50 1,822 1,940 19 1,959 SALE OF U.K. CREDIT CARD BUSINESS 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 HSBC Bank plc ("HBEU"), aU.K. based subsidiary of HSBC, for an aggregate purchase price of $3.0 billion.The purchase price, which was determined based on a comparative analysis ofsales of other credit card portfolios, was paid in a combination of cash and$261 million of preferred stock issued by a subsidiary of HBEU with a rate ofone-year Sterling LIBOR, plus 1.30 percent. In addition to the assets referredto above, the sale also included the account origination platform, including themarketing and credit employees associated with this function, as well as thelease associated with the credit card call center and the related leaseholds andcall center employees to provide customer continuity after the transfer as wellas to allow HBEU direct ownership and control of origination 136 and customer service. We have retained the collection operations related to thecredit card operations and have entered into a service level agreement for aperiod of not less than two years to provide collection services and othersupport services, including components of the compliance, financial reportingand human resource functions, for the sold credit card operations to HBEU for afee. Additionally, the management teams of HBEU and our remaining U.K.operations will be jointly involved in decision making involving card marketingto ensure that growth objectives are met for both businesses. Because the saleof this business is between affiliates under common control, the premiumreceived in excess of the book value of the assets transferred of $182 million,including the goodwill assigned to this business, has been recorded as anincrease to additional paid in capital and has not been included in earnings. Infuture periods, the net interest income, fee income and provision for creditlosses related to the U.K. credit card business will be reduced, while otherincome will be increased by the receipt of servicing and support servicesrevenue from HBEU. We do not anticipate that the net effect of this sale willresult in a material reduction of net income of our consolidated results. ACQUISITION OF HSBC FINANCE CORPORATION BY HSBC HOLDINGS PLC On March 28, 2003,we were acquired by HSBC by way of merger in a purchase business combination.HSBC believes that the acquisition offers significant opportunities to extendour business model into countries and territories currently served by HSBC andbroadens the product range available to the enlarged customer base. Under theterms of the acquisition agreement, each share of our approximately 476 millionoutstanding common shares at the time of acquisition was converted into theright to receive, at the holder's election, either 2.675 ordinary shares ofHSBC, of nominal value $0.50 each ("HSBC Ordinary Shares"), or 0.535 Americandepositary shares, each representing an interest in five HSBC Ordinary Shares.Additionally, each of our depositary shares representing, respectively,one-fortieth of a share of 8 1/4% cumulative preferred stock, Series 1992-A,one-fortieth of a share of 7.50% cumulative preferred stock, Series 2001-A,one-fortieth of a share of 7.60% cumulative preferred stock, Series 2002-A andone-fortieth of a share of 7 5/8% cumulative preferred stock, Series 2002-B, wasconverted into the right to receive $25 in cash per depositary share, plusaccrued and unpaid dividends up to but not including the effective date of theacquisition which was an aggregate amount of approximately $1.1 billion. Inconsideration of HSBC transferring sufficient funds to make the paymentsdescribed above with respect to our depositary shares, we issued the Series ACumulative Preferred Stock ("Series A Preferred Stock") in the amount of $1.1billion to HSBC on March 28, 2003. Also on March 28, 2003, we called for redemption all the issued and outstandingshares of our 5.00% cumulative preferred stock, $4.50 cumulative preferred stockand $4.30 cumulative preferred stock totaling $114 million. Pursuant to theterms of these issues of preferred stock, we paid a redemption price of $50.00per share of 5.00% cumulative preferred stock, $103.00 per share of $4.50cumulative preferred stock and $100.00 per share of $4.30 cumulative preferredstock, plus, in each case, all dividends accrued and unpaid, whether or notearned or declared, to the redemption date. Additionally, on March 28, 2003, wedeclared a dividend of $0.8694 per share on our common stock, which was paid onMay 6, 2003 to our holders of record on March 28, 2003. In conjunction with our acquisition by HSBC, we incurred acquisition relatedcosts of $198 million. Consistent with the guidelines for accounting forbusiness combinations, these costs were expensed in our statement of income forthe period January 1 through March 28, 2003. The purchase price paid by HSBC for our common stock plus related purchaseaccounting adjustments was valued at $14.7 billion and is recorded as"Additional paid-in capital" in the accompanying consolidated balance sheet. Thepurchase price was allocated to our assets and liabilities based on theirestimated fair values at the acquisition date based, in part, on third partyvaluation data. During the first quarter of 2004, we made final adjustments tothe allocation of purchase price to our assets and liabilities. Since theone-year anniversary of our acquisition by HSBC was completed during the firstquarter of 2004, no further acquisition-related adjustments to the purchaseprice allocation will occur, except for changes in estimates for the tax basisin our assets and liabilities or other tax estimates recorded at the date of ouracquisition by HSBC pursuant to Statement of Financial Accounting Standards No.109, "Accounting for Income Taxes." 137 4. SALE OF DOMESTIC PRIVATE LABEL RECEIVABLE PORTFOLIO AND ADOPTION OF FFIEC POLICIES-------------------------------------------------------------------------------- On December 29, 2004, we sold our domestic private label receivable portfolio(excluding retail sales contracts at our consumer lending business), includingthe retained interests associated with securitized private label receivables, toHSBC Bank USA for an aggregate purchase price of $12.4 billion and recorded again of $663 million ($423 million after-tax). Included in this gain was therelease of $505 million in credit loss reserves associated with the portfolio.The domestic private label receivable portfolio sold consisted of receivableswith a balance of $12.2 billion ($15.6 billion on a managed basis). The purchaseprice was determined based upon an independent valuation opinion. We retained the customer relationships and by agreement will sell additionaldomestic private label receivable originations (excluding retail salescontracts) generated under current and future private label accounts to HSBCBank USA on a daily basis at fair market value. We will also service thereceivables for HSBC Bank USA for a fee under a service agreement that wasreviewed by the staff of the Board of Governors of the Federal Reserve Board(the "Federal Reserve Board".) Upon receipt of regulatory approval for the sale of this domestic private labelreceivable portfolio, we adopted charge-off and account management policies inaccordance with the Uniform Retail Credit Classification and Account ManagementPolicy issued by the Federal Financial Institutions Examination Council ("FFIECPolicies") for our domestic private label (excluding retail sales contracts atour consumer lending business) and MasterCard and Visa portfolios. The adoptionof FFIEC charge-off policies for our domestic private label (excluding retailsales contracts at our consumer lending business) and MasterCard/Visareceivables resulted in a reduction to our 2004 net income of $121 million. 5. SECURITIES-------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRDECEMBER 31, 2005 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------------- (IN MILLIONS)Corporate debt securities............................ $2,337 $23 $(38) $2,322Money market funds................................... 