HSBC Holdings Regulatory News (HSBA)

5 Mar 2007 12:45

HSBC Holdings PLC05 March 2007 Part 2 of 5 Additional resources continue to be directed towards expansion of core retailbanking businesses outside of residential mortgage banking, including investmentin the HSBC brand, expansion of the core branch network in existing and newgeographic areas, and continued rollout of the internet savings product. Netinterest income associated with the core banking operations grew 19% for 2006 asa result of favorable interest rate spreads on a growing deposit base. Asexpected during the expansion build-out phase, expense growth associated withexpansion initiatives has outpaced related core banking revenue growth. Average deposit balances grew $5 billion (18%) in 2006. Balance sheet growthduring 2006 was highlighted by successful rollout of the internet savingsproduct. The following table summarizes results for the PFS segment. ------------------------------------------------------------------------------------------------------------ 2006 Compared 2005 Compared to 2005 to 2004 Increase/(Decrease) Increase/(Decrease) ---------------------- --------------------Year Ended December 31 2006 2005 2004 Amount % Amount %------------------------------------------------------------------------------------------------------------ ($ in millions) Net interest income .......... $ 1,232 $ 1,202 $ 1,088 $ 30 2 $ 114 10Other revenues ............... 447 406 358 41 10 48 13 ------- ------- ------- --------- ------- ------- ------Total revenues ............... 1,679 1,608 1,446 71 4 162 11Operating expenses ........... 1,192 1,002 922 190 19 80 9 ------- ------- ------- --------- ------- ------- ------ 487 606 524 (119) (20) 82 16Provision for credit losses .. 58 103 81 (45) (44) 22 27 ------- ------- ------- --------- ------- ------- ------Income before income tax expense ................... $ 429 $ 503 $ 443 $ (74) (15) $ 60 14 ======= ======= ======= ========= ======= ======= ====== 2006 Compared to 2005 Commentary regarding net interest income begins on page 34 of this Form 10-K. Higher operating expenses for 2006 were due to: o higher staff costs from additional headcount recruited to support investment in branch expansion and the internet savings program. Greater emphasis was also placed on recruiting staff dedicated to sales and customer relationship activities, which changed the staff mix, and contributed to higher expenses; o higher marketing and other direct costs associated with expansion of the core banking network and growth of the internet savings business; o higher expenses within the residential mortgage banking business throughout 2006, partly due to reduced cost deferrals related to a reduced volume of loan originations; o increased fees paid to HTSU, as HUSI continued to upgrade its branch sales platform; and o allocations of various increased corporate expenses to the PFS business segment, including various compensation costs. The provision for credit losses decreased $45 million, mainly due to changes inbankruptcy legislation in 2005, which accelerated charge offs and impairmentactivity related to the legacy MasterCard/Visa credit card and automotivefinance portfolios in that year. 51 2005 Compared to 2004 Commentary regarding net interest income begins on page 34 of this Form 10-K. Higher other revenues for 2005 were primarily due to: o higher residential mortgage servicing revenue, primarily resulting from significant reversals of temporary MSRs impairment allowances recorded in 2004; and o effective in October 2004, HBUS became the originating lender for HSBC Finance Corporation's Taxpayer Financial Services program. Gains recognized for tax refund anticipation loans sold to HSBC Finance Corporation's Taxpayer Financial Services business were $19 million in 2005. In addition, 2005 results reflect a reduction in gains on sale of properties andother assets, as follows: 2005 o $26 million of gains on sales of certain properties to unaffiliated third parties. 2004 o $99 million gain on sale of certain MasterCard/Visa credit card relationships to HSBC Finance Corporation; and o $45 million gain on sale of an equity investment. Increased operating expenses for 2005 were due to: o increased personnel, marketing and other direct expenses associated with expanded consumer lending and retail banking operations; and o increased fees paid to HTSU, as HUSI has continued to upgrade its technology environment. The provision for credit losses increased $22 million, as a direct result ofincreased consumer loan balances. Consumer Finance (CF) In December 2004, HUSI acquired $12 billion of loans, primarily private labelcredit card receivables, from HSBC Finance Corporation. The CF segment, whichwas initiated in 2005, includes the PLRP and other consumer loans acquired fromHSBC Finance Corporation and its correspondents. Results of the CF segment havebeen positively impacted by growth of private label credit card receivablesincluded within the PLRP and by decreased amortization of premiums paid to HSBCFinance Corporation for those receivables. Private label credit card receivableshave grown to $17 billion at December 31, 2006, due to the addition of newcredit card relationships and to reduced funding requirements associated withoff-balance sheet securitization trusts. 52 The following table summarizes results for the CF segment. ---------------------------------------------------------------------------------------------------------------------- 2006 Compared 2005 Compared to 2005 to 2004 Increase/(Decrease) Increase/(Decrease) ------------------- -------------------Year Ended December 31 2006 2005 2004 Amount % Amount %---------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income .................... $ 738 $ 583 $ 182 $ 155 27 $ 401 220Other revenues ......................... 501 356 2 145 41 354 * -------- -------- -------- -------- -------- -------- --------Total revenues ......................... 1,239 939 184 300 32 755 410Operating expenses ..................... 441 424 17 17 4 407 * -------- -------- -------- -------- -------- -------- -------- 798 515 167 283 55 348 208Provision for credit losses ............ 659 599 22 60 10 577 * -------- -------- -------- -------- -------- -------- --------Income (loss) before income tax expense .................. $ 139 $ (84) $ 145 $ 223 265 $ (229) * ======== ======== ======== ======== ======== ======== ======== * Not meaningful. 2006 Compared to 2005 The following tables summarize the impact of the PLRP on earnings for 2006 and2005 in comparison with the other portfolios included within this segment,mainly higher quality nonconforming residential mortgage loans. ---------------------------------------------------------------------------------------------------------------------- TotalYear Ended December 31 PLRP Other CF Segment---------------------------------------------------------------------------------------------------------------------- (in millions) 2006Net interest income ............................................................... $ 645 $ 93 $ 738Other revenues .................................................................... 501 -- 501 -------- -------- ----------Total revenues .................................................................... 1,146 93 1,239Operating expenses ................................................................ 425 16 441 -------- -------- ---------- 721 77 798Provision for credit losses ....................................................... 636 23 659 -------- -------- ----------Income before income tax expense .................................................. $ 85 $ 54 $ 139 ======== ======== ========== 2005Net interest income ............................................................... $ 435 $ 148 $ 583Other revenues .................................................................... 356 -- 356 -------- -------- ----------Total revenues .................................................................... 791 148 939Operating expenses ................................................................ 408 16 424 -------- -------- ---------- 383 132 515Provision for credit losses ....................................................... 564 35 599 -------- -------- ----------(Loss) income before income tax expense ........................................... $ (181) $ 97 $ (84) ======== ======== ========== Commentary regarding net interest income begins on page 34 of this Form 10-K. Other revenues are primarily comprised of credit card fees and securitizationrevenue. Fee income has grown significantly in 2006 due to significant growth inthe number of accounts included within the PLRP, higher on-balance sheetreceivable balances, increased late fees and lower fees paid to merchantpartners. Higher fees were partially offset by lower securitization revenue,which decreased due to significantly reduced balance requirements associatedwith off-balance sheet securitization trusts (refer to Note 9 of theconsolidated financial statements, beginning on page 121 of this Form 10-K, forfurther information regarding HUSI's securitization activities). Operating expenses are primarily fees paid to HSBC Finance Corporation for loanservicing, fees paid to HTSU for technology services, and other administrativeexpenses. Higher servicing fees paid for 2006 resulted directly from portfoliogrowth. Higher provision for credit losses for the PLRP portfolio is generallyconsistent with higher credit card receivable balances. 53 In accordance with Federal Financial Institutions Examination Council (FFIEC)guidance, HUSI completed its implementation of new minimum monthly paymentrequirements for domestic private label credit card accounts during the firstquarter of 2006, resulting in an immaterial impact on 2006 CF segment results. Commercial Banking (CMB) Improved 2006 results, before the provision for credit losses, were primarilydue to continued rollout of business expansion initiatives, as HUSI continued toexpand its geographic presence in the U.S. Office locations and staffing levelswere expanded in 2006 and 2005, as were loan and deposit products offered tosmall businesses, middle-market and commercial real estate customers, inconjunction with increased marketing efforts. Average loans and deposits grew $1billion (7%) and $3 billion (29%) respectively, in 2006. The following table summarizes results for the CMB segment. ---------------------------------------------------------------------------------------------------------------------- 2006 Compared 2005 Compared to 2005 to 2004 Increase/(Decrease) Increase/(Decrease) ------------------- -------------------Year Ended December 31 2006 2005 2004 Amount % Amount %---------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income .................... $ 745 $ 662 $ 586 $ 83 13 $ 76 13Other revenues ......................... 274 228 200 46 20 28 14 -------- -------- -------- -------- -------- -------- --------Total revenues ......................... 1,019 890 786 129 14 104 13Operating expenses ..................... 508 410 374 98 24 36 10 -------- -------- -------- -------- -------- -------- -------- 511 480 412 31 6 68 17Provision (credit) for credit losses .............................. 62 22 (26) 40 182 48 185 -------- -------- -------- -------- -------- -------- --------Income before income tax expense ............................. $ 449 $ 458 $ 438 $ (9) (2) $ 20 5 ======== ======== ======== ======== ======== ======== ======== 2006 Compared to 2005 Commentary regarding net interest income begins on page 34 of this Form 10-K. Higher other revenues primarily resulted from: o sales of Venezuelan Brady Bonds and related instruments during 2006; o increased syndication fees resulting from a strategic decision by the Commercial Real Estate business to mitigate risk by reducing the balance sheet; and o higher other fees resulting from business expansion. Higher operating expenses primarily resulted from: o higher personnel costs from additional staff to support expansion initiatives. Recruitment of additional relationship managers also changed the mix of staff and drove costs higher; o higher marketing and other direct costs associated with branch expansion initiatives and new lending offices; and o to a lesser extent, allocation to CMB of various increased corporate expenses, including increased compensation costs. Increased provision for credit losses for 2006 resulted from higher allowancerequirements associated with higher criticized commercial assets, and highercharge offs associated with the growing small business loan portfolio. Inaddition, net commercial loan charge offs for 2006 reflect a more normalizedcredit environment in comparison to lower net charge offs recorded in the prioryear. 54 2005 Compared to 2004 Commentary regarding net interest income begins on page 34 of this Form 10-K. Higher other revenues for 2005 resulted from the successful rollout of plannedexpansion of various small business, middle-market and real estate commerciallending programs. During 2005, HUSI sold certain properties to unaffiliated third parties,resulting in $14 million of gains recorded in other revenues within the CMBsegment. Increased operating expenses resulted from the business expansion initiativesand from increased fees paid to HTSU for technology services as HUSI continuedto upgrade its technology environment. The provision for credit losses increased $48 million in 2005 as a direct resultof higher commercial loan portfolio balances. In addition, unusually highrecoveries of loan balances previously charged off were recorded in 2004. Creditquality continued to be strong and well-managed during 2005. Corporate, Investment Banking and Markets (CIBM) Various treasury and traded markets activities were expanded in 2006 and 2005,resulting in new products offered to customers, increased marketing efforts forthose products, and an expanded infrastructure to support growth initiatives. Asa result of these initiatives, average loans increased $5 billion (69%) in 2006. Strong trading results more than offset lower balance sheet management revenues,which were adversely affected by rising short-term interest rates and aflattening yield curve that reduced net interest income and limitedopportunities to profit from placing funds generated from operations. The following table summarizes results for the CIBM segment. ---------------------------------------------------------------------------------------------------------------------- 2006 Compared 2005 Compared to 2005 to 2004 Increase/(Decrease) Increase/(Decrease) ------------------- -------------------Year Ended December 31 2006 2005 2004 Amount % Amount %---------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income .................... $ 181 $ 456 $ 766 $ (275) (60) $ (310) (40)Other revenues ......................... 1,011 641 534 370 58 107 20 -------- -------- -------- -------- -------- -------- --------Total revenues ......................... 1,192 1,097 1,300 95 9 (203) (16)Operating expenses ..................... 803 650 525 153 24 125 24 -------- -------- -------- -------- -------- -------- -------- 389 447 775 (58) (13) (328) (42)Provision (credit) for credit losses .............................. 10 (47) (95) 57 121 48 51 -------- -------- -------- -------- -------- -------- --------Income before income tax expense ............................. $ 379 $ 494 $ 870 $ (115) (23) $ (376) (43) ======== ======== ======== ======== ======== ======== ======== 2006 Compared to 2005 Commentary regarding net interest income begins on page 34 of this Form 10-K. Higher trading revenues, included in other revenues, were attributable toexpanded operations and favorable market conditions related to precious metals,foreign exchange and structured products desks, especially during the first sixmonths of the year. Refer to page 46 of this Form 10-K for additional analysisand commentary regarding trading revenues. 55 Excluding the trading revenues impact noted above, higher other revenues for2006 mainly resulted from: o higher fee-based income, primarily within the transaction banking business, resulting from expanded product offerings; and o one additional quarter in 2006 of service fees generated by a subsidiary transferred to HUSI from HSBC in March 2005, which provides accounting and valuation services for hedge fund clients. Partially offsetting these increases were decreased realized gains on sales ofsecurities for 2006 (refer to page 112 of this Form 10-K). Higher operating expenses were mainly due to the first full year impact of thebusiness expansion initiatives begun in 2005, as well as additional investmentsin early 2006 to support the growing complexity of the CIBM business.Specifically, cost growth in Global Markets was primarily driven by expansionwithin the mortgage-backed securities, structured derivative and equitybusinesses. Similarly, operating expenses grew in Transaction Banking, primarilythe payments and cash management and the securities services businesses, asbusiness volumes grew to historical highs, which drove higher transaction costsand increased support for expanded capacity. Staff costs increased due to higher performance incentives, which rose in linewith revenue growth, and due to the effect of additional people recruitedthroughout 2005 and in early 2006. Business support areas, such as market risk,credit and operations staff, also grew to support the expansion of variousbusiness lines. Transition of senior executives also contributed to highercompensation costs. The net provision credit for 2005 resulted from continuation of relatively lowcharge offs and higher than normal recoveries of amounts previously charged off.Although recoveries have decreased during 2006, charge offs remain low andcredit quality remains well managed. Further commentary regarding credit qualitybegins on page 58 of this Form 10-K. 2005 Compared to 2004 Commentary regarding net interest income begins on page 34 of this Form 10-K. Increased other revenues for 2005 were mainly due to increased trading revenuesand increased gains on sales of securities. Increased fee-based income,resulting from business expansion initiatives, also contributed to the overallincrease in other revenues. Increased operating expenses resulted from: o increased direct expenses associated with expanded operations in risk management and transaction banking businesses, and higher professional fees related to the mortgage-backed securities business; o increased expenses associated with development of an infrastructure to support the growing complexity of the CIBM business; and o increased fees paid to HTSU and other HSBC affiliates for technology services, as CIBM required additional information technology resources to support system conversions and business expansion. Partially offsetting these increases were decreases in incentive compensationexpense resulting from a change in the amortization period utilized forshare-based compensation, and decreased incentive compensation expenses. The provision for credit losses increased during 2005. The net provision creditfor 2004 reflected a period of unusually low loan charge offs and relativelyhigh recoveries of amounts previously charged off. The smaller net provisioncredit for 2005 resulted from continuation of relatively low charge offs, butlower recoveries of amounts previously charged off. 56 Private Banking (PB) During 2006 and 2005, additional resources have been allocated to opening newU.S. offices, and to expanding products offered and services provided tocustomers served by the PB business segment. As a result of these initiatives,average loans and deposits increased $1 billion (14%) and $2 billion (31%) in2006, respectively. The PB segment includes an equity investment in a non-consolidated foreign HSBCaffiliate (the foreign equity investment). Other revenues for 2006 includedhigher earnings from that foreign equity investment, while other revenues for2005 included a gain on sale of a separate investment in a foreign equity fundto an HSBC affiliate. 