HSBC Holdings Regulatory News (HSBA)

5 Mar 2007 12:45

HSBC Holdings PLC05 March 2007 Part 3 of 5 HSBC USA INC.--------------------------------------------------------------------------------CONSOLIDATED STATEMENT OF CASH FLOWS Year Ended December 31, 2006 2005 2004------------------------------------------------------------------------------------------------------------- (in millions) Cash flows from operating activities Net income ......................................................... $ 1,036 $ 976 $ 1,258 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation, amortization and deferred taxes .................... 503 442 428 Provision (credit) for credit losses ............................. 823 674 (17) Net change in other assets and liabilities ....................... 29 495 (1,444) Net change in loans held for sale to HSBC Markets (USA) Inc. (HMUS): Loans acquired from originators ................................ (16,089) (5,061) -- Sales of loans to HMUS ......................................... 15,867 2,188 -- Net change in other loans held for sale .......................... 63 63 (427) Net change in loans attributable to tax refund anticipation loans program: Originations of loans .......................................... (16,100) (15,100) -- Sales of loans to HSBC Finance Corporation, including premium ...................................................... 15,888 15,100 -- Net change in trading assets and liabilities ..................... (2,255) (2,774) (3,267) Net change in fair value of derivatives and hedged items ......... 689 (248) 166 --------- -------- -------- Net cash provided by (used in) operating activities ............ 454 (3,245) (3,303) --------- -------- --------Cash flows from investing activities Net change in interest bearing deposits with banks ................. 681 (225) (1,933) Net change in federal funds sold and securities purchased under resale agreements ................................................ (9,207) (1,442) (680) Net change in securities available for sale: Purchases of securities available for sale ....................... (8,043) (12,301) (11,311) Proceeds from sales of securities available for sale ............. 2,611 3,825 5,868 Proceeds from maturities of securities available for sale ........ 3,203 4,273 5,578 Net change in securities held to maturity: Purchases of securities held to maturity ......................... (166) (694) (1,190) Proceeds from maturities of securities held to maturity .......... 364 1,401 1,815 Net change in loans: Originations, net of collections ................................. 23,083 19,405 (19,482) Loans purchased from HSBC Finance Corporation .................... (23,908) (23,084) (16,227) Net cash used for acquistions of properties and equipment .......... (81) (29) (11) Net change in other investments and related accounts ............... (193) (240) (255) --------- -------- -------- Net cash used in investing activities .......................... (11,656) (9,111) (37,828) --------- -------- --------Cash flows from financing activities Net change in deposits ............................................. 12,735 11,834 16,546 Net change in short-term borrowings ................................ (1,293) (2,936) 2,811 Net change in long-term debt: Issuance of long-term debt ....................................... 6,860 6,127 20,762 Repayment of long-term debt ...................................... (8,019) (706) (1,083) Preferred stock issuance, net of issuance costs .................... 365 794 -- Other increases in capital surplus ................................. 15 (278) 2,391 Dividends paid ..................................................... (543) (720) (148) --------- -------- -------- Net cash provided by financing activities ...................... 10,120 14,115 41,279 --------- -------- --------Net change in cash and due from banks ................................. (1,082) 1,759 148Cash and due from banks at beginning of year .......................... 4,441 2,682 2,534 --------- -------- --------Cash and due from banks at end of year ................................ $ 3,359 $ 4,441 $ 2,682 ========= ======== ========Cash paid for: Interest ............................................... $ 4,811 $ 2,785 $ 1,195 Income taxes ........................................... 504 566 569 The accompanying notes are an integral part of the consolidated financialstatements. Pending settlement receivables/payables related to securities and trading assetsand liabilities are treated as non-cash items for cash flow reporting. 97 HSBC BANK USA, NATIONAL ASSOCIATION--------------------------------------------------------------------------------CONSOLIDATED BALANCE SHEET December 31, 2006 2005----------------------------------------------------------------------------------------------------- (in millions) AssetsCash and due from banks ................................................... $ 3,297 $ 4,440Interest bearing deposits with banks ...................................... 2,193 2,917Federal funds sold and securities purchased under resale agreements ....... 13,704 4,562Trading assets ............................................................ 24,751 19,807Securities available for sale ............................................. 19,500 17,548Securities held to maturity (fair value $2,926 and $3,126)December 31, 2006 and 2005, respectively .................................. 2,864 3,044Loans ..................................................................... 90,125 90,214Less - allowance for credit losses ........................................ 894 845 ---------- ---------- Loans, net ............................................................. 89,231 89,369 ---------- ----------Properties and equipment, net ............................................. 538 536Intangible assets ......................................................... 521 462Goodwill .................................................................. 2,111 2,090Other assets .............................................................. 6,963 5,904 ---------- ----------Total assets .............................................................. $ 165,673 $ 150,679 ========== ========== LiabilitiesDeposits in domestic offices: Noninterest bearing .................................................... $ 12,818 $ 12,002 Interest bearing ....................................................... 63,878 55,566Deposits in foreign offices: Noninterest bearing .................................................... 727 320 Interest bearing ....................................................... 29,842 27,160 ---------- ---------- Total deposits ....................................................... 107,265 95,048 ---------- ----------Trading liabilities ....................................................... 14,033 10,644Short-term borrowings ..................................................... 2,698 3,383Interest, taxes and other liabilities ..................................... 3,253 3,167Long-term debt ............................................................ 26,166 26,549 ---------- ----------Total liabilities ......................................................... 153,415 138,791 ---------- ----------Shareholder's equityCommon shareholder's equity: Common stock ($100 par; 50,000 shares authorized; 20,005 and 20,004 shares issued and outstanding) ....................................... 2 2 Capital surplus ........................................................ 