315 - - 315U.S. government sponsored enterprises(1)............. 96 - (2) 94U.S. government and Federal agency debt securities... 744 - (4) 740Non-government mortgage backed securities............ 88 - (1) 87Other................................................ 463 1 (5) 459 ------ --- ---- ------Subtotal............................................. 4,043 24 (50) 4,017Accrued investment income............................ 34 - - 34 ------ --- ---- ------Total securities available for sale.................. $4,077 $24 $(50) $4,051 ====== === ==== ====== 138 GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRDECEMBER 31, 2004 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------------- (IN MILLIONS)Corporate debt securities............................ $2,520 $27 $(14) $2,533Money market funds................................... 230 - - 230U.S. government sponsored enterprises(1)............. 100 - (1) 99U.S. government and Federal agency debt securities... 323 - (3) 320Non-government mortgage backed securities............ 44 - - 44Other................................................ 385 1 (3) 383 ------ --- ---- ------Subtotal............................................. 3,602 28 (21) 3,609Accrued investment income............................ 36 - - 36 ------ --- ---- ------Total securities available for sale.................. $3,638 $28 $(21) $3,645 ====== === ==== ====== --------------- (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Proceeds from the sale of available-for-sale investments totaled approximately$.4 billion in 2005, $.9 billion in 2004, $.7 billion in the period March 29through December 31, 2003 and $.8 billion in the period January 1 through March28, 2003. We realized gross gains of $10 million in 2005, $15 million in 2004,$18 million in the period March 29 through December 31, 2003 and $41 million inthe period January 1 through March 28, 2003. We realized gross losses of $10million in 2005, $3 million in 2004, $.4 million in the period March 29 throughDecember 31, 2003 and $3 million in the period January 1 through March 28, 2003on those sales. A summary of gross unrealized losses and related fair values as of December 31,2005, classified as to the length of time the losses have existed is presentedin the following table: LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- GROSS AGGREGATE GROSS AGGREGATE NUMBER OF UNREALIZED FAIR VALUE OF NUMBER OF UNREALIZED FAIR VALUE OFDECEMBER 31, 2005 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS------------------------------------------------------------------------------------------------------------- (IN MILLIONS)Corporate debt securities.............. 243 $(12) $527 392 $(26) $996U.S. government sponsored enterprises............. 32 -(1) 26 25 (2) 64U.S. government and Federal agency debt securities.............. 15 (1) 49 43 (3) 139Non-government mortgage... 3 -(1) 4 16 (1) 22Other..................... 14 (1) 78 46 (4) 181 --------------- (1) Less than $500 thousand. The gross unrealized losses on our securities available for sale have increasedduring 2005 due to a general increase in interest rates. The contractual termsof these securities do not permit the issuer to settle the securities at a priceless than the par value of the investment. Since substantially all of thesesecurities are rated A- or better, and because we have the ability and intent tohold these investments until maturity or a market price recovery, thesesecurities are not considered other-than temporarily impaired. The amortized cost of our securities available for sale was adjusted to fairmarket value at the time of the merger with HSBC. See Note 25, "Fair Value ofFinancial Instruments," for further discussion of the relationship between thefair value of our assets and liabilities. 139 Contractual maturities of and yields on investments in debt securities were asfollows: AT DECEMBER 31, 2005 ---------------------------------------------------- DUE AFTER 1 AFTER 5 WITHIN BUT WITHIN BUT WITHIN AFTER 1 YEAR 5 YEARS 10 YEARS 10 YEARS TOTAL---------------------------------------------------------------------------------------------------- (IN MILLIONS)Corporate debt securities: Amortized cost.............................. $418 $989 $317 $613 $2,337 Fair value.................................. 416 963 313 630 2,322 Yield(1).................................... 4.57% 3.96% 5.07% 5.76% 4.69%U.S. government sponsored enterprises: Amortized cost.............................. - 9 $ 14 $ 73 $ 96 Fair value.................................. - 9 14 71 94 Yield(1).................................... - 3.34 4.21% 3.97% 3.95%U.S. government and Federal agency debt securities: Amortized cost.............................. $566 $111 $ 7 $ 60 $ 744 Fair value.................................. 565 108 7 60 740 Yield(1).................................... 4.13% 3.67% 4.39% 4.68% 4.11% --------------- (1) Computed by dividing annualized interest by the amortized cost of respective investment securities. 6. RECEIVABLES-------------------------------------------------------------------------------- Receivables consisted of the following: AT DECEMBER 31, ------------------- 2005 2004--------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured......................................... $ 82,826 $ 64,820Auto finance................................................ 10,704 7,544MasterCard/Visa............................................. 24,110 14,635Private label............................................... 2,520 3,411Personal non-credit card.................................... 19,545 16,128Commercial and other........................................ 208 317 -------- --------Total owned receivables..................................... 139,913 106,855HSBC acquisition purchase accounting fair value adjustments............................................... 63 201Accrued finance charges..................................... 1,831 1,394Credit loss reserve for owned receivables................... (4,521) (3,625)Unearned credit insurance premiums and claims reserves...... (505) (631)Interest-only strip receivables............................. 23 323Amounts due and deferred from receivable sales.............. 185 298 -------- --------Total owned receivables, net................................ 136,989 104,815Receivables serviced with limited recourse.................. 4,074 14,225 -------- --------Total managed receivables, net.............................. $141,063 $119,040 ======== ======== HSBC acquisition purchase accounting fair value adjustments representadjustments which have been "pushed down" to record our receivables at fairvalue at the date of acquisition by HSBC. 140 We have a subsidiary, Decision One Mortgage Company, LLC, which directlyoriginates mortgage loans sourced by mortgage brokers and sells all loans tosecondary market purchasers, including our Mortgage Services businesses. Loansheld for sale to external parties by this subsidiary totaled $1.7 billion atDecember 31, 2005 and $1.1 billion at December 31, 2004 and are included in realestate secured receivables. In December 2005, we sold our U.K. based credit card operations, including $2.5billion of receivables ($3.1 billion on a managed basis) and the relatedretained interests in securitized credit card receivables to HBEU. See Note 3,"Acquisitions and Divestitures," for additional information regarding this sale. As discussed more fully in Note 3, "Acquisitions and Divestitures," as part ofour acquisition of Metris on December 1, 2005, we acquired $5.3 billion ofreceivables. The receivables acquired as part of our acquisition of Metris in2005 were subject to the requirements of SOP 03-3 to the extent there wasevidence of deterioration of credit quality since origination and for which itwas probable, at acquisition, that all contractually required payments would notbe collected and that the associated line of credit had been closed. Thefollowing table summarizes the outstanding receivable balances, the cash flowsexpected to be collected and the fair value of the receivables to which SOP 03-3has been applied: (IN MILLIONS)---------------------------------------------------------------------------Outstanding contractual receivable balance at acquisition... $925Cash flows expected to be collected at acquisition.......... 