2006 results also have been impacted by increased creditloss provision expense associated with a specific commercial lendingrelationship. The following table summarizes results for the Private Banking (PB) segment. ---------------------------------------------------------------------------------------------------------------------- 2006 Compared 2005 Compared to 2005 to 2004 Increase/(Decrease) Increase/(Decrease) ------------------- -------------------Year Ended December 31 2006 2005 2004 Amount % Amount %---------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income .................... $ 199 $ 172 $ 130 $ 27 16 $ 42 32Other revenues ......................... 305 257 204 48 19 53 26 -------- -------- -------- -------- -------- -------- --------Total revenues ......................... 504 429 334 75 17 95 28Operating expenses ..................... 311 272 263 39 14 9 3 -------- -------- -------- -------- -------- -------- -------- 193 157 71 36 23 86 121Provision (credit) for credit losses .............................. 34 (3) 1 37 * (4) (400) -------- -------- -------- -------- -------- -------- --------Income before income tax expense ............................. $ 159 $ 160 $ 70 $ (1) (1) $ 90 129 ======== ======== ======== ======== ======== ======== ======== * Not meaningful. 2006 Compared to 2005 Commentary regarding net interest income begins on page 34 of this Form 10-K. Fee income from wealth and tax advisory services is significantly higher for2006, due to expanded services offered to customers. In addition, during 2006,earnings from a foreign equity investment increased $44 million due to its saleof shares in a foreign equity fund to an HSBC affiliate. Excluding thistransaction, equity earnings from this foreign equity investment are alsogenerally higher in 2006. In the second quarter of 2005, HUSI sold its shares inthe same foreign equity fund to an HSBC affiliate resulting in a gain of $48million. Increased operating expenses for 2006 mainly resulted from additional resourcesbeing allocated to this segment to expand the services provided. Higherpersonnel costs were driven by increased staff count and by increasedcompensation expenses related to transition of senior executives. In addition,fees charged by HSBC affiliates grew in 2006 due to higher technology relatedcosts and higher charges related to global outsourcing services. Increased provision for credit losses during 2006 directly relates to a specificcommercial loan relationship for which a combination of charge offs andincreased allowances for credit losses resulted in a $29 million provision.Further commentary regarding credit quality begins on page 58 of this Form 10-K. 57 2005 Compared to 2004 Commentary regarding net interest income begins on page 34 of this Form 10-K. Other revenues included a $48 million gain from the sale of shares in a foreignequity fund to an HSBC affiliate. Increased operating expenses generally resulted from additional resources beingallocated to this segment to expand the services provided. Partially offsettingincreased operating expenses was the reversal of a portion of a provision forU.S. withholding tax costs related to deficiencies in client tax documentation,which was recorded in the fourth quarter of 2004. Credit Quality-------------------------------------------------------------------------------- Overview HUSI enters into a variety of transactions in the normal course of business thatinvolve both on and off-balance sheet credit risk. Principal among theseactivities is lending to various commercial, institutional, governmental andindividual customers. HUSI participates in lending activity throughout the U.S.and, on a limited basis, internationally. HUSI's approach toward credit risk management is summarized on pages 72-74 ofthis Form 10-K. HUSI's methodology and accounting policies related to its allowance for creditlosses are presented in Critical Accounting Policies beginning on page 25 and inNote 2 of the consolidated financial statements beginning on page 99 of thisForm 10-K. Problem Loan Management Nonaccruing loans by portfolio, impaired loans and criticized assets aresummarized in Note 7 of the consolidated financial statements beginning on page117 of this Form 10-K. Nonaccruing Loans HUSI's policies and practices for placing loans on nonaccruing status aresummarized in Note 2 of the consolidated financial statements, beginning on page99 of this Form 10-K. 58 Nonaccruing loan statistics are summarized in the following table. -------------------------------------------------------------------------------------------------------------- 2006 2005 2004 2003 2002-------------------------------------------------------------------------------------------------------------- ($ in millions) Nonaccruing loans Balance at end of period: Commercial: Construction and other real estate ............. $ 33 $ 15 $ 33 $ 30 $ 29 Other commercial ............................... 69 70 117 233 242 ------- ------- ------- ------- ------- Total commercial ............................... 102 85 150 263 271 ------- ------- ------- ------- ------- Consumer: Residential mortgages .......................... 182 138 99 78 88 Credit card receivables ........................ 1 -- -- 22 27 Other consumer loans ........................... -- -- 1 3 1 ------- ------- ------- ------- ------- Total consumer loans ........................... 183 138 100 103 116 ------- ------- ------- ------- ------- Total nonaccruing loans .............................. $ 285 $ 223 $ 250 $ 366 $ 387 ======= ======= ======= ======= ======= As a percent of loans: Commercial: Construction and other real estate ............. .37% .16% .40% .43% .46% Other commercial ............................... .34 .38 .80 2.00 1.78 ------- ------- ------- ------- ------- Total commercial ............................... .35 .31 .65 1.41 1.36 ------- ------- ------- ------- ------- Consumer: Residential mortgages .......................... .46 .31 .21 .29 .42 Credit card receivables ........................ .01 -- -- 1.89 2.37 Other consumer loans ........................... -- -- .03 .15 .05 ------- ------- ------- ------- ------- Total consumer loans ........................... .30 .22 .16 .35 .49 ------- ------- ------- ------- ------- Total ................................................ .32% .25% .29% .76% .89% ======= ======= ======= ======= =======Interest income on nonaccruing loans (Year Ended December 31): Amount which would have been recorded had the associated loans been current in accordance with their original terms .............. $ 21 $ 25 $ 23 $ 28 $ 37 Amount actually recorded ............................. 8 12 17 12 9 Interest that has been accrued but unpaid on loans placed on nonaccruing statusgenerally is reversed and reduces current income at the time loans are socategorized. Interest income on these loans may be recognized to the extent ofcash payments received. In those instances where there is doubt as tocollectibility of principal, any cash interest payments received are applied asreductions of principal. Loans are not reclassified as accruing until interestand principal payments are brought current and future payments are reasonablyassured. Impaired Loans A loan is considered to be impaired when it is deemed probable that allprincipal and interest amounts due, according to the contractual terms of theloan agreement, will not be collected. Probable losses from impaired loans arequantified and recorded as a component of the overall allowance for creditlosses. Generally, impaired loans include loans in nonaccruing status, loanswhich have been assigned a specific allowance for credit losses, loans whichhave been partially or wholly charged off, and loans designated as troubled debtrestructurings. Impaired loan statistics are summarized in the following table. -------------------------------------------------------------------------------------------------------------- 2006 2005 2004 2003 2002-------------------------------------------------------------------------------------------------------------- (in millions) Impaired loans: Balance at end of period ................................ $ 100 $ 90 $ 236 $ 267 $ 288 Amount with impairment reserve .......................... 35 27 210 179 170 Impairment reserve ...................................... 13 10 18 86 89 59 Criticized Assets Criticized asset classifications are based on the risk rating standards ofHUSI's primary regulator. Problem loans are assigned various criticized facilitygrades under HUSI's allowance for credit losses methodology. The followingfacility grades are deemed to be criticized. Special Mention - generally includes loans that are protected by collateraland/or the credit worthiness of the customer, but are potentially weak basedupon economic or market circumstances which, if not checked or corrected, couldweaken HUSI's credit position at some future date. Substandard - includes loans that are inadequately protected by the underlyingcollateral and/or general credit worthiness of the customer. These loans presenta distinct possibility that HUSI will sustain some loss if the deficiencies arenot corrected. This category also includes certain non-investment gradesecurities, as required by HUSI's principal regulator. Doubtful - includes loans that have all the weaknesses exhibited by substandardloans, with the added characteristic that the weaknesses make collection orliquidation in full of the recorded loan highly improbable. However, althoughthe possibility of loss is extremely high, certain factors exist which maystrengthen the credit at some future date, and therefore the decision to chargeoff the loan is deferred. Loans graded as doubtful are required to be placed innonaccruing status. Criticized assets are summarized in the following table. --------------------------------------------------------------------------------------------------------- Increase/(Decrease) from ------------------------------------------ December 31, 2005 December 31, 2004 December 31, ------------------- ------------------- 2006 Amount % Amount %--------------------------------------------------------------------------------------------------------- ($ in millions) Special mention: Commercial loans ......................... $ 1,364 $ 658 93 $ 580 74 ------------ --------- ------ --------- ------Substandard: Commercial loans ......................... 765 612 400 551 257 Consumer loans ........................... 601 147 32 225 60 Non-investment grade securities .......... 30 (84) (74) 30 -- ------------ --------- ------ --------- ------ 1,396 675 94 806 137 ------------ --------- ------ --------- ------Doubtful: Commercial loans ......................... 32 7 28 (14) (30) ------------ --------- ------ --------- ------Total ....................................... $ 2,792 $ 1,340 92 $ 1,372 97 ============ ========= ====== ========= ====== The increase in substandard commercial loans is addressed under Commercial LoanCredit Quality on page 64. Higher substandard consumer loans primarily relate toprivate label credit card receivables and, to a lesser extent, to residentialmortgage loans acquired from HSBC Finance Corporation. At December 31, 2006,substandard credit card receivables and residential mortgage loans represented1.8% and .6% of their respective total loan portfolios. Concentrations of Credit Risk A concentration of credit risk is defined as a significant credit exposure withan individual or group engaged in similar activities or affected similarly byeconomic conditions. HUSI's concentrations of credit risk include: o residential mortgage loans with high loan-to-value (LTV) ratios and no mortgage insurance, which could result in potential inability to recover the entire investment in loans involving foreclosed or damaged properties; o interest-only residential mortgage loans, which allow customers to pay only the accruing interest for a period of time, resulting in lower payments during the initial loan period; o concentrations of second liens within the residential mortgage loan portfolio; and o adjustable rate residential mortgage loans that will experience their first interest rate resets within the next two years. 60 Additional disclosures regarding credit risk concentrations are provided in Note7 of the consolidated financial statements, beginning on page 117 of this Form10-K. Cross-Border Net Outstandings Cross-border net outstandings, as calculated in accordance with FederalFinancial Institutions Examination Council (FFIEC) guidelines, are amountspayable to HUSI by residents of foreign countries regardless of the currency ofclaim and local country claims in excess of local country obligations.Cross-border net outstandings include deposits placed with other banks, loans,acceptances, securities available for sale, trading securities, revaluationgains on foreign exchange and derivative contracts and accrued interestreceivable. Excluded from cross-border net outstandings are, among other things,the following: local country claims funded by non-local country obligations(U.S. dollar or other non-local currencies), principally certificates of depositissued by a foreign branch, where the providers of funds agree that, in theevent of the occurrence of a sovereign default or the imposition of currencyexchange restrictions in a given country, they will not be paid until suchdefault is cured or currency restrictions lifted or, in certain circumstances,they may accept payment in local currency or assets denominated in localcurrency (hereinafter referred to as constraint certificates of deposit); andcross-border claims that are guaranteed by cash or other external liquidcollateral. Cross-border net outstandings that exceed .75% of total assets atyear-end are summarized in the following table. -------------------------------------------------------------------------------- Banks and Commercial Other Financial and Institutions Industrial Total-------------------------------------------------------------------------------- (in millions)December 31, 2006: France ......................... $ 1,782 $ 49 $ 1,831 Canada ......................... 1,305 793 2,098 United Kingdom ................. 1,738 1,127 2,865 --------------- ---------- ----------- $ 4,825 $ 1,969 $ 6,794 =============== ========== =========== December 31, 2005: United Kingdom ................. $ 1,497 $ 970 $ 2,467 =============== ========== =========== December 31, 2004: United Kingdom ................. $ 2,724 $ 1,086 $ 3,810 =============== ========== =========== 61 Provision and Allowance for Credit Losses An analysis of the provision for credit losses is provided on page 38 of thisForm 10-K. An analysis of overall changes in the allowance for credit losses and relatedallowance ratios is presented in the following table. -------------------------------------------------------------------------------------------------------------Year Ended December 31 2006 2005 2004 2003 2002------------------------------------------------------------------------------------------------------------- ($ in millions) Total loans at year end ................... $ 90,237 $ 90,342 $ 84,947 $ 48,474 $ 43,636Average total loans ....................... 88,853 87,898 60,328 44,187 42,054 Allowance for credit losses: Balance at beginning of year ........... $ 846 $ 788 $ 399 $ 493 $ 506 Allowance related to acquisitions and (dispositions), net ............. (8) -- 485 (15) (2) Charge offs: Commercial ............................. 136 75 54 160 151 Consumer: Residential mortgages ............... 37 24 15 3 3 Credit card receivables ............. 728 659 65 59 63 Other consumer loans ................ 111 113 23 21 24 ---------- ---------- ---------- ---------- ---------- Total consumer loans ................ 876 796 103 83 90 ---------- ---------- ---------- ---------- ----------Total charge offs ......................... 1,012 871 157 243 241 ---------- ---------- ---------- ---------- ---------- Recoveries on loans charged off: Commercial ............................. 38 71 60 35 21 Consumer: Residential mortgages ............... 2 1 2 1 1 Credit card receivables ............. 170 146 8 8 8 Other consumer loans ................ 38 37 8 7 5 ---------- ---------- ---------- ---------- ---------- Total consumer loans ................ 210 184 18 16 14 ---------- ---------- ---------- ---------- ----------Total recoveries .......................... 248 255 78 51 35 ---------- ---------- ---------- ---------- ---------- Total net charge offs ..................... 