10,124 9,709 Retained earnings ...................................................... 2,348 2,192 Accumulated other comprehensive loss ................................... (216) (15) ---------- ----------Total shareholder's equity ................................................ 12,258 11,888 ---------- ----------Total liabilities and shareholder's equity ................................ $ 165,673 $ 150,679 ========== ========== 98 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Organization-------------------------------------------------------------------------------- HSBC USA Inc., incorporated under the laws of Maryland, is a New York Statebased bank holding company, and an indirect wholly owned subsidiary of HSBCNorth America Holdings Inc. (HNAH). HSBC USA Inc. and its subsidiaries arecollectively referred to as "HUSI". HNAH is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC).Effective January 1, 2004, HSBC created a new North American organizationalstructure, HNAH, as the top-tier bank holding company parent. HUSI routinelyconducts transactions in the normal course of business with HNAH's otherprincipal direct and indirect subsidiaries, which include: o HSBC Finance Corporation, a consumer finance company; o HSBC Bank USA, National Association (HBUS), HUSI's principal banking subsidiary; o HSBC Bank Canada (HBCA), a Canadian banking subsidiary; o HSBC Markets (USA) Inc. (HMUS), a holding company for investment banking and markets subsidiaries in the U.S.; and o HSBC Technology & Services (USA) Inc. (HTSU), a provider of information technology services for other HNAH subsidiaries and to other subsidiaries of HSBC. On July 1, 2004, HUSI consolidated its then existing banking operations under asingle national charter, following approval from the Office of the Comptrollerof the Currency (the OCC). Note 2. Summary of Significant Accounting Policies and New AccountingPronouncements-------------------------------------------------------------------------------- Significant Accounting Policies Basis of Presentation The accounting and reporting policies of HUSI conform to accounting principlesgenerally accepted in the United States of America (U.S. GAAP). The preparationof financial statements in conformity with U.S. GAAP requires the use ofestimates and assumptions that affect reported amounts in the financialstatements and accompanying notes. Actual results could differ from thoseestimates. Certain reclassifications have been made to prior year amounts toconform with the current year's presentation. Principles of Consolidation The consolidated financial statements include the accounts of HUSI and itssubsidiaries. HUSI consolidates subsidiaries in which it holds, directly orindirectly, more than 50% of the voting rights, or where it exercises control. HUSI, in the ordinary course of business, makes use of Variable Interest Entity(VIE) structures in a variety of business activities, primarily to facilitateclient needs. VIE structures are utilized after careful consideration of themost appropriate structure needed to achieve HUSI's control and risk managementobjectives and to help ensure an efficient and appropriate structure from aregulatory and taxation perspective. HUSI determines whether a VIE should be consolidated by evaluating if it is theprimary beneficiary of the VIE as defined by Financial Accounting StandardsBoard Interpretation No. 46 (Revised) (FIN 46R). The primary beneficiarygenerally maintains control over the VIE, and will generally receive themajority of the risks and rewards of the assets of the VIE. Based upon thisassessment, HUSI has determined that it is the primary beneficiary of certainVIEs, and has therefore consolidated these VIEs into its consolidated financialstatements. 99 Unaffiliated trusts to which HUSI has transferred securitized receivables whichare qualifying special purpose entities (QSPEs), as defined by Statement ofFinancial Accounting Standards No. 140, Accounting for Transfers and Servicingof Financial Assets and Extinguishment of Liabilities (SFAS 140), are notconsolidated. All material intercompany accounts and transactions have been eliminated.Investments in companies in which the percentage of ownership is at least 20%,but not more than 50%, are generally accounted for under the equity method andreported as equity method investments in other assets. Foreign Currency Translation HUSI has foreign operations in several countries. The accounts of HUSI's foreignoperations are measured using local currency as the functional currency. Assetsand liabilities are translated into United States dollars at the rate ofexchange in effect on the balance sheet date. Income and expenses are translatedat average monthly exchange rates. Net exchange gains or losses resulting fromsuch translation are included in common shareholder's equity as a component ofaccumulated other comprehensive income. Foreign currency denominatedtransactions in other than the local functional currency are translated usingthe period end exchange rate with any foreign currency transaction gain or lossrecognized currently in income. Cash and Cash Equivalents For the purpose of reporting cash flows, cash and cash equivalents include cashon hand and amounts due from banks. Resale and Repurchase Agreements HUSI enters into purchases and borrowings of securities under agreements toresell (resale agreements) and sales of securities under agreements torepurchase (repurchase agreements) substantially identical securities. Resaleagreements and repurchase agreements are generally accounted for as securedlending and secured borrowing transactions, respectively. The amounts advanced under resale agreements and the amounts borrowed underrepurchase agreements are carried on the consolidated balance sheet at theamount advanced or borrowed, plus accrued interest to date. Interest earned onresale agreements is reported as interest income. Interest paid on repurchaseagreements is reported as interest expense. HUSI offsets resale and repurchaseagreements executed with the same counterparty under legally enforceable nettingagreements that meet the applicable netting criteria as permitted by U.S. GAAP. Repurchase agreements may require HUSI to deposit cash or other collateral withthe lender. In connection with resale agreements, it is the policy of HUSI toobtain possession of collateral, which may include the securities purchased,with market value in excess of the principal amount loaned. The market value ofthe collateral subject to the resale and repurchase agreements is regularlymonitored, and additional collateral is obtained or provided when appropriate,to ensure appropriate collateral coverage of these secured financingtransactions. Collateral HUSI pledges assets as collateral as required for various transactions involvingsecurity repurchase agreements, public deposits, Treasury tax and loan notes,derivative agreements, short-term borrowings and long-term borrowings. Assetsthat have been pledged as collateral, including those that can be sold orrepledged by the secured party, continue to be reported on HUSI's consolidatedbalance sheet. HUSI also accepts collateral, primarily as part of various transactionsinvolving security resale agreements. Collateral accepted by HUSI, includingcollateral that can be sold or repledged by HUSI, is excluded from HUSI'sconsolidated balance sheet. 