HSBC Holdings Regulatory News (HSBA)

6 Mar 2006 11:02

HSBC Holdings PLC06 March 2006 15. DERIVATIVE FINANCIAL INSTRUMENTS-------------------------------------------------------------------------------- Our business activities involve analysis, evaluation, acceptance and managementof some degree of risk or combination of risks. Accordingly, we havecomprehensive risk management policies to address potential financial risks,which include credit risk (which includes counterparty credit risk), liquidityrisk, market risk, and operational risks. Our risk management policy is designedto identify and analyze these risks, to set appropriate limits and controls, andto monitor the risks and limits continually by means of reliable and up-to-dateadministrative and information systems. Our risk management policies areprimarily carried out in accordance with practice and limits set by the HSBCGroup Management Board. The HSBC Finance Corporation Asset Liability Committee("ALCO") meets regularly to review risks and approve appropriate risk managementstrategies within the limits established by the HSBC Group Management Board.Additionally, our Audit Committee receives regular reports on our liquiditypositions in relation to the established limits. In accordance with the policiesand strategies established by ALCO, in the normal course of business, we enterinto various transactions involving derivative financial instruments. Thesederivative financial instruments primarily are used to manage our market risk.For further information on our strategies for managing interest rate and foreignexchange rate risk, see the "Risk Management" section within our Management'sDiscussion and Analysis of Financial Condition and Results of Operations. OBJECTIVES FOR HOLDING DERIVATIVE FINANCIAL INSTRUMENTS Market risk (whichincludes interest rate and foreign currency exchange risks) is the possibilitythat a change in interest rates or foreign exchange rates will cause a financialinstrument to decrease in value or become more costly to settle. We try tomanage this risk by borrowing money with similar interest rate and maturityprofiles; however, there are instances when this cannot be achieved. Over time,customer demand for our receivable products shifts between fixed rate andfloating rate products, based on market conditions and preferences. These shiftsin loan products result in different funding strategies and produce differentinterest rate risk exposures. We maintain an overall risk management strategythat uses a variety of interest rate and currency derivative financialinstruments to mitigate our exposure to fluctuations caused by changes ininterest rates and currency exchange rates. We manage our exposure to interestrate risk primarily through the use of interest rate swaps, but also useforwards, futures, options, and other risk management instruments. We manage ourexposure to foreign currency exchange risk primarily through the use of currencyswaps, options and forwards. We do not use leveraged derivative financialinstruments for interest rate risk management. Interest rate swaps are contractual agreements between two counterparties forthe exchange of periodic interest payments generally based on a notionalprincipal amount and agreed-upon fixed or floating rates. The majority of ourinterest rate swaps are used to manage our exposure to changes in interest ratesby converting floating rate assets or debt to fixed rate or by converting fixedrate assets or debt to floating rate. We have also 156 entered into currency swaps to convert both principal and interest payments ondebt issued from one currency to the appropriate functional currency. Forwards and futures are agreements between two parties, committing one to selland the other to buy a specific quantity of an instrument on some future date.The parties agree to buy or sell at a specified price in the future, and theirprofit or loss is determined by the difference between the arranged price andthe level of the spot price when the contract is settled. We have used bothinterest rate and foreign exchange rate forward contracts as well as interestrate futures contracts. We use foreign exchange rate forward contracts to reduceour exposure to foreign currency exchange risk. Interest rate forward andfutures contracts are used to hedge resets of interest rates on our floatingrate assets and liabilities. Cash requirements for forward contracts include thereceipt or payment of cash upon the sale or purchase of the instrument. Purchased options grant the purchaser the right, but not the obligation, toeither purchase or sell a financial instrument at a specified price within aspecified period. The seller of the option has written a contract which createsan obligation to either sell or purchase the financial instrument at theagreed-upon price if, and when, the purchaser exercises the option. We use capsto limit the risk associated with an increase in rates and floors to limit therisk associated with a decrease in rates. CREDIT RISK By utilizing derivative financial instruments, we are exposed tocounterparty credit risk. Counterparty credit risk is our primary exposure onour interest rate swap portfolio. Counterparty credit risk is the risk that thecounterparty to a transaction fails to perform according to the terms of thecontract. We control the counterparty credit (or repayment) risk in derivativeinstruments through established credit approvals, risk control limits,collateral, and ongoing monitoring procedures. Our exposure to credit risk forfutures is limited as these contracts are traded on organized exchanges. Eachday, changes in futures contract values are settled in cash. In contrast, swapagreements and forward contracts have credit risk relating to the performance ofthe counterparty. Beginning in the third quarter of 2003, we began utilizing anaffiliate, HSBC Bank USA, as the primary provider of new domestic derivativeproducts. We have never suffered a loss due to counterparty failure. At December 31, 2005, most of our existing derivative contracts are with HSBCsubsidiaries, making them our primary counterparty in derivative transactions.Most swap agreements require that payments be made to, or received from, thecounterparty when the fair value of the agreement reaches a certain level.Generally, third-party swap counterparties provide collateral in the form ofcash which are recorded in our balance sheet as derivative related liabilitiesand totaled $91 million at December 31, 2005. Affiliate swap counterpartiesprovide collateral in the form of securities, as required, which are notrecorded on our balance sheet. At December 31, 2005, the fair value of ouragreements with affiliate counterparties was below the $1.2 billion levelrequiring posting of collateral. At December 31, 2005, we had derivativecontracts with a notional value of approximately $75.9 billion, including $71.3billion outstanding with HSBC Bank USA. Derivative financial instruments aregenerally expressed in terms of notional principal or contract amounts which aremuch larger than the amounts potentially at risk for nonpayment bycounterparties. FAIR VALUE AND CASH FLOW HEDGES To manage our exposure to changes in interestrates, we enter into interest rate swap agreements and currency swaps which havebeen designated as fair value or cash flow hedges under SFAS No. 133. Prior tothe acquisition by HSBC, the majority of our fair value and cash flow hedgeswere effective hedges which qualified for the shortcut method of accounting.Under the Financial Accounting Standards Board's interpretations of SFAS No.133, the shortcut method of accounting was no longer allowed for interest rateswaps which were outstanding at the time of the acquisition by HSBC. As a resultof the acquisition, we were required to reestablish and formally document thehedging relationship associated with all of our fair value and cash flow hedginginstruments and assess the effectiveness of each hedging relationship, both atinception of the acquisition and on an ongoing basis. Due to deficiencies in ourcontemporaneous hedge documentation at the time of acquisition, we lost theability to apply hedge accounting to our entire cash flow and fair value hedgingportfolio that existed at the time of acquisition by HSBC. During 2005, wereestablished hedge treatment under the long haul method of accounting for asignificant number of the derivatives in this portfolio. We continue to evaluatethe steps required to regain hedge accounting treatment under SFAS No. 133 forthe remaining swaps which do not currently qualify for hedge accounting. The 157 majority of all derivative financial instruments entered into subsequent to theacquisition qualify as effective hedges under SFAS No. 133. Fair value hedges include interest rate swaps which convert our fixed rate debtto variable rate debt and currency swaps which convert debt issued from onecurrency into pay variable debt of the appropriate functional currency. Hedgeineffectiveness associated with fair value hedges is recorded in other revenuesas derivative income (expense) and was a gain of $117 million ($75 million aftertax) in 2005, a gain of $.6 million ($.4 million after tax) in 2004, a gain of$.8 million ($.5 million after tax) in the period March 29 through December 31,2003, and a gain of $3 million ($2 million after tax) in the period January 1through March 28, 2003. All of our fair value hedges were associated with debtduring 2005, 2004 and 2003. We recorded fair value adjustments for unexpiredfair value hedges which decreased the carrying value of our debt by $695 millionat December 31, 2005 and $60 million at December 31, 2004. Fair valueadjustments for unexpired fair value hedges on a "predecessor" basis areincluded in the HSBC acquisition purchase accounting fair value adjustment todebt as a result of push-down accounting effective March 29, 2003 when the"successor" period began. Cash flow hedges include interest rate swaps which convert our variable ratedebt or assets to fixed rate debt or assets and currency swaps which convertdebt issued from one currency into pay fixed debt of the appropriate functionalcurrency. Gains and (losses) on unexpired derivative instruments designated ascash flow hedges (net of tax) are reported in accumulated other comprehensiveincome and totaled a gain of $237 million ($151 million after tax) at December31, 2005 and $83 million ($53 million after tax) at December 31, 2004. We expect$110 million ($70 million after tax) of currently unrealized net gains will bereclassified to earnings within one year, however, these unrealized gains willbe offset by increased interest expense associated with the variable cash flowsof the hedged items and will result in no net economic impact to our earnings.Hedge ineffectiveness associated with cash flow hedges is recorded in otherrevenues as derivative income was a loss of $76 million ($49 million after tax)in 2005 and was immaterial in 2004 and was a gain of $.5 million ($.3 millionafter tax) in the period March 29 through December 31, 2003. Hedgeineffectiveness associated with cash flow hedges was immaterial for the periodJanuary 1 through March 28, 2003. At December 31, 2005, $234 million of derivative instruments, at fair value,were recorded in derivative financial assets and $292 million in derivativerelated liabilities. At December 31, 2004, $4.0 billion of derivativeinstruments, at fair value, were recorded in derivative financial assets and $70million in derivative related liabilities. Information related to deferred gains and losses before taxes on terminatedderivatives was as follows: 2005 2004----------------------------------------------------------------------------------------- (IN MILLIONS)Deferred gains.............................................. $ 173 $ 210Deferred losses............................................. 215 168Weighted-average amortization period: Deferred gains............................................ 4 YEARS 7 years Deferred losses........................................... 5 YEARS 8 yearsIncreases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt............................................ $ (111) $ (61) Accumulated other comprehensive income.................... 69 103 158 Information related to deferred gains and losses before taxes on discontinuedhedges was as follows: 2005 2004---------------------------------------------------------------------------------- (IN MILLIONS)Deferred gains.............................................. $ 197 $-Deferred losses............................................. 152 -Weighted-average amortization period: Deferred gains............................................ 5 YEARS - Deferred losses........................................... 6 YEARS -Increases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt............................................ $ (56) - Accumulated other comprehensive income.................... 101 - Amortization of net deferred gains (losses) totaled ($12) million in 2005, ($23)million in 2004, ($7) million in the period March 29 through December 31, 2003and $80 million in the period January 1 through March 28, 2003. HEDGES OF NET INVESTMENTS IN FOREIGN OPERATIONS Prior to the acquisition byHSBC, we used forward-exchange contracts and foreign currency options to hedgeour net investments in foreign operations. We used these hedges to protectagainst adverse movements in exchange rates. Net gains and (losses) (net of tax)related to these derivatives were included in accumulated other comprehensiveincome and totaled $.1 million in the period March 29 through December 31, 2003for the contracts that terminated subsequent to the acquisition by HSBC and($12) million in the period January 1 through March 28, 2003. We have notentered into foreign exchange contracts to hedge our investment in foreignsubsidiaries since our acquisition by HSBC. NON-QUALIFYING HEDGING ACTIVITIES We may also use forward rate agreements,interest rate caps, exchange traded futures, and interest rate and currencyswaps which are not designated as hedges under SFAS No. 133, either because theydo not qualify as effective hedges or because we lost the ability to apply hedgeaccounting following our acquisition by HSBC as discussed above. These financialinstruments are economic hedges but do not qualify for hedge accounting and areprimarily used to minimize our exposure to changes in interest rates andcurrency exchange rates. Unrealized and realized gains (losses) on derivativeswhich were not designated as hedges are reported in other revenues as derivativeincome and totaled $208 million ($133 million after tax) in 2005, $510 million($324 million after tax) in 2004; $285 million ($181 million after tax) in theperiod March 29, 2003 through December 31, 2003 and $(1) million ($(.7) millionafter tax) in the period January 1 through March 28, 2003. DERIVATIVE INCOME Derivative income as discussed above includes realized andunrealized gains and losses on derivatives which do not qualify as effectivehedges under SFAS No. 133 as well as the ineffectiveness on derivativesassociated with our qualifying hedges and is summarized in the table below: 2005 2004 2003-------------------------------------------------------------------------------- (IN MILLIONS)Net realized gains (losses)................................. $ 52 $ 68 $ 54Mark-to-market on derivatives which do not qualify as effective hedges.......................................... 156 442 230Ineffectiveness............................................. 