764 616 79 192 206 ---------- ---------- ---------- ---------- ---------- Provision charged (credited) to income .... 823 674 (17) 113 195 ---------- ---------- ---------- ---------- ---------- Balance at end of year .................... $ 897 $ 846 $ 788 $ 399 $ 493 ========== ========== ========== ========== ========== Allowance ratios: Total net charge offs to average loans: Commercial ............................. .35% .02% (.03)% .63% .66% Consumer: Residential mortgages ............... .08 .05 .04 .01 .01 Credit card receivables ............. 3.49 3.81 4.69 4.57 5.00 Other consumer loans ................ 2.47 2.41 .71 .72 .96 ---------- ---------- ---------- ---------- ---------- Total consumer loans ................ 1.10 .96 .21 .28 .34 ---------- ---------- ---------- ---------- ---------- Total loans ............................ .86% .70% .13 % .43% .49% ========== ========== ========== ========== ========== Year-end allowance to: Year-end total loans ................ .99% .94% .93 % .82% 1.13% Year-end total nonaccruing loans (1) ........................ 314.74% 379.37% 315.20 % 109.02% 127.39% (1) The increased allowance for credit losses at the end of 2006, 2005 and 2004 resulted from the acquisition of the private label credit card receivables from HSBC Finance Corporation. As these receivable balances are typically maintained as accruing until charged off, there were no loan balances included in this portfolio which were classified as nonaccruing, resulting in a significant increase in the ratio of allowance to nonaccruing loans for 2006, 2005 and 2004 as compared with prior years. 62 Changes in the allowance for credit losses during 2006 and 2005, by general loancategories, are summarized in the following tables. ----------------------------------------------------------------------------------------------------------------------- Residential Credit OtherYear Ended December 31 Commercial Mortgage Card Consumer Unallocated Total----------------------------------------------------------------------------------------------------------------------- (in millions) 2006Balance at beginning of year ........ $ 162 $ 34 $ 600 $ 36 $ 14 $ 846 ---------- ----------- ----------- ----------- ----------- ---------- Allowance related to dispositions ... -- -- (8) -- -- (8) Charge offs ......................... 136 37 728 111 -- 1,012Recoveries .......................... 38 2 170 38 -- 248 ---------- ----------- ----------- ----------- ----------- ----------Net charge offs ..................... 98 35 558 73 -- 764 ---------- ----------- ----------- ----------- ----------- ---------- Provision charged (credited) to income ......................... 139 32 592 63 (3) 823 ---------- ----------- ----------- ----------- ----------- ---------- Balance at end of year .............. $ 203 $ 31 $ 626 $ 26 $ 11 $ 897 ========== =========== =========== =========== =========== ========== 2005Balance at beginning of year ........ $ 182 $ 20 $ 553 $ 20 $ 13 $ 788 ---------- ----------- ----------- ----------- ----------- ---------- Charge offs ......................... 75 24 659 113 -- 871Recoveries .......................... 71 1 146 37 -- 255 ---------- ----------- ----------- ----------- ----------- ----------Net charge offs ..................... 4 23 513 76 -- 616 ---------- ----------- ----------- ----------- ----------- ---------- Provision charged (credited) to income ......................... (16) 37 560 92 1 674 ---------- ----------- ----------- ----------- ----------- ---------- Balance at end of year .............. $ 162 $ 34 $ 600 $ 36 $ 14 $ 846 ========== =========== =========== =========== =========== ========== An allocation of the allowance for credit losses by major loan categories ispresented in the following table. The 2004 decrease in the unallocated portionnoted in the table is due to refinement in the allowance methodology during thatyear. ------------------------------------------------------------------------------------------------------------------------ 2006 2005 2004 2003 2002 ----------------- ----------------- ---------------- ----------------- ---------------- % of % of % of % of % of Loans Loans Loans Loans Loans to Total to Total to Total to Total to Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans------------------------------------------------------------------------------------------------------------------------ ($ in millions) Commercial ............. $ 203 33 $ 162 31 $ 182 27 $ 252 39 $ 346 46Consumer: Residential mortgages 31 44 34 49 20 55 13 55 11 47 Credit card receivables 626 20 600 17 553 14 54 2 51 3 Other consumer ....... 26 3 36 3 20 4 16 4 27 4Unallocated reserve .... 11 -- 14 -- 13 -- 64 -- 58 -- ------ -------- ------ -------- ------ -------- ------ -------- ------ --------Total .................. $ 897 100 $ 846 100 $ 788 100 $ 399 100 $ 493 100 ====== ======== ====== ======== ====== ======== ====== ======== ====== ======== 63 Commercial Loan Credit Quality Components of the commercial allowance for credit losses, as well as movementsin comparison with prior years, are summarized in the following table. ------------------------------------------------------------------------------------------------------- Increase (Decrease) from --------------------------------------------- December 31, 2005 December 31, 2004 December 31, --------------------- --------------------- 2006 Amount % Amount %------------------------------------------------------------------------------------------------------- ($ in millions) On-balance sheet allowance: Specific ............................ $ 14 $ 5 56 $ (4) (22) Collective .......................... 189 40 27 39 26 Transfer risk ....................... -- (4) (100) (14) (100) ------------ --------- --------- --------- --------- 203 41 25 21 12 Unallocated ......................... 11 (3) (21) (2) (15) ------------ --------- --------- --------- --------- Total on-balance sheet allowance .... 214 38 22 19 10 ------------ --------- --------- --------- ---------Off-balance sheet allowance ............ 98 10 11 8 9 ------------ --------- --------- --------- ---------Total commercial allowances ............ $ 312 $ 48 18 $ 27 9 ============ ========= ========= ========= ========= 2006 HUSI's growth initiatives during 2005 and 2006 have resulted in a continuingtrend of growth in the size and complexity of HUSI's commercial loan portfolio.In addition, certain segments of the economy continue to show signs of slowing,resulting in higher probabilities of default, which is a key driver for creditgrading. The resulting net increase in criticized assets in 2006, in combinationwith increased loan balances, resulted in higher specific and collectiveallowances at December 31, 2006. Criticized asset classifications are based on the risk rating standards ofHUSI's primary regulator. Higher substandard criticized assets (refer to page 60of this Form 10-K) resulted mainly from downgrades in auto and insuranceindustry exposures within the CIBM business segment, and middle marketcommercial exposures within CMB. The downgrades resulted in part from changes inthe credit metrics for specific credits within these industries and portfolios.Total nonaccruing commercial loans, as a percentage of total commercial loans,remain low and are flat year over year. In addition, commercial loan net chargeoffs remain below historical averages. Based upon evaluation of the repaymentcapacity of the obligors, including support from adequately margined collateral,performance on guarantees, and other mitigating factors, impairment is modestlyhigher at December 31, 2006 as compared with prior reporting periods, and isadequately reflected in the allowances for specific and collective impairment. Continued increases in provisions and allowances for credit losses are expectedin the near future due to growing portfolio risk resulting from: o HUSI's continued geographic expansion; o increased borrower concentrations; o increased number and complexity of products offered; and o continuing signs of stress within certain segments of the economy. HUSI management continues to monitor and reduce exposures to those industriesconsidered to be higher risk. During 2006, HUSI management began to make moreextensive use of available tools to more actively manage net exposure within itscorporate loan portfolios with an increased syndication capacity as well asincreased use of credit default swaps to economically hedge and reduce certainexposures. Any sudden and/or unexpected adverse economic events or trends couldsignificantly affect credit quality and increase provisions for credit losses.For example, HUSI management is monitoring rising interest rates and high energyprices, which could potentially lead to a deceleration of U.S. economicactivity. Recent events in the Middle East may also worsen the overall energypicture. 64 2005 Calendar year 2004 was a period of unusually low charge offs and high recoveriesof commercial loans. During 2005, charge offs increased 39%, but the level ofcharge offs was still well below 2003 and prior year levels. Recoveriesincreased again in 2005 due to sales of certain problem credits at amountshigher than recorded book values. Commercial loan credit quality was generally stable throughout 2005. Nonaccruingcommercial loans decreased for the fifth consecutive year, reflecting HUSI'sgenerally strong credit underwriting standards and improving economic conditionsin recent years. Criticized assets classified as "substandard" increased $131million during 2005, primarily due to the addition of non-investment gradesecurities to the calculation of these assets. Excluding these securities,criticized commercial loans declined among all categories during 2005. Credit Card Receivable Credit Quality Credit card receivables are primarily private label receivables, includingclosed and open ended contracts, acquired from HSBC Finance Corporation.Receivables included in the private label credit card portfolio are generallymaintained in accruing status until being charged off six months afterdelinquency. The following table provides credit quality data for credit cardreceivables. ----------------------------------------------------------------------------------------------------December 31 2006 2005---------------------------------------------------------------------------------------------------- ($ in millions) Accruing credit card receivables contractually past due 90 days or more: Balance at end of period .................................................... $ 339 $ 248 As a percent of total credit card receivables ............................... 1.86% 1.60% Allowance for credit losses associated with credit card receivables: Balance at end of period .................................................... $ 626 $ 600 As a percent of total credit card receivables ............................... 3.43% 3.87% Net charge offs of credit card receivables: Total for the period ........................................................ $ 558 $ 513 Annualized net charge offs as a percent of average credit card receivables .. 3.49% 3.81% 2006 The allowance for credit losses associated with credit card receivablesincreased $26 million (4%) during 2006. Net charge off and provision activityduring 2006, as well as the allowance balance at December 31, 2006, aregenerally consistent with increased private label credit card receivablebalances (refer to page 52 of this Form 10-K for commentary regarding creditcard receivables). 2005 The allowance for credit losses associated with credit card receivablesincreased $47 million during 2005. During the second half of the year, HUSIrecorded an incremental $15 million allowance for credit losses associated withHurricane Katrina and new bankruptcy legislation. Excluding these incrementalprovisions, allowance activity reflects normal portfolio experience for theincreased balances associated with the private label receivables. 65 Residential Mortgage Loan Credit Quality 2006 The allowance for credit losses related to residential mortgage loans decreased9% during 2006. Lower loan balances resulted in lower allowance requirementsduring the year. HUSI's residential mortgage portfolio is primarily comprised ofprime mortgage loans, for which credit quality remained strong during 2006 and2005. 2005 The allowance for credit losses associated with residential mortgage loansincreased 70% during 2005, primarily due to significant growth in this loanportfolio during 2005 and 2004. Reserve for Off-Balance Sheet Exposures HUSI maintains a separate reserve for credit risk associated with certainoff-balance sheet exposures including letters of credit, unused commitments toextend credit and financial guarantees. This reserve, included in otherliabilities, was $98 million and $88 million at December 31, 2006 and 2005,respectively. Credit and Market Risks Associated with Derivative Contracts Credit (or repayment) risk in derivative instruments is minimized by enteringinto transactions with high quality counterparties, including other HSBCentities. Counterparties include financial institutions, government agencies,both foreign and domestic, corporations, funds (mutual funds, hedge funds,etc.), insurance companies and private clients. These counterparties are subjectto regular credit review by the credit risk management department. Mostderivative contracts are governed by an International Swaps and DerivativesAssociation Master Agreement. Depending on the type of counterparty and thelevel of expected activity, bilateral collateral arrangements may also berequired. The total risk in a derivative contract is a function of a number of variables,such as: o whether counterparties exchange notional principal; o volatility of interest rates, currencies, equity or corporate reference entity used as the basis for determining contract payments; o maturity and liquidity of contracts; o credit worthiness of the counterparties in the transaction; and o existence and value of collateral received from counterparties to secure exposures. The following table presents credit risk exposure and net fair value associatedwith derivative contracts. In the table, current credit risk exposure is therecorded fair value of derivative receivables, which represents revaluationgains from the marking to market of derivative contracts held for tradingpurposes, for all counterparties with an International Swaps and DerivativesAssociation Master Agreement in place. Future credit risk exposure in the following table is measured using rulescontained in the risk-based capital guidelines published by U.S. bankingregulatory agencies. The risk exposure calculated in accordance with therisk-based capital guidelines potentially overstates actual credit exposure,because: o the risk-based capital guidelines ignore collateral that may have been received from counterparties to secure exposures; and o the risk-based capital guidelines compute exposures over the life of derivative contracts. However, many contracts contain provisions that allow a bank to close out the transaction if the counterparty fails to post required collateral. As a result, these contracts have potential future exposures that are often much smaller than the future exposures derived from the risk-based capital guidelines. 66 The net credit risk exposure amount in the following table does not reflect theimpact of bilateral netting (i.e., netting with a single counterparty when abilateral netting agreement is in place). However, the risk-based capitalguidelines recognize that bilateral netting agreements reduce credit risk andtherefore allow for reductions of risk-weighted assets when netting requirementshave been met. In addition, risk-based capital rules require that nettedexposures of various counterparties be assigned risk-weightings, which result inrisk-weighted amounts for regulatory capital purposes that are a fraction of theoriginal netted exposures. -------------------------------------------------------------------------------December 31 2006 2005------------------------------------------------------------------------------- (in millions)Risk associated with derivative contracts:Current credit risk exposure ................. $ 11,398 $ 8,155Future credit risk exposure .................. 72,447 61,548 ---------- ----------Total risk exposure .......................... 83,845 69,703Less: collateral held against exposure ....... (3,989) (1,850) ---------- ----------Net credit risk exposure ..................... $ 79,856 $ 67,853 ========== ========== The table below summarizes the risk profile of the counterparties of HUSI's onbalance sheet exposure to derivative contracts, net of cash and other highlyliquid collateral. ------------------------------------------------------------------------------- Percent of Current Credit Risk Exposure, Net of Collateral ------------------------------Rating equivalent at December 31 2006 2005-------------------------------------------------------------------------------AAA to AA- ................................... 46% 28%A+ to A- ..................................... 31 39BBB+ to BBB- ................................. 15 22BB+ to B- .................................... 4 4CCC+ and below ............................... 4 7 ----- ----Total ........................................ 100% 100% ===== ==== Market risk is the adverse effect that a change in interest rates, currency, orimplied volatility rates has on the value of a financial instrument. HUSImanages the market risk associated with interest rate and foreign exchangecontracts by establishing and monitoring limits as to the types and degree ofrisk that may be undertaken. HUSI also manages the market risk associated withthe trading derivatives through hedging strategies that correlate the rates,price and spread movements. HUSI measures this risk daily by using Value at Risk(VAR) and other methodologies. HUSI's Asset and Liability Policy Committee is responsible for monitoring anddefining the scope and nature of various strategies utilized to manage interestrate risk that are developed through its analysis of data from financialsimulation models and other internal and industry sources. The resulting hedgestrategies are then incorporated into HUSI's overall interest rate riskmanagement and trading strategies. 