100 The market value of collateral accepted or pledged by HUSI is regularlymonitored and additional collateral is obtained or provided as necessary toensure appropriate collateral coverage in these transactions. Trading Assets and Liabilities Financial instruments utilized in trading activities are stated at fair value.Fair value is generally based on quoted market prices. If quoted market pricesare not available, fair values are estimated based on dealer quotes, pricingmodels or quoted prices for instruments with similar characteristics. Realizedand unrealized gains and losses are recognized in trading revenues. Securities Debt securities that HUSI has the ability and intent to hold to maturity arereported at cost, adjusted for amortization of premiums and accretion ofdiscounts which are recognized as adjustments to yield over the expected livesof the related securities. Securities acquired principally for the purpose ofselling them in the near term are classified as trading assets and reported atfair value with unrealized gains and losses included in earnings. Equity securities that are not quoted on a recognized exchange are notconsidered to have a readily determinable fair value, and are recorded at cost,less any provisions for impairment. Unquoted equity securities, which includeFederal Home Loan Bank (FHLB) stock, Federal Reserve Bank (FRB) stock andMasterCard Class B securities, are recorded in other assets. All other securities are classified as available for sale and carried at fairvalue, with unrealized gains and losses, net of related income taxes, recordedas adjustments to common shareholder's equity as a component of accumulatedother comprehensive income. The fair value of securities is based on current market quotations whereavailable, or internal valuation models that approximate market pricing. Thevalidity of internal pricing models is regularly substantiated by reference toactual market prices realized upon sale or liquidation of these instruments. Realized gains and losses on sales of securities not classified as tradingassets are computed on a specific identified cost basis and are reported inother revenues as security gains, net. HUSI regularly evaluates its securitiesto identify declines in fair value that are considered other than temporary. Anydecline in the fair value of investments which is deemed to be other thantemporary is charged against current earnings in other revenues and a new costbasis is established for the security. Fair value adjustments to tradingsecurities and gains and losses on the sale of such securities are reported inother revenues as trading revenues. Loans Loans are stated at their amortized cost, which represents the principal amountoutstanding, net of unearned income, charge offs, unamortized purchase premiumor discount, unamortized nonrefundable fees and related direct loan originationcosts and purchase accounting fair value adjustments. Loans are further reducedby the allowance for credit losses. Loans held for sale are carried at the lower of aggregate cost or market valueand remain presented as loans in the consolidated balance sheet. Fair marketvalue is determined based on quoted fair market prices for similar loans,outstanding investor commitments or discounted cash flow analysis using marketassumptions. Increases in the valuation allowance utilized to adjust loans heldfor sale to market value, and subsequent recoveries of prior allowancesrecorded, are recorded in other income in the consolidated income statement. Premiums and discounts, including purchase accounting fair value adjustments onreceivables, are recognized as adjustments to yield over the expected lives ofthe related loans. Interest income is recorded based on methods that result inlevel rates of return over the terms of the loans. 101 Restructured loans are loans for which the original contractual terms have beenpermanently modified to provide for terms that are less than HUSI would bewilling to accept for new loans with comparable risk because of deterioration inthe borrower's financial condition. Interest on these loans is accrued at therenegotiated rates. Loan Charge Off Policies and Practices Commercial loan balances are charged off at the time all or a portion of thebalance is deemed uncollectible. Consumer loan charge off policies, which vary by product, are summarized below. Residential Mortgage Loans Carrying values in excess of net realizable value are charged off at or beforethe time foreclosure is completed or when settlement is reached with theborrower. If foreclosure is not pursued, and there is no reasonable expectationfor recovery, the account is generally charged off no later than the end of themonth in which the account becomes six months contractually delinquent. Auto Finance Carrying values in excess of net realizable value are generally charged off nolater than the month in which the account becomes four months contractuallydelinquent. MasterCard/Visa and Private Label Credit Card Loans Loan balances are generally charged off by the end of the month in which theaccount becomes six months contractually delinquent. Other Consumer Loans Loan balances are generally charged off the month following the month in whichthe account becomes four months contractually delinquent. Nonaccruing Loan Policies and Practices HUSI's nonaccruing policies vary by product and are summarized below. Commercial Commercial loans are categorized as nonaccruing when, in the opinion ofmanagement, reasonable doubt exists with respect to the ultimate collectibilityof interest or principal based on certain factors including period of time pastdue and adequacy of collateral. At the time a loan is classified as nonaccruing,any accrued interest recorded on the loan is generally deemed uncollectible andcharged against income. Interest income on these loans is subsequentlyrecognized only to the extent of cash received or until the loan is placed onaccrual status. In those instances where there is doubt as to collectibility ofprincipal, any interest payments received are applied to principal. Loans arenot reclassified as accruing until interest and principal payments are broughtcurrent and future payments are reasonably assured. Consumer Residential mortgage loans are generally designated as nonaccruing whencontractually delinquent for more than three months. Credit card receivables andother consumer loans generally accrue interest until charge off. 102 Loan Fees and Costs Nonrefundable fees and related direct costs associated with the origination ofloans are deferred and netted against outstanding loan balances. Theamortization of net deferred fees, which include points on real estate securedloans and costs, is recognized in interest income, generally by the interestmethod, based on the estimated or contractual lives of the related loans.Amortization periods are periodically adjusted for loan prepayments and changesin other market assumptions. MasterCard/Visa annual fees, net of direct lendingcosts, are deferred and amortized on a straight-line basis over one year.Nonrefundable fees related to lending activities other than direct loanorigination are recognized as other revenues over the period in which therelated service is provided. This includes fees associated with the issuance ofloan commitments where the likelihood of the commitment being exercised isconsidered remote. In the event of the exercise of the commitment, the remainingunamortized fee is recognized in interest income over the loan term using theinterest method. Other credit-related fees, such as standby letter of creditfees, loan syndication and agency fees are recognized as other operating incomeover the period the related service is performed. Net deferred costs totaled$356 million at