563Basis in acquired receivables at acquisition................ 432 The carrying amount of these receivables at December 31, 2005 of $414 million isincluded in the MasterCard/Visa receivables in the table above. At December 31,2005, no credit loss reserve for these acquired receivables has been establishedas there has been no change in anticipated future cash flows since the Metrisacquisition. The outstanding contractual balance of these receivables atDecember 31, 2005 is $804 million. At the time of the Metris acquisition, the anticipated cash flows from theseacquired receivables exceeded the amount paid for the receivables. The followingsummarizes the Accretable Yield on these receivables at December 31, 2005: (IN MILLIONS)---------------------------------------------------------------------------Accretable yield established for Metris acquisition......... $(131)Accretable yield amortized to interest income during 2005... 9 -----Balance at December 31, 2005................................ $(122) ===== Foreign receivables included in owned receivables were as follows: AT DECEMBER 31, --------------------------------------------------- UNITED KINGDOM AND THE REST OF EUROPE CANADA ------------------------ ------------------------ 2005 2004 2003 2005 2004 2003----------------------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured....................... $1,654 $1,832 $1,354 $1,380 $1,042 $ 841Auto finance.............................. - - - 270 54 -MasterCard/Visa........................... - 2,264 1,605 147 - -Private label............................. 1,330 2,249 2,142 834 821 729Personal non-credit card.................. 3,038 3,562 2,741 607 517 467Commercial and other...................... - - 1 - 2 2 ------ ------ ------ ------ ------ ------Total..................................... $6,022 $9,907 $7,843 $3,238 $2,436 $2,039 ====== ====== ====== ====== ====== ====== Foreign owned receivables represented 7 percent of owned receivables at December31, 2005 and 12 percent of owned receivables at December 31, 2004. 141 Receivables serviced with limited recourse consisted of the following: AT DECEMBER 31, ---------------- 2005 2004------------------------------------------------------------------------------ (IN MILLIONS)Real estate secured......................................... $ - $ 81Auto finance................................................ 1,192 2,679MasterCard/Visa............................................. 1,875 7,583Private label............................................... - -Personal non-credit card.................................... 1,007 3,882 ------ -------Total....................................................... $4,074 $14,225 ====== ======= The combination of receivables owned and receivables serviced with limitedrecourse, which comprises our managed portfolio, is shown below: AT DECEMBER 31, ------------------- 2005 2004--------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured......................................... $ 82,826 $ 64,901Auto finance................................................ 11,896 10,223MasterCard/Visa............................................. 25,985 22,218Private label............................................... 2,520 3,411Personal non-credit card.................................... 20,552 20,010Commercial and other........................................ 208 317 -------- --------Total....................................................... $143,987 $121,080 ======== ======== We maintain facilities with third parties which provide for the securitizationor secured financing of receivables on both a revolving and non-revolving basistotaling $15 billion, of which $5.6 billion were utilized at December 31, 2005.The amount available under these facilities will vary based on the timing andvolume of public securitization or secured financing transactions and ourgeneral liquidity plans. Contractual maturities of owned receivables were as follows: AT DECEMBER 31, 2005 ------------------------------------------------------------------- 2006 2007 2008 2009 2010 THEREAFTER TOTAL-------------------------------------------------------------------------------------------------- (IN MILLIONS)Real estate secured.......... $ 421 $ 341 $ 343 $ 389 $ 493 $80,839 $ 82,826Auto finance................. 2,539 2,290 2,154 1,831 1,271 619 10,704MasterCard/Visa.............. 3,415 2,739 2,311 1,961 1,673 12,011 24,110Private label................ 1,372 454 365 193 64 72 2,520Personal non-credit card..... 2,369 1,724 1,916 3,007 5,393 5,136 19,545Commercial and other......... 9 - - - 55 144 208 ------- ------ ------ ------ ------ ------- --------Total........................ $10,125 $7,548 $7,089 $7,381 $8,949 $98,821 $139,913 ======= ====== ====== ====== ====== ======= ======== A substantial portion of consumer receivables, based on our experience, will berenewed or repaid prior to contractual maturity. The above maturity scheduleshould not be regarded as a forecast of future cash collections. The ratio ofannual cash collections of principal on owned receivables to average principalbalances, excluding credit card receivables, approximated 33 percent in 2005 and39 percent in 2004. 142 The following table summarizes contractual maturities of owned receivables dueafter one year by repricing characteristic: AT DECEMBER 31, 2005 -------------------------- OVER 1 BUT WITHIN OVER 5 YEARS 5 YEARS---------------------------------------------------------------------------------------- (IN MILLIONS)Receivables at predetermined interest rates................. $23,089 $81,463Receivables at floating or adjustable rates................. 7,878 17,358 ------- -------Total....................................................... $30,967 $98,821 ======= ======= Nonaccrual owned consumer receivables totaled $3.5 billion (including $463million relating to foreign operations) at December 31, 2005 and $3.0 billion(including $432 million relating to foreign operations) at December 31, 2004.Interest income that would have been recorded if such nonaccrual receivables hadbeen current and in accordance with contractual terms was approximately $475million (including $66 million relating to foreign operations) in 2005 and $377million (including $50 million relating to foreign operations) in 2004. Interestincome that was included in finance and other interest income prior to theseloans being placed on nonaccrual status was approximately $229 million(including $31 million relating to foreign operations) in 2005 and $197 million(including $27 million relating to foreign operations) in 2004. For an analysisof reserves for credit losses on an owned and managed basis, see our "Analysisof Credit Loss Reserves Activity" in Management's Discussion and Analysis andNote 7, "Credit Loss Reserves." Interest-only strip receivables are reported net of our estimate of probablelosses under the recourse provisions for receivables serviced with limitedrecourse. Reductions to our interest-only strip receivables in 2005 reflect theimpact of reduced securitization levels, including our decision to structure newcollateralized funding transactions as secured financings. Amounts due and deferred from receivable sales include assets established forcertain receivable sales, including funds deposited in spread accounts, and netcustomer payments due from (to) the securitization trustee. We issued securities backed by dedicated home equity loan receivables of $4.5billion in 2005 and $3.3 billion in 2004. We issued securities backed bydedicated auto finance loan receivables of $3.4 billion in 2005 and $1.8 billionin 2004. We issued securities backed by dedicated MasterCard/Visa credit cardreceivables of $1.8 billion in 2005. For accounting purposes, these transactionswere structured as secured financings, therefore, the receivables and therelated debt remain on our balance sheet. Additionally, as part of the Metrisacquisition we assumed $4.6 billion of securities backed by MasterCard/Visareceivables which are accounted for as secured financings. Real estate securedreceivables included closed-end real estate secured receivables totaling $8.4billion at December 31, 2005 and $7.7 billion at December 31, 2004 that securedthe outstanding debt related to these transactions. Auto finance receivablestotaling $4.6 billion at December 31, 2005 and $2.6 billion at December 31, 2004secured the outstanding debt related to these transactions. MasterCard/ Visacredit card receivables of $8.8 billion at December 31, 2005 secured theoutstanding debt related to these transactions. There were no transactionsstructured as secured financings in 2004 for MasterCard/Visa credit cardreceivables. 