67 Off-Balance Sheet Arrangements and Contractual Obligations-------------------------------------------------------------------------------- Off-Balance Sheet Arrangements The following table presents maturity information related to various off-balancesheet arrangements. Descriptions of the various arrangements follow the table. ------------------------------------------------------------------------------------------------------------ Balance at December 31, 2006 --------------------------------------------------- One Over One Over Balance at Year Through Five December 31, or Less Five Years Years Total 2005------------------------------------------------------------------------------------------------------------ (in millions) Standby letters of credit, net of participations (1) ................... $ 3,775 $ 3,371 $ 113 $ 7,259 $ 6,114Commercial letters of credit ........... 748 47 -- 795 806Loan sales with recourse (2) ........... -- 1 7 8 9Credit derivative contracts (3) ........ 16,630 248,055 166,946 431,631 222,419Commitments to extend credit: Commercial .......................... 18,644 32,172 5,046 55,862 51,284 Consumer ............................ 9,627 -- -- 9,627 8,305Securities lending indemnifications .... -- -- -- -- 4,135 ---------- ---------- ------------ ----------- ------------Total .................................. $ 49,424 $ 283,646 $ 172,112 $ 505,182 $ 293,072 ========== ========== ============ =========== ============ (1) Includes $542 million and $523 million issued for the benefit of HSBC affiliates at December 31, 2006 and 2005, respectively. (2) $7 million of this amount is indemnified by HSBC affiliates at December 31, 2006 and 2005. (3) Includes $71,908 million and $51,202 million issued for the benefit of HSBC affiliates at December 31, 2006 and 2005, respectively. Letters of Credit HUSI may issue a letter of credit for the benefit of a customer, authorizing athird party to draw on the letter for specified amounts under certain terms andconditions. The issuance of a letter of credit is subject to HUSI's creditapproval process and collateral requirements. HUSI issues two types of lettersof credit, commercial and standby. o A commercial letter of credit is drawn down on the occurrence of an expected underlying transaction, such as the delivery of goods. Upon the occurrence of the transaction, a commercial letter of credit is recorded as a customer acceptance in other assets and other liabilities until settled. o A standby letter of credit is issued to third parties for the benefit of a customer and is essentially a guarantee that the customer will perform, or satisfy some obligation, under a contract. It irrevocably obligates HUSI to pay a third party beneficiary when a customer either: (1) in the case of a performance standby letter of credit, fails to perform some contractual non-financial obligation, or (2) in the case of a financial standby letter of credit, fails to repay an outstanding loan or debt instrument. Fees are charged for issuing letters of credit commensurate with the customer'scredit evaluation and the nature of any collateral. Included in otherliabilities are deferred fees on standby letters of credit, representing thefair value of HUSI's "stand ready obligation to perform" under these guarantees,amounting to $21 million and $19 million at December 31, 2006 and 2005,respectively. Also included in other liabilities is an allowance for creditlosses on unfunded standby letters of credit of $25 million and $20 million atDecember 31, 2006 and 2005, respectively. Loan Sales with Recourse HUSI generally sells loans and other assets without recourse. In years prior to2006, HUSI's mortgage banking subsidiary sold residential mortgage loans withrecourse upon borrower default, with partial indemnification from third parties. 68 Credit Derivatives HUSI enters into credit derivative contracts both for its own benefit and tosatisfy the needs of its customers. Credit derivatives are arrangements thatprovide for one party (the "beneficiary") to transfer the credit risk of a"reference asset" to another party (the "guarantor"). Under this arrangement theguarantor assumes the credit risk associated with the reference asset withoutdirectly purchasing it. The beneficiary agrees to pay to the guarantor aspecified fee. In return, the guarantor agrees to pay the beneficiary an agreedupon amount if there is a default during the term of the contract. In accordance with its policy, HUSI offsets most of the market risk it assumesin selling credit guarantees through a credit derivative contract with anothercounterparty. Credit derivatives, although having characteristics of aguarantee, are accounted for as derivative instruments and are carried at fairvalue. The commitment amount included in the table on the preceding page is themaximum amount that HUSI could be required to pay, without consideration of theapproximately equal amount receivable from third parties and any associatedcollateral. Commitments to Extend Credit Commitments include arrangements whereby HUSI is contractually obligated toextend credit in the form of loans, participations in loans, lease financingreceivables, or similar transactions. Consumer commitments are comprised ofunused credit card lines and commitments to extend credit secured by residentialproperties. HUSI has the right to change or terminate any terms or conditions ofa customer's credit card or home equity line of credit account, uponnotification to the customer. Securities Lending Indemnifications Through December 31, 2005, HUSI occasionally lent securities of customers, on afully collateralized basis, as an agent to third party borrowers. Customers wereindemnified against the risk of loss, and collateral was obtained from theborrower with a market value exceeding the value of the loaned securities.Securities lending activities were terminated during the first quarter of 2006. Commitments to Repurchase Mortgage Loans Previously Sold In the normal course of business, HUSI's mortgage banking subsidiary routinelysells loans to investors in the secondary market. As a result, HUSI iscontractually obligated to repurchase loans in the case of a breach ofrepresentation or warranty, or in the case of an early payment default. 69 Contractual Obligations Obligations to make future payments under contracts are presented in thefollowing table. ------------------------------------------------------------------------------------------------------------ One Over One Over Year Through FiveDecember 31, 2006 or Less Five Years Years Total------------------------------------------------------------------------------------------------------------ (in millions) Subordinated long-term debt and perpetual capital notes (1) ..... $ -- $ 900 $ 4,561 $ 5,461Other long-term debt, including capital lease obligations (1) ... 7,468 10,862 5,614 23,944Pension and other postretirement benefit obligations (2) ........ 58 266 431 755Minimum future rental commitments on operating leases (3) ....... 81 239 189 509Purchase obligations (4) ........................................ 89 110 -- 199 -------- ---------- ------- -------Total ........................................................... $ 7,696 $ 12,377 $10,795 $30,868 ======== ========== ======= ======= (1) Represents future principal payments related to debt instruments included in Note 15 of the consolidated financial statements beginning on page 127 of this Form 10-K. (2) Represents estimated future employee service expected to be paid based on assumptions used to measure HUSI's benefit obligation at December 31, 2006. See Note 23 of the consolidated financial statements beginning on page 142 of this Form 10-K. (3) Represents expected minimum lease payments under noncancellable operating leases for premises and equipment included in Note 25 of the consolidated financial statements beginning on page 148 of this Form 10-K. (4) Represents binding agreements for facilities management and maintenance contracts, custodial account processing services, internet banking services, consulting services, real estate services and other services. Risk Management-------------------------------------------------------------------------------- Overview Some degree of risk is inherent in virtually all of HUSI's activities. For theprincipal activities undertaken by HUSI, the most important types of risks areconsidered to be credit, interest rate, market, liquidity, operational,fiduciary and reputational. Market risk broadly refers to price risk inherent inmark to market positions taken on trading and non-trading instruments.Operational risk technically includes legal and compliance risk. However, sincecompliance risk, including anti-money laundering (AML) risk, has such broadscope within HUSI's businesses, it is addressed below as a separate functionaldiscipline. The objective of HUSI's risk management system is to identify, measure andmonitor risks so that: o the potential costs can be weighed against the expected rewards from taking the risks; o unexpected losses can be minimized; o appropriate disclosures can be made to all concerned parties; o adequate protections, capital and other resources can be put in place to weather all significant risks; and o compliance with all relevant laws, regulations and regulatory requirements is ensured through staff education, adequate processes and controls, and ongoing monitoring efforts. Historically, HUSI's approach toward risk management has emphasized a culture ofbusiness line responsibility combined with central requirements fordiversification of customers and businesses. Extensive centrally determinedrequirements for controls, limits, reporting and the escalation of issues havebeen detailed in HUSI's and HSBC's policies and procedures. In addition, HUSIhas a formal independent compliance function, the staff of which has beenaligned with, and has advised, each business and support function. 70 As a result of an increasingly complex business environment, increasedregulatory scrutiny, and the evolution of improved risk management tools andstandards, HUSI has significantly upgraded, and continues to upgrade, itsmethodologies and systems. New practices and techniques have been developed thatinvolve data development, modeling, simulation and analysis, managementinformation systems development, self-assessment, and staff education programs.HUSI has a senior leadership structure under the direction of the Chief RiskOfficer, which includes dedicated independent risk specialists for operational,AML and fiduciary risk, in addition to the existing specialists for managingother risks. Staffing has been expanded, especially in the areas ofcompliance/AML and market risk. Risk management oversight begins with HUSI's Board of Directors and its variouscommittees, principally the Audit Committee. Specific oversight of various riskmanagement processes is provided by the Risk Management Committee, which wasassisted by five principal subcommittees through 2006: o the Credit Risk Committee; o the Asset and Liability Policy Committee; o the Operational Risk Management Committee; o the Fiduciary Risk Management Committee; and o the Compliance Risk Management Committee. The Risk Management Committee and each sub-committee were chartered by the Boardof Directors. While the charters were tailored to reflect the roles andresponsibilities of each committee, they all had the following common themes: o defining risk appetites, policies and limits; o monitoring and assessing exposures, trends and the effectiveness of risk management; o reporting to the Board of Directors; and o promulgating a suitable risk taking, risk management, and compliance culture. In early 2007, in order to foster more enterprise-wide risk oversight, the RiskManagement Committee assumed responsibility for the functions of the Credit Riskand Compliance Risk Management Committees. Day-to-day management of credit risk is centralized under the Chief CreditOfficer. For retail consumer loan portfolios, such as credit cards, installmentloans, and residential mortgages, the Chief Credit Officer leverages off theconsumer credit management skills and tools of HSBC Finance Corporation.Day-to-day management of interest rate and market risk is centralizedprincipally under the Treasurer. Operational, fiduciary, and compliance risk isdecentralized and is the responsibility of each business and support unit.However, for all risk types, there are independent risk specialists that setstandards, develop new risk methodologies, maintain central risk databases, andconduct reviews and analysis. The Chief Risk Officer and the Executive VicePresidents for Compliance and Anti-Money Laundering provide day-to-day oversightof these activities and work closely with internal audit, and senior riskofficers and specialists at HNAH and HSBC. Economic and Regulatory Capital Economic Capital Economic capital is defined as the amount of capital required to sustain abusiness through a complete business cycle, enabling the business to absorbunexpected losses and thus minimize the probability of insolvency. Economiccapital is measured at the business unit level based on four categories of risk: o Credit risk o Operational risk o Market risk o Interest rate risk 71 Whereas regulatory capital is calculated at the total bank level as a measure ofthe minimum capital needed for regulatory compliance and is based on the amountof capital maintained in relation to risk-weighted assets at a specific point intime, economic capital is actually a measure of risk. As a result, economiccapital can be compared to total corporate capital resources and, since it canbe assigned to each business unit according to its risk characteristics, it canbe used to establish business performance measures, make pricing decisions orset portfolio guidelines. Economic capital is an internal measure developed by HUSI based on its uniqueset of diverse businesses, risk appetites, and management practices. In 2004,HUSI began to calculate economic capital from statistical analyses of possiblelosses related to credit, market, interest rate and operational risk. HUSIcalculates economic capital sufficient to cover losses over a one year timehorizon at a 99.95% confidence level. This is consistent with HBUS's "AA"rating, as "AA" rated credits have historically defaulted at a rate of about.05% per year. The one year time horizon is also consistent with traditionalplanning and budgeting time horizons. Quantification of possible losses relatedto other risks, such as fiduciary and reputational risk, are broadly coveredunder the credit, market and operational risk measurements. Basel Capital Standards The timing of HNAH's and HUSI's preparations relative to Basel II is summarizedon page 12 of this Form 10-K. Only the most advanced approaches towardimplementation of the Basel II framework are expected to be adopted by U.S.regulators. For credit risk and operational risk, bank holding companies mustadopt the Advanced Internal Ratings Based approach and the Advanced MeasurementApproach, respectively, as described in the Basel framework. The final Baselframework will include new rules and definitions for traded products, which willresult in revised market risk assessment. HUSI will continue to leverage its internal economic capital development programin its preparations for the new capital adequacy standards. Many of thepractices related to the calculation of economic capital will be used to satisfyregulatory requirements. While HUSI expects to qualify to use the new approachesin time to meet the final required implementation date in the U.S., the Basel IIframework must essentially be in place on January 1, 2008 to meet HSBCrequirements. Credit Risk Management Credit risk is the potential that a borrower or counterparty will default on acredit obligation, as well as the impact on the value of credit instruments dueto changes in the probability of borrower default. For HUSI, credit risk is inherent in various on and off-balance sheetinstruments and arrangements: o in loan portfolios; o in investment portfolios; o in unfunded commitments such as letters of credit and lines of credit that customers can draw upon; and o in treasury instruments, such as interest rate swaps which, if more valuable today than when originally contracted, may represent an exposure to the counterparty to the contract. While credit risk exists widely within HUSI, diversification among variouscommercial and consumer portfolios helps HUSI to lessen risk exposure. HUSI assesses, monitors and controls credit risk with formal standards, policiesand procedures. An independent Credit Risk function is maintained under thedirection of Co-Chief Credit Officers, who report directly to the ChiefExecutive Officer of HUSI, and indirectly to the Chief Risk Officer of HNAH andto the Group General Manager, Head of Credit and Risk for HSBC. 72 The responsibilities of the credit risk function include: o Formulating credit policies - HUSI's policies are designed to ensure that various retail and commercial business units operate within clear standards of acceptable credit risk. HUSI's policies ensure that the HSBC standards are consistently implemented across all businesses and that all regulatory requirements are also considered. Credit policies are reviewed and approved annually by the Audit Committee. o Approving new credit exposures and independently assessing large exposures annually - The Co-Chief Credit Officers delegate credit authority to various lending units throughout HUSI. However, most large credits are reviewed and approved centrally through a dedicated Credit Approval Unit that reports directly to the Co-Chief Credit Officers. In addition, the Co-Chief Credit Officers coordinate the approval of material credits with HSBC Group Credit and Risk which, subject to certain agreed-upon limits, will review and concur on material new and renewal transactions. o Maintaining and developing HUSI's risk rating system - HUSI utilizes a two-dimensional credit risk rating system in order to categorize exposures meaningfully and facilitate focused management of the attendant risks. This ratings system is comprised of a 22 category Customer Risk Rating which considers the probability of default of