December 31, 2006 and $402 million at December 31, 2005. Allowance for Credit Losses HUSI maintains an allowance for credit losses that is, in the judgment ofmanagement, adequate to absorb estimated probable losses of principal, interestand fees inherent in its commercial and consumer loan portfolios. The adequacyof the allowance for credit losses is assessed within the context of appropriateU.S. GAAP guidance, and is based, in part, upon an evaluation of various factorsincluding: o an analysis of individual exposures where applicable; o current and historical loss experience; o changes in the overall size and composition of the portfolio; and o specific adverse situations and general economic conditions. HUSI also assesses the overall adequacy of the allowance by considering keyratios such as reserves to nonperforming loans and reserves as a percentage ofnet charge offs in developing its loss reserve estimates. Loss estimates arereviewed periodically and adjustments are reported in earnings when they becomeknown. These estimates are influenced by factors outside of the control of HUSImanagement, such as consumer payment patterns and economic conditions, and thereis uncertainty inherent in these estimates, making it reasonably possible thatthey could change. For commercial and select consumer loan assets, HUSI conducts a periodicassessment on a loan-by-loan basis of losses it believes to be inherent in theloan portfolio. When it is deemed probable, based upon known facts andcircumstances, that full contractual interest and principal on an individualloan will not be collected in accordance with its contractual terms, the loan isconsidered impaired. An impairment reserve is established based upon the presentvalue of expected future cash flows, discounted at the loan's original effectiveinterest rate, or as a practical expedient, the loan's observable market priceor the fair value of the collateral if the loan is collateral dependent.Generally, impaired loans include loans in nonaccruing status, loans which havebeen assigned a specific allowance for credit losses, loans which have beenpartially charged off, and loans designated as troubled debt restructures.Problem commercial loans are assigned various criticized facility grades underthe allowance for credit losses methodology. 103 Formula-based reserves are also established against commercial loans when, basedupon an analysis of relevant data, it is probable that a loss has been incurredand the amount of that loss can be reasonably estimated, even though an actualloss has yet to be identified. A separate reserve for credit losses associatedwith off-balance sheet exposures including letters of credit, guarantees toextend credit and financial guarantees is also maintained and included in otherliabilities, which incorporates estimates of the probability that customers willactually draw upon off-balance sheet obligations. This estimation methodologyuses the probability of default from the customer rating assigned to eachcounterparty, the "Loss Given Default" rating assigned to each transaction orfacility based on the collateral securing the transaction, and the measure ofexposure based on the transaction. These reserves are determined by reference tocontinuously monitored and updated historical loss rates or factors, derivedfrom a migration analysis which considers net charge off experience by loan andindustry type in relation to internal credit grading. Probable losses for pools of homogeneous consumer loans are generally estimatedusing a roll rate migration analysis that estimates the likelihood that a loanwill progress through the various stages of delinquency, or buckets, andultimately charge off. This analysis considers delinquency status, lossexperience and severity and takes into account whether loans are in bankruptcy,have been restructured, rewritten, or are subject to forbearance, an externaldebt management plan, hardship, modification, extension or deferment. Theallowance for credit losses on consumer receivables also takes intoconsideration the loss severity expected based on the underlying collateral, ifany, for the loan in the event of default. In addition, loss estimates onconsumer receivables are maintained to reflect HUSI's judgment of portfolio riskfactors, which may not be fully reflected in the statistical roll ratecalculation. Risk factors considered in establishing loss reserves on consumerloans include recent growth, product mix, bankruptcy trends, geographicconcentrations, economic conditions, portfolio seasoning, account managementpolicies and practices and current levels of charge offs and delinquencies. Repossessed Collateral Real estate owned with the intent to sell within a reasonable period isclassified as held for sale at the date of foreclosure and is valued at thelower of cost or fair value less estimated costs to sell and recorded in otherassets. These values are periodically reviewed and reduced, if necessary. Costsof holding real estate and related gains and losses on disposition are creditedor charged to operations as incurred as a component of operating expense. Properties and Equipment, Net Properties and equipment are recorded at cost, net of accumulated depreciation.Depreciation is recorded on a straight-line basis over the estimated usefullives of the related assets, which generally range from 3 to 40 years. Leaseholdimprovements are depreciated over the lesser of the economic useful life of theimprovement or the term of the lease. Costs of maintenance and repairs areexpensed as incurred. Mortgage Servicing Rights Effective January 1, 2006, upon adoption of SFAS 156 (refer to New AccountingPronouncements on page 109), mortgage servicing rights (MSRs) are initiallymeasured at fair value at the time that the related loans are sold andperiodically re-measured using the fair value measurement method. This methodrequires that MSRs be measured at fair value at each reporting date with changesin fair value reflected in income in the period that the changes occur. Prior toJanuary 1, 2006, MSRs were recorded at the lower of cost or fair value asrequired by previous accounting requirements. MSRs are subject primarily to interest rate risk, in that their fair value willfluctuate as a result of changes in the interest rate environment. Fair value isdetermined based upon the application of valuation models and other inputs. Thevaluation models incorporate assumptions market participants would use inestimating future cash flows. These assumptions include expected prepayments,default rates and market based option adjusted spreads. 