143 7. CREDIT LOSS RESERVES-------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: AT DECEMBER 31, --------------------------- 2005 2004 2003----------------------------------------------------------------------------------------- (IN MILLIONS)Owned receivables: Credit loss reserves at beginning of period............... $ 3,625 $ 3,793 $ 3,333 Provision for credit losses............................... 4,543 4,334 3,967 Charge-offs............................................... (4,100) (4,409) (3,878) Recoveries................................................ 447 376 291 Other, net................................................ 6 (469) 80 ------- ------- ------- Credit loss reserves for owned receivables................ 4,521 3,625 3,793 ------- ------- -------Receivables serviced with limited recourse: Credit loss reserves at beginning of period............... 890 2,374 1,759 Provision for credit losses............................... 107 188 2,275 Charge-offs............................................... (768) (1,743) (1,764) Recoveries................................................ 60 102 97 Other, net................................................ (74) (31) 7 ------- ------- ------- Credit loss reserves for receivables serviced with limited recourse............................................... 215 890 2,374 ------- ------- -------Credit loss reserves for managed receivables................ $ 4,736 $ 4,515 $ 6,167 ======= ======= ======= Reductions to the provision for credit losses and overall reserve levels onreceivables serviced with limited recourse in 2005 and 2004 reflect the impactof reduced securitization levels, including our decision to structure newcollateralized funding transactions as secured financings. Further analysis of credit quality and credit loss reserves is presented in Item7, "Management's Discussion and Analysis of Financial Condition and Results ofOperations" of Form 10-K under the caption "Credit Quality." 8. ASSET SECURITIZATIONS-------------------------------------------------------------------------------- We have sold auto finance, MasterCard and Visa, private label and personalnon-credit card receivables in various securitization transactions. We continueto service and receive servicing fees on the outstanding balance of thesesecuritized receivables. We also retain rights to future cash flows arising fromthese receivables after the investors receive their contractual return. We havealso, in certain cases, retained other subordinated interests in thesesecuritizations. These transactions result in the recording of an interest-onlystrip receivable which represents the value of the future residual cash flowsfrom securitized receivables. The investors and the securitization trusts haveonly limited recourse to our assets for failure of debtors to pay. That recourseis limited to our rights to future cash flow and any subordinated interest weretain. Servicing assets and liabilities are not recognized in conjunction withour securitizations since we receive adequate compensation relative to currentmarket rates to service the receivables sold. See Note 2, "Summary ofSignificant Accounting Policies," for further discussion on our accounting forinterest-only strip receivables. In the third quarter of 2004, we began to structure all new collateralizedfunding transactions as secured financings. However, because existing publicMasterCard and Visa credit card transactions were structured as sales torevolving trusts that require replenishments of receivables to supportpreviously issued securities, receivables will continue to be sold to thesetrusts until the revolving periods end, the last of which is expected to occurin early 2008 based on current projections. After December 29, 2004, privatelabel trusts that publicly issued securities are now replenished by HSBC BankUSA as a result of the daily sales of new domestic 144 private label credit card originations to HSBC Bank USA. In addition, we willcontinue to replenish at reduced levels, certain non-public personal non-creditcard securities issued to conduits and record the resulting replenishment gainsfor a period of time to manage liquidity. Since our securitized receivables havevarying lives, it will take a period of time for these receivables to pay-offand the related interest-only strip receivables to be reduced to zero. Securitization related revenue includes income associated with the current andprior period securitization of receivables with limited recourse structured assales. Such income includes gains on sales, net of our estimate of probablecredit losses under the recourse provisions, servicing income and excess spreadrelating to those receivables. MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003------------------------------------------------------------------------------------------------------ (IN MILLIONS)Net initial gains(1).......................... $ - $ 25 $ 135 $ 41Net replenishment gains(2).................... 154 414 411 137Servicing revenue and excess spread........... 57 569 481 256 ---- ------ ------ ----Total securitization related revenue.......... $211 $1,008 $1,027 $434 ==== ====== ====== ==== --------------- (1) Net initial gains reflect inherent recourse provisions of $47 million in 2004, $825 million in the period March 29 to December 31, 2003 and $138 million in the period January 1 to March 28, 2003. (2) Net replenishment gains reflect inherent recourse provisions of $252 million in 2005, $850 million in 2004, $656 million in the period March 29 to December 31, 2003 and $193 million in the period January 1 to March 28, 2003. Our interest-only strip receivables, net of the inherent recourse provisions andexcluding the mark-to-market adjustment recorded in accumulated othercomprehensive income, in 2005 the U.K. credit card portion purchased by HBEU andin 2004, the private label portion purchased by HSBC Bank USA decreased $253million in 2005, $466 million in 2004, $400 million in the period March 29 toDecember 31, 2003, and $30 million in the period January 1 to March 28, 2003. 145 Net initial gains, which represent gross initial gains net of our estimate ofprobable credit losses under the recourse provisions, and the key economicassumptions used in measuring the net initial gains from securitizations were asfollows: PERSONAL AUTO MASTERCARD/ PRIVATE NON-CREDITYEAR ENDED DECEMBER 31, FINANCE VISA LABEL CARD TOTAL-----------------------------------------------------------------------------------------------------2005Net initial gains (in millions)................ $ - $ - $ - $ - $ -Key economic assumptions:(1) Weighted-average life (in years)............. - - - - Payment speed................................ - - - - Expected credit losses (annual rate)......... - - - - Discount rate on cash flows.................. - - - - Cost of funds................................ - - - -2004Net initial gains (in millions)................ $ 6(2) $ 14 $ 5 $ - $ 25Key economic assumptions:(1) Weighted-average life (in years)............. 2.1 .3 .4 - Payment speed................................ 35.0% 93.5% 93.5% - Expected credit losses (annual rate)......... 5.7 4.9 4.8 - Discount rate on cash flows.................. 