an obligor and a separate assessment of a transaction's potential loss given default. This approach increasingly allows for a more granular analysis of risk and trends. Rating methodology is based upon a wide range of financial analytics together with market data-based tools which are core inputs to the assessment of counterparty risk. Although automated risk-rating processes are increasingly in use, for the larger facilities ultimate responsibility for setting risk grades rests in each case with the final approving executive. Risk grades are reviewed frequently and amendments, where necessary, are implemented promptly. o Measuring portfolio credit risk - Over the past few years, the advanced credit ratings system has been used to implement a credit economic capital risk measurement system to measure the risk in HUSI's credit portfolios, using the measure in certain internal and Board of Directors reporting. Simulation models are used to determine the amount of unexpected losses, beyond expected losses, that HUSI must be prepared to support with capital given its targeted debt rating. Monthly credit economic capital reports are generated and reviewed with management and the business units. Efforts continue to refine both the inputs and assumptions used in the credit economic capital model to increase its usefulness in pricing and the evaluation of large and small commercial and retail customer portfolio products and business unit return on risk. o Monitoring portfolio performance - HUSI has implemented a credit data warehouse to centralize the reporting of its credit risk, support the analysis of risk using tools such as economic capital, and to calculate its credit loss reserves. This data warehouse will also support HSBC's wider effort to meet the requirements of Basel II and to generate credit reports for management and the Board of Directors. o Establishing counterparty and portfolio limits - HUSI monitors and limits its exposure to individual counterparties and to the combined exposure of related counterparties. In addition, selected industry portfolios, such as real estate and structured products, are subject to caps that are established by the Co-Chief Credit Officers and reviewed where appropriate by management committees and the Board of Directors. Counterparty credit exposure related to derivative activities is also managed under approved limits. Since the exposure related to derivatives is variable and uncertain, HUSI uses internal risk management methodologies to calculate the 95% worst-case potential future exposure for each customer. These methodologies take into consideration, among other factors, cross-product close-out netting, collateral received from customers under Collateral Support Annexes (CSAs), termination clauses, and off-setting positions within the portfolio. o Managing problem commercial loans - Special attention is paid to problem loans. When appropriate, HUSI's Special Credits Unit provides customers with intensive management and control support in order to help them avoid default wherever possible and maximize recoveries. 73 o Establishing allowances for credit losses - The Co-Chief Credit Officers share the responsibility with the Chief Financial Officer for establishing appropriate levels of allowances for credit losses inherent in various loan portfolios. o Overseeing retail credit risk - Each retail business unit is supported by dedicated advanced risk analytics units. The Co-Chief Credit Officers provide independent oversight of credit risk associated with these retail portfolios and is supported by expertise from HNAH's Retail Credit Management unit, under the direction of HNAH's Chief Risk Officer. o Chairing the Credit Risk Management Committee - Through 2006 the Chief Credit Officer chaired the Credit Risk Management Committee and was responsible for strategic and collective oversight of the scope of risk taken, the adequacy of the tools used to measure it, and the adequacy of reporting. Early in 2007, responsibility for credit risk management was transferred to the Risk Management Committee. Asset/Liability Management Asset and liability management includes management of liquidity, interest rateand market risk. Liquidity risk is the potential that an institution will beunable to meet its obligations as they become due or fund its customers becauseof inadequate cash flow or the inability to liquidate assets or obtain fundingitself. Market risk includes both interest rate and trading risk. Interest raterisk is the potential impairment of net interest income due to mismatchedpricing between assets and liabilities and off-balance sheet instruments. Marketrisk is the potential for losses in daily mark to market positions (mostlytrading) due to adverse movements in money, foreign exchange, equity or othermarkets. In managing these risks, HUSI seeks to protect both its income streamand the value of its assets. HUSI has substantial, but historically well controlled, interest rate risk inlarge part as a result of its large portfolio of residential mortgages andmortgage backed securities, which consumers can prepay without penalty, and to alesser extent the result of its large base of demand and savings deposits. Thesedeposits can be withdrawn by consumers at will, but historically they have beena stable source of relatively low cost funds. Market risk exists principally intreasury businesses and to a lesser extent in the residential mortgage businesswhere mortgage servicing rights and the pipeline of forward mortgage sales arehedged. HUSI has little foreign exchange exposure from investments in overseasoperations, which are limited in scope. Total equity investments, excludingstock owned in the Federal Reserve and New York Federal Home Loan Bank,represent less than 4% of total available for sale securities. The management of liquidity, interest rate and most market risk is centralizedin treasury and mortgage banking operations. In all cases, the valuation ofpositions and tracking of positions against limits is handled independently byHUSI's finance units. Oversight of all liquidity, interest rate and market risksis provided by the Asset and Liability Policy Committee (ALCO) which is chairedby the Chief Financial Officer. Subject to the approval of the HUSI Board ofDirectors and HSBC, ALCO sets the limits of acceptable risk, monitors theadequacy of the tools used to measure risk, and assesses the adequacy ofreporting. ALCO also conducts contingency planning with regard to liquidity. 74 Liquidity Risk Management Liquidity risk is the risk that an institution will be unable to meet itsobligations as they become due because of an inability to liquidate assets orobtain adequate funding. Liquidity is managed to provide the ability to generatecash to meet lending, deposit withdrawal and other commitments at a reasonablecost in a reasonable amount of time, while maintaining routine operations andmarket confidence. HUSI is planning its funding and liquidity management inconjunction with HSBC Finance Corporation and HSBC, as the markets increasinglyview debt issuances from the separate companies within the context of theircommon parent company. Liquidity management is performed at HUSI and at HBUS.Each entity is required to have sufficient liquidity for a crisis situation.ALCO is responsible for the development and implementation of related policiesand procedures to ensure that the minimum liquidity ratios and a strong overallliquidity position are maintained. In carrying out this responsibility, ALCO projects cash flow requirements anddetermines the level of liquid assets and available funding sources to have atHUSI's disposal, with consideration given to anticipated deposit and balancesheet growth, contingent liabilities, and the ability to access wholesalefunding markets. HUSI's liquidity management approach has been supplemented byincreased deposits, potential sales (e.g. residential mortgage loans), andsecuritizations (e.g. credit cards) in liquidity contingency plans. In addition,ALCO monitors the overall mix of deposit and funding concentrations to avoidundue reliance on individual funding sources and large deposit relationships. Itmust also maintain a liquidity management contingency plan, which identifiescertain potential early indicators of liquidity problems, and actions that canbe taken both initially and in the event of a liquidity crisis, to minimize thelong-term impact on HUSI's business and customer relationships. In the event ofa cash flow crisis, HUSI's objective is to fund cash requirements without accessto the wholesale unsecured funding market for at least one year. Contingencyfunding needs will be satisfied primarily through the sale of the investmentportfolio and liquidation of the residential mortgage portfolio. Securities maybe sold or used as collateral in a repurchase agreement depending on thescenario. Portions of the mortgage and PLRP portfolios may be sold, securitized,or used for collateral at the FHLB to increase borrowings. Deposits from a diverse mix of "core" retail, commercial and public sources andonline savings accounts represent a significant, cost-effective and stablesource of liquidity under normal operating conditions. Total deposits increased$13 billion and $12 billion during 2006 and 2005, respectively. Online savingsaccount growth was $6 billion and $1 billion for 2006 and 2005, respectively. Inconjunction with a minimal change in total loans in 2006, this deposit growthled to improved liquidity ratios at HBUS and to reduced borrowing in the globalcapital and wholesale markets. In particular, HUSI's loans to deposits ratioimproved significantly during 2006. HUSI's ability to regularly attract wholesale funds at a competitive cost isenhanced by strong ratings from the major credit ratings agencies. In June 2006,Standard and Poor's upgraded the ratings of HBUS and HUSI. At December 31, 2006,HUSI and HBUS maintained the following long and short-term debt ratings: ----------------------------------------------------------------------------------------------- Moody's S&P Fitch----------------------------------------------------------------------------------------------- HUSI: Short-term borrowings ........................................ P-1 A-1+ F1+ Long-term debt ............................................... Aa3 AA- AA HBUS: Short-term borrowings ........................................ P-1 A-1+ F1+ Long-term debt ............................................... Aa2 AA AA HUSI's continued success and prospects for growth are dependent upon access tothe global capital markets. Numerous factors, internal and external, may impactHUSI's access to and costs associated with issuing debt in these markets. Thesefactors include HUSI's debt ratings, overall economic conditions, overallcapital markets volatility and the effectiveness of HUSI's management of creditrisks inherent in its customer base. 75 Cash resources, short-term investments and a trading asset portfolio areavailable to provide highly liquid funding for HUSI. Additional liquidity isprovided by debt securities. Approximately $3 billion of debt securities in thisportfolio at December 31, 2006 are expected to mature in 2007. The remaining $20billion of debt securities not expected to mature in 2007 are available toprovide liquidity by serving as collateral for secured borrowings, or if needed,by being sold. Further liquidity is available through HUSI's ability to sell orsecuritize loans in secondary markets through whole-loan sales andsecuritizations. In 2006, HUSI sold residential mortgage loans of approximately$9.6 billion. The amount of residential mortgage loans and credit cardreceivables available to be sold or securitized totaled approximately $54billion at December 31, 2006. The economics and long-term business impact of obtaining liquidity from assetsmust be weighed against the economics of obtaining liquidity from liabilities,along with consideration given to the associated capital ramifications of thesetwo alternatives. Currently, assets would be used to supplement liquidityderived from liabilities only in a crisis scenario. It is the policy of HBUS to maintain both primary and secondary collateral inorder to ensure precautionary borrowing availability from the Federal Reserve.Primary collateral is that which is physically maintained at the FederalReserve, and serves as a safety net against any unexpected funding shortfallsthat may occur. Secondary collateral is collateral that is acceptable to theFederal Reserve, but is not maintained there. If unutilized borrowing capacitywere to be low, secondary collateral would be identified and maintained asnecessary. Further liquidity is available from the Federal Home Loan Bank of NewYork. As of December 31, 2006, HUSI had outstanding advances of $5 billion. HUSIhas access to further borrowings based on the amount of mortgages pledged ascollateral to the FHLB. HUSI maintains sufficient liquidity to meet all unsecured debt obligationsscheduled to mature in 2007 at its parent company level without the need forincremental access to the unsecured markets. As of December 31, 2006, HBUS candeclare dividends to HUSI, without regulatory approval, of approximately $1.6billion, adjusted by the effect of net income (loss) for 2007 up to the date ofsuch dividend declaration. However, in determining the extent of dividends topay, HBUS must also consider the effect of dividend payments on applicablerisk-based capital and leverage ratio requirements, as well as policy statementsof federal regulatory agencies that indicate that banking organizations shouldgenerally pay dividends out of current operating earnings. HUSI filed a shelf registration statement with the Securities and ExchangeCommission in April 2006, under which it may issue debt securities, preferredstock, either separately or represented by depositary shares, warrants, purchasecontracts and units. HUSI satisfies the eligibility requirements for designationas a "well-known seasoned issuer", based on amended SEC rules regardingregistration, communications and offerings which took effect in December 2005.During 2006, HUSI issued perpetual non-cumulative preferred stock totalingapproximately $.4 billion and $.1 billion senior debt from this shelf. In December 2006, HBUS increased the size of its Global Bank Note Program from$20 billion to $40 billion, which provides for issuance of subordinated andsenior notes. Borrowings from the Global Bank Note Program totaled $1.6 billionin 2006. There is approximately $23 billion of availability remaining. At December 31, 2006, HUSI also had a $2 billion back-up credit facility forissuances of commercial paper. 76 Interest Rate Risk Management HUSI is subject to interest rate risk associated with the repricingcharacteristics of its balance sheet assets and liabilities. Specifically, asinterest rates change, amounts of interest earning assets and liabilitiesfluctuate, and interest earning assets reprice at intervals that do notcorrespond to the maturities or repricing patterns of interest bearingliabilities. This mismatch between assets and liabilities in repricingsensitivity results in shifts in net interest income as interest rates move. Tohelp manage the risks associated with changes in interest rates, and to managenet interest income within ranges of interest rate risk that managementconsiders acceptable, HUSI uses derivative instruments such as interest rateswaps, options, futures and forwards as hedges to modify the repricingcharacteristics of specific assets, liabilities, forecasted transactions or firmcommitments. The following table shows the repricing structure of assets and liabilities asof December 31, 2006. For assets and liabilities whose cash flows are subject tochange due to movements in interest rates, such as the sensitivity of mortgageloans to prepayments, data is reported based on the earlier of expectedrepricing or maturity and reflects anticipated prepayments based on the currentrate environment. The resulting "gaps" are reviewed to assess the potentialsensitivity to earnings with respect to the direction, magnitude and timing ofchanges in market interest rates. Data shown is as of year end, and one-dayfigures can be distorted by temporary swings in assets or liabilities. -------------------------------------------------------------------------------------------------------------- Within After One After Five After One But Within But Within TenDecember 31, 2006 Year Five Years Ten Years Years Total-------------------------------------------------------------------------------------------------------------- (in millions) Commercial loans ........................... $ 26,316 $ 2,153 $ 855 $ 158 $ 29,482Residential mortgages ...................... 19,417 16,692 2,483 1,216 39,808Credit card receivables .................... 13,554 4,706 -- -- 18,260Other consumer loans ....................... 1,424 1,252 11 -- 2,687 --------- ---------- ---------- --------- --------- Total loans ........................... 60,711 24,803 3,349 1,374 90,237 --------- ---------- ---------- --------- --------- Securities available for sale and securities held to maturity ........................ 4,789 7,879 4,704 5,383 22,755Other assets ............................... 51,255 3,860 850 -- 55,965 --------- ---------- ---------- --------- --------- Total assets .......................... 116,755 36,542 8,903 6,757 168,957 --------- ---------- ---------- --------- --------- Domestic deposits (1): Savings and demand .................... 33,195 8,677 9,320 -- 51,192 Certificates of deposit ............... 15,173 815 90 184 16,262Long-term debt ............................. 23,160 2,857 1,468 1,767 29,252Other liabilities/equity ................... 62,419 8,976 332 524 72,251 --------- ---------- ---------- --------- --------- Total liabilities and equity .......... 133,947 21,325 11,210 2,475 168,957 --------- ---------- ---------- --------- --------- Total balance sheet gap ............... (17,192) 15,217 (2,307) 4,282 -- --------- ---------- ---------- --------- ---------Effect of derivative contracts ............. 