104 HUSI uses certain derivative financial instruments including options andinterest rate swaps to protect against the decline in economic value of MSRs.These instruments have not been designated as qualifying hedges in accordancewith U.S. GAAP guidelines and are therefore recorded as trading instruments thatare marked to market through earnings. Goodwill Goodwill, representing the excess of purchase price over the fair value ofidentifiable net assets acquired, results from purchase business combinations.Goodwill is not amortized, but is reviewed for impairment annually using adiscounted cash flow methodology. Impairment may be reviewed earlier ifcircumstances indicate that the carrying amount may not be recoverable. HUSIconsiders significant and long-term changes in industry and economic conditionsto be primary indicators of potential impairment. Receivables Sold and Serviced with Limited Recourse and Securitization Revenue Certain private label credit card receivables have been securitized and sold toinvestors with limited recourse. Recourse is limited to HUSI's rights to futurecash flow and any subordinated interest that HUSI may retain. Upon sale, thereceivables are removed from the balance sheet and a gain on sale is recognizedfor the difference between the carrying value of the receivables and theadjusted sales proceeds. The adjusted sales proceeds include cash received andthe present value estimate of future cash flows to be received over the lives ofthe sold receivables. Future cash flows are based on estimates of prepayments,the impact of interest rate movements on yields of receivables and securitiesissued, delinquency of receivables sold, servicing fees and other factors. Theresulting gain is also adjusted by a provision for estimated probable lossesunder the recourse provision. This provision, and the related reserve forreceivables serviced with limited recourse, are established at the time of saleto cover all probable credit losses over the life of the receivables sold basedon historical experience and estimates of expected future performance. Themethodologies vary depending upon the type of receivables sold, using eitherhistorical net charge off rates applied to the expected balances to be receivedover the remaining life of the receivable or a historical static pool analysis.The reserves are reviewed periodically by evaluating the estimated future cashflows of each securitized pool to ensure that there is sufficient remaining cashflow to cover estimated future credit losses. Any changes to the estimates forthe reserve for receivables serviced with limited recourse are made in theperiod they become known. Gains on sales net of recourse provisions, servicingincome and excess spread relating to securitized receivables are reported in theaccompanying consolidated statement of income as securitization revenue. In connection with these transactions, HUSI records an interest-only stripreceivable, representing HUSI's contractual right to receive interest and othercash flows from the securitization trusts. HUSI's interest-only stripreceivables are reported at fair value using discounted cash flow estimates as aseparate component of receivables net of HUSI's estimate of probable lossesunder the recourse provisions. Cash flow estimates include estimates ofprepayments, the impact of interest rate movements on yields of receivables andsecurities issued, delinquency of receivables sold, servicing fees and estimatedprobable losses under the recourse provisions. Unrealized gains and losses arerecorded as adjustments to common shareholder's equity in accumulated othercomprehensive income, net of income taxes. The interest-only strip receivablesare reviewed for impairment quarterly or earlier if events indicate that thecarrying value may not be recovered. Any decline in the fair value of theinterest-only strip receivable which is deemed to be other than temporary ischarged against current earnings. HUSI has also, in certain cases, retained other subordinated interests in thesesecuritizations. Neither the interest-only strip receivables nor the othersubordinated interests are in the form of securities. Prior to the third quarter of 2004, private label credit card collateralizedfunding transactions were structured as sales to revolving trusts that requiredreplenishments to support previously issued securities. Since the third quarterof 2004, all new collateralized funding transactions have been structured assecured financings. HUSI has also continued to replenish, at reduced levels, certain non-publicprivate label securities issued to conduits in order to manage liquidity. 105 Income Taxes HNAH files a consolidated federal income tax return, which includes HUSI.Deferred tax assets and liabilities are recognized for the estimated future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases, as well as the estimated future tax consequences attributable to netoperating loss and tax credit carryforwards. These deferred tax assets andliabilities are measured using the tax rates and laws that are expected to be ineffect. A valuation allowance is established if, based on available evidence, itis more likely than not that some portion or all of the deferred tax asset willnot be realized. Foreign taxes paid are applied as credits to reduce federalincome taxes payable, to the extent that such credits can be utilized. Derivative Financial Instruments Derivative financial instruments are recognized on the balance sheet at theirfair value. On the date a derivative contract is entered into, HUSI designatesit as either: o a qualifying hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge); o a qualifying hedge of the variability of cash flows to be received or paid related to a recognized asset, liability or forecasted transaction (cash flow hedge); or o as a trading or non-qualifying hedge. Changes in the fair value of a derivative that has been designated and qualifiesas a fair value hedge, along with the changes in the fair value of the hedgedasset or liability that is attributable to the hedged risk (including losses orgains on firm commitments), are recorded in current period earnings. Changes inthe fair value of a derivative that has been designated and qualifies as a cashflow hedge, to the extent effective as a hedge, are recorded in accumulatedother comprehensive income, net of income taxes, and reclassified into earningsin the period during which the hedged item affects earnings. Ineffectiveness isreflected in current earnings. Changes in the fair value of derivatives held fortrading purposes or which do not qualify for hedge accounting are reported incurrent period earnings. At the inception of each hedge, HUSI formally documents all relationshipsbetween hedging instruments and hedged items, as well as its risk managementobjective and strategy for undertaking various hedge transactions, the nature ofthe hedged risk, and how hedge effectiveness and ineffectiveness will bemeasured. This process includes linking all derivatives that are designated asfair value or cash flow hedges to specific assets and liabilities on the balancesheet or to specific firm commitments or forecasted transactions. HUSI alsoformally assesses, both at inception and on a recurring basis, whether thederivatives that are used in hedging transactions are highly effective inoffsetting changes in fair values or cash flows of hedged items and whether theyare expected to continue to be highly effective in future periods. Thisassessment is conducted using statistical regression analysis. Earnings volatility may result from the on-going mark to market of certaineconomically viable derivative contracts that do not satisfy the hedgingrequirements under U.S. GAAP, as well as from the hedge ineffectivenessassociated with the qualifying contracts. 