41 1 2 ---- ---- ----Total....................................................... $249 $511 $286 ==== ==== ==== 159 DERIVATIVE FINANCIAL INSTRUMENTS The following table summarizes derivativefinancial instrument activity: EXCHANGE TRADED NON-EXCHANGE TRADED --------------------------------- ------------------------------------------ INTEREST RATE FOREIGN EXCHANGE FUTURES CONTRACTS INTEREST RATE CONTRACTS --------------------- OPTIONS RATE CURRENCY -------------------- PURCHASED SOLD PURCHASED SWAPS SWAPS PURCHASED SOLD---------------------------------------------------------------------------------------------------------2005Notional amount, 2004.... $ - $ - $ 1,691 $ 45,253 $18,150 $ 1,146 $ 614New contracts............ - - - 1 - - -New contracts purchased from subsidiaries of HSBC................... - - - 25,373 6,824 1,113 4,860Matured or expired contracts.............. - - (1,691) (5,657) (3,225) (482) (4,762)Terminated contracts..... - - - (15,362) - (142) (247)In-substance maturities(1).......... - - - - - - -Assignment of contracts to subsidiaries of HSBC................... - - - - - - - ----- ----- ------- -------- ------- -------- --------Notional amount, 2005.... $ - $ - $ - $ 49,608 $21,719 $ 1,635 $ 465 ===== ===== ======= ======== ======= ======== ========Fair value, 2005(3): Fair value hedges...... $ - $ - $ - $ (612) $ (178) $ - $ - Cash flow hedges....... - - - 103 658 (22) - Net investment in foreign operations... - - - - - - - Non-hedging derivatives.......... - - - (31) 24 - - ----- ----- ------- -------- ------- -------- -------- Total.................. $ - $ - $ - $ (540) $ 504 $ (22) $ - ===== ===== ======= ======== ======= ======== ========2004Notional amount, 2003.... $ - $ - $ 1,900 $ 41,312 $16,538 $ 1,223 $ 594New contracts............ - - - - - 1,628 1,432New contracts purchased from subsidiaries of HSBC................... - - 3,491 29,607 11,457 17,988 8,778Matured or expired contracts.............. - - (3,700) (7,568) (1,407) (14,343) (4,840)Terminated contracts..... - - - (7,211) (5,333) - -In-substance maturities(1).......... - - - - - (5,350) (5,350)Assignment of contracts to subsidiaries of HSBC................... - - - (10,887) (3,105) - - ----- ----- ------- -------- ------- -------- --------Notional amount, 2004.... $ - $ - $ 1,691 $ 45,253 $18,150 $ 1,146 $ 614 ===== ===== ======= ======== ======= ======== ========Fair value, 2004(3): Fair value hedges...... $ - $ - $ - $ (46) $ - $ - $ 2 Cash flow hedges....... - - - 12 403 24 - Net investment in foreign operations... - - - - - - - Non-hedging derivatives.......... - - - (81) 3,670 - - ----- ----- ------- -------- ------- -------- -------- Total.................. $ - $ - $ - $ (115) $ 4,073 $ 24 $ 2 ===== ===== ======= ======== ======= ======== ========2003Notional amount, 2002.... $ - $ - $ 3,400 $ 44,506 $11,661 $ 376 $ 2,525New contracts............ 600 (600) - 7,601 1,219 20,102 17,548New contracts purchased from subsidiaries of HSBC................... - - 3,385 25,369 10,399 3,144 642Matured or expired contracts.............. - - (4,404) (15,137) (1,401) (3,190) (912)Terminated contracts..... - - (481) (11,984) (146) - -In-substance maturities(1).......... (600) 600 - - - (19,209) (19,209)Assignment of contracts to subsidiaries of HSBC................... - - - (9,043) (5,194) - -Loss of shortcut accounting(2): Terminated contracts... - - - (26,530) - - - New contracts.......... - - - 26,530 - - - ----- ----- ------- -------- ------- -------- --------Notional amount, 2003.... $ -- $ - $ 1,900 $ 41,312 $16,538 $ 1,223 $ 594 ===== ===== ======= ======== ======= ======== ========Fair value, 2003(3): Fair value hedges...... $ - $ - $ - $ 138 $ 101 $ - $ 23 Cash flow hedges....... - - - (147) 419 41 - Net investment in foreign operations... - - - - - - - Non-hedging derivatives.......... - - - (162) 2,500 - - ----- ----- ------- -------- ------- -------- -------- Total.................. $ - $ - $ - $ (171) $ 3,020 $ 41 $ 23 ===== ===== ======= ======== ======= ======== ======== NON-EXCHANGE TRADED ---------------------------- INTEREST RATE FORWARD CONTRACTS CAPS ------------------ AND PURCHASED SOLD FLOORS TOTAL------------------------- ---------------------------------------2005Notional amount, 2004.... $ 374 $- $ 4,380 $ 71,608New contracts............ - - 30 31New contracts purchased from subsidiaries of HSBC................... 1,707 - - 39,877Matured or expired contracts.............. - - (1,894) (17,741)Terminated contracts..... (1,909) - (249) (17,909)In-substance maturities(1).......... - - - -Assignment of contracts to subsidiaries of HSBC................... - - - - ------- -- ------- --------Notional amount, 2005.... $ 172 $- $ 2,267 $ 75,866 ======= == ======= ========Fair value, 2005(3): Fair value hedges...... $ - $- $ - $ (790) Cash flow hedges....... - - - 739 Net investment in foreign operations... - - - - Non-hedging derivatives.......... - - - (7) ------- -- ------- -------- Total.................. $ - $- $ - $ (58) ======= == ======= ========2004Notional amount, 2003.... $ 174 $- $ 6,627 $ 68,368New contracts............ - - - 3,060New contracts purchased from subsidiaries of HSBC................... 1,643 - 444 73,408Matured or expired contracts.............. (1,443) - (2,691) (35,992)Terminated contracts..... - - - (12,544)In-substance maturities(1).......... - - - (10,700)Assignment of contracts to subsidiaries of HSBC................... - - - (13,992) ------- -- ------- --------Notional amount, 2004.... $ 374 $- $ 4,380 $ 71,608 ======= == ======= ========Fair value, 2004(3): Fair value hedges...... $ - $- $ - $ (48) Cash flow hedges....... - - - 439 Net investment in foreign operations... - - - - Non-hedging derivatives.......... - - - 3,589 ------- -- ------- -------- Total.................. $ - $- $ - $ 3,980 ======= == ======= ========2003Notional amount, 2002.... $ 159 $- $ 7,221 $ 69,848New contracts............ 906 - - 48,576New contracts purchased from subsidiaries of HSBC................... 174 - 4,333 47,446Matured or expired contracts.............. (506) - (4,927) (30,477)Terminated contracts..... (559) - - (13,170)In-substance maturities(1).......... - - - (39,618)Assignment of contracts to subsidiaries of HSBC................... - - - (14,237)Loss of shortcut accounting(2): Terminated contracts... - - - (26,530) New contracts.......... - - - 26,530 ------- -- ------- --------Notional amount, 2003.... $ 174 $- $ 6,627 $ 68,368 ======= == ======= ========Fair value, 2003(3): Fair value hedges...... $ - $- $ - $ 216 Cash flow hedges....... - - - 313 Net investment in foreign operations... - - - - Non-hedging derivatives.......... - - - 2,338 ------- -- ------- -------- Total.................. $ - $- $ - $ 2,867 ======= == ======= ======== 160 --------------- (1) Represent contracts terminated as the market execution technique of closing the transaction either (a) just prior to maturity to avoid delivery of the underlying instrument or (b) at the maturity of the underlying items being hedged. (2) Under the Financial Accounting Standards Board's interpretations of SFAS No. 133, the shortcut method of accounting was no longer allowed for interest rate swaps which were outstanding at the time of the acquisition by HSBC. (3) (Bracketed) unbracketed amounts represent amounts to be (paid) received by us had these positions been closed out at the respective balance sheet date. Bracketed amounts do not necessarily represent risk of loss as the fair value of the derivative financial instrument and the items being hedged must be evaluated together. See Note 24, 'Fair Value of Financial Instruments,' for further discussion of the relationship between the fair value of our assets and liabilities. We operate in three functional currencies, the U.S. dollar, the British poundand the Canadian dollar. The U.S. dollar is the functional currency forexchange-traded interest rate futures contracts and options. Non-exchange tradedinstruments are restated in U.S. dollars by country as follows: FOREIGN EXCHANGE INTEREST RATE RATE CONTRACTS FORWARD OTHER RISK INTEREST RATE CURRENCY ---------------- CONTRACTS MANAGEMENT SWAPS SWAPS PURCHASED SOLD PURCHASED INSTRUMENTS--------------------------------------------------------------------------------------------------------- (IN MILLIONS)2005United States................. $47,693 $21,175 $1,622 $465 $ - $2,267Canada........................ 995 - 13 - 172 -United Kingdom................ 920 544 - - - - ------- ------- ------ ---- ---- ------ $49,608 $21,719 $1,635 $465 $172 $2,267 ======= ======= ====== ==== ==== ======2004United States................. $42,365 $17,543 $1,146 $599 $ - $4,345Canada........................ 582 - - 15 374 -United Kingdom................ 2,306 607 - - - 35 ------- ------- ------ ---- ---- ------ $45,253 $18,150 $1,146 $614 $374 $4,380 ======= ======= ====== ==== ==== ======2003United States................. $39,653 $14,995 $1,223 $593 $ - $6,595Canada........................ 405 - - 1 174 -United Kingdom................ 1,254 1,543 - - - 32 ------- ------- ------ ---- ---- ------ $41,312 $16,538 $1,223 $594 $174 $6,627 ======= ======= ====== ==== ==== ====== The table below reflects the items hedged using derivative financial instrumentswhich qualify for hedge accounting at December 31, 2005. The critical terms ofthe derivative financial instruments have been designed to match those of therelated asset or liability. FOREIGN INTEREST RATE CURRENCY EXCHANGE RATE SWAPS SWAPS CONTRACTS---------------------------------------------------------------------------------------------------- (IN MILLIONS)Investment securities..................................... $ - $ - $ -Commercial paper, bank and other borrowings............... 920 - 1,622Long term debt............................................ 45,913 18,689 -Advances to foreign subsidiaries.......................... - - 465 ------- ------- ------Total items hedged using derivative financial instruments............................................. $46,833 $18,689 $2,087 ======= ======= ====== 161 The following table summarizes the maturities and related weighted-averagereceive/pay rates of interest rate swaps outstanding at December 31, 2005: 2006 2007 2008 2009 2010 2011 THEREAFTER TOTAL----------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS)PAY A FIXED RATE/RECEIVE A FLOATING RATE: Notional value............... $8,892 $7,471 $3,320 $2,569 $ 232 $ 153 $ 450 $23,087 Weighted-average receive rate....................... 4.40% 4.36% 4.63% 4.75% 4.66% 5.15% 5.66% 4.49% Weighted-average pay rate.... 3.54 4.34 4.81 4.88 4.10 4.36 4.97 4.12 ------ ------ ------ ------ ------ ------ ------ -------PAY A FLOATING RATE/RECEIVE A FIXED RATE: Notional value............... $ 291 $ 483 $2,608 $4,953 $3,142 $5,550 $9,494 $26,521 Weighted-average receive rate....................... 3.55 3.12 3.72 4.04 4.27 4.55 4.98 4.46 Weighted-average pay rate.... 4.68 4.44 4.52 4.31 3.85 4.59 4.39 4.37 ------ ------ ------ ------ ------ ------ ------ -------Total notional value........... $9,183 $7,954 $5,928 $7,522 $3,374 $5,703 $9,944 $49,608 ====== ====== ====== ====== ====== ====== ====== =======TOTAL WEIGHTED-AVERAGE RATES ON SWAPS: Receive rate................. 4.37% 4.29% 4.23% 4.28% 4.30% 4.56% 5.01% 4.47% Pay rate..................... 3.58 4.34 4.68 4.50 3.87 4.58 4.42 4.25 The floating rates that we pay or receive are based on spot rates fromindependent market sources for the index contained in each interest rate swapcontract, which generally are based on either 1, 3 or 6-month LIBOR. Thesecurrent floating rates are different than the floating rates in effect when thecontracts were initiated. Changes in spot rates impact the variable rateinformation disclosed above. However, these changes in spot rates also impactthe interest rate on the underlying assets or liabilities. We use derivativefinancial instruments as either qualifying hedging instruments under SFAS No.133 or economic hedges to hedge the volatility of earnings resulting fromchanges in interest rates on the underlying hedged items. Use of interest rateswaps which qualify as effective hedges under SFAS No. 133 increased our netinterest income by 24 basis points in 2005, 49 basis points in 2004 and 49 basispoints in 2003. 16. INCOME TAXES-------------------------------------------------------------------------------- Total income taxes were: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003---------------------------------------------------------------------------------------------------------------- (IN MILLIONS)Provision for income taxes related to operations................................ $891 $1,000 $690 $182Income taxes related to adjustments included in common shareholder's(s') equity: Unrealized gains (losses) on investments and interest-only strip receivables, net.................................... (29) (71) 105 (13) Unrealized gains (losses) on cash flow hedging instruments.................... 74 61 (9) 57 Minimum pension liability................. 2 (2) - - Foreign currency translation adjustments............................ (6) 12 - (7) Exercise of stock based compensation...... (9) (18) (15) (2) Tax on sale of U.K. credit card business to affiliate........................... (21) - - - ---- ------ ---- ----Total....................................... $902 $ 982 $771 $217 ==== ====== ==== ==== 162 Provisions for income taxes related to operations were: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003------------------------------------------------------------------------------------------------------ (IN MILLIONS)CURRENTUnited States................................. $1,253 $ 593 $688 $ 74Foreign....................................... 4 59 85 19 ------ ------ ---- ----Total current................................. 1,257 652 773 93 ------ ------ ---- ----DEFERREDUnited States................................. (396) 348 (87) 91Foreign....................................... 30 - 4 (2) ------ ------ ---- ----Total deferred................................ (366) 348 (83) 89 ------ ------ ---- ----Total income taxes............................ $ 891 $1,000 $690 $182 ====== ====== ==== ==== The significant components of deferred provisions attributable to income fromoperations were: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003------------------------------------------------------------------------------------------------------ (IN MILLIONS)Deferred income tax (benefit) provision (excluding the effects of other components)................................. $(342) $348 $(83) $89Adjustment of valuation allowance............. (2) - - -Change in operating loss carryforwards........ (12) - - -Adjustment to statutory tax rate.............. (10) - - - ----- ---- ---- ---Deferred income tax provision................. $(366) $348 $(83) $89 ===== ==== ==== === Income before income taxes were: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003------------------------------------------------------------------------------------------------------ (IN MILLIONS)United States................................. $2,560 $2,786 $1,801 $379Foreign....................................... 103 154 246 49 ------ ------ ------ ----Total income before income taxes.............. $2,663 $2,940 $2,047 $428 ====== ====== ====== ==== 163 Effective tax rates are analyzed as follows: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003------------------------------------------------------------------------------------------------------ (IN MILLIONS)Statutory Federal income tax rate............. 35.0% 35.0% 35.0% 35.0%Increase (decrease) in rate resulting from: State and local taxes, net of Federal benefit.................................. .9 1.4 1.4 1.9 Low income housing and other tax credits.... (3.2) (2.9) (3.0) (5.1) Noncurrent tax requirements................. - - (1.5) (3.0) Nondeductible acquisition costs............. - - - 11.0 Other....................................... .8 .5 1.8 2.7 ---- ---- ---- -----Effective tax rate............................ 33.5% 34.0% 33.7% 42.5% ==== ==== ==== ===== Temporary differences which gave rise to a significant portion of deferred taxassets and liabilities were as follows: AT DECEMBER 31, --------------- 2005 2004----------------------------------------------------------------------------- (IN MILLIONS)DEFERRED TAX ASSETSCredit loss reserves........................................ $1,438 $1,497Other reserves.............................................. 129 73Market value adjustment..................................... 95 214Debt........................................................ 80 162Other....................................................... 429 397 ------ ------Total deferred tax assets................................... 2,171 2,343Valuation allowance......................................... (28) (28) ------ ------Total deferred tax assets net of valuation allowance........ 2,143 2,315 ------ ------DEFERRED TAX LIABILITIESIntangibles................................................. 779 934Fee income.................................................. 545 375Deferred loan origination costs............................. 239 189Receivables................................................. 163 231Leveraged lease transactions, net........................... 78 129Receivables sold............................................ 22 413Other....................................................... 162 191 ------ ------Total deferred tax liabilities.............................. 1,988 2,462 ------ ------Net deferred tax asset (liability).......................... $ 155 $ (147) ====== ====== In addition, provision for U.S. income taxes had not been made at December 31,2004 on $80 million of undistributed, untaxed earnings of Household LifeInsurance Company accumulated in its Policyholders' Surplus Account under taxlaws in effect prior to 1984. This amount would have been subject to taxation inthe event Household Life Insurance Company made distributions in excess of itsShareholders' Surplus Account (generally undistributed accumulated after-taxearnings) and certain other events. If Household Life Insurance Company had beensubject to tax on the full amount of its Policyholders' Surplus Account, theadditional income tax payable would have been approximately $28 million. 164 Unlike prior law provisions treating distributions by a life insurance companyas first coming out of its Shareholders' Surplus Account and then out of itsPolicyholders' Surplus Account, the American Jobs Creation Act of 2004 (the"AJCA") contains provisions that would reverse such order and treatdistributions as first coming out of Policyholders' Surplus Account and then outof a Shareholders' Surplus Account. These new provisions also eliminated theimposition of the income tax on any distributions from a Policyholders' SurplusAccount. Such provisions apply to distributions made by a life insurance companyafter December 31, 2004 and before January 1, 2007. Household Life Insurance Company paid a dividend in the year ended December 31,2005 in an amount in excess of the Policyholders' Surplus Account. This dividendeliminated the balance in that account and the potential for a tax on any futuredistributions from the account. Provision for U.S. income tax had not been made on net undistributed earnings offoreign subsidiaries of $118 million at December 31, 2005 and $643 million atDecember 31, 2004. Determination of the amount of unrecognized deferred taxliability related to investments in foreign subsidiaries is not practicable. The AJCA included provisions to allow a deduction of 85% of certain foreignearnings that are repatriated in 2004 or 2005. We elected to apply thisprovision to a $489 million distribution in December 2005 by our U.K.subsidiary. Tax of $26 million related to this distribution is included as partof the current 2005 U.S. tax expense shown above. At December 31, 2005, we had net operating loss carryforwards of $987 millionfor state tax purposes which expire as follows: $332 million in 2006-2010; $150million in 2011-2015; $287 million in 2016-2020 and $218 million in 2021-2025. 17. REDEEMABLE PREFERRED STOCK-------------------------------------------------------------------------------- In conjunction with our acquisition by HSBC, our 7.625%, 7.60%, 7.50% and 8.25%preferred stock was converted into the right to receive cash which totaledapproximately $1.1 billion. In consideration of HSBC transferring sufficientfunds to make these payments, we issued the Series A cumulative preferred stockto HSBC on March 28, 2003. Simultaneous with our acquisition by HSBC, we calledfor redemption our $4.30, $4.50 and 5.00% preferred stock. Through a series oftransactions which concluded in October 2004, the Series A Preferred Stock weretransferred from HSBC to HINO. On December 15, 2005, we issued four shares ofcommon stock to HINO in exchange for the Series A Preferred Stock. See Note 19,"Related Party Transactions," for further discussion. In June 2005, we issued 575,000 shares of 6.36 percent Non-Cumulative PreferredStock, Series B ("Series B Preferred Stock"). Dividends on the Series BPreferred Stock are non-cumulative and payable quarterly at a rate of 6.36percent commencing September 15, 2005. The Series B Preferred Stock may beredeemed at our option after June 23, 2010 at $1,000 per share, plus accrueddividends. The redemption and liquidation value is $1,000 per share plus accruedand unpaid dividends. The holders of Series B Preferred Stock are entitled topayment before any capital distribution is made to the common shareholder andhave no voting rights except for the right to elect two additional members tothe board of directors in the event that dividends have not been declared andpaid for six quarters, or as otherwise provided by law. Additionally, as long asany shares of the Series B Preferred Stock are outstanding, the authorization,creation or issuance of any class or series of stock which would rank prior tothe Series B Preferred Stock with respect to dividends or amounts payable uponliquidation or dissolution of HSBC Finance Corporation must be approved by theholders of at least two-thirds of the shares of Series B Preferred Stockoutstanding at that time. Related issuance costs of $16 million have beenrecorded as a reduction of additional paid-in capital. In 2005, we declareddividends totaling $17 million on the Series B Preferred Stock which were paidprior to December 31, 2005. 165 18. ACCUMULATED OTHER COMPREHENSIVE INCOME-------------------------------------------------------------------------------- Accumulated other comprehensive income includes certain items that are reporteddirectly within a separate component of shareholders' equity. The followingtable presents changes in accumulated other comprehensive income balances. 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)Unrealized gains (losses) on investments and interest-only strip receivables: Balance at beginning of period.............. $ 54 $168 $294 $ 319 Effect of push-down accounting of HSBC's purchase price on net assets............. - - (294) - Other comprehensive income for period: Net unrealized holding gains (losses) arising during period, net of tax of $29 million, $67 million, $(111) million and $0 million, respectively... (56) (106) 179 - Reclassification adjustment for gains realized in net income, net of taxes of $- million, $4 million, $6 million and $13 million, respectively.............. - (8) (11) (25) ----- ---- ---- ----- Total other comprehensive income for period................................... (56) (114) 168 (25) ----- ---- ---- ----- Balance at end of period.................... (2) 54 168 294 ----- ---- ---- -----Unrealized gains (losses) on cash flow hedging instruments: Balance at beginning of period.............. 119 (11) (636) (737) Effect of push-down accounting of HSBC's purchase price on net assets............. - - 636 - Other comprehensive income for period: Net gains (losses) arising during period, net of tax of $(92) million, $(34) million, $19 million and $(10) million, respectively........................... 173 72 (22) 19 Reclassification adjustment for losses realized in net income, net of tax of $18 million, $(27) million, $(10) million and $(47) million, respectively........................... (32) 58 11 82 ----- ---- ---- ----- Total other comprehensive income for period................................... 141 130 (11) 101 ----- ---- ---- ----- Balance at end of period.................... 260 119 (11) (636) ----- ---- ---- ----- 166 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)Minimum pension liability: Balance at beginning of period.............. (4) - (30) (30) Effect of push-down accounting of HSBC's purchase price on net assets............. - - 30 - Other comprehensive income for period: Pension liability settlement adjustment, net of tax of $(2) million in 2005 and $2 million in 2004..................... 4 (4) - - ----- ---- ---- ----- Total other comprehensive income for period................................... 4 (4) - - ----- ---- ---- ----- Balance at end of period.................... - (4) - (30) ----- ---- ---- -----Foreign currency translation adjustments: Balance at beginning of period.............. 474 286 (271) (247) Effect of push-down accounting of HSBC's purchase price on net assets............. - - 271 - Other comprehensive income for period: Translation gains, net of tax of $6 million, $(12) million, $0 million and $7 million, respectively............... (253) 188 286 (24) ----- ---- ---- ----- Total other comprehensive income for period................................... (253) 188 286 (24) ----- ---- ---- ----- Balance at end of period.................... 221 474 286 (271) ----- ---- ---- -----Total accumulated other comprehensive income (loss) at end of period..................... $ 479 $643 $443 $(643) ===== ==== ==== ===== 19. RELATED PARTY TRANSACTIONS-------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and itssubsidiaries. These transactions include funding arrangements, purchases andsales of receivables, servicing arrangements, information technology services,item and statement processing services, banking and other miscellaneousservices. The following tables present related party balances and the income and(expense) generated by related party transactions: AT DECEMBER 31, 2005 2004--------------------------------------------------------------------------------- (IN MILLIONS)ASSETS, (LIABILITIES) AND EQUITY:Derivative financial assets (liability), net................ $ (260) $ 3,297Affiliate preferred stock received in sale of U.K. credit card business............................................. 261 -Other assets................................................ 518 604Due to affiliates........................................... (15,534) (13,789)Other liabilities........................................... (445) (168)Series A Preferred Stock.................................... - 1,100(1)Premium on sale of U.K. credit card business to affiliate recorded as an increase to additional paid in capital..... 182 - --------------- (1) In December 2005, the $1.1 billion Series A preferred stock plus all accrued and unpaid dividends was exchanged for a like amount of common equity and the Series A preferred stock was retired. We issued 4 shares of common equity to HINO as part of the exchange. 167 FOR THE YEAR ENDED DECEMBER 31, 2005 2004 2003-----------------------------------------------------------------------------------INCOME/(EXPENSE):Interest expense on borrowings from HSBC and subsidiaries... $(713) $(343) $ (73)Interest income on advances to HSBC affiliates.............. 37 5 -HSBC Bank USA: Real estate secured servicing revenues.................... 16 13 - Real estate secured sourcing, underwriting and pricing revenues............................................... 3 4 - Gain on bulk sale of real estate secured receivables...... - 15 16 Gain on bulk sale of domestic private label receivable portfolio.............................................. - 663 - Gain on daily sale of domestic private label receivable originations........................................... 379 3 - Gain on daily sale of MasterCard/Visa receivables......... 34 21 - Taxpayer financial services loan origination fees......... (15) - - Domestic private label receivable servicing fees.......... 368 3 - MasterCard/Visa receivable servicing fees................. 11 1 - Other processing, origination and support revenues........ 17 15 -Support services from HSBC affiliates, primarily HSBC Technology and Services (USA) Inc. ("HTSU")............... (889) (750) -HTSU: Rental revenue............................................ 42 33 - Administrative services revenue........................... 14 18 - Servicing revenue......................................... 5 - -Other servicing fees from HSBC affiliates................... 6 3 -Stock based compensation expense with HSBC.................. (66) (45) - The notional value of derivative contracts outstanding with HSBC subsidiariestotaled $72.2 billion at December 31, 2005 and $62.6 billion at December 31,2004. Affiliate swap counterparties provide collateral in the form of securitiesas required, which are not recorded on our balance sheet. At December 31, 2005,the fair value of our agreements with affiliate counterparties was below the$1.2 billion level requiring posting of collateral. As such, at December 31,2005, we were not holding any swap collateral from HSBC affiliates in the formof securities. At December 31, 2004, affiliate swap counterparties had providedcollateral in the form of securities, which were not recorded on our balancesheet, totaling $2.2 billion. We have extended a line of credit of $2 billion to HSBC USA Inc. at interestrates comparable to third-party rates for a line of credit with similar terms.No balances were outstanding under this line at December 31, 2005. The balanceoutstanding under this line was $.6 billion at December 31, 2004 and is includedin other assets. Interest income associated with this line of credit is recordedin interest income and reflected as interest income on advances to HSBCaffiliates in the table above. We extended a revolving line of credit of $.5 billion to HTSU on June 28, 2005at interest rates comparable to third-party rates for a line of credit withsimilar terms. The balance outstanding under this line of credit was $.4 billionat December 31, 2005 and is included in other assets. Interest income associatedwith this line of credit is recorded in interest income and reflected asinterest income on advances to HSBC affiliates in the table above. We extended a promissory note of $.5 billion to HSBC Securities (USA) Inc.("HSI") on June 27, 2005 at interest rates comparable to third-party rates for aline of credit with similar terms. This promissory note was repaid during July2005. We also extended a promissory note of $.5 billion to HSI on September 29,2005. This promissory note was repaid during October 2005. We extended anadditional promissory note of $150 million to HSI on December 28, 2005 and isincluded in other assets. This note was repaid during January 2006. Interestincome associated with this line of credit is recorded in interest income andreflected as interest income on advances to HSBC affiliates in the table above. 