14,843 (12,484) (772) (1,587) -- --------- ---------- ---------- --------- --------- Total gap position .................... $ (2,349) $ 2,733 $ (3,079) $ 2,695 $ -- ========= ========== ========== ========= ========= (1) Does not include purchased or wholesale treasury deposits. The placement of administered deposits such as savings and demand for interest rate risk purposes reflects behavioral expectations associated with these balances. Long-term core balances are differentiated from more fluid balances in an effort to reflect anticipated shifts of non-core balances to other deposit products or equities over time. 77 Various techniques are utilized to quantify and monitor risks associated withthe repricing characteristics of HUSI's assets, liabilities and derivativecontracts. In the course of managing interest rate risk, Present Value of a Basis Point(PVBP) analysis is utilized in conjunction with a combination of other riskassessment techniques, including economic value of equity, dynamic simulationmodeling, capital risk and Value at Risk (VAR) analyses. The combination ofthese tools enables management to identify and assess the potential impact ofinterest rate movements and take appropriate action. This combination oftechniques, with some focusing on the impact of interest rate movements on thevalue of the balance sheet (PVBP, economic value of equity, VAR) and othersfocusing on the impact of interest rate movements on earnings (dynamicsimulation modeling) allows for comprehensive analyses from differentperspectives. A key element of managing interest rate risk is the management of the convexityof the balance sheet, largely resulting from the mortgage related products onthe balance sheet. Convexity risk arises as mortgage loan consumers change theirbehavior significantly in response to large rate movements in market rates, butdo not change behavior appreciably for smaller changes in market rates. Certainof the interest rate management tools described below, such as dynamicsimulation modeling and economic value of equity, better capture the embeddedconvexity in the balance sheet, while measures such as PVBP are designed tocapture the risk of smaller changes in rates. Refer to Market Risk Management, beginning on page 80 of this Form 10-K, forcommentary regarding the use of VAR analyses to monitor and manage interest rateand other market risks. The assessment techniques discussed below act as a guide for managing interestrate risk associated with balance sheet composition and off-balance sheethedging strategy (the risk position). Calculated values within limit rangesreflect an acceptable risk position, although possible future unfavorable trendsmay prompt adjustments to on or off-balance sheet exposure. Calculated valuesoutside of limit ranges will result in consideration of adjustment of the riskposition, or consideration of temporary dispensation from making adjustments. Present Value of a Basis Point (PVBP) PVBP is the change in value of the balance sheet for a one basis point upwardmovement in all interest rates. The following table reflects the PVBP positionat December 31, 2006. --------------------------------------------------------------------------------December 31, 2006 Values-------------------------------------------------------------------------------- (in millions)Institutional PVBP movement limit ............................... $ 7.5PVBP position at period end ..................................... 2.1 Economic Value of Equity Economic value of equity is the change in value of the assets and liabilities(excluding capital and goodwill) for either a 200 basis point gradual rateincrease or decrease. The following table reflects the economic value of equityposition at December 31, 2006. --------------------------------------------------------------------------------December 31, 2006 Values (%)--------------------------------------------------------------------------------Institutional economic value of equity limit .................... +/- 20Projected change in value (reflects projected rate movements on January 1, 2007): Change resulting from a gradual 200 basis point increase in interest rates .......................................... (4) Change resulting from a gradual 200 basis point decrease in interest rates ................... ...................... (5) The loss in value for a 200 basis point increase or decrease in rates is aresult of the negative convexity of the residential whole loan and mortgagebacked securities portfolios. If rates decrease, the projected prepaymentsrelated to these portfolios will accelerate, causing less appreciation than acomparable term, non-convex instrument. If rates increase, projected prepaymentswill slow, which will cause the average lives of these positions to extend andresult in a greater loss in market value. 78 Dynamic Simulation Modeling Various modeling techniques are utilized to monitor a number of interest ratescenarios for their impact on net interest income. These techniques include bothrate shock scenarios which assume immediate market rate movements by as much as200 basis points, as well as scenarios in which rates rise or fall by as much as200 basis points over a twelve month period. The following table reflects theimpact on net interest income of the scenarios utilized by these modelingtechniques. -----------------------------------------------------------------------------------------------------------December 31, 2006 Amount %----------------------------------------------------------------------------------------------------------- ($ in millions) Projected change in net interest income (reflects projected rate movements on January 1, 2007): Institutional base earnings movement limit ........................................ (10) Change resulting from a gradual 200 basis point increase in the yield curve ....... $ (146) (5) Change resulting from a gradual 200 basis point decrease in the yield curve ....... 214 7 Change resulting from a gradual 100 basis point increase in the yield curve ....... (67) (2) Change resulting from a gradual 100 basis point decrease in the yield curve ....... 99 3 Other significant scenarios monitored (reflects projected rate movements on January 1, 2007): Change resulting from an immediate 100 basis point increase in the yield curve .... (109) (4) Change resulting from an immediate 100 basis point decrease in the yield curve .... 155 5 Change resulting from an immediate 200 basis point increase in the yield curve .... (236) (8) Change resulting from an immediate 200 basis point decrease in the yield curve .... 196 6 The projections do not take into consideration possible complicating factorssuch as the effect of changes in interest rates on the credit quality, size andcomposition of the balance sheet. Therefore, although this provides a reasonableestimate of interest rate sensitivity, actual results will vary from theseestimates, possibly by significant amounts. Capital Risk/Sensitivity of Other Comprehensive Income Large movements of interest rates could directly affect some reported capitalbalances and ratios. The mark to market valuation of available for salesecurities is credited on a tax effective basis to accumulated othercomprehensive income. Although this valuation mark is excluded from Tier 1 andTier 2 capital ratios, it is included in two important accounting based capitalratios: the tangible common equity to tangible assets and the tangible commonequity to risk weighted assets. As of December 31, 2006, HUSI had an availablefor sale securities portfolio of approximately $20 billion with a net negativemark to market of $298 million included in tangible common equity of $8 billion.An increase of 25 basis points in interest rates of all maturities would lowerthe mark to market by approximately $162 million to a net loss of $460 millionwith the following results on the tangible capital ratios. ----------------------------------------------------------------------------------------- Proforma - Reflecting 25 Basis PointsDecember 31, 2006 Actual Increase in Rates----------------------------------------------------------------------------------------- Tangible common equity to tangible assets .............. 4.83% 4.78%Tangible common equity to risk weighted assets ......... 6.52 6.44 79 Market Risk Management Value at Risk (VAR) VAR analysis is used to estimate the potential losses that could occur on riskpositions as a result of movements in market rates and prices over a specifiedtime horizon and to a given level of confidence. VAR calculations are performedfor all material trading activities and as a tool for managing interest raterisk inherent in non-trading activities. HUSI calculates VAR daily for a one-dayholding period to a 99% confidence level. At a 99% confidence level for atwo-year observation period, HUSI is setting as its limit the fifth worst lossperformance in the last 500 business days. VAR - Overview The VAR methodology used by HUSI is based on historical simulation. Thehistorical simulation model derives plausible future scenarios from historicalmarket rate data, taking account of inter-relationships between differentmarkets and rates, such as the relationship between interest rates and foreignexchange rates. Potential movements in market prices are calculated withreference to market data from the last two years. The model incorporates theimpact of option features in the underlying exposures. For reporting purposes, in the second quarter of 2006, HUSI changed the assumedholding period from a ten-day period to a one-day period as this reflects theway HUSI manages its risk positions. Comparative VAR amounts have been restatedto reflect this change. Although a valuable guide to risk, VAR should always be viewed in the context ofits limitations. For example: o the use of historical data as a proxy for estimating future events may not encompass all potential events, particularly those which are extreme in nature; o the use of a one-day holding period assumes that all positions can be liquidated or hedged in one day. This may not fully reflect the market risk arising at times of severe liquidity shortages, when a one-day holding period may be insufficient to liquidate or hedge all positions fully; o the use of a 99% confidence level, by definition, does not take into account losses that might occur beyond this level of confidence; and o VAR is calculated on the basis of exposures outstanding at the close of business and therefore does not necessarily reflect intra-day exposures. VAR - Trading Activities HUSI's management of market risk is based on restricting individual operationsto trading within a list of permissible instruments, and enforcing rigorousapproval procedures for new products. In particular, trading in the more complexderivative products is restricted to offices with appropriate levels of productexpertise and robust control systems. In addition, at both portfolio and position levels, market risk in tradingportfolios is monitored and controlled using a complementary set of techniques,including VAR and various techniques for monitoring interest rate risk (refer topages 77-79 of this Form 10-K). These techniques quantify the impact on capitalof defined market movements. Trading portfolios reside primarily within the Markets unit of the CIBM businesssegment, which include warehoused residential mortgage loans purchased forsecuritizations and within the mortgage banking subsidiary included within thePFS business segment. Portfolios include foreign exchange, derivatives, preciousmetals (gold, silver, platinum), equities and money market instruments including"repos" and securities. Trading occurs as a result of customer facilitation,proprietary position taking, and economic hedging. In this context, economichedging may include, for example, forward contracts to sell residentialmortgages and derivative contracts which, while economically viable, may notsatisfy the hedge requirements of Statement of Financial Accounting StandardsNo. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS133). 80 The trading portfolios have defined limits pertaining to items such aspermissible investments, risk exposures, loss review, balance sheet size andproduct concentrations. "Loss review" refers to the maximum amount of loss thatmay be incurred before senior management intervention is required. The following table summarizes trading VAR for 2006. ------------------------------------------------------------------------------------------------------- Full Year 2006 December 31, ------------------------------------------ December 31, 2006 Minimum Maximum Average 2005------------------------------------------------------------------------------------------------------- (in millions) Total trading ....... $ 9 $ 8 $ 46 $ 18 $ 17Precious metals ..... 2 -- (1) 5 1 2Credit derivatives .. 4 3 13 6 6Equities ............ -- (1) -- (1) 1 -- (1) -- (1)Foreign exchange .... 2 1 7 2 1Interest rate ....... 13 9 56 23 22 (1) Less than $500 thousand. The following table summarizes the frequency distribution of daily marketrisk-related revenues for Treasury trading activities during calendar year 2006.Market risk-related Treasury trading revenues include realized and unrealizedgains (losses) related to Treasury trading activities, but exclude the relatednet interest income. Analysis of the 2006 gain (loss) data shows that thelargest daily gain was $32 million and the largest daily loss was $14 million. -----------------------------------------------------------------------------------------Ranges of daily Treasury trading revenue earned from market risk-related activities Below $(5) to $0 to $5 to Over (in millions) $(5) $0 $5 $10 $10----------------------------------------------------------------------------------------- Number of trading days market risk-related revenue was within the stated range ......... 30 48 73 56 43 VAR - Non-trading Activities The principal objective of market risk management of non-trading portfolios isto optimize net interest income. Market risk in non-trading portfolios arisesprincipally from mismatches between the future yield on assets and their fundingcost, as a result of interest rate changes. Analysis of this risk is complicatedby having to make assumptions on optionality in certain product areas, forexample, mortgage prepayments, and from behavioral assumptions regarding theeconomic duration of liabilities which are contractually repayable on demand.The prospective change in future net interest income from non-trading portfolioswill be reflected in the current realizable value of these positions, shouldthey be sold or closed prior to maturity. In order to manage this riskoptimally, market risk in non-trading portfolios is transferred to GlobalMarkets or to separate books managed under the supervision of ALCO. Once marketrisk has been consolidated in Global Markets or ALCO-managed books, the netexposure is typically managed through the use of interest rate swaps withinagreed-upon limits. The following table summarizes non-trading VAR for 2006, assuming a 99%confidence level for a two-year observation period and a one-day "holdingperiod". -------------------------------------------------------------------------------------- Full Year 2006 December 31, ---------------------------------- December 31, 2006 Minimum Maximum Average 2005-------------------------------------------------------------------------------------- (in millions) Interest rate ........ $ 24 $ 19 $ 86 $ 47 $ 70 81 Trading Activities - HSBC Mortgage Corporation (USA) HSBC Mortgage Corporation (USA) is HUSI's mortgage banking subsidiary. Tradingoccurs in mortgage banking operations as a result of an economic hedging programintended to offset changes in value of mortgage servicing rights and the salableloan pipeline. Economic hedging may include, for example, forward contracts tosell residential mortgages and derivative contracts used to protect the value ofMSRs. MSRs are assets that represent the present value of net servicing income(servicing fees, ancillary income, escrow and deposit float, net of servicingcosts). MSRs are separately recognized upon the sale of the underlying loans orat the time that servicing rights are purchased. MSRs are subject to interestrate risk, in that their value will decline as a result of actual and expectedacceleration of prepayment of the underlying loans in a falling interest rateenvironment. Interest rate risk is mitigated through an active hedging program that usestrading securities and derivative instruments to offset changes in value ofMSRs. Since the hedging program involves trading activity, risk is quantifiedand managed using a number of risk assessment techniques. Rate Shock Analysis Modeling techniques are used to monitor certain interest rate scenarios fortheir impact on the economic value of net hedged MSRs, as reflected in thefollowing table. ---------------------------------------------------------------------------------------------------------December 31, 2006 Value--------------------------------------------------------------------------------------------------------- (in millions) Projected change in net market value of hedged MSRs portfolio (reflects projected rate movements on January 1, 2007): Value of hedged MSRs portfolio .................................................... $ 474 Change resulting from an immediate 50 basis point decrease in the yield curve: Change limit (no worse than) ................................................... (16) Calculated change in net market value .......................................... (4) Change resulting from an immediate 50 basis point increase in the yield curve: Change limit (no worse than) ................................................... (8) Calculated change in net market value .......................................... 5 Change resulting from an immediate 100 basis point increase in the yield curve: Change limit (no worse than) ................................................... (12) Calculated change in net market value .......................................... 