106 Embedded Derivatives HUSI may acquire or originate a financial instrument that contains a derivativeinstrument "embedded" within it. Upon origination or acquisition of any suchinstrument, HUSI assesses whether the economic characteristics of the embeddedderivative are clearly and closely related to the economic characteristics ofthe principal component of the financial instrument (i.e., the host contract)and whether a separate instrument with the same terms as the embedded instrumentwould meet the definition of a derivative instrument. With the adoption ofStatement of Financial Accounting Standards No. 155, Accounting for CertainHybrid Financial Instruments (SFAS 155), the election now exists to account foran entire financial instrument at fair value through profit and loss if thefinancial instrument contains an embedded derivative that would otherwiserequire bifurcation. Hybrid financial instruments that HUSI has elected to carryat fair value continue to be reported in their existing balance sheetclassification. When it is determined that: (1) the embedded derivative possesses economiccharacteristics that are not clearly and closely related to the economiccharacteristics of the host contract; and (2) a separate instrument with thesame terms would qualify as a derivative instrument, the embedded derivative iseither separated from the host contract (bifurcated), carried at fair value, anddesignated as a trading instrument or the entire financial instrument is carriedat fair value with all changes in fair value recorded to current periodearnings. If bifurcation is elected, any gain recognized at inception related tothe derivative is effectively embedded in the host contract and is recognizedover the life of the financial instrument. Hedge Discontinuation HUSI discontinues hedge accounting prospectively when: o the derivative is no longer effective or expected to be effective in offsetting changes in the fair value or cash flows of a hedged item (including firm commitments or forecasted transactions); o the derivative expires or is sold, terminated, or exercised; o it is unlikely that a forecasted transaction will occur; o the hedged firm commitment no longer meets the definition of a firm commitment; or o the designation of the derivative as a hedging instrument is no longer appropriate. When hedge accounting is discontinued because it is determined that thederivative no longer qualifies as an effective fair value or cash flow hedge,the derivative will continue to be carried on the balance sheet at fair value. In the case of a fair value hedge of a recognized asset or liability, as long asthe hedged item continues to exist on the balance sheet, the hedged item will nolonger be adjusted for changes in fair value. The basis adjustment that hadpreviously been recorded to the hedged item during the period from thedesignation date to the hedge discontinuation date is recognized as anadjustment to the yield of the hedged item over the remaining life of the hedgeditem. In the case of a cash flow hedge of a recognized asset or liability, as long asthe hedged item continues to exist on the balance sheet, the effective portionof the changes in fair value of the hedging derivative will no longer bereclassified into other comprehensive income. The balance applicable to thediscontinued hedging relationship will be recognized in earnings over theremaining life of the hedged item as an adjustment to yield. If the hedged itemwas a firm commitment or forecasted transaction that is not expected to occur,any amounts recorded on the balance sheet related to the hedged item, includingany amounts recorded in other comprehensive income, are reclassified to currentperiod earnings. In the case of either a fair value hedge or a cash flow hedge, if the previouslyhedged item is sold or extinguished, the basis adjustment to the underlyingasset or liability or any remaining unamortized other comprehensive incomebalance will be reclassified to current period earnings. In all other situations in which hedge accounting is discontinued, thederivative will be carried at fair value on the balance sheet, with changes inits fair value recognized in current period earnings unless redesignated as aqualifying hedge. 107 Day One Revenue Recognition HUSI recognizes gains and losses at the inception of derivative transactionsonly when the fair value of the transaction can be verified to similar markettransactions or if all significant pricing model assumptions can be verified toobservable market data. If profit or loss is not recognized at inception due tomarket observability, the net unrealized gain or loss associated with thesetransactions is recorded in trading and is offset by a reserve until thetransaction can be verified to observable market data. Interest Rate Lock and Purchase Agreements HUSI enters into commitments to originate residential mortgage loans whereby theinterest rate on the loan is set prior to funding (rate lock commitments). HUSIalso enters into commitments to purchase residential mortgage loans through itscorrespondent channel (purchase commitments). Both rate lock and purchasecommitments for residential mortgage loans that are classified as held for saleare considered to be derivatives. Rate lock and purchase commitments that areconsidered to be derivatives are recorded at fair value in other assets or otherliabilities in the consolidated balance sheet. Changes in fair value arerecorded in other income in the consolidated statement of income. Pension and Other Post-Retirement Benefits At December 31, 2006, as a result of the adoption of SFAS 158 (see NewAccounting Pronouncements on the following page), HUSI recognized the fundedstatus of pension and other post retirement benefits on the balance sheet withthe offset to accumulated other comprehensive income. Prior to 2006, the fundedstatus of these plans was not recognized on the balance sheet. Net pension andpost-retirement benefit cost charged to current earnings related to these plansis based on various actuarial assumptions regarding expected future experience. Certain HUSI employees are participants in various defined contribution andother non-qualified supplemental retirement plans. HUSI's contributions to theseplans are charged to current earnings. Through various subsidiaries, HUSI maintains various 401(k) plans coveringsubstantially all employees. Employer contributions to the plan, which arecharged to current earnings, are based on employee contributions. Stock-Based Compensation HUSI uses the fair value method of accounting for stock awards granted toemployees under various stock option and employee stock purchase plans. Stockcompensation costs are recognized prospectively for all new awards granted underthese plans. Compensation expense relating to share options is calculated usinga binomial lattice methodology that is based on the underlying assumptions ofthe Black-Scholes option pricing model and is charged to expense over thevesting period, generally three to five years. When modeling awards with vestingdependent on performance targets, these performance targets are incorporatedinto the model using Monte Carlo simulation. The expected life of these awardsdepends on the behavior of the award holders, which is incorporated into themodel consistent with historic observable data. Compensation expense relating to restricted stock rights (RSRs) is based uponthe market value of the RSRs on the date of grant and is charged to earningsover the vesting period of the RSRs, generally three to five years. Transactions With Related Parties In the normal course of business, HUSI enters into transactions with HSBC andits subsidiaries. These transactions occur at prevailing market rates and termsand include funding arrangements, administrative and operational support, andother miscellaneous services. All material related party balances andtransactions among various direct and indirect subsidiaries of HUSI areeliminated in consolidation. 