10.0 9.0 10.0 - Cost of funds................................ 3.0 1.5 1.4 -2003Net initial gains (in millions)................ $ 56 $ 25 $ 51 $ 44 $176Key economic assumptions:(1) Weighted-average life (in years)............. 2.1 .4 .7 1.7 Payment speed................................ 35.4% 93.3% 74.5% 43.3% Expected credit losses (annual rate)......... 6.1 5.1 5.7 12.0 Discount rate on cash flows.................. 10.0 9.0 10.0 11.0 Cost of funds................................ 2.2 1.8 1.8 2.1 --------------- (1) Weighted-average annual rates for securitizations entered into during the period for securitizations of loans with similar characteristics. (2) In 2004, auto finance was involved in a securitization which later was restructured as a secured financing. The initial gain reflected above was the gain on the initial transaction that remained after the securitization was restructured, as required under Emerging Issues Task Force Issue No. 02-9. Certain securitization trusts, such as credit cards, are established at fixedlevels and require frequent sales of new receivables into the trust to replacereceivable run-off. These replenishments totaled $8.8 billion in 2005, $30.3billion in 2004 and $30.9 billion in 2003. 146 Cash flows received from securitization trusts were as follows: PERSONAL REAL ESTATE AUTO MASTERCARD/ PRIVATE NON-CREDITYEAR ENDED DECEMBER 31, SECURED FINANCE VISA LABEL CARD TOTAL------------------------------------------------------------------------------------------------------ (IN MILLIONS)2005Proceeds from initial securitizations................ $ - $ - $ - $ - $ - $ -Servicing fees received.......... - 45 97 - 46 188Other cash flow received on retained interests(1).......... - 40 243 - 52 3352004Proceeds from initial securitizations................ $ - $ -(2) $550 $ 190 $ - $ 740Servicing fees received.......... 1 86 185 93 161 526Other cash flow received on retained interests(1).......... 4 (1) 696 252 80 1,0312003Proceeds from initial securitizations................ $ - $1,523 $670 $1,250 $3,320 $6,763Servicing fees received.......... 4 117 202 82 136 541Other cash flow received on retained interests(1).......... 10 92 844 249 183 1,378 --------------- (1) Other cash flows include all cash flows from interest-only strip receivables, excluding servicing fees. (2) In 2004, auto finance was involved in a securitization which was later restructured as a secured financing. These transactions are reported net in the table above. At December 31, 2005, the sensitivity of the current fair value of theinterest-only strip receivables to an immediate 10 percent and 20 percentunfavorable change in assumptions are presented in the table below. Thesesensitivities are based on assumptions used to value our interest-only stripreceivables at December 31, 2005. PERSONAL AUTO MASTERCARD/ NON-CREDIT FINANCE VISA CARD------------------------------------------------------------------------------------------------Carrying value (fair value) of interest-only strip receivables............................................... $ (13) $ 20 $ 16Weighted-average life (in years)............................ 1.2 .3 .5Payment speed assumption (annual rate)...................... 55.8% 96.3% 86.9% Impact on fair value of 10% adverse change................ $ (5) $ (2) $ (1) Impact on fair value of 20% adverse change................ (12) (4) (2)Expected credit losses (annual rate)........................ 10.6% 4.6% 9.4% Impact on fair value of 10% adverse change................ $ (12) $ (2) $ (4) Impact on fair value of 20% adverse change................ (25) (3) (8)Discount rate on residual cash flows (annual rate).......... 10.0% 9.0% 11.0% Impact on fair value of 10% adverse change................ $ (2) $ - $ - Impact on fair value of 20% adverse change................ (3) - -Variable returns to investors (annual rate)................. - 2.9% 5.7% Impact on fair value of 10% adverse change................ $ - $ (1) $ (2) Impact on fair value of 20% adverse change................ - (2) (5) These sensitivities are hypothetical and should not be considered to bepredictive of future performance. As the figures indicate, the change in fairvalue based on a 10 percent variation in assumptions cannot necessarily beextrapolated because the relationship of the change in assumption to the changein fair value may not be linear. Also, in this table, the effect of a variationin a particular assumption on the fair value of the residual cash flow iscalculated independently from any change in another assumption. In reality,changes in one factor 147 may contribute to changes in another (for example, increases in market interestrates may result in lower prepayments) which might magnify or counteract thesensitivities. Furthermore, the estimated fair values as disclosed should not beconsidered indicative of future earnings on these assets. Static pool credit losses are calculated by summing actual and projected futurecredit losses and dividing them by the original balance of each pool of asset.Due to the short term revolving nature of MasterCard and Visa receivables, theweighted-average percentage of static pool credit losses is not considered to bematerially different from the weighted-average charge-off assumptions used indetermining the fair value of our interest-only strip receivables in the tableabove. At December 31, 2005, static pool credit losses for auto finance loanssecuritized in 2003 were estimated to be 10.6 percent and for auto finance loanssecuritized in 2002 were estimated to be 14.8 percent. Receivables and two-month-and-over contractual delinquency for our managed andserviced with limited recourse portfolios were as follows: AT DECEMBER 31, ----------------------------------------------------- 2005 2004 ------------------------- ------------------------- RECEIVABLES DELINQUENT RECEIVABLES DELINQUENT OUTSTANDING RECEIVABLES OUTSTANDING RECEIVABLES------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)MANAGED RECEIVABLES: First mortgage(1)............................. $ 21 8.41% $ 26 5.04% Real estate secured........................... 82,826 2.72 64,901 2.97 Auto finance.................................. 11,896 2.76 10,223 2.96 MasterCard/Visa............................... 25,985 3.52 22,218 3.98 Private label................................. 2,520 5.43 3,411 4.13 Personal non-credit card...................... 20,552 9.54 20,010 9.30 -------- ----- -------- ----- Total consumer................................ 143,800 3.89 120,789 4.24 Commercial.................................... 187 - 291 - -------- ----- -------- -----Total managed receivables....................... $143,987 3.89% $121,080 4.23% -------- ----- -------- -----RECEIVABLES SERVICED WITH LIMITED RECOURSE: Real estate secured........................... $ - -% $ (81) 12.35% Auto finance.................................. (1,192) 6.63 (2,679) 5.49 MasterCard/Visa............................... (1,875) 1.60 (7,583) 2.24 Personal non-credit card...................... (1,007) 12.41 (3,882) 11.88 -------- ----- -------- -----Total receivables serviced with limited recourse...................................... (4,074) 5.74 (14,225) 5.54 -------- ----- -------- -----OWNED CONSUMER RECEIVABLES...................... $139,726 3.84% $106,564 4.07% ======== ===== ======== ===== --------------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. 148 Average receivables and net charge-offs for our managed and serviced withlimited recourse portfolios were as follows: YEAR ENDED DECEMBER 31, ----------------------------------------------------- 2005 2004 ------------------------- ------------------------- AVERAGE NET AVERAGE NET RECEIVABLES CHARGE-OFFS RECEIVABLES CHARGE-OFFS-------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)MANAGED RECEIVABLES: First mortgage(1).............................. $ 24 .90% $ 32 2.39% Real estate secured............................ 73,120 .76 56,462 1.10 Auto finance................................... 10,937 4.56 9,432 5.80 MasterCard/Visa(2)............................. 