168 On March 31, 2005, we extended a line of credit of $.4 billion to HINO which wasrepaid during the second quarter of 2005. This line of credit was at interestrates comparable to third-party rates for a line of credit with similar terms.During the second quarter of 2004, we made advances to our immediate parent,HINO, totaling $266 million which were repaid during the third quarter of 2004.Interest income associated with this line of credit is recorded in interestincome and reflected as interest income on advances to HSBC affiliates in thetable above. Due to affiliates includes amounts owed to subsidiaries of HSBC (other thanpreferred stock). This funding was at interest rates (both the underlyingbenchmark rate and credit spreads) comparable to third-party rates for debt withsimilar maturities. At December 31, 2005, we had commercial paper back stop credit facility of $2.5billion from HSBC domestically and a revolving credit facility of $5.3 billionfrom HSBC in the U.K. At December 31, 2004, we had commercial paper back stopcredit facility of $2.5 billion from HSBC domestically and a revolving creditfacility of $7.5 billion from HSBC in the U.K. As of December 31, 2005, $4.2billion was outstanding under the U.K. lines and no balances were outstanding onthe domestic lines. As of December 31, 2004, $7.4 billion was outstanding on theU.K. lines and no balances were outstanding on the domestic lines. Annualcommitment fee requirements to support availability of these lines totaled $2million in 2005 and 2004 and are included as a component of interestexpense - HSBC affiliates. In December 2005, we sold our U.K. credit card business, including $2.5 billionof receivables ($3.1 billion on a managed basis), the associated cardholderrelationships and the related retained interests in securitized credit cardreceivables to HBEU, a U.K. based subsidiary of HSBC, for an aggregate purchaseprice of $3.0 billion. The purchase price, which was determined based on acomparative analysis of sales of other credit card portfolios, was paid in acombination of cash and $261 million of preferred stock issued by a subsidiaryof HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In additionto the assets referred to above, the sale also included the account originationplatform, including the marketing and credit employees associated with thisfunction, as well as the lease associated with the credit card call center andrelated leaseholds and call center employees to provide customer continuityafter the transfer as well as to allow HBEU direct ownership and control oforigination and customer service. We have retained the collection operationsrelated to the credit card operations and have entered into a service levelagreement for a period of not less than two years to provide collection servicesand other support services, including components of the compliance, financialreporting and human resource functions, for the sold credit card operations toHBEU for a fee. Additionally, the management teams of HBEU and our remainingU.K. operations will be jointly involved in decision making involving cardmarketing to ensure that growth objectives are met for both businesses. Becausethe sale of this business is between affiliates under common control, thepremium received in excess of the book value of the assets transferred of $182million, including the goodwill assigned to this business, has been recorded asan increase to additional paid in capital and has not been included in earnings.In future periods, the net interest income, fee income and provision for creditlosses for the International Segment will be reduced, while other income will beincreased by the receipt of servicing revenue for these credit card receivablesfrom HBEU. We do not anticipate that the net effect of this sale will result ina material reduction of net income of our consolidated results. In December 2004, we sold our domestic private label receivable portfolio(excluding retail sales contracts at our consumer lending business), includingthe retained interests associated with our securitized domestic private labelreceivables to HSBC Bank USA for $12.4 billion. We recorded an after-tax gain onthe sale of $423 million in 2004. See Note 4, "Sale of Domestic Private LabelReceivable Portfolio and Adoption of FFIEC Policies." We continue to service thesold private label receivables and receive servicing fee income from HSBC BankUSA for these services. As of December 31, 2005, we were servicing $17.1 billionof domestic private label receivables for HSBC Bank USA. We received servicingfee income from HSBC Bank USA of $368 million in 2005 and $3 million duringDecember 2004 subsequent to the initial bulk sale. The servicing fee income isincluded in the table above. We continue to maintain the related customeraccount relationships and, therefore, sell new domestic private label receivableoriginations (excluding retail sales contracts) to HSBC Bank USA on a dailybasis. We sold $21,050 million of private label receivables to HSBC Bank USA in2005 and $12,394 million during December 2004 including the initial bulk saleand the 169 subsequent daily sales of new originations. The gains associated with the saleof these receivables are reflected in the table above and are recorded in gainon receivable sales to HSBC affiliates. In the first quarter of 2004, we sold approximately $.9 billion of real estatesecured receivables from our mortgage services business to HSBC Bank USA andrecorded a pre-tax gain of $15 million on the sale. Under a separate servicingagreement, we have agreed to service all real estate secured receivables sold toHSBC Bank USA including all future business it purchases from ourcorrespondents. As of December 31, 2005, we were servicing $4.6 billion of realestate secured receivables for HSBC Bank USA. We also received fees from HSBCBank USA pursuant to a service level agreement under which we sourced,underwrote and priced $1.5 billion of real estate secured receivables purchasedby HSBC Bank USA during 2005 and $2.8 billion in 2004. The servicing fee revenueassociated with these receivables is recorded in servicing fees from HSBCaffiliates and are reflected as real estate secured servicing revenues in theabove table. Fees received for sourcing, underwriting and pricing thereceivables have been recorded as other income and are reflected as real estatesecured sourcing, underwriting and pricing revenues from HSBC Bank USA in theabove table. Purchases of real estate secured receivables from ourcorrespondents by HSBC Bank USA were discontinued effective September 1, 2005.We continue to service the receivables HSBC Bank USA previously purchased fromthese correspondents. Under various service level agreements, we also provide various services to HSBCBank USA. These services include credit card servicing and processing activitiesthrough our credit card services business, loan origination and servicingthrough our auto finance business and other operational and administrativesupport. Fees received for these services are reported as servicing fees fromHSBC affiliates and are included in the table above. During 2003, Household Capital Trust VIII issued $275 million in mandatorilyredeemable preferred securities to HSBC. The terms of this issuance were asfollows: (DOLLARS ARE IN MILLIONS)----------------------------------------------------------------------------------------Junior Subordinated Notes: Principal balance......................................... $284 Redeemable by issuer...................................... September 26, 2008 Stated maturity........................................... November 15, 2033Preferred Securities: Rate...................................................... 6.375% Face value................................................ $275 Issue date................................................ September 2003 Interest expense recorded on the underlying junior subordinated notes totaled$18 million in 2005 and $18 million in 2004. The interest expense for theHousehold Capital Trust VIII is included in interest expense - HSBC affiliatesin the consolidated statement of income and is reflected as a component ofinterest expense on borrowings from HSBC and subsidiaries in the table above. During 2004, our Canadian business began to originate and service auto loans foran HSBC affiliate in Canada. Fees received for these services are included inother income and are reflected in other income from HSBC affiliates in the abovetable. Effective October 1, 2004, HSBC Bank USA became the originating lender for loansinitiated by our taxpayer financial services business for clients of variousthird party tax preparers. We purchase the loans originated by HSBC Bank USAdaily for a fee. Origination fees paid to HSBC Bank USA totaled $15 million in2005. These origination fees are included as an offset to taxpayer financialservices revenue and are reflected as taxpayer financial services loanorigination fees in the above table. On July 1, 2004, HSBC Bank Nevada, National Association ("HSBC Bank Nevada"),formerly known as Household Bank (SB), N.A., purchased the account relationshipsassociated with $970 million of MasterCard and Visa credit card receivables fromHSBC Bank USA for approximately $99 million, which are included in 170 intangible assets. The receivables continue to be owned by HSBC Bank USA.Originations of new accounts and receivables are made by HSBC Bank Nevada andnew receivables are sold daily to HSBC Bank USA. We sold $2,055 million ofcredit card receivables to HSBC Bank USA in 2005 and $1,029 million in 2004. Thegains associated with the sale of these receivables are reflected in the tableabove and are recorded in gain on receivable sales to HSBC affiliates. Effective January 1, 2004, our technology services employees, as well astechnology services employees from other HSBC entities in North America, weretransferred to HTSU. In addition, technology related assets and softwarepurchased subsequent to January 1, 2004 are generally purchased and owned byHTSU. Technology related assets owned by HSBC Finance Corporation prior toJanuary 1, 2004 currently remain in place and were not transferred to HTSU. Inaddition to information technology services, HTSU also provides certain itemprocessing and statement processing activities to us pursuant to a masterservice level agreement. Support services from HSBC affiliates includes servicesprovided by HTSU as well as banking services and other miscellaneous servicesprovided by HSBC Bank USA and other subsidiaries of HSBC. We also receiverevenue from HTSU for rent on certain office space, which has been recorded as areduction of occupancy and equipment expenses, and for certain administrativecosts, which has been recorded as other income. Additionally, in a separate transaction in December 2005, we transferred ourinformation technology services employees in the U.K. to a subsidiary of HBEU.Subsequent to the transfer, operating expenses relating to informationtechnology, which have previously been reported as salaries and fringe benefitsor other servicing and administrative expenses, are now billed to us by HBEU andreported as support services from HSBC affiliates. During the first quarter of2006, we anticipate that the information technology equipment in the U.K. willbe sold to HBEU for a purchase price equal to the book value of these assets. In addition, we utilize HSBC Markets (USA) Inc., a related HSBC entity, to leadmanage a majority of our ongoing debt issuances. Fees paid for such servicestotaled approximately $59 million in 2005 and $18 million in 2004. These feesare amortized over the life of the related debt as a component of interestexpense. In consideration of HSBC transferring sufficient funds to make the paymentsdescribed in Note 3, "Acquisitions and Divestitures," with respect to certainHSBC Finance Corporation preferred stock, we issued the Series A Preferred Stockin the amount of $1.1 billion to HSBC on March 28, 2003. In September 2004, HNAHissued a new series of preferred stock totaling $1.1 billion to HSBC in exchangefor our outstanding Series A Preferred Stock. In October 2004, our immediateparent, HINO, issued a new series of preferred stock to HNAH in exchange for ourSeries A Preferred Stock. We paid dividends on our Series A Preferred Stock of$66 million in October 2005 and $108 million in October 2004. On December 15,2005, we issued 4 shares of common stock to HINO in exchange for the Series APreferred Stock. Employees of HSBC Finance Corporation participate in one or more stockcompensation plans sponsored by HSBC. Our share of the expense of these planswas $66 million in 2005 and $45 million in 2004. These expenses are recorded insalary and employee benefits and are reflected in the above table. 20. STOCK OPTION PLANS-------------------------------------------------------------------------------- STOCK OPTION PLANS The HSBC Holdings Group Share Option Plan (the "Group ShareOption Plan"), which replaced the former Household stock option plans, was along-term incentive compensation plan available to certain employees prior to2005. Grants were usually made annually. At the 2005 HSBC Annual Meeting ofStockholders, HSBC adopted and the shareholders' approved the HSBC Share Plan("Group Share Plan") to replace this plan. During 2005, no further options weregranted to employees although stock option grants from previous years remain ineffect subject to the same conditions as before. In lieu of options, in 2005,these employees received grants of shares of HSBC stock subject to certainvesting conditions as discussed further below. Options granted to employees in2004 vest 100% upon the attainment of certain company performance conditions ineither year 3, 4 or 5 and expire ten years from the date of grant. If theperformance conditions are not met in year 5, the options will be forfeited.Options granted to employees in 2003 will vest 75 percent in year three with theremaining 25 percent vesting in year four and expire ten years from the date ofgrant. Options are granted at market value. Compensation expense related to theGroup Share Option Plan, which is 171 recognized over the vesting period, totaled $6 million in 2005, $8 million in2004 and $1 million for the period March 29 through December 31, 2003. Information with respect to the Group Share Option Plan is as follows: 2005 2004 2003 --------------------- --------------------- ---------------------- WEIGHTED- WEIGHTED- WEIGHTED- HSBC AVERAGE HSBC AVERAGE HSBC AVERAGE ORDINARY PRICE PER ORDINARY PRICE PER ORDINARY PRICE PER SHARES SHARE SHARES SHARE SHARES SHARE--------------------------------------------------------------------------------------------------------Outstanding at beginning of year.......................... 6,245,800 $14.96 4,069,800 $15.31 - $ -Granted......................... - - 2,638,000 14.37 4,069,800 15.31Exercised....................... - - - - - -Transferred..................... (30,000) 15.31 (462,000) 14.69 - -Expired or canceled............. (40,000) 14.37 - - - - --------- ------ --------- ------ ---------- ------Outstanding at end of year...... 6,175,800 14.96 6,245,800 14.96 4,069,800 15.31 ========= ====== ========= ====== ========== ======Exercisable at end of year...... - $ - - $ - - $ - ========= ====== ========= ====== ========== ======Weighted-average fair value of options granted............... $ - $ 2.68 $ 4.74 ====== ====== ====== The transfers shown above relate to employees who have transferred to other HSBCentities during each year. The transfers in 2005 primarily relate to certain ofour U.K. employees who were transferred to HBEU as part of the sale of our U.K.credit card business in December 2005. The transfers in 2004 relate to ourtechnology services employees who were transferred to HTSU effective January 1,2004. The following table summarizes information about stock options outstanding underthe Group Share Option Plan at December 31, 2005. OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------- ----------------------- WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGERANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISEEXERCISE PRICES OUTSTANDING LIFE PRICE OUTSTANDING PRICE-------------------------------------------------------------------------------------------------------$12.51 - $15.00......................... 2,266,000 8.34 $14.37 - $-$15.01 - $17.50......................... 