108 New Accounting Pronouncements During 2006, the following additional accounting pronouncements were adopted. Effective January 1, 2006, HUSI adopted Statement of Financial AccountingStandards No. 123 (Revised), Share-Based Payment, (SFAS 123R). Because HUSI hadpreviously adopted the fair value method of accounting for all equity basedawards, the adoption of SFAS 123R did not have a material impact on HUSI'sfinancial position or results of operations. Effective January 1, 2006, HUSI adopted Statement of Financial AccountingStandards No. 154, Accounting Changes and Error Corrections: a replacement ofAPB Opinion No. 20 and FASB Statement No. 3 (SFAS 154). The adoption of SFAS 154did not have any impact on HUSI's financial position or results of operations. In February 2006, the FASB issued Statement of Financial Accounting StandardsNo. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155). SFAS155 permits companies to elect to measure at fair value entire financialinstruments containing embedded derivatives that would otherwise have to bebifurcated and accounted for separately. SFAS 155 also requires companies toidentify interests in securitized financial assets that are free standingderivatives or contain embedded derivatives that would have to be accounted forseparately, clarifies which interest-only and principal-only strip receivablesare subject to Statement of Financial Accounting Standards No. 133, Accountingfor Derivative Instruments and Hedging Activities (SFAS 133), and amendsStatement of Financial Accounting Standards No. 140, Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140)to revise the conditions of a qualifying special purpose entity. SFAS 155 iseffective for all financial instruments acquired or issued after the beginningof a company's first fiscal year that begins after September 15, 2006. Earlyadoption is permitted as of the beginning of a company's fiscal year, providedthe company has not yet issued financial statements for that fiscal year. HUSIelected to early adopt SFAS 155 effective January 1, 2006. The adoption of SFAS155 did not have a material impact on HUSI's financial position or results ofoperations. In March 2006, the FASB issued Statement of Financial Accounting Standards No.156, Accounting for Servicing of Financial Assets (SFAS 156). SFAS 156 amendspreviously issued guidance with respect to accounting for separately recognizedloan servicing rights. HUSI early adopted this standard as of January 1, 2006and elected to account for residential mortgage servicing rights at fair valueprospectively. Refer to Notes 6 and 11 of the consolidated financial statementsfor information relating to the adoption of SFAS 156. In September 2006, the FASB issued Statement of Financial Accounting StandardsNo. 158, Employer's Accounting for Defined Benefit Pension and OtherPostretirement Plans (SFAS 158). SFAS 158 requires balance sheet recognition ofthe funded status of pension and other postretirement benefits with the offsetto accumulated other comprehensive income. Employers will recognize actuarialgains and losses, prior service cost, and any remaining transition amounts whenrecognizing a plan's funded status. SFAS 158 is effective for fiscal yearsending after December 15, 2006. The adoption of SFAS 158 did not have a materialimpact on HUSI's financial position or results of operations. In September 2006, the United States Securities and Exchange Commission (SEC)issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements (SAB 108). SAB 108 addresses how the effects of prior yearuncorrected misstatements should be considered when quantifying misstatements incurrent year financial statements. SAB 108 requires companies to quantifymisstatements using both the balance sheet and income statement approaches andto evaluate whether either approach results in quantifying an error that ismaterial in light of relevant quantitative and qualitative factors. SAB 108 iseffective for fiscal years ending after November 15, 2006. The adoption of SAB108 did not have any impact on HUSI's financial position or results ofoperations. 109 The following additional accounting pronouncements were issued in 2006 and 2007and will be effective for HUSI in future periods. In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertaintyin Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48). FIN 48establishes threshold and measurement attributes for financial statementmeasurement and recognition of tax positions taken or expected to be taken in atax return. FIN 48 also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure andtransition. FIN 48 is effective for fiscal years beginning after December 15,2006. The adoption of FIN 48 on January 1, 2007 did not have a material impacton HUSI's financial position or results of operations. In September 2006, the FASB issued Statement of Financial Accounting StandardsNo. 157, Fair Value Measurements (SFAS 157). SFAS 157 establishes a singleauthoritative definition of fair value, sets out a framework for measuring fairvalue, and requires additional disclosures about fair value measurements. SFAS157 is effective for fiscal years beginning after November 15, 2007 and interimperiods within those years. Early application is permissible only if no annualor interim financial statements have been issued for the earlier periods. HUSIis currently evaluating the impact that adoption of SFAS 157 will have on itsfinancial position and results of operations. In December 2006, the FASB issued proposed FASB Staff Position No. FIN 39-a,Amendment of FASB Interpretation No. 39 (Proposed FSP FIN39-a). Proposed FSP FIN39-a would allow entities that are party to a master netting arrangement tooffset the receivable or payable recognized upon payment or receipt of cashcollateral against fair value amounts recognized for derivative instruments thathave been offset under the same master netting arrangement in accordance withFASB Interpretation No. 39. The guidance in this proposed FSP will be effectivefor fiscal years beginning after December 15, 2006. Entities will be required torecognize the effects of applying this FSP as a change in accounting principlethrough retrospective application for all financial statements presented unlessit is impracticable to do so. HUSI is currently evaluating the impact thatadoption will have on its financial position. In February 2007, the FASB issued Statement of Financial Accounting StandardsNo. 159, The Fair Value Option for Financial Assets and Financial Liabilities(SFAS 159), which creates an alternative measurement method for certainfinancial assets and liabilities. SFAS 159 permits fair value to be used forboth the initial and subsequent measurements on a contract-by-contract election,with changes in fair value to be recognized in earnings as those changes occur.This election is referred to as the "fair value option". SFAS 159 also requiresadditional disclosures to compensate for the lack of comparability that willarise from the use of the fair value option. SFAS 159 is effective for fiscalyears beginning after November 15, 2007, with early adoption permitted as of thebeginning of a company's fiscal year, provided the company has not yet issuedfinancial statements for that fiscal year. HUSI is currently evaluating theimpact the adoption of SFAS 159 will have on its financial position and resultsof operations. Note 3. Acquisitions and Divestitures-------------------------------------------------------------------------------- 2006 and 2005 There were no material business acquisitions or divestitures during 2006 or2005. 2004 On December 29, 2004, HUSI purchased approximately $12 billion of private labelloans, primarily credit card receivables, from HSBC Finance Corporation at fairvalue. HSBC Finance Corporation retained the customer relationships associatedwith these balances. This portfolio acquisition resulted in creation of theConsumer Finance business segment in 2005. See Note 24 beginning page 147 ofthis Form 10-K for a summary of HUSI's results by business segment. 