22,694 6.78 20,674 7.29 Private label(2)............................... 2,948 4.83 17,579 6.03 Personal non-credit card....................... 19,956 8.11 18,986 10.20 -------- ---- -------- ----- Total consumer.............................. 129,679 3.36 123,165 4.61 Commercial..................................... 231 2.60 322 - -------- ---- -------- -----Total managed receivables........................ $129,910 3.36% $123,487 4.59% -------- ---- -------- -----RECEIVABLES SERVICED WITH LIMITED RECOURSE: Real estate secured............................ $ (23) -% $ (159) 1.26% Auto finance................................... (1,863) 10.90 (3,647) 9.57 MasterCard/Visa(2)............................. (4,871) 5.52 (9,099) 5.30 Private label(2)............................... - - (4,550) 5.63 Personal non-credit card....................... (2,398) 9.84 (4,792) 11.54 -------- ---- -------- -----Total receivables serviced with limited recourse....................................... (9,155) 7.73 (22,247) 7.38 -------- ---- -------- -----OWNED CONSUMER RECEIVABLES(2).................... $120,524 3.03% $100,918 4.00% ======== ==== ======== ===== --------------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. (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 managed basis net charge-off by 2 basis points for MasterCard/Visa and 112 basis points for private label receivables and increased receivables serviced with limited recourse net charge-offs by 2 basis points for MasterCard/Visa and 94 basis points for private label receivables and increased owned consumer net charge-offs by 16 basis points. 9. PROPERTIES AND EQUIPMENT, NET-------------------------------------------------------------------------------- AT DECEMBER 31, ------------- DEPRECIABLE 2005 2004 LIFE----------------------------------------------------------------------------------------- (IN MILLIONSLand........................................................ - $ 28 $ 27Buildings and improvements.................................. 10-40 years 288 280Furniture and equipment..................................... 3 - 10 376 348 ---- ----Total....................................................... 692 655Accumulated depreciation and amortization................... 234 168 ---- ----Properties and equipment, net............................... $458 $487 ==== ==== 149 Depreciation and amortization expense totaled $131 million in 2005, $127 millionin 2004, $101 million in the period March 29 through December 31, 2003 and $33million in the period January 1 through March 28, 2003. 10. INTANGIBLE ASSETS-------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYINGDECEMBER 31, 2005 GROSS AMORTIZATION VALUE---------------------------------------------------------------------------------------------- (IN MILLIONSPurchased credit card relationships and related programs.... $1,736 $442 $1,294Retail services merchant relationships...................... 270 149 121Other loan related relationships............................ 326 104 222Trade names................................................. 717 13 704Technology, customer lists and other contracts.............. 282 143 139 ------ ---- ------Total....................................................... $3,331 $851 $2,480 ====== ==== ====== ACCUMULATED CARRYINGDECEMBER 31, 2004 GROSS AMORTIZATION VALUE---------------------------------------------------------------------------------------------- (IN MILLIONSPurchased credit card relationships and related programs.... $1,723 $355 $1,368Retail services merchant relationships...................... 270 95 175Other loan related relationships............................ 326 71 255Trade names................................................. 718 - 718Technology, customer lists and other contracts.............. 281 92 189 ------ ---- ------Total....................................................... $3,318 $613 $2,705 ====== ==== ====== During the third quarter of 2005, we completed our annual impairment test ofintangible assets. As a result of our testing, we recorded an impairment chargerelated to a trade name in the United Kingdom. This charge is included as acomponent of amortization of intangibles in our consolidated income statement.For all other intangible assets, we determined that the fair value of eachintangible asset exceeded its carrying value, resulting in a conclusion thatnone of our remaining intangible assets are impaired. Weighted-average amortization periods for our intangible assets as of December31, 2005 were as follows: (IN MONTHS)-------------------------------------------------------------------------Purchased credit card relationships and related programs.... 115Retail services merchant relationships...................... 60Other loan related relationships............................ 110Technology, customer lists and other contracts.............. 61Intangible assets........................................... 90 Intangible amortization expense totaled $345 million in 2005, $363 million in2004, $246 million in the period March 29 through December 31, 2003 and $12million in the period January 1 through March 28, 2003. The trade names are not subject to amortization as we believe they haveindefinite lives. The remaining acquired intangibles are being amortized asapplicable over their estimated useful lives either on a straight-line basis orin proportion to the underlying revenues generated. These useful lives rangefrom 5 years for retail services merchant relationships to approximately 10years for certain loan related relationships. Our purchased credit cardrelationships have estimated residual values of $162 million as of December 31,2005. 150 Estimated amortization expense associated with our intangible assets for each ofthe following years is as follows: YEAR ENDING DECEMBER 31, (IN MILLIONS)---------------------------------------------------------------------------2006........................................................ $2692007........................................................ 2522008........................................................ 2102009........................................................ 1972010........................................................ 168Thereafter.................................................. 520 11. GOODWILL-------------------------------------------------------------------------------- Goodwill balances associated with our foreign businesses will change from periodto period due to movements in foreign exchange. Since the one-year anniversaryin the first quarter of 2004 of our acquisition by HSBC, no furtheracquisition-related adjustments to the goodwill resulting from our acquisitionby HSBC will occur, except for changes in estimates of the tax basis in ourassets and liabilities or other tax estimates recorded at the date of ouracquisition by HSBC, pursuant to Statement of Financial Accounting Standards No.109, "Accounting for Income Taxes," and for the movements in foreign exchangerates discussed above. Changes in the carrying amount of goodwill are as follows: 2005 2004----------------------------------------------------------------------------- (IN MILLIONS)Balance at beginning of year................................ $6,856 $6,697 2005 acquisitions, primarily Metris....................... 