3,909,800 7.85 15.31 - - The fair value of each option granted under the Group Share Option Plan in 2004,measured at the grant date, was calculated using a binomial lattice methodologythat is based on the underlying assumptions of the Black-Scholes option pricingmodel. When modeling options with vesting that are dependent on attainment ofcertain performance conditions over a period of time, these performance targetsare incorporated into the model using Monte-Carlo simulation. The expected lifeof options depends on the behavior of option holders, which is incorporated intothe option model consistent with historic observable data. The fair values areinherently subjective and uncertain due to the assumptions made and thelimitations of the model used. Prior to 2004, options were valued using asimpler methodology also based on the Black-Scholes option pricing model. Thesignificant weighted average assumptions used to estimate the fair value of theoptions granted by year are as follows: 2005 2004 2003----------------------------------------------------------------------------------------Risk-free interest rate..................................... - 4.9% 5.3%Expected life............................................... - 6.9 years 5 yearsExpected volatility......................................... - 25.0% 30.0% Prior to our acquisition by HSBC, certain employees were eligible to participatein the former Household stock option plan. Employee stock options generallyvested equally over four years and expired 10 years from the date of grant. Uponcompletion of our acquisition by HSBC, all options granted prior to November2002 172 vested and became outstanding options to purchase HSBC ordinary shares. Optionsgranted under the former Household plan subsequent to October 2002 wereconverted into options to purchase ordinary shares of HSBC, but did not vestunder the change in control. Compensation expense related to the formerHousehold plan totaled $6 million in 2005, $8 million in 2004, $5 million in theperiod March 29 through December 31, 2003 and $4 million in the period January 1through March 28, 2003. Prior to 2003, non-employee directors annually received options to purchaseshares of Household's common stock at the stock's fair market value on the daythe option was granted. Director options had a term of ten years and one day,fully vested six months from the date granted, and once vested were exercisableat any time during the option term. In November 2002, non-employee directorschose not to receive their annual option to purchase 10,000 shares ofHousehold's common stock in light of the transaction with HSBC. Instead, eachdirector received a cash payment of $120,000 which was the fair market value ofthe options he or she would have otherwise received. None of our non-employeedirectors currently receive equity as part of their retainer. Information with respect to stock options granted under the former Householdplan is as follows: 2005 2004 2003 ---------------------- ---------------------- ---------------------- WEIGHTED- WEIGHTED- WEIGHTED- HSBC AVERAGE HSBC AVERAGE HSBC AVERAGE ORDINARY PRICE PER ORDINARY PRICE PER ORDINARY PRICE PER SHARES SHARE SHARES SHARE SHARES SHARE--------------------------------------------------------------------------------------------------------Outstanding at beginning of year........................ 38,865,993 $15.71 45,194,343 $14.76 19,850,371 $36.80Granted....................... - - - - - -Exercised..................... (2,609,665) 10.92 (5,780,935) 8.43 (439,087) 11.04Transferred (142,292) 12.15 (517,321) 14.58 - -Expired or canceled........... (82,030) 7.97 (30,094) 10.66 (231,557) 53.28 ---------- ------ ---------- ------ ---------- ------Outstanding at March 28, 2003........................ - - - - 19,179,727 37.20Conversion to HSBC ordinary shares...................... - - - - 51,305,796 13.90Exercised..................... - - - - (4,749,726) 5.00Expired or canceled........... - - - - (1,361,727) 16.49 ---------- ------ ---------- ------ ---------- ------Outstanding at end of year.... 36,032,006 $16.09 38,865,993 $15.71 45,194,343 $14.76 ========== ====== ========== ====== ========== ======Exercisable at end of year.... 34,479,337 $16.21 35,373,778 $16.21 39,743,144 $15.32 ========== ====== ========== ====== ========== ====== The transfers shown above primarily relate to employees who have transferred toHTSU during each year. The following table summarizes information about stock options outstanding underthe former Household plan, all of which are in HSBC ordinary shares, at December31, 2005: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------- ----------------------- WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGERANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISEEXERCISE PRICES OUTSTANDING LIFE PRICE OUTSTANDING PRICE-------------------------------------------------------------------------------------------------------$4.01 - $5.00........................... 8,576 2.64 $ 2.54 8,576 $ 2.54$5.01 - $10.00.......................... 730,947 1.58 8.98 730,947 8.98$10.01 - $12.50......................... 7,039,515 6.20 10.77 5,486,846 10.77$12.51 - $15.00......................... 8,276,901 2.50 14.08 8,276,901 14.08$15.01 - $17.50......................... 6,140,562 3.64 16.95 6,140,562 16.95$17.51 - $20.00......................... 6,371,183 4.84 18.41 6,371,183 18.41$20.01 - $25.00......................... 7,464,322 5.87 21.37 7,464,322 21.37 RESTRICTED SHARE PLANS Subsequent to our acquisition by HSBC, key employees arealso provided awards in the form of restricted shares ("RSRs") under HSBC'sRestricted Share Plan prior to 2005 and under the Group Share Plan beginning in2005. Annual awards to employees in 2005 are fully vested after three years. 173 Awards to employees in 2004 vest over five years contingent upon the achievementof certain company performance targets. Additionally, in 2004, we made a smallnumber of RSR awards subject only to vesting conditions, which conditions canvary depending on the nature of the award, the longest of which vests over afive year period. Awards in 2003 generally vested over a three or five yearperiod and did not require the achievement of company performance targets. Information with respect to RSRs awarded under HSBC's Restricted SharePlan/Group Share Plan, all of which are in HSBC ordinary shares, is as follows: MARCH 29 YEAR ENDED YEAR ENDED THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, 2005 2004 2003---------------------------------------------------------------------------------------------------RSRs awarded........................................... 6,669,152 2,996,878 5,893,889Weighted-average fair market value per share........... $ 15.86 $ 15.09 $ 12.43RSRs outstanding at December 31........................ 11,787,706 7,030,688 5,893,889Compensation cost: (in millions) Pre-tax.............................................. $ 42 $ 17 $ 9 After-tax............................................ 27 11 6 Prior to the merger, Household's executive compensation plans also provided forissuance of RSRs which entitled an employee to receive a stated number of sharesof Household common stock if the employee satisfied the conditions set by theCompensation Committee for the award. Upon completion of the merger with HSBC,all RSRs granted under the former Household plan prior to November 2002 vestedand became outstanding shares of HSBC. RSRs granted under the former Householdplan subsequent to October 2002 were converted into rights to receive HSBCordinary shares. Upon vesting, the employee can elect to receive either HSBCordinary shares or American depository shares. Information with respect to RSRs awarded under the pre-merger Household plan,all of which are in HSBC ordinary shares, is as follows: 2005 2004 2003-----------------------------------------------------------------------------------------------RSRs awarded............................................. - - 134,552Weighted-average fair market value per share............. $ - $ - $ 27.11RSRs outstanding at December 31.......................... 1,309,073 2,238,628 2,512,242Compensation cost: (in millions) Pre-tax................................................ $ 6 $ 8 $ 23 After-tax.............................................. 4 5 15 The pre-tax compensation cost with respect to the RSR's awarded under thepre-merger Household plan reflected above includes $5 million for the periodMarch 29 to December 31, 2003. EMPLOYEE STOCK PURCHASE PLANS The HSBC Holdings Savings-Related Share OptionPlan (the "HSBC Sharesave Plan"), which replaced the former Household employeestock purchase plan, allows eligible employees to enter into savings contractsto save up to approximately $400 per month, with the option to use the savingsto acquire ordinary shares of HSBC at the end of the contract period. There arecurrently two types of plans offered which allow the participant to selectsaving contracts of either a 3 or 5 year length. The options are exercisablewithin six months following the third or fifth year, respectively, of thecommencement 174 of the related savings contract, at a 20 percent discount for options granted in2005, 2004 and 2003. HSBC ordinary shares granted and the related fair value ofthe options for 2005, 2004 and 2003 are presented below: 2005 2004 2003 ------------------------ ------------------------ ------------------------ HSBC FAIR VALUE HSBC FAIR VALUE HSBC FAIR VALUE ORDINARY PER SHARE OF ORDINARY PER SHARE OF ORDINARY PER SHARE OF SHARES SHARES SHARES SHARES SHARES SHARES GRANTED GRANTED GRANTED GRANTED GRANTED GRANTED--------------------------------------------------------------------------------------------------------3 year vesting period... 1,064,168 3.73 1,124,776 $3.44 2,810,598 $3.195 year vesting period... 236,782 3.78 303,981 3.80 903,171 3.28 Compensation expense related to the grants under the HSBC Sharesave Plan totaled$6 million in 2005, $5 million in 2004 and $2 million for the period March 29through December 31, 2003. The fair value of each option granted under the HSBC Sharesave Plan wasestimated as of the date of grant using a third party option pricing model in2005 and 2004 and the Black-Scholes option pricing model in 2003. The fair valueestimates used the following weighted-average assumptions: 2005 2004 2003-------------------------------------------------------------------------------------------------Risk-free interest rate.............................. 4.3% 4.9% 4.1%Expected life........................................ 3 OR 5 YEARS 3 or 5 years 3 or 5 yearsExpected volatility.................................. 20.0% 25.0% 30.0% Prior to the merger, we also maintained an Employee Stock Purchase Plan (the"ESPP"). The ESPP provided a means for employees to purchase shares of ourcommon stock at 85 percent of the lesser of its market price at the beginning orend of a one-year subscription period. The ESPP was terminated on March 7, 2003and 775,480 shares of our common stock were purchased on that date. Compensationexpense related to the ESPP totaled $7 million in the period January 1 to March28, 2003. 21. PENSION AND OTHER POSTRETIREMENT BENEFITS-------------------------------------------------------------------------------- DEFINED BENEFIT PENSION PLANS In November 2004, sponsorship of the domesticdefined benefit pension plan of HSBC Finance Corporation and the domesticdefined benefit pension plan of HSBC Bank USA were transferred to HNAH.Effective January 1, 2005, the two separate plans were combined into a singleHNAH defined benefit pension plan which facilitates the development of a unifiedemployee benefit policy and unified employee benefit plan administration forHSBC companies operating in the United States. As a result, the pensionliability relating to our domestic defined benefit plan of $49 million, net oftax, was transferred to HNAH as a capital transaction in the first quarter of2005. The components of pension expense for the domestic defined benefit planreflected in our consolidated statement of income are shown in the table below.The pension expense for the year ended December 31, 2005 reflects the portion ofthe pension expense of the combined HNAH pension plan which has been allocatedto HSBC Finance Corporation. MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003------------------------------------------------------------------------------------------------------------ (IN MILLIONS)Service cost - benefits earned during the period................................... $ 46 $ 52 $ 35 $ 10Interest cost on projected benefit obligation............................... 54 46 31 4Expected return on assets.................. (78) (82) (44) (15)Amortization of prior service cost......... - - - -Recognized losses.......................... 4 (5) - 14 ---- ---- ---- ----Pension expense............................ $ 26 $ 11 $ 22 $ 13 ==== ==== ==== ==== 175 The information and activity presented below as of and for the year endedDecember 31, 2005 relates to the post-merger HNAH defined benefit pension plan,unless noted otherwise. The information and activity presented as of December31, 2004 and for the year then ended and for the periods March 29 throughDecember 31, 2005 and January 1 through March 28, 2003 reflect the pre-mergerHSBC Finance Corporation domestic defined benefit pension plan balances andactivity. The assumptions used in determining pension expense of the domestic definedbenefit plan are as follows: 2005 2004 2003---------------------------------------------------------------------------------------------------- (POST-MERGER) (PRE-MERGER) (PRE-MERGER)Discount rate(1)....................................... 6.00% 6.25% 6.50%Salary increase assumption............................. 3.75 3.75 4.0Expected long-term rate of return on plan assets....... 8.33 8.75 8.0 --------------- (1) The discount rate used for the period January 1 through March 28, 2003 was 6.75%. HNAH retains both an unrelated third party as well as an affiliate to provideinvestment consulting services. Given the plan's current allocation of equityand fixed income securities and using investment return assumptions which arebased on long term historical data, the long term expected return for planassets is reasonable. The funded status of the domestic defined benefit pensionplan is shown below. The components shown below as of December 31, 2005 reflectthe funded status of the post-merger HNAH pension plan and not the interests ofHSBC Finance Corporation. AT DECEMBER 31, ---------------------------- 2005 2004------------------------------------------------------------------------------------------ (POST-MERGER) (PRE-MERGER) (IN MILLIONS)Funded status............................................... $(146) $(19)Unrecognized net actuarial loss (gain)...................... 502 (57)Unamortized prior service cost.............................. 3 - ----- ----Prepaid pension cost/(Accrued pension liability)............ $ 359 $(76) ===== ==== There were no intangible assets recognized on HSBC Finance Corporation's balancesheet at December 31, 2004. A reconciliation of beginning and ending balances of the fair value of planassets associated with the domestic defined benefit pension plan is shown below.The activity shown for the year ended December 31, 2005 reflects the activity ofthe merged HNAH plan. YEAR ENDED DECEMBER 31, ---------------------------- 2005 2004------------------------------------------------------------------------------------------ (POST-MERGER) (PRE-MERGER) (IN MILLIONS)Fair value of plan assets at beginning of year.............. $1,000 $ 969Transfer in of assets from the former HSBC Bank USA pension plan...................................................... 1,304 -Actual return on plan assets................................ 