4 Economic Value of MSRs The economic value of the net, hedged MSRs portfolio is monitored on a dailybasis for interest rate sensitivity. If the economic value declines by more thanestablished limits for one day or one month, various levels of managementreview, intervention and/or corrective actions are required. Hedge Volatility The following table summarized the frequency distribution of the weekly economicvalue of the MSR asset during calendar year 2006. This includes the change inthe market value of the MSR asset net of changes in the market value of theunderlying hedging positions used to hedge the asset. The changes in economicvalue are adjusted for changes in MSR valuation assumptions that were madeduring the course of the year. ------------------------------------------------------------------------------------------Ranges of mortgage economic value from Below $(2) to $0 to $2 to Over market risk-related activities (in millions) $(2) $0 $2 $4 $4------------------------------------------------------------------------------------------ Number of trading weeks market risk-related revenue was within the stated range .......... 8 17 17 7 3 82 Operational Risk Operational risk is the risk of loss arising through fraud, unauthorizedactivities, error, omission, inefficiency, system failure or from externalevents. It is inherent in every business organization and covers a wide spectrumof issues. HUSI has established an independent Operational Risk Management discipline. TheOperational Risk Management Committee, chaired by the Executive Vice President -Operations, is responsible for oversight of the operational risks being taken,the analytic tools used to monitor those risks, and reporting. Results from thisCommittee are communicated to the Risk Management Committee and subsequently tothe Audit Committee of the Board of Directors. Business unit line management isresponsible for managing and controlling all risks and for communicating andimplementing all control standards. A Corporate Operational Risk Coordinatorprovides functional oversight by coordinating the following activities: o maintaining a network of business line Operational Risk Coordinators; o developing scoring and risk assessment tools and databases; o providing training and developing awareness; and o independently reviewing and reporting the assessments of operational risks. Management of operational risk includes identification, assessment, monitoring,control and mitigation, rectification and reporting of the results of riskevents and compliance with local regulatory requirements. These key componentsof the Operational Risk Management process have been communicated by issuance ofa high level standard. Key features within the standard that have been addressedin HUSI's Operational Risk Management program include: o each business and support department is responsible for the identification and management of their operational risks; o each risk is evaluated and scored by its likelihood to occur, its potential impact on shareholder value and by exposure based on the effectiveness of current controls to prevent or mitigate losses. An operational risk automated database is used to record risk assessments and track risk mitigation action plans. The risk assessments are reviewed at least annually, or as business conditions change; o key risk indicators are established where appropriate, and monitored/tracked; and o the database is also used to track operational losses for analysis of root causes, comparison with risk assessments and lessons learned. Management practices include standard monthly reporting to business linemanagers, senior management and the Operational Risk Management Committee ofhigh risks, risk mitigation action plan exceptions, losses and key riskindicators. Monthly certification of internal controls includes an operationalrisk attestation. Operational Risk Management is an integral part of the newproduct development process and the management performance measurement process.An online certification process, attesting to the completeness and accuracy ofoperational risk, is completed by senior business management on an annual basis. Analysis of primary types of operational risks reflects a 60% concentration inprocess risk. The remaining 40% is divided fairly equally between the otherthree primary operational risk types - systems, people and external events. Thesame percent distribution of primary operational risk types applies for thehigher or more critical operational risks. Within the process risk type, greaterthan 75% of risk is concentrated within internal and external reporting andpayment/settlement/delivery risk. Internal audits, including audits by specialist teams in information technologyand treasury, provide an important check on controls and test institutionalcompliance with the Operational Risk Management policy. An annual review of internal controls is conducted by internal audit as part ofHUSI's compliance with the Federal Deposit Insurance Corporation Improvement Act(FDICIA) and its comprehensive examination and documentation of controls acrossHUSI involving all business and support units. 83 Compliance Risk Compliance risk is the risk arising from failure to comply with relevant laws,regulations and regulatory requirements governing the conduct of specificbusinesses. It is a composite risk that can result in regulatory sanctions,financial penalties, litigation exposure and loss of reputation. Compliance riskis inherent throughout the HUSI organization. Consistent with HSBC's commitment to ensure adherence with applicable regulatoryrequirements for all of its world-wide affiliates, HUSI has implemented amulti-faceted Compliance Risk Management Program. This program addresses thefollowing priorities, among other issues: o anti-money laundering (AML) regulations; o fair lending laws; o dealings with affiliates; o the Community Reinvestment Act; o permissible activities; and o conflicts of interest. Oversight of the Compliance Risk Management Program was provided by the AuditCommittee of the Board of Directors through the Risk Management Committee and,through 2006, by its Compliance Risk Management Subcommittee. The effectivenessof the overall compliance program was overseen and counsel was provided to lineand compliance management on major potential issues, strategic policy-makingdecisions and reputational risk matters. Internal audit, through continuousmonitoring and periodic audits, tests the effectiveness of the overallCompliance Risk Management Program. The overall Corporate Compliance program elements include identification,assessment, monitoring, control and mitigation of the risk and timely resolutionof the results of risk events. These functions are generally performed by linemanagement, with oversight provided by Corporate Compliance. Controls formitigating compliance risk are incorporated into business operating policies andprocedures. Processes are in place to ensure controls are appropriately updatedto reflect changes in regulatory requirements as well as changes in businesspractices, including new or revised products, services and marketing programs. Awide range of compliance training is provided to relevant staff, includingmandated programs for such areas as anti-money laundering, fair lending andprivacy. The independent Corporate Compliance function is comprised of separate CorporateCompliance units focusing on General Compliance and Anti-Money Laundering (AML)compliance, as well as various compliance teams supporting specific businessunits. The Corporate Compliance function is responsible for the followingactivities: o advising management on compliance matters; o providing independent assessment, monitoring and review; and o reporting compliance issues to HUSI senior management and Board of Directors, as well as to HSBC Group Compliance. The Corporate Compliance function has established a rigorous independent reviewprogram which includes assessing the effectiveness of controls and testing foradherence to compliance policies and procedures. The review program is executedby centralized review teams and specialized business compliance officers whowork collaboratively to complement each others efforts. 84 Fiduciary Risk Fiduciary risk is the risk associated with offering services honestly andproperly to clients in a fiduciary capacity in accordance with Regulation 12 CFR9, Fiduciary Activity of National Banks. Fiduciary capacity is defined in theregulation as: o serving traditional fiduciary duties such as trustee, executor, administrator, registrar of stocks and bonds, guardian, receiver or assignee, or o providing investment advice for a fee, or o processing investment discretion on behalf of another. Fiduciary risks, as defined above, reside in Private Banking businesses(including Investment Management, Personal Trust, Custody, Middle OfficeOperations) and other business lines outside of Private Banking (includingRetirement Financial Services and Corporate Trust). However, HUSI's FiduciaryRisk Management infrastructure is also responsible for fiduciary risksassociated with certain SEC regulated Registered Investment Advisors (RIA),which lie outside of the traditional regulatory fiduciary risk definition forbanks. The fiduciary risks present in both banking and RIA business lines almostalways occur where HUSI is entrusted to handle and execute client businessaffairs and transactions in a fiduciary capacity. HUSI's policies and proceduresfor addressing fiduciary risks generally address various risk categoriesincluding suitability, conflicts, fairness, disclosure, fees, AML, operational,safekeeping, efficiencies, etc. Oversight for the Fiduciary Risk Management function falls to the Fiduciary RiskManagement Committee of the Risk Management Committee. This committee is chairedby the Senior Executive Vice President - Private Banking and Wealth Managementand includes the Chief Risk Officer and the Senior Vice President - FiduciaryRisk. The Senior Vice President - Fiduciary Risk is responsible for anindependent Fiduciary Risk Management Unit that is responsible for day to dayoversight of the Fiduciary Risk Management function. The main goals andobjectives of this unit include: o development and implementation of control self assessments, which have been completed for all fiduciary businesses; o developing, tracking and collecting rudimentary key risk indicators (KRI), and collecting data regarding errors associated with these risks. KRIs for each fiduciary business are in the process of being expanded; o designing, developing and implementing risk monitoring tools, approaches and programs for the relevant business lines and senior management that will facilitate the identification, evaluation, monitoring, measurement, management and reporting of fiduciary risks. In this regard, a common database is used for compliance, operational and fiduciary risks; and o ongoing development and implementation of more robust and enhanced key risk indicator/key performance indicator process with improved risk focused reporting. 85 Business Continuity Planning HUSI is committed to the protection of employees, customers and shareholders bya quick response to all threats to the organization, whether they are of aphysical or financial nature. HUSI is governed by the HNAH Crisis ManagementFramework, which provides an enterprise-wide response and communication approachfor managing major business continuity events or incidents. It is designed to beflexible and is scaled to the scope and magnitude of the event or incident. The Crisis Management Framework works in tandem with the HNAH CorporateContingency Planning Policy, business continuity plans and key businesscontinuity committees to manage events. The North American Crisis ManagementCommittee, a 24/7 standing committee, is activated to manage the CrisisManagement process in concert with senior HUSI management. This committeeprovides critical strategic management of business continuity crisis issues,risk management, communication, coordination and recovery management. Tacticalmanagement of business continuity issues is handled by the Corporate and LocalIncident Response Teams in place at each major site. HUSI also has designated anInstitutional Manager for Business Continuity who plays a key role on the CrisisManagement Committee. All major business and support functions have a seniorrepresentative assigned to HUSI's Business Continuity Planning Committee, whichis chaired by the Institutional Manager. HUSI has dedicated certain work areas as hot and warm backup sites, which serveas primary business recovery locations. HUSI has concentrations of majoroperations in both upstate and downstate New York. This geographic split ofmajor operations is leveraged to provide secondary business recovery sites formany critical business and support areas of HUSI. Remote working arrangementsare also a key component of HUSI's business continuity approach. HUSI has built its own data center with the intention of developing the highestlevel of resiliency for disaster recovery as defined by industry standards. Datais mirrored synchronously to the disaster recovery site across duplicate darkfiber loops. A high level of network backup resiliency has been established. Ina disaster situation, HUSI is positioned to bring main systems and serverapplications online within predetermined timeframes. HUSI tests business continuity and disaster recovery resiliency and capabilitythrough routine contingency tests and actual events. Business continuity anddisaster recovery programs have been strengthened in numerous areas as a resultof these tests or actual events. There is a continuing effort to enhance theprogram well beyond the traditional business resumption and disaster recoverymodel. In 2003, HUSI determined the applicability of the Interagency Paper on "SoundPractices to Strengthen the Resiliency of the U.S. Financial System". HUSI hasmet the requirements of the paper for the businesses impacted by the compliancedue date. 86 Glossary of Terms-------------------------------------------------------------------------------- Balance Sheet Management - Represents HUSI's activities to manage interest raterisk associated with the repricing characteristics of balance sheet assets andliabilities. Efficiency Ratio - Ratio of total operating expenses, reduced by minorityinterests, to the sum of net interest income and other revenues. Federal Reserve - the Federal Reserve Board; the principal regulator for HUSI. Global Bank Note Program - $40 billion note program, under which HBUS issuessenior and subordinated debt. Goodwill - Represents the excess of purchase price over the fair value ofidentifiable net assets acquired, reduced by liabilities assumed, for businesscombinations. HBMD - HSBC National Bank (USA); a wholly-owned U.S. banking subsidiary of HUSI. HBUS - HSBC Bank USA, National Association; HUSI's principal wholly-owned U.S.banking subsidiary. HMUS - HSBC Markets (USA) Inc.; an indirect wholly-owned subsidiary of HNAH, anda holding company for investment banking and markets subsidiaries in the U.S. HNAH - HSBC North America Holdings Inc.; a wholly-owned subsidiary of HSBC andHSBC's top-tier bank holding company in North America. HNAI - HSBC North America Inc.; an indirect wholly-owned subsidiary of HNAH. HSBC - HSBC Holdings plc.; HNAH's U.K. parent company. HSBC Affiliate - any direct or indirect subsidiary of HSBC outside of the HUSIconsolidated group of entities. HSBC Finance Corporation - an indirect wholly-owned consumer finance companysubsidiary of HNAH. HTCD - HSBC Trust Company (Delaware); a wholly-owned U.S. banking subsidiary ofHUSI. HTSU - HSBC Technology & Services (USA) Inc.; an indirect wholly-ownedsubsidiary of HNAH which provides information technology services to allsubsidiaries of HNAH and to other subsidiaries of HSBC. HUSI - HSBC USA Inc.; the registrant, and a wholly-owned subsidiary of HNAI. Intangible Assets - Assets (not including financial assets) that lack physicalsubstance. HUSI's acquired intangible assets include mortgage servicing rightsand favorable lease arrangements. Mortgage Servicing Rights (MSRs) - Intangible assets representing the right toservice mortgage loans, which are recognized at the time the related loans aresold or the rights are acquired. Net Interest Margin to Earning Assets - Net interest income divided by averageinterest earning assets for a given period. Net Interest Margin to Total Assets - Net interest income divided by averagetotal assets for a given period. Nonaccruing Loans - Loans for which interest is no longer accrued becauseultimate collection is unlikely. OCC - the Office of the Comptroller of the Currency; the principal regulator forHBUS. 87 Private Label Receivable Portfolio (PLRP) - Loan and credit card receivableportfolio acquired from HSBC Finance Corporation on December 29, 2004. Rate of Return on Common Shareholder's Equity - Net income, reduced by preferreddividends, divided by average common shareholder's equity for a given period. Rate of Return on Total Assets - Net income after taxes divided by average totalassets for a given period. SEC - The Securities and Exchange Commission. Total Average Shareholders' Equity to Total Assets - Average total shareholders'equity divided by average total assets for a given period. Total Period End Shareholders' Equity to Total Assets - Total shareholders'equity divided by total assets as of a given date. Item 7A. Quantitative and Qualitative Disclosures about Market Risk-------------------------------------------------------------------------------- Refer to pages 77-82 in Item 7, Management's Discussion and Analysis ofFinancial Condition and Results of Operations, for commentary and analysisregarding "Interest Rate Risk Management" and "Market Risk Management". 88 This page is intentionally left blank. 89 CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES - THREE YEARS The following table shows the major consolidated assets, liabilities andshareholders' equity, together with their respective interest amounts and ratesearned or paid on a taxable equivalent basis. 2006 ------------------------------------- Balance Interest Rate* ------------------------------------- AssetsInterest bearing deposits with banks ....................................... $ 4,517 $ 225 4.98%Federal funds sold and securities purchased under resale agreements ........ 10,326 526 5.10Trading assets ............................................................. 10,893 418 3.84Securities ................................................................. 22,177 1,145 5.16Loans Commercial .............................................................. 