533 - Write off of goodwill allocated to the U.K. credit card business sold to HBEU.................................. (218) - Change in estimate of the tax basis of assets and liabilities recorded in the HSBC acquisition........... (76) (56) Final adjustments to HSBC purchase price allocation....... - 141 Impact of foreign currency translation.................... (92) 74 ------ ------Balance at end of year...................................... $7,003 $6,856 ====== ====== Goodwill established as a result of our acquisition by HSBC has not beenallocated to or included in the reported results of our reportable segments asthe acquisition by HSBC was outside of the ongoing operational activities of ourreportable segments. This is consistent with management's view of our reportablesegment results. Goodwill of $522 million resulting from our acquisition ofMetris and $11 million related to the acquisition of a small mortgage brokeragefirm by our Canadian operations are included in the reported results of theCredit Card Services and International Segments, respectively, as theseacquisitions specifically related to the operations of these segments and isconsistent with management's view of the segment results. During the third quarter of 2005, we completed our annual impairment test ofgoodwill. For purposes of this test, we assigned the goodwill to our reportingunits (as defined in SFAS No. 142, "Goodwill and Other Intangible Assets"). The fair value of each of the reporting units to which goodwill was assignedexceeded its carrying value including goodwill, resulting in a conclusion thatnone of our goodwill is impaired. As required by SFAS No. 142, "Goodwill and Other Intangible Assets," subsequentto the sale of the U.K. credit card business we performed an interim goodwillimpairment test for our remaining U.K. and European operations. As the estimatedfair value of our remaining U.K. and European operations exceeded its carryingvalue subsequent to the sale, we concluded that the remaining goodwill assignedto this reporting unit was not impaired. 151 12. DEPOSITS-------------------------------------------------------------------------------- The following table shows domestic and foreign deposits at December 31, 2005. AT DECEMBER 31, --------------------------------------- 2005(1) 2004(1) ------------------ ------------------ WEIGHTED- WEIGHTED- AVERAGE AVERAGE AMOUNT RATE AMOUNT RATE------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)Time certificates....................................... $ 9 5.8% $12 5.3%Savings accounts........................................ 27 3.1 34 1.5Demand accounts......................................... 1 - 1 - --- --- --- ---Total deposits.......................................... $37 3.7% $47 2.4% === === === === --------------- (1) Includes $2 million in domestic deposits at December 31, 2005. There were no domestic deposits at December 31, 2004. Average deposits and related weighted-average interest rates for our foreignoperations are included in the table below. Average domestic deposits wereimmaterial in 2005. AT DECEMBER 31, ------------------------------------------------------------------ 2005 2004 2003 -------------------- -------------------- -------------------- WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE DEPOSITS RATE DEPOSITS RATE DEPOSITS RATE------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)FOREIGNTime certificates.................. $ 9 5.6% $40 2.5% $953 3.5%Savings and demand accounts........ 28 1.5 48 1.4 38 2.8 --- --- --- --- ---- ---Total foreign deposits............. 37 2.5 88 1.9 991 3.5 --- --- --- --- ---- ---Total deposits..................... $40 2.3% $88 1.9% $992 3.5% === === === === ==== === Interest expense on total deposits was $1 million in 2005, $2 million in 2004,$28 million in the period March 29 through December 31, 2003 and $8 million inthe period January 1 through March 28, 2003. Interest expense on domesticdeposits was zero in 2005 and 2004 and insignificant in 2003. Maturities of time certificates in amounts of $100,000 or more at December 31,2005, all of which were foreign, were: (IN MILLIONS)---------------------------------------------------------------------------3 months or less............................................ $-Over 3 months through 6 months.............................. -Over 6 months through 12 months............................. -Over 12 months.............................................. 9 --Total....................................................... $9 == Contractual maturities of time certificates within each interest rate range atDecember 31, 2005 were as follows: INTEREST RATE 2006 2007 2008 2009 2010 THEREAFTER TOTAL----------------------------------------------------------------------------------------------------4.00% - 5.99%................................ $- $9 $- $- $- $- $9 == == == == == == == 152 13. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS-------------------------------------------------------------------------------- COMMERCIAL BANK AND OTHER PAPER BORROWINGS TOTAL-------------------------------------------------------------------------------------------------2005Balance................................................... $11,360 $ 57 $11,417Highest aggregate month-end balance....................... 14,864Average borrowings........................................ 11,877 71 11,948Weighted-average interest rate: At year-end............................................. 4.2% 4.0% 4.2% Paid during year........................................ 3.4 2.7 3.42004Balance................................................... $ 8,969 $ 44 $ 9,013Highest aggregate month-end balance....................... 16,179Average borrowings........................................ 11,403 38 11,441Weighted-average interest rate: At year-end............................................. 2.2% 2.6% 2.2% Paid during year........................................ 1.8 1.9 1.82003Balance................................................... $ 8,256 $ 866 $ 9,122Highest aggregate month-end balance....................... 9,856Average borrowings........................................ 6,357 1,187 7,544Weighted-average interest rate: At year-end............................................. 1.2% 3.6% 1.4% Paid during year........................................ 1.6 3.9 2.0 Commercial paper included obligations of foreign subsidiaries of $442 million atDecember 31, 2005, $248 million at December 31, 2004 and $307 million atDecember 31, 2003. Bank and other borrowings included obligations of foreignsubsidiaries of $20 million at December 31, 2005, $44 million at December 31,2004 and $832 million at December 31, 2003. Interest expense for commercial paper, bank and other borrowings totaled $401million in 2005, $211 million in 2004, $130 million in the period March 29through December 31, 2003 and $19 million in the period January 1 through March28, 2003. We maintain various bank credit agreements primarily to support commercial paperborrowings and also to provide funding in the U.K. We had committed back-uplines and other bank lines of $16.3 billion at December 31, 2005, including $8.0billion with HSBC and subsidiaries and $18.0 billion at December 31, 2004,including $10.1 billion with HSBC and subsidiaries. Our U.K. subsidiary haddrawn $4.2 billion on its bank lines of credit (all with HSBC) at December 31,2005 and had $7.4 billion drawn on its bank lines of credit (all with HSBC), atDecember 31, 2004. A $4.0 billion revolving credit facility with HSBC PrivateBank (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. Formalcredit lines are reviewed annually and expire at various dates through 2008.Borrowings under these lines generally are available at a surcharge over LIBOR.The most restrictive financial covenant contained in the back-up line agreementsthat could restrict availability is an obligation to maintain minimumshareholder's equity of $10.0 billion which is substantially below our December31, 2005 common and preferred shareholder's(s') equity balance of $19.5 billion.Because our U.K. subsidiary receives its funding directly from HSBC, weeliminated all third-party back-up lines at our U.K. subsidiary in 2004. Annualcommitment fee requirements to support availability of these lines at December31, 2005 totaled 153 $7 million and included $2 million for the HSBC lines. Annual commitment feerequirements to support availability of these lines at December 31, 2004 totaled$7 million and included $2 million for the HSBC lines. 14. LONG TERM DEBT (WITH ORIGINAL MATURITIES OVER ONE YEAR)-------------------------------------------------------------------------------- AT DECEMBER 31, ------------------- 2005 2004--------------------------------------------------------------------------------- (IN MILLIONS)SENIOR DEBT FIXED RATE: 8.875% Adjustable Conversion-Rate Equity Security Units................................................. $ 541 $ 529 Secured financings: 1.50% to 2.99%; due 2005 to 2007..................... - 239 3.00% to 3.99%; due 2006 to 2008..................... 