168 92Employer contributions...................................... - -Benefits paid............................................... (89) (61) ------ ------Fair value of plan assets at end of year.................... $2,383 $1,000 ====== ====== It is currently not anticipated that employer contributions to the domesticdefined benefit plan will be made in 2006. 176 The allocation of the domestic pension plan assets at December 31, 2005 and 2004is as follows: PERCENTAGE OF PLAN ASSETS AT DECEMBER 31, ---------------------------- 2005 2004------------------------------------------------------------------------------------------ (POST-MERGER) (PRE-MERGER)Equity securities........................................... 69% 77%Debt securities............................................. 31 21Other....................................................... - 2 --- ---Total....................................................... 100% 100% === === There were no investments in HSBC ordinary shares or American depository sharesat December 31, 2005 or 2004. The primary objective of the defined benefit pension plan is to provide eligibleemployees with regular pension benefits. Since the domestic plans are governedby the Employee Retirement Income Security Act of 1974 ("ERISA"), ERISAregulations serve as guidance for the management of plan assets. Consistent withprudent standards of preservation of capital and maintenance of liquidity, thegoals of the plans are to earn the highest possible rate of return consistentwith the tolerance for risk as determined by the investment committee in itsrole as a fiduciary. In carrying out these objectives, short-term fluctuationsin the value of plan assets are considered secondary to long-term investmentresults. Both a third party and an affiliate are used to provide investmentconsulting services such as recommendations on the type of funds to be investedin and monitoring the performance of fund managers. In order to achieve thereturn objectives of the plans, the plans are diversified to ensure that adverseresults from one security or security class will not have an unduly detrimentaleffect on the entire investment portfolio. Assets are diversified by type,characteristic and number of investments as well as by investment style ofmanagement organization. Equity securities are invested in large, mid and smallcapitalization domestic stocks as well as international stocks. A reconciliation of beginning and ending balances of the projected benefitobligation of the domestic defined benefit pension plan is shown below. Theprojected benefit obligation shown for the year ended December 31, 2005 reflectsthe projected benefit obligation of the merged HNAH plan. YEAR ENDED DECEMBER 31, ---------------------------- 2005 2004------------------------------------------------------------------------------------------ (POST-MERGER) (PRE-MERGER) (IN MILLIONS)Projected benefit obligation at beginning of year........... $1,019 $ 898Transfer in from the HSBC Bank USA defined benefit plan..... 1,174 -Service cost................................................ 94 52Interest cost............................................... 130 46Actuarial gains............................................. 202 84Benefits paid............................................... (89) (61) ------ ------Projected benefit obligation at end of year................. $2,530 $1,019 ====== ====== Our share of the projected benefit obligation at December 31, 2005 isapproximately $1.1 billion. The accumulated benefit obligation for thepost-merger domestic HNAH defined benefit pension plan was $2.2 billion atDecember 31, 2005. Our share of the accumulated benefit obligation at December31, 2005 was approximately $1.0 billion. The accumulated benefit obligation forthe pre-merger domestic defined benefit pension plan was $1.0 billion atDecember 31, 2004. 177 Estimated future benefit payments for the HNAH domestic defined benefit plan andHSBC Finance Corporation's share of those payments are as follows: HSBC FINANCE CORPORATION'S HNAH SHARE---------------------------------------------------------------------------------- (IN MILLIONS)2006........................................................ $102 $ 512007........................................................ 112 572008........................................................ 121 602009........................................................ 129 632010........................................................ 136 652011-2015................................................... 848 389 The assumptions used in determining the projected benefit obligation of thedomestic defined benefit plans at December 31 are as follows: 2005 2004 2003---------------------------------------------------------------------------------------------------- (POST-MERGER) (PRE-MERGER) (PRE-MERGER)Discount rate.......................................... 5.70% 6.00% 6.25%Salary increase assumption............................. 3.75 3.75 3.75 FOREIGN DEFINED BENEFIT PENSION PLANS We sponsor various additional definedbenefit pension plans for our foreign based employees. Pension expense for ourforeign defined benefit pension plans was $2 million in 2005, $2 million in2004, $2 million in the period March 29 through December 31, 2003 and $1 millionin the period January 1 through March 31, 2003. For our foreign plan, the fairvalue of plan assets was $135 million at December 31, 2005 and $122 million atDecember 31, 2004. The projected benefit obligation for our foreign definedbenefit pension plans was $164 million at December 31, 2005 and $143 million atDecember 31, 2004. SUPPLEMENTAL RETIREMENT PLAN A non-qualified supplemental retirement plan isalso provided. This plan, which is currently unfunded, provides eligibleemployees defined pension benefits outside the qualified retirement plan.Benefits are based on average earnings, years of service and age at retirement.The projected benefit obligation was $73 million at December 31, 2005 and $82million at December 31, 2004. Pension expense related to the supplementalretirement plan was $11 million in 2005, $19 million in 2004, $9 million in theperiod March 29 through December 31, 2003 and $3 million in the period January 1through March 28, 2003. An additional minimum liability of $6 million related tothis plan was recognized in 2004 and reversed in 2005. DEFINED CONTRIBUTION PLANS Various 401(k) savings plans and profit sharing plansexist for employees meeting certain eligibility requirements. Under these plans,each participant's contribution is matched by the company up to a maximum of 6percent of the participant's compensation. Prior to the merger with HSBC,company contributions were in the form of Household common stock. Subsequent tothe merger, company contributions are in the form of cash. Total expense forthese plans for HSBC Finance Corporation was $91 million in 2005, $82 million in2004, $50 million in the period March 29 through December 31, 2003 and $21million in the period January 1 through March 28, 2003. Effective January 1, 2005, HSBC Finance Corporation's 401(k) savings plansmerged with the HSBC Bank USA's 401(k) savings plan under HNAH. POSTRETIREMENT PLANS OTHER THAN PENSIONS Our employees also participate in planswhich provide medical, dental and life insurance benefits to retirees andeligible dependents. These plans cover substantially all employees who meetcertain age and vested service requirements. We have instituted dollar limits onour payments under the plans to control the cost of future medical benefits. 178 The net postretirement benefit cost included the following: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003------------------------------------------------------------------------------------------------------ (IN MILLIONS)Service cost - benefits earned during the period...................................... $ 5 $ 4 $ 3 $1Interest cost................................. 15 13 10 1Expected return on assets..................... - - - 2Amortization of prior service cost............ - - - -Recognized (gains) losses..................... - - - - --- --- --- --Net periodic postretirement benefit cost...... $20 $17 $13 $4 === === === == The assumptions used in determining the net periodic postretirement benefit costfor our domestic postretirement benefit plans are as follows: 2005 2004 2003--------------------------------------------------------------------------------Discount rate............................................... 6.00% 6.25% 6.50%Salary increase assumption.................................. 3.75 3.75 4.0 --------------- (1) The discount rate used for the period January 1 through March 28, 2003 was 6.75%. A reconciliation of the beginning and ending balances of the accumulatedpostretirement benefit obligation is as follows: YEAR ENDED DECEMBER 31, ------------- 2005 2004--------------------------------------------------------------------------- (IN MILLIONS)Accumulated benefit obligation at beginning of year......... $254 $252Service cost................................................ 5 4Interest cost............................................... 15 13Foreign currency exchange rate changes...................... 1 1Actuarial gains............................................. (15) (2)Benefits paid............................................... (18) (14) ---- ----Accumulated benefit obligation at end of year............... $242 $254 ==== ==== Our postretirement benefit plans are funded on a pay-as-you-go basis. Wecurrently estimate that we will pay benefits of approximately $17 millionrelating to our postretirement benefit plans in 2006. The components of theaccrued postretirement benefit obligation are as follows: AT DECEMBER 31, --------------- 2005 2004----------------------------------------------------------------------------- (IN MILLIONS)Funded status............................................... $(242) $(254)Unamortized prior service cost.............................. 7 3Unrecognized net actuarial gain............................. (33) (9) ----- -----Accrued postretirement benefit obligation................... $(268) $(260) ===== ===== 179 Estimated future benefit payments for our domestic plans are as follows: (IN MILLIONS)----------------------------------------------------------------------------2006........................................................ $172007........................................................ 172008........................................................ 182009........................................................ 192010........................................................ 192011-2015................................................... 97 The assumptions used in determining the benefit obligation of our domesticpostretirement benefit plans at December 31 are as follows: 2005 2004 2003--------------------------------------------------------------------------------Discount rate............................................... 5.70% 6.00% 6.25%Salary increase assumption.................................. 3.75 3.75 3.75 A 10.5 percent annual rate of increase in the gross cost of covered health carebenefits was assumed for 2006. This rate of increase is assumed to declinegradually to 5.0 percent in 2014. Assumed health care cost trend rates have an effect on the amounts reported forhealth care plans. A one-percentage point change in assumed health care costtrend rates would increase (decrease) service and interest costs and thepostretirement benefit obligation as follows: ONE PERCENT ONE PERCENT INCREASE DECREASE--------------------------------------------------------------------------------------- (IN MILLIONS)Effect on total of service and interest cost components..... $.7 $(.6)Effect on postretirement benefit obligation................. 9 (8) 22. BUSINESS SEGMENTS-------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services, andInternational. Our segments are managed separately and are characterized bydifferent middle-market consumer lending products, origination processes, andlocations. Our Consumer segment consists of our consumer lending, mortgageservices, retail services, and auto finance businesses. Our Credit Card Servicessegment consists of our domestic MasterCard and Visa credit card business. OurInternational segment consists of our foreign operations in Canada, the UnitedKingdom and the rest of Europe. The Consumer segment provides real estatesecured, automobile secured, personal non-credit card and private label loans,including retail sales contracts. Loans are offered with both revolving andclosed-end terms and with fixed or variable interest rates. Loans are originatedthrough branch locations, correspondents, mortgage brokers, direct mail,telemarketing, independent merchants or automobile dealers. The Credit CardServices segment offers MasterCard and Visa credit card loans throughout theUnited States primarily via strategic affinity and co-branding relationships,direct mail, and our branch network to non-prime customers. The Internationalsegment offers secured and unsecured lines of credit and secured and unsecuredclosed-end loans primarily in the United Kingdom, Canada, the Republic ofIreland, Slovakia, the Czech Republic and Hungary. In addition, the UnitedKingdom operation offers credit insurance in connection with all loan products.We also cross sell our credit cards to existing real estate secured, privatelabel and tax services customers. All segments offer products and servicecustomers through the Internet. The All Other caption includes our insurance andtaxpayer financial services and commercial businesses, as well as our corporateand treasury activities, each of which falls below the quantitative thresholdtests under SFAS No. 131 for determining reportable segments. There have been nochanges in the basis of our segmentation or any changes in the measurement ofsegment profit as compared with the prior year presentation. 180 The accounting policies of the reportable segments are described in Note 2,"Summary of Significant Accounting Policies." For segment reporting purposes,intersegment transactions have not been eliminated. We generally account fortransactions between segments as if they were with third parties. We evaluateperformance and allocate resources based on income from operations after incometaxes and returns on equity and managed assets. We have historically monitored our operations and evaluated trends on a managedbasis (a non-GAAP financial measure), which assumes that securitized receivableshave not been sold and are still on our balance sheet. This is because thereceivables that we securitize are subjected to underwriting standardscomparable to our owned portfolio, are generally serviced by operating personnelwithout regard to ownership and result in a similar credit loss exposure for us.In addition, we fund our operations, and make decisions about allocatingresources such as capital on a managed basis. When reporting on a managed basis,net interest income, provision for credit losses and fee income related toreceivables securitized are reclassified from securitization related revenue inour owned statement of income into the appropriate caption. Income statement information included in the table for 2003 combines January 1through March 28, 2003 (the "predecessor period") and March 29 to December 31,2003 (the "successor" period) in order to present "combined" financial resultsfor 2003. As a result, managed and owned basis consolidated totals for 2003include combined information from both the "successor" and "predecessor" periodswhich impacts comparability to the current period. Fair value adjustments related to purchase accounting resulting from ouracquisition by HSBC and related amortization have been allocated to Corporate,which is included in the "All Other" caption within our segment disclosure.Reconciliation of our managed basis segment results to managed basis and ownedbasis consolidated totals are as follows: MANAGED CREDIT ADJUSTMENTS/ BASIS CARD INTER- ALL RECONCILING CONSOLIDATED CONSUMER SERVICES NATIONAL OTHER ITEMS TOTALS------------------------------------------------------------------------------------------------------- (IN MILLIONS)YEAR ENDED DECEMBER 31, 2005Net interest income............ $ 6,887 $ 2,150 $ 907 $ (668) $ - $ 9,276Securitization related revenue...................... (622) (192) 20 (43) - (837)Fee and other income........... 1,194 2,016 563 1,250 (140)(2) 4,883Intersegment revenues.......... 108 21 17 (6) (140)(2) -Provision for credit losses.... 2,461 1,564 642 (27) 10(3) 4,650Depreciation and amortization................. 14 23 28 392 - 457Total costs and expenses....... 2,638 1,370 847 1,154 - 6,009Income tax expense (benefit)... 853 376 5 (289) (54)(4) 891Net income..................... 1,498 661 (5) (287) (95) 1,772Receivables.................... 108,345 26,181 9,260 201 - 143,987Assets......................... 109,214 27,109 10,109 22,845 (8,534)(5) 160,743Expenditures for long-lived assets(7).................... 24 4 21 28 - 77 -------- ------- ------- ------- ------- -------- OWNED BASIS SECURITIZATION CONSOLIDATED ADJUSTMENTS TOTALS------------------------------- ----------------------------- (IN MILLIONS)YEAR ENDED DECEMBER 31, 2005Net interest income............ $ (892)(6) $ 8,384Securitization related revenue...................... 1,048(6) 211Fee and other income........... (263)(6) 4,620Intersegment revenues.......... - -Provision for credit losses.... (107)(6) 4,543Depreciation and amortization................. - 457Total costs and expenses....... - 6,009Income tax expense (benefit)... - 891Net income..................... - 1,772Receivables.................... (4,074)(8) 139,913Assets......................... (4,074)(8) 156,669Expenditures for long-lived assets(7).................... - 77 -------- -------- 181 MANAGED CREDIT ADJUSTMENTS/ BASIS CARD INTER- ALL RECONCILING CONSOLIDATED CONSUMER SERVICES NATIONAL OTHER ITEMS TOTALS------------------------------------------------------------------------------------------------------- (IN MILLIONS)YEAR ENDED DECEMBER 31, 2004Net interest income............ $ 7,699 $ 2,070 $ 797 $ (309) $ - $ 10,257Securitization related revenue...................... (1,433) (338) (88) (145) - (2,004)Fee and other income, excluding gain on sale of domestic private label credit card receivables.................. 638 1,731 503 1,412 (137)(2) 4,147Gain on bulk sale of domestic private label credit card receivables.................. 683 - - (20) - 663Intersegment revenues.......... 101 25 15 (4) (137)(2) -Provision for credit losses.... 2,575 1,625 336 (16) 2(3) 4,522Depreciation and amortization................. 13 53 34 383 - 483Total costs and expenses....... 2,528 1,238 726 1,109 - 5,601Income tax expense (benefit)... 915 216 53 (133) (51)(4) 1,000Net income..................... 1,563 380 95 (10) (88) 1,940Operating net income(1)........ 1,247 381 95 3 (88) 1,638Receivables.................... 87,839 19,670 13,263 308 - 121,080Assets......................... 89,809 20,049 14,236 28,921 (8,600)(5) 144,415Expenditures for long-lived assets(7).................... 18 4 20 54 - 96 -------- ------- ------- ------- ------- --------YEAR ENDED DECEMBER 31, 2003Net interest income............ $ 7,333 $ 1,954 $ 753 $ 148 $ - $ 10,188Securitization related revenue...................... 337 (6) 17 (201) - 147Fee and other income........... 664 1,537 380 1,139 (147)(2) 3,573Intersegment revenues.......... 107 30 12 (2) (147)(2) -Provision for credit losses.... 4,275 1,598 359 3 7(3) 6,242Depreciation and amortization................. 14 52 30 295 - 391HSBC acquisition related costs incurred by HSBC Finance Corporation.................. - - - 198 - 198Total costs and expenses....... 2,358 1,099 530 1,204 - 5,191Income tax expense (benefit)... 631 287 90 (80) (56)(4) 872Net income..................... 1,061 500 170 (30) (98) 1,603Operating net income(1)........ 1,061 500 170 137 (98) 1,770Receivables.................... 87,104 19,552 11,003 920 - 118,579Assets......................... 89,791 22,505 11,923 29,754 (8,720)(5) 145,253Expenditures for long-lived assets(7).................... 30 3 18 83 - 134 -------- ------- ------- ------- ------- -------- OWNED BASIS SECURITIZATION CONSOLIDATED ADJUSTMENTS TOTALS------------------------------- ----------------------------- (IN MILLIONS)YEAR ENDED DECEMBER 31, 2004Net interest income............ $ (2,455)(6) $ 7,802Securitization related revenue...................... 3,012(6) 1,008Fee and other income, excluding gain on sale of domestic private label credit card receivables.................. (745)(6) 3,402Gain on bulk sale of domestic private label credit card receivables.................. - 663Intersegment revenues.......... - -Provision for credit losses.... (188)(6) 4,334Depreciation and amortization................. - 483Total costs and expenses....... - 5,601Income tax expense (benefit)... - 1,000Net income..................... - 1,940Operating net income(1)........ - 1,638Receivables.................... (14,225)(8) 106,855Assets......................... (14,225)(8) 130,190Expenditures for long-lived assets(7).................... - 96 -------- --------YEAR ENDED DECEMBER 31, 2003Net interest income............ $ (2,874)(6) $ 7,314Securitization related revenue...................... 1,314(6) 1,461Fee and other income........... (715)(6) 2,858Intersegment revenues.......... - -Provision for credit losses.... (2,275)(6) 3,967Depreciation and amortization................. - 391HSBC acquisition related costs incurred by HSBC Finance Corporation.................. - 198Total costs and expenses....... - 5,191Income tax expense (benefit)... - 872Net income..................... - 1,603Operating net income(1)........ - 1,770Receivables.................... (26,201)(8) 92,378Assets......................... (26,201)(8) 119,052Expenditures for long-lived assets(7).................... - 134 -------- -------- --------------- (1) This non-GAAP financial measure is provided for comparison of our operating trends only and should be read in conjunction with our owned basis GAAP financial information. Operating net income in 2004 excludes the gain on the bulk sale of domestic private label credit card receivables of $423 million (after-tax) and the impact of the adoption of FFIEC charge-off policies for the domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard/Visa credit card portfolios of $121 million (after-tax). In 2003, operating net income excludes $167 million (after-tax) of HSBC acquisition related costs and other merger related items incurred by HSBC Finance Corporation. In 2002, operating net income excludes the $333 million (after-tax) for the settlement charge and related expenses and the loss of $240 million (after-tax) from the disposition of Thrift assets and deposits. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures. (2) Eliminates intersegment revenues. (3) Eliminates bad debt recovery sales between operating segments. (4) Tax benefit associated with items comprising adjustments/reconciling items. (5) Eliminates investments in subsidiaries and intercompany borrowings. (6) Reclassifies net interest income, fee income and provision for credit losses relating to securitized receivables to other revenues. (7) Includes goodwill associated with purchase business combinations other than the HSBC merger as well as capital expenditures. (8) Represents receivables serviced with limited recourse. 182 23. COMMITMENTS AND CONTINGENT LIABILITIES-------------------------------------------------------------------------------- LEASE OBLIGATIONS: We lease certain offices, buildings and equipment for periodswhich generally do not exceed 25 years. The leases have various renewal options.The office space leases generally require us to pay certain operating expenses.Net rental expense under operating leases was $132 million in 2005, $117 millionin 2004, $112 million in the period March 29 through December 31, 2003 and $36million in the period January 1 through March 28, 2003. We have lease obligations on certain office space which has been subleasedthrough the end of the lease period. Under these agreements, the sublessee hasassumed future rental obligations on the lease. Future net minimum lease commitments under noncancelable operating leasearrangements were: MINIMUM MINIMUM RENTAL SUBLEASEYEAR ENDING DECEMBER 31, PAYMENTS INCOME NET---------------------------------------------------------------------------------------- (IN MILLIONS)2006........................................................ $197 $ 76 $1212007........................................................ 136 28 1082008........................................................ 118 28 902009........................................................ 96 27 692010........................................................ 61 16 45Thereafter.................................................. 123 1 122 ---- ---- ----Net minimum lease commitments............................... $731 $176 $555 ==== ==== ==== In January 2006 we entered into a lease for a building in the Village ofMettawa, Illinois. The new facility will consolidate our Prospect Heights, MountProspect and Deerfield offices. Construction of the building will begin in thespring of 2006 with the move planned for first and second quarter 2008. Anestimate of the future net minimum lease commitment associated with this leasewill not be finalized until later in 2006. LITIGATION: Both we and certain of our subsidiaries are parties to various legalproceedings resulting from ordinary business activities relating to our currentand/or former operations which affect all three of our reportable segments.Certain of these activities are or purport to be class actions seeking damagesin significant amounts. These actions include assertions concerning violationsof laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certainthat we will ultimately prevail in each instance. Also, as the ultimateresolution of these proceedings is influenced by factors that are outside of ourcontrol, it is reasonably possible our estimated liability under theseproceedings may change. However, based upon our current knowledge, our defensesto these actions have merit and any adverse decision should not materiallyaffect our consolidated financial condition, results of operations or cashflows. OTHER COMMITMENTS: At December 31, 2005, our mortgage services business hadcommitments with numerous correspondents to purchase up to $1.6 billion of realestate secured receivables at fair market value, subject to availability basedon underwriting guidelines specified by our mortgage services business. Thesecommitments have terms of up to one year and can be renewed upon mutualagreement. 24. FAIR VALUE OF FINANCIAL INSTRUMENTS-------------------------------------------------------------------------------- We have estimated the fair value of our financial instruments in accordance withSFAS No. 107, "Disclosures About Fair Value of Financial Instruments" ("SFAS No.107"). Fair value estimates, methods and assumptions set forth below for ourfinancial instruments are made solely to comply with the requirements of SFASNo. 107 and should be read in conjunction with the financial statements andnotes in this Annual Report. 183 A significant portion of our financial instruments do not have a quoted marketprice. For these items, fair values were estimated by discounting estimatedfuture cash flows at estimated current market discount rates. Assumptions usedto estimate future cash flows are consistent with management's assessmentsregarding ultimate collectibility of assets and related interest and withestimates of product lives and repricing characteristics used in ourasset/liability management process. All assumptions are based on historicalexperience adjusted for future expectations. Assumptions used to determine fairvalues for financial instruments for which no active market exists areinherently judgmental and changes in these assumptions could significantlyaffect fair value calculations. As required under generally accepted accounting principles, a number of otherassets recorded on the balance sheets (such as acquired credit cardrelationships, the value of consumer lending relationships for originatedreceivables and the franchise values of our business units) are not consideredfinancial instruments and, accordingly, are not valued for purposes of thisdisclosure. However, on March 29, 2003, as a result of our acquisition by HSBC,these other assets were adjusted to their fair market value based, in part, onthird party valuation data, under the "push-down" method of accounting. (SeeNote 3, "Acquisitions.") We believe there continues to be substantial valueassociated with these assets based on current market conditions and historicalexperience. Accordingly, the estimated fair value of financial instruments, asdisclosed, does not fully represent our entire value, nor the changes in ourentire value. The following is a summary of the carrying value and estimated fair value of ourfinancial instruments: AT DECEMBER 31, ------------------------------------------------------------------------- 2005 2004 ----------------------------------- ----------------------------------- CARRYING ESTIMATED CARRYING ESTIMATED VALUE FAIR VALUE DIFFERENCE VALUE FAIR VALUE DIFFERENCE------------------------------------------------------------------------------------------------------ (IN MILLIONS)ASSETS:Cash....................... $ 903 $ 903 $ - $ 392 $ 392 $ -Interest bearing deposits with banks............... 384 384 - 603 603 -Securities purchased under agreements to resell..... 78 78 - 2,651 2,651 -Securities................. 4,051 4,051 - 3,645 3,645 -Receivables................ 136,989 137,591 602 104,815 105,314 499Due from affiliates........ 518 518 - 604 604 -Derivative financial assets................... 234 234 - 4,049 4,049 - --------- --------- ------- --------- --------- -------Total assets............... 143,157 143,759 602 116,759 117,258 499 --------- --------- ------- --------- --------- ------- LIABILITIES:Deposits................... (37) (37) - (47) (47) -Commercial paper, bank and other borrowings......... (11,417) (11,417) - (9,013) (9,013) -Due to affiliates.......... (15,534) (15,568) (34) (13,789) (13,819) (30)Long term debt............. (105,163) (106,314) (1,151) (85,378) (86,752) (1,374)Insurance policy and claim reserves................. (1,291) (1,336) (45) (1,303) (1,370) (67)Derivative financial liabilities.............. (292) (292) - (70) (70) - --------- --------- ------- --------- --------- -------Total liabilities.......... (133,734) (134,964) (1,230) (109,600) (111,071) (1,471) --------- --------- ------- --------- --------- -------Total...................... $ 9,423 $ 8,795 $ (628) $ 7,159 $ 6,187 $ (972) ========= ========= ======= ========= ========= ======= 184 CASH: Carrying value approximates fair value due to cash's liquid nature. INTEREST BEARING DEPOSITS WITH BANKS: Carrying value approximates fair value dueto the asset's liquid nature. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL: The fair value of securitiespurchased under agreements to resell approximates carrying value due to theirshort-term maturity. SECURITIES: Securities are classified as available-for-sale and are carried atfair value on the balance sheets. Fair values are based on quoted market pricesor dealer quotes. If a quoted market price is not available, fair value isestimated using quoted market prices for similar securities. RECEIVABLES: The fair value of adjustable rate receivables generallyapproximates carrying value because interest rates on these receivables adjustwith changing market interest rates. The fair value of fixed rate consumerreceivables was estimated by discounting future expected cash flows at interestrates which approximate the current interest rates that would achieve a similarreturn on assets with comparable risk characteristics. Receivables also includesour interest-only strip receivables. The interest-only strip receivables arecarried at fair value on our balance sheets. Fair value is based on an estimateof the present value of future cash flows associated with securitizations ofcertain real estate secured, auto finance, MasterCard and Visa, private labeland personal non-credit card receivables. DEPOSITS: The fair value of our savings and demand accounts equaled the carryingamount as stipulated in SFAS No. 107. The fair value of fixed rate timecertificates was estimated by discounting future expected cash flows at interestrates that we offer on such products at the respective valuation dates. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS: The fair value of these instrumentsapproximates existing carrying value because interest rates on these instrumentsadjust with changes in market interest rates due to their short-term maturity orrepricing characteristics. DUE TO AFFILIATES: The estimated fair value of our debt instruments due toaffiliates was determined by discounting future expected cash flows at interestrates offered for similar types of debt instruments. Carrying value is typicallyused to estimate the fair value of floating rate debt. LONG TERM DEBT: The estimated fair value of our fixed rate debt instruments wasdetermined using either quoted market prices or by discounting future expectedcash flows at current interest rates offered for similar types of debtinstruments. Carrying value is typically used to estimate the fair value offloating rate debt. INSURANCE POLICY AND CLAIM RESERVES: The fair value of insurance reserves forperiodic payment annuities was estimated by discounting future expected cashflows at estimated market interest rates at December 31, 2005 and 2004. The fairvalue of other insurance reserves is not required to be determined in accordancewith SFAS No. 107. DERIVATIVE FINANCIAL ASSETS AND LIABILITIES: All derivative financial assets andliabilities, which exclude amounts receivable from or payable to swapcounterparties, are carried at fair value on the balance sheet. Where practical,quoted market prices were used to determine fair value of these instruments. Fornon-exchange traded contracts, fair value was determined using discounted cashflow modeling techniques in lieu of market value quotes. We enter into foreignexchange contracts to hedge our exposure to currency risk on foreign denominateddebt. We also enter into interest rate contracts to hedge our exposure tointerest rate risk on assets and liabilities, including debt. As a result,decreases/increases in the fair value of derivative financial instruments whichhave been designated as effective hedges are offset by a correspondingincrease/decrease in the fair value of the individual asset or liability beinghedged. See Note 15, "Derivative Financial Instruments," for additionaldiscussion of the nature of these items. 25. ATTORNEY GENERAL SETTLEMENT-------------------------------------------------------------------------------- In October 2002, we reached agreement with a multi-state working group of stateattorneys general and regulatory agencies to effect a nationwide resolution ofalleged violations of Federal and/or state consumer protection, consumerfinancing and banking laws and regulations with respect to secured real estatelending from Household Finance Corporation and Beneficial Corporation and theirsubsidiaries conducting retail 185 branch consumer lending operations. This agreement, and related subsequentconsent decrees and similar documentation entered into with each of the 50states and the District of Columbia, are referred to collectively as the"Multi-State Settlement Agreement", which became effective on December 16, 2002.Pursuant to the Multi-State Settlement Agreement, we funded a $484 millionsettlement fund that was divided among the states (and the District ofColumbia), with each state receiving a proportionate share of the funds basedupon the volume of the retail branch originated real estate secured loans wemade in that state during the period of January 1, 1999 to September 30, 2002.No fines, penalties or punitive damages were assessed by the states pursuant tothe Multi-State Settlement Agreement. In August 2003, notices of a claims procedure were distributed to holders ofapproximately 591,000 accounts identified as having potential claims.Approximately 82% of customers accepted funds in settlement and had executed arelease of all civil claims against us relating to the specified consumerlending practices. All checks were mailed. Each state agreed that the settlementresolves all current civil investigations and proceedings by the attorneysgeneral and state lending regulators relating to the lending practices at issue. We recorded a pre-tax charge of $525 million ($333 million after-tax) during thethird quarter of 2002 related to the Multi-State Settlement Agreement. Thecharge reflects the costs of this settlement agreement and related matters andhas been reflected in the statement of income in total costs and expenses. 26. CONCENTRATION OF CREDIT RISK-------------------------------------------------------------------------------- A concentration of credit risk is defined as a significant credit exposure withan individual or group engaged in similar activities or having similar economiccharacteristics that would cause their ability to meet contractual obligationsto be similarly affected by changes in economic or other conditions. We generally serve non-conforming and non-prime consumers. Such customers areindividuals who have limited credit histories, modest incomes, highdebt-to-income ratios or have experienced credit problems caused by occasionaldelinquencies, prior charge-offs, bankruptcy or other credit related actions. Asa result, the majority of our secured receivables have a high loan-to-valueratio. Due to customer demand we offer interest-only loans and expect tocontinue to do so. These interest-only loans allow customers to pay only theaccruing interest for a period of time which results in lower payments duringthe initial loan period. Depending on a customer's financial situation, thesubsequent increase in the required payment to begin making payment towards theloan principal could affect our customer's ability to repay the loan at somefuture date when the interest rate resets and/or principal payments arerequired. As with all our other non-conforming and nonprime loan products, weunderwrite and price interest only loans in a manner that is appropriate tocompensate for their higher risk. At December 31, 2005, the outstanding balanceof our interest-only loans was $4.7 billion, or 3.3% of managed receivables. Because we primarily lend to consumers, we do not have receivables from anyindustry group that equal or exceed 10 percent of total owned or managedreceivables at December 31, 2005 and 2004. We lend nationwide and ourreceivables on both an owned and managed basis are distributed as follows atDecember 31, 2005: PERCENT OF TOTAL DOMESTICSTATE/REGION RECEIVABLES-------------------------------------------------------------------------------California.................................................. 12%Midwest (IL, IN, IA, KS, MI, MN, MO, NE, ND, OH, SD, WI).... 23Southeast (AL, FL, GA, KY, MS, NC, SC, TN).................. 21Middle Atlantic (DE, DC, MD, NJ, PA, VA, WV)................ 15Southwest (AZ, AR, LA, NM, OK, TX).......................... 10Northeast (CT, ME, MA, NH, NY, RI, VT)...................... 10West (AK, CO, HI, ID, MT, NV, OR, UT, WA, WY)............... 9 186 27. GEOGRAPHIC DATA-------------------------------------------------------------------------------- The tables below summarize our owned basis assets, revenues and income beforeincome taxes by material country. Purchase accounting adjustments are reportedwithin the appropriate country. AT DECEMBER 31, ----------------------------------------------------------- IDENTIFIABLE ASSETS LONG-LIVED ASSETS(1) ------------------------------ -------------------------- 2005 2004 2003 2005 2004 2003----------------------------------------------------------------------------------------------- (IN MILLIONS)United States..................... $145,955 $115,938 $107,342 $9,382 $ 8,974 $ 9,132United Kingdom.................... 7,006 11,468 9,401 403 942 809Canada............................ 3,479 2,581 2,183 153 129 137Europe............................ 229 203 126 3 3 2 -------- -------- -------- ------ ------- -------Total............................. $156,669 $130,190 $119,052 $9,941 $10,048 $10,080 ======== ======== ======== ====== ======= ======= --------------- (1) Includes properties and equipment, goodwill and acquired intangibles. YEAR ENDED DECEMBER 31, --------------------------------------------------------- REVENUES INCOME BEFORE INCOME TAXES --------------------------- --------------------------- 2005 2004 2003 2005 2004 2003-------------------------------------------------------------------------------------------------- (IN MILLIONS)United States.......................... $16,003 $14,346 $13,146 $2,609 $2,858 $2,235United Kingdom......................... 1,563 1,316 1,091 (37) 6 147Canada................................. 450 340 284 96 82 68Europe................................. 31 16 40 (5) (6) 25 ------- ------- ------- ------ ------ ------Total.................................. $18,047 $16,018 $14,561 $2,663 $2,940 $2,475 ======= ======= ======= ====== ====== ====== 187 HSBC Finance Corporation--------------------------------------------------------------------------------SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) THREE THREE THREE THREE THREE THREE THREE THREE MONTHS MONTHS MONTHS MONTHS MONTHS MONTHS MONTHS MONTHS ENDED ENDED ENDED ENDED ENDED ENDED ENDED ENDED DEC. 31, SEPT. 30, JUNE 30, MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31, 2005 2005 2005 2005 2004 2004 2004 2004------------------------------------------------------------------------------------------------------------------------ (IN MILLIONS)Finance and other interest income........................ $3,725 $3,402 $3,139 $2,950 $3,001 $2,779 $2,637 $2,528Interest expense................ 1,427 1,239 1,104 1,062 918 810 707 708 ------ ------ ------ ------ ------ ------ ------ ------Net interest income............. 2,298 2,163 2,035 1,888 2,083 1,969 1,930 1,820Provision for credit losses on owned receivables............. 1,310 1,361 1,031 841 1,286 1,123 997 928 ------ ------ ------ ------ ------ ------ ------ ------Net interest income after provision for credit losses... 988 802 1,004 1,047 797 846 933 892 ------ ------ ------ ------ ------ ------ ------ ------Securitization related revenue....................... 31 41 54 85 127 267 266 348Insurance revenue............... 239 229 229 221 221 203 204 211Investment income............... 35 33 33 33 30 36 30 41Fee income...................... 469 439 354 306 282 302 242 265Derivative income (expense)..... (34) (53) 76 260 263 72 124 52Taxpayer financial services income........................ 17 (1) 18 243 8 (3) 6 206Other income.................... 386 414 360 314 164 163 180 100Gain on bulk sale of private label receivables............. - - - - 663 - - - ------ ------ ------ ------ ------ ------ ------ ------Total other revenues............ 1,143 1,102 1,124 1,462 1,758 1,040 1,052 1,223 ------ ------ ------ ------ ------ ------ ------ ------Salaries and fringe benefits.... 536 513 526 497 472 472 457 485Sales incentives................ 108 117 90 82 104 91 90 78Occupancy and equipment expense....................... 82 83 82 87 86 77 77 83Other marketing expenses........ 170 196 185 180 199 174 131 132Other servicing and administrative expenses....... 235 149 143 258 209 235 198 226Support services from HSBC affiliates.................... 237 226 217 209 194 183 196 177Amortization of acquired intangibles................... 65 90 83 107 85 83 79 116Policyholders' benefits......... 109 109 116 122 113 93 93 113 ------ ------ ------ ------ ------ ------ ------ ------Total costs and expenses........ 1,542 1,483 1,442 1,542 1,462 1,408 1,321 1,410 ------ ------ ------ ------ ------ ------ ------ ------Income before income taxes...... 589 421 686 967 1,093 478 664 705Income taxes.................... 196 140 214 341 381 153 231 235 ------ ------ ------ ------ ------ ------ ------ ------Net income...................... $ 393 $ 281 $ 472 $ 626 $ 712 $ 325 $ 433 $ 470 ====== ====== ====== ====== ====== ====== ====== ======Operating net income(1)......... $ 393 $ 281 $ 472 $ 626 $ 410 $ 325 $ 433 $ 470 ====== ====== ====== ====== ====== ====== ====== ====== --------------- (1)Operating net income is a non-GAAP financial measure and is provided for comparison of our operating trends only and should be read in conjunction with our owned basis GAAP financial information. For 2004, operating net income excludes the $121 million decrease in net income relating to the adoption of Federal Financial Institutions Examination Council charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard/ Visa receivables and the $423 million (after-tax) gain on the bulk sale of domestic private label receivables to an affiliate. 188 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE.-------------------------------------------------------------------------------- There were no disagreements on accounting and financial disclosure mattersbetween HSBC Finance Corporation and its independent accountants during 2005. ITEM 9A. CONTROLS AND PROCEDURES.-------------------------------------------------------------------------------- We maintain a system of internal and disclosure controls and procedures designedto ensure that information required to be disclosed by HSBC Finance Corporationin the reports we file or submit under the Securities Exchange Act of 1934, asamended, (the "Exchange Act"), is recorded, processed, summarized and reportedon a timely basis. Our Board of Directors, operating through its auditcommittee, which is composed entirely of independent outside directors, providesoversight to our financial reporting process. We conducted an evaluation, with the participation of the Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of our disclosurecontrols and procedures as of the end of the period covered by this report.Based upon that evaluation, the Chief Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures were effective asof the end of the period covered by this report so as to alert them in a timelyfashion to material information required to be disclosed in reports we fileunder the Exchange Act. There have been no significant changes in our internal and disclosure controlsor in other factors which could significantly affect internal and disclosurecontrols subsequent to the date that we carried out our evaluation. HSBC Finance Corporation continues the process to complete a thorough review ofits internal controls as part of its preparation for compliance with therequirements of Section 404 of the Sarbanes-Oxley Act of 2002. Section 404requires our management to report on, and our external auditors to attest to,the effectiveness of our internal control structure and procedures for financialreporting. As a non-accelerated filer under Rule 12b-2 of the Exchange Act, ourfirst report under Section 404 will be contained in our Form 10-K for the periodended December 31, 2007. ITEM 9B. OTHER INFORMATION.-------------------------------------------------------------------------------- None. This information is provided by RNS The company news service from the London Stock Exchange