28,080 1,764 6.28 Consumer: Residential mortgages ................................................ 41,826 2,200 5.26 Credit cards ......................................................... 15,987 1,329 8.31 Other consumer ....................................................... 2,960 279 9.42 ----------- ----------- ------- Total consumer .......................................................... 60,773 3,808 6.27 ----------- ----------- ------- Total loans ............................................................. 88,853 5,572 6.27 ----------- ----------- -------Other ...................................................................... 1,496 91 6.07 ----------- ----------- -------Total earning assets ....................................................... 138,262 $ 7,977 5.77% ----------- ----------- -------Allowance for credit losses ................................................ (932)Cash and due from banks .................................................... 3,977Other assets ............................................................... 24,971 -----------Total assets ............................................................... $ 166,278 =========== Liabilities and Shareholders' EquityDeposits in domestic offices Savings deposits ........................................................ $ 34,910 $ 981 2.81% Other time deposits ..................................................... 26,286 1,152 4.38Deposits in foreign offices Foreign banks deposits .................................................. 8,019 392 4.89 Other time and savings .................................................. 14,128 588 4.16 ----------- ----------- -------Total interest bearing deposits ............................................ 83,343 3,113 3.73 ----------- ----------- -------Short-term borrowings ...................................................... 10,880 300 2.76Long-term debt ............................................................. 28,735 1,457 5.07 ----------- ----------- -------Total interest bearing liabilities ......................................... 122,958 4,870 3.96 ----------- ----------- -------Net interest income / Interest rate spread ................................. $ 3,107 1.81% ----------- -------Noninterest bearing deposits ............................................... 12,869Other liabilities .......................................................... 18,414Total shareholders' equity ................................................. 12,037 -----------Total liabilities and shareholders' equity ................................. $ 166,278 ===========Net interest margin on average earning assets .............................. 2.25% -------Net interest margin on average total assets ................................ 1.87% ======= * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and feeearnings divided by daily average amounts of total interest earning assets,including the daily average amount on nonperforming loans. Loan interest for theyears ended December 31, 2006, 2005 and 2004 included fees of $53 million, $47million and $78 million, respectively. 90 2005 2004 -------------------------------------- ---------------------------------- Balance Interest Rate* Balance Interest Rate* --------------------------------------------------------------------------- (in millions) AssetsInterest bearing deposits with banks ... $ 3,577 $ 120 3.35% $ 2,499 $ 41 1.66%Federal funds sold and securities purchased under resale agreements ............. 5,481 190 3.48 4,682 74 1.58Trading assets ......................... 7,234 275 3.80 5,654 165 2.92Securities ............................. 19,024 899 4.73 18,224 885 4.86Loans Commercial .......................... 24,192 1,233 5.10 19,919 831 4.17 Consumer: Residential mortgages ............ 47,093 2,321 4.93 37,134 1,831 4.94 Credit cards ..................... 13,455 812 6.04 1,216 107 8.80 Other consumer ................... 3,158 264 8.36 2,059 143 6.93 ------------ ----------- --------- ----------- ---------- -------- Total consumer ...................... 63,706 3,397 5.33 40,409 2,081 5.15 ------------ ----------- --------- ----------- ---------- -------- Total loans ......................... 87,898 4,630 5.27 60,328 2,912 4.83 ------------ ----------- --------- ----------- ---------- --------Other .................................. 647 32 4.95 549 18 3.37 ------------ ----------- --------- ----------- ---------- --------Total earning assets ................... 123,861 $ 6,146 4.96% 91,936 $ 4,095 4.45% ------------ ----------- --------- ----------- ---------- --------Allowance for credit losses ............ (910) (359)Cash and due from banks ................ 3,717 3,275Other assets ........................... 20,508 17,374 ------------ -----------Total assets ........................... $ 147,176 $ 112,226 ============ =========== Liabilities and Shareholders' EquityDeposits in domestic offices Savings deposits .................... $ 25,536 $ 318 1.25% $ 23,986 $ 179 0.75% Other time deposits ................. 25,845 822 3.18 16,561 365 2.20Deposits in foreign offices Foreign banks deposits .............. 8,440 255 3.03 7,162 97 1.35 Other time and savings .............. 14,173 376 2.65 14,737 184 1.25 ------------ ----------- --------- ----------- ---------- --------Total interest bearing deposits ........ 73,994 1,771 2.39 62,446 825 1.32 ------------ ----------- --------- ----------- ---------- --------Short-term borrowings .................. 10,868 270 2.48 8,889 127 1.42Long-term debt ......................... 25,274 1,025 4.06 10,086 385 3.82 ------------ ----------- --------- ----------- ---------- --------Total interest bearing liabilities ..... 110,136 3,066 2.78 81,421 1,337 1.64 ------------ ----------- --------- ----------- ---------- --------Net interest income / Interest rate spread $ 3,080 2.18% $ 2,758 2.81% ----------- --------- ---------- --------Noninterest bearing deposits ........... 11,529 10,407Other liabilities ...................... 13,957 12,341Total shareholders' equity ............. 11,554 8,057 ------------ -----------Total liabilities and shareholders' equity ................................. $ 147,176 $ 112,226 ============ ===========Net interest margin on average earning assets ................................. 2.49% 3.00% --------- --------Net interest margin on average total assets ................................. 2.09% 2.46% ========= ======== 91 ITEM 8. Financial Statements and Supplementary Data-------------------------------------------------------------------------------- Page Report of Independent Registered Public Accounting Firm ................ 93 HSBC USA Inc.: Consolidated Statement of Income .................................... 94 Consolidated Balance Sheet .......................................... 95 Consolidated Statement of Changes in Shareholders' Equity ........... 96 Consolidated Statement of Cash Flows ................................ 97 HSBC Bank USA, National Association: Consolidated Balance Sheet .......................................... 98 Notes to Consolidated Financial Statements ............................. 99 92 Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders of HSBC USA Inc.: We have audited the accompanying consolidated balance sheets of HSBC USA Inc.and subsidiaries (the Company) as of December 31, 2006 and 2005, and the relatedconsolidated statements of income, changes in shareholders' equity, and cashflows for each of the years in the three-year period ended December 31, 2006,and the accompanying consolidated balance sheets of HSBC Bank USA, N.A. andsubsidiaries (the Bank) as of December 31, 2006 and 2005. These consolidatedfinancial statements are the responsibility of the Company's management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits. We conducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we planand perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of the Company as ofDecember 31, 2006 and 2005, and the results of their operations and their cashflows for each of the years in the three-year period ended December 31, 2006,and the financial position of the Bank as of December 31, 2006 and 2005, inconformity with U.S. generally accepted accounting principles. /s/ KPMG LLP New York, New YorkMarch 2, 2007 93 HSBC USA INC.--------------------------------------------------------------------------------CONSOLIDATED STATEMENT OF INCOME Year Ended December 31, 2006 2005 2004------------------------------------------------------------------------------------------------------ (in millions) Interest income: Loans ........................................................ $ 5,572 $ 4,630 $ 2,912 Securities ................................................... 1,119 882 868 Trading assets ............................................... 418 275 165 Short-term investments ....................................... 751 310 115 Other ........................................................ 91 32 18 --------- --------- ----------Total Interest Income ........................................... 7,951 6,129 4,078 --------- --------- ----------Interest expense: Deposits ..................................................... 3,113 1,771 825 Short-term borrowings ........................................ 300 270 127 Long-term debt ............................................... 1,457 1,025 385 --------- --------- ----------Total interest expense .......................................... 4,870 3,066 1,337 --------- --------- ----------Net interest income ............................................. 3,081 3,063 2,741Provision (credit) for credit losses ............................ 823 674 (17) --------- --------- ----------Net interest income after provision for credit losses ........... 2,258 2,389 2,758 --------- --------- ----------Other revenues: Trust income ................................................. 88 87 95 Service charges .............................................. 204 195 196 Credit card fees ............................................. 580 323 82 Other fees and commissions ................................... 401 304 316 Securitization revenue ....................................... 18 114 -- HSBC affiliate income ........................................ 208 130 147 Other income ................................................. 184 193 230 Residential mortgage banking revenue (expense) ............... 96 64 (120) Trading revenues ............................................. 755 395 288 Securities gains, net ........................................ 29 106 85 --------- --------- ----------Total other revenues ............................................ 2,563 1,911 1,319 --------- --------- ----------Operating expenses: Salaries and employee benefits ............................... 1,300 1,052 947 Occupancy expense, net ....................................... 221 182 176 Support services from HSBC affiliates ........................ 1,076 919 420 Other expenses ............................................... 658 605 558 --------- --------- ----------Total operating expenses ........................................ 3,255 2,758 2,101 --------- --------- ----------Income before income tax expense ................................ 1,566 1,542 1,976Income tax expense .............................................. 530 566 718 --------- --------- ----------Net income ...................................................... $ 1,036 $ 976 $ 1,258 ========= ========= ========== The accompanying notes are an integral part of the consolidated financialstatements. 94 HSBC USA INC.--------------------------------------------------------------------------------CONSOLIDATED BALANCE SHEET December 31, 2006 2005------------------------------------------------------------------------------------------- (in millions) AssetsCash and due from banks ......................................... $ 3,359 $ 4,441Interest bearing deposits with banks ............................ 2,320 3,001Federal funds sold and securities purchased under resale agreements ................................................... 13,775 4,568Trading assets .................................................. 26,038 21,220Securities available for sale ................................... 19,783 17,764Securities held to maturity (fair value $3,040 and $3,262 at December 31, 2006 and 2005, respectively ..................... 2,972 3,171Loans ........................................................... 90,237 90,342Less - allowance for credit losses .............................. 897 846 --------- --------- Loans, net ................................................. 89,340 89,496 --------- ---------Properties and equipment, net ................................... 540 538Intangible assets ............................................... 521 463Goodwill ........................................................ 2,716 2,694Other assets .................................................... 7,593 6,503 --------- ---------Total assets .................................................... $ 168,957 $ 153,859 ========= =========LiabilitiesDeposits in domestic offices: Noninterest bearing .......................................... $ 12,813 $ 12,040 Interest bearing ............................................. 63,942 55,566Deposits in foreign offices: Noninterest bearing .......................................... 727 320 Interest bearing ............................................. 27,068 23,889 --------- --------- Total deposits ............................................ 104,550 91,815 --------- ---------Trading liabilities ............................................. 14,046 10,710Short-term borrowings ........................................... 5,073 6,367Interest, taxes and other liabilities ........................... 3,775 3,778Long-term debt .................................................. 29,252 29,595 --------- ---------Total liabilities ............................................... 156,696 142,265 --------- ---------Shareholders' equityPreferred stock ................................................. 1,690 1,316Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 706 shares issued and outstanding) ........................... -- (1) -- (1)Capital surplus ................................................. 8,124 8,118Retained earnings ............................................... 2,661 2,172Accumulated other comprehensive loss ............................ (214) (12) --------- --------- Total common shareholder's equity ............................ 10,571 10,278 --------- ---------Total shareholders' equity ...................................... 12,261 11,594 --------- ---------Total liabilities and shareholders' equity ...................... $ 168,957 $ 153,859 ========= ========= The accompanying notes are an integral part of the consolidated financialstatements. (1) Less than $500 thousand 95 HSBC USA INC.--------------------------------------------------------------------------------CONSOLIDATED STATEMENT OF CHANGESIN SHAREHOLDERS' EQUITY 2006 2005 2004---------------------------------------------------------------------------------------------------------- (in millions) Preferred stockBalance, January 1 ................................................. $ 1,316 $ 500 $ 500Preferred stock issuances, net of redemptions (see Note 18) ........ 374 816 -- --------- -------- --------Balance, December 31, .............................................. 1,690 1,316 500 --------- -------- -------- Common stockBalance, January 1 and December 31, ................................ -- (1) -- (1) -- (1) --------- -------- -------- Capital surplusBalance, January 1, ................................................ 8,118 8,418 6,027Capital contribution from parent ................................... 15 3 2,411Preferred stock issuance costs (see Note 18) ....................... (9) (22) --Employee benefit plans and other ................................... -- (281) (20) --------- -------- --------Balance, December 31, .............................................. 8,124 8,118 8,418 --------- -------- -------- Retained earningsBalance, January 1, ................................................ 2,172 1,917 807Net income ......................................................... 1,036 976 1,258Cash dividends declared on preferred stock ......................... (88) (46) (23)Cash dividends declared on common stock ............................ (455) (675) (125)Cumulative effect of change in accounting for mortgage servicing assets (see Notes 6 and 11) ..................................... (4) -- -- --------- -------- --------Balance, December 31, .............................................. 2,661 2,172 1,917 --------- -------- -------- Accumulated other comprehensive incomeBalance, January 1, ................................................ (12) 31 128 Increase in net unrealized losses on securities, net of tax ........ (71) (149) (40)(Decrease) increase in net unrealized gains on derivatives classified as cash flow hedges, net of tax ....................... (106) 104 (58)(Decrease) increase in net unrealized gains on interest only strip receivables, net of tax .................................... (7) 7 --Foreign currency translation adjustments, net of tax ............... -- (1) (5) 1 --------- -------- --------Other comprehensive loss, net of tax ............................... (184) (43) (97) Cumulative effect of change in accounting for pension and postretirement benefits (see Note 23), net of tax ............... (18) -- -- --------- -------- --------Balance, December 31, .............................................. (214) (12) 31 --------- -------- --------Total shareholders' equity, december 31, ........................... $ 12,261 $ 11,594 $ 10,866 ========= ======== ======== Comprehensive incomeNet income ......................................................... $ 1,036 $ 976 $ 1,258Other comprehensive loss, net of tax ............................... (184) (43) (97) --------- -------- --------Comprehensive income ............................................... $ 852 $ 933 $ 1,161 ========= ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. (1) Less than $500 thousand 96 This information is provided by RNS The company news service from the London Stock Exchange More to Follow