3,947 346 4.00% to 4.49%; due 2006 to 2009..................... 2,254 - 4.50% to 4.99%; due 2006 to 2010..................... 1,024 - 7.00% to 7.49%; due 2005............................. - 51 7.50% to 7.99%; due 2005............................. - 10 8.00% to 8.99%; due 2005............................. - 11 Other fixed rate senior debt: 2.40% to 3.99%; due 2006 to 2010..................... 2,864 6,310 4.00% to 4.99%; due 2006 to 2023..................... 21,902 10,878 5.00% to 5.49%; due 2006 to 2023..................... 6,188 5,082 5.50% to 5.99%; due 2006 to 2024..................... 7,188 6,922 6.00% to 6.49%; due 2006 to 2033..................... 8,453 8,380 6.50% to 6.99%; due 2006 to 2033..................... 8,076 9,247 7.00% to 7.49%; due 2006 to 2032..................... 4,587 6,333 7.50% to 7.99%; due 2006 to 2032..................... 4,906 7,450 8.00% to 9.00%; due 2006 to 2012..................... 1,244 3,497 VARIABLE INTEREST RATE: Secured financings - 2.63% to 5.28%; due 2006 to 2010.................................................. 7,893 6,668 Other variable interest rate senior debt - 2.16% to 6.73%; due 2006 to 2018............................... 21,488 10,555SENIOR SUBORDINATED DEBT - 4.56%, due 2005.................. - 170JUNIOR SUBORDINATED NOTES ISSUED TO CAPITAL TRUSTS.......... 1,443 722UNAMORTIZED DISCOUNT........................................ (341) (296)HSBC ACQUISITION PURCHASE ACCOUNTING FAIR VALUE ADJUSTMENTS............................................... 1,506 2,274 -------- -------TOTAL LONG TERM DEBT........................................ $105,163 $85,378 ======== ======= HSBC acquisition purchase accounting fair value adjustments representadjustments which have been "pushed down" to record our long term debt at fairvalue at the date of our acquisition by HSBC. Secured financings of $15.1 billion at December 31, 2005 are secured by $21.8billion of real estate secured, auto finance and MasterCard/Visa credit cardreceivables. Secured financings of $7.3 billion at December 31, 2004 are securedby $10.3 billion of real estate secured and auto finance receivables. At December 31, 2005, long term debt included carrying value adjustmentsrelating to derivative financial instruments which decreased the debt balance by$862 million and a foreign currency translation adjustment relating to ourforeign denominated debt which increased the debt balance by $272 million. AtDecember 31, 2004, long term debt included carrying value adjustments relatingto derivative financial instruments which 154 decreased the debt balance by $121 million and a foreign currency translationadjustment relating to our foreign denominated debt which increased the debtbalance by $4 billion. Weighted-average interest rates were 5.3 percent at December 31, 2005 and 5.1percent at December 31, 2004 (excluding HSBC acquisition purchase accountingadjustments). Interest expense for long term debt was $3.7 billion in 2005, $2.6billion in 2004, $1.8 billion in the period March 29 through December 31, 2003and $870 million in the period January 1 through March 28, 2003. The mostrestrictive financial covenants contained in the terms of our debt agreementsare the maintenance of a minimum shareholder's equity of $10.0 billion which issubstantially lower than our common and preferred shareholder's(s') equitybalance of $19.5 billion at December 31, 2005. Debt denominated in a foreigncurrency is included in the applicable rate category based on the effective U.S.dollar equivalent rate as summarized in Note 15, "Derivative FinancialInstruments." In 2002, we issued $541 million of 8.875 percent Adjustable Conversion-RateEquity Security Units. Each Adjustable Conversion-Rate Equity Security Unitconsisted initially of a contract to purchase, for $25, a number of shares ofHSBC Finance Corporation (formerly known as Household International, Inc.)common stock on February 15, 2006 and a senior note issued by our then whollyowned subsidiary, Household Finance Corporation, with a principal amount of $25.Since the time the units were issued, HSBC Finance Corporation was acquired byHSBC Holdings plc and Household Finance Corporation was merged with and intoHSBC Finance. As a result of these transactions, the stock purchase contractsnow obligate holders to purchase, for $25, between 2.6041 and 3.1249 HSBCordinary shares on February 15, 2006, and HSBC Finance Corporation has succeededHousehold Finance Corporation as the obligor on the senior notes. In November2005 we remarketed the notes and reset the rate. The net proceeds from the saleof the units were allocated between the purchase contracts and the seniorunsecured notes on our balance sheet based on the fair value of each at the dateof the offering. During 2005, .1 million stock purchase contracts wereexercised. During 2004, .6 million stock purchase contracts were exercised. AtDecember 31, 2005, unexercised stock purchase contracts totaled 1.3 million. Theremaining stock purchase contracts matured on February 15, 2006 and HSBC issuedordinary shares for the remaining stock purchase contracts on that date. Thesettlement rate for each such purchase contract was 2.6041 HSBC ordinary shares. The following table summarizes our junior subordinated notes issued to capitaltrusts ("Junior Subordinated Notes") and the related company obligatedmandatorily redeemable preferred securities ("Preferred Securities"): HOUSEHOLD CAPITAL HOUSEHOLD CAPITAL HOUSEHOLD CAPITAL TRUST IX TRUST VII TRUST VI ("HCT IX") ("HCT VII") ("HCT VI")----------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)JUNIOR SUBORDINATED NOTES: Principal balance....................... $ 1,031 $ 206.2 $ 206.2 Interest rate........................... 5.91% 7.5% 8.25% Redeemable by issuer.................... November 2015 November 2006 January 2006 Stated maturity......................... November 2035 November 2031 January 2031PREFERRED SECURITIES: Rate.................................... 5.91% 7.5% 8.25% Face value.............................. $ 1,000 $ 200 $ 200 Issue date.............................. November 2005 November 2001 January 2001 The Preferred Securities must be redeemed when the Junior Subordinated Notes arepaid. The Junior Subordinated Notes have a stated maturity date, but areredeemable by us, in whole or in part, beginning on the dates indicated above atwhich time the Preferred Securities are callable at par ($25 per PreferredSecurity) plus accrued and unpaid dividends. Dividends on the PreferredSecurities are cumulative, payable quarterly in arrears, and are deferrable atour option for up to five years. We cannot pay dividends on our preferred andcommon stocks during such deferments. The Preferred Securities have aliquidation value of $25 per preferred security. 155 Our obligations with respect to the Junior Subordinated Notes, when consideredtogether with certain undertakings of HSBC Finance Corporation with respect tothe Trusts, constitute full and unconditional guarantees by us of the Trusts'obligations under the respective Preferred Securities. Maturities of long term debt at December 31, 2005 were as follows: (IN MILLIONS)---------------------------------------------------------------------------2006........................................................ $ 19,5802007........................................................ 19,0462008........................................................ 15,0502009........................................................ 11,4722010........................................................ 11,402Thereafter.................................................. 28,613 --------Total....................................................... $105,163 ======== Certain components of our long term debt may be redeemed prior to its statedmaturity. This information is provided by RNS The company news service from the London Stock Exchange