110 Note 4. Federal Funds Sold and Securities Purchased Under Resale Agreements-------------------------------------------------------------------------------- Federal funds sold and securities borrowed or purchased under agreements toresell are summarized in the following table. -------------------------------------------------------------------------------- December 31 2006 2005-------------------------------------------------------------------------------- (in millions) Federal funds sold ...................................... $ 6,781 $ -- Securities purchased under agreements to resell ......... 6,994 4,568 ------- ------- Total ................................................... $13,775 $ 4,568 ======= ======= Funds generated from deposits growth during 2006 were primarily invested inshort-term investments such as Federal funds sold and securities purchased underresale agreements. Note 5. Trading Assets and Liabilities-------------------------------------------------------------------------------- Trading assets and liabilities are summarized in the following table. -------------------------------------------------------------------------------- December 31 2006 2005-------------------------------------------------------------------------------- (in millions) Trading assets: U.S. Treasury ...................................... $ 646 $ 148 U.S. Government agency ............................. 1,902 1,238 Asset backed securities ............................ 3,053 1,981 Corporate bonds .................................... 1,420 2,786 Other securities ................................... 4,903 4,626 Precious metals .................................... 2,716 2,286 Fair value of derivatives .......................... 11,398 8,155 -------- -------- $ 26,038 $ 21,220 ======== ======== Trading liabilities: Securities sold, not yet purchased ................. $ 1,914 $ 1,808 Payables for precious metals ....................... 1,336 1,161 Fair value of derivatives .......................... 10,796 7,741 -------- -------- $ 14,046 $ 10,710 ======== ======== 111 Note 6. Securities-------------------------------------------------------------------------------- At December 31, 2006 and 2005, HUSI held no securities of any single issuer(excluding the U.S. Treasury, U.S. Government sponsored enterprises and U.S.Government agencies) with a book value that exceeded 10% of shareholders'equity. The amortized cost and fair value of the available for sale and held tomaturity securities portfolios are summarized in the following table. ---------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized FairDecember 31, 2006 Cost Gains Losses Value---------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury ........................................... $ 1,535 $ 3 $ (8) $ 1,530 U.S. Government sponsored enterprises (1) ............... 10,682 30 (257) 10,455 U.S. Government agency issued or guaranteed ............. 3,793 6 (72) 3,727 Obligations of U.S. states and political subdivisions ... 515 4 (1) 518 Asset backed securities ................................. 578 1 (3) 576 Other domestic debt securities .......................... 1,343 3 (19) 1,327 Foreign debt securities ................................. 860 7 (3) 864 Equity securities ....................................... 775 11 -- 786 ---------- ---------- ---------- ---------- Securities available for sale ........................... $ 20,081 $ 65 $ (363) $ 19,783 ========== ========== ========== ========== Securities held to maturity: U.S. Treasury ........................................... $ -- $ -- $ -- $ -- U.S. Government sponsored enterprises (1) ............... 1,845 43 (17) 1,871 U.S. Government agency issued or guaranteed ............. 584 25 (2) 607 Obligations of U.S. states and political subdivisions ... 325 19 -- 344 Other domestic debt securities .......................... 167 2 (2) 167 Foreign debt securities ................................. 51 -- -- 51 ---------- ---------- ---------- ---------- Securities held to maturity ............................. $ 2,972 $ 89 $ (21) $ 3,040 ========== ========== ========== ========== (1) Includes primarily mortgage backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). ---------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized FairDecember 31, 2005 Cost Gains Losses Value---------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury ........................................... $ 711 $ -- $ (4) $ 707 U.S. Government sponsored enterprises (1) ............... 10,850 25 (251) 10,624 U.S. Government agency issued or guaranteed ............. 2,466 10 (48) 2,428 Obligations of U.S. states and political subdivisions ... 487 -- (5) 482 Asset backed securities ................................. 1,165 2 (4) 1,163 Other domestic debt securities .......................... 1,700 6 (15) 1,691 Foreign debt securities ................................. 611 8 (5) 614 Equity securities ....................................... 49 6 -- 55 ---------- ---------- ---------- ---------- Securities available for sale ........................... $ 18,039 $ 57 $ (332) $ 17,764 ========== ========== ========== ========== Securities held to maturity: U.S. Treasury ........................................... $ 83 $ -- $ -- $ 83 U.S. Government sponsored enterprises (1) ............... 1,860 57 (21) 1,896 U.S. Government agency issued or guaranteed ............. 644 31 (1) 674 Obligations of U.S. states and political subdivisions ... 369 25 -- 394 Other domestic debt securities .......................... 164 1 (1) 164 Foreign debt securities ................................. 51 -- -- 51 ---------- ---------- ---------- ---------- Securities held to maturity ............................. $ 3,171 $ 114 $ (23) $ 3,262 ========== ========== ========== ========== (1) Includes primarily mortgage backed securities issued by the FNMA and FHLMC. 112 HUSI adopted Statement of Financial Accounting Standards No. 156, Accounting forServicing of Financial Assets (SFAS 156) effective January 1, 2006 (refer to NewAccounting Pronouncements on page 109 of this Form 10-K). In accordance withSFAS 156, HUSI elected to reclassify securities used to offset changes ineconomic value of mortgage servicing rights from the available for saleportfolio to trading assets at the effective date. At December 31, 2005, thesesecurities had an amortized cost of $115 million and a fair value of $111million. The cumulative effect of $4 million was recorded as an adjustment toretained earnings in 2006. A summary of gross unrealized losses and related fair values, classified as tothe length of time the losses have existed, is presented in the following table. ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year --------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair ValueDecember 31, 2006 Securities Losses of Investment Securities Losses of Investment------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury ................... 8 $ (1) $ 527 6 $ (7) $ 566 U.S. Government sponsored enterprises (1) .............. 211 (114) 3,158 482 (143) 5,042 U.S. Government agency issued or guaranteed ......... 691 (40) 2,334 268 (32) 1,076 Obligations of U.S. states and political subdivisions ....... 12 (1) 85 3 * 27 Asset backed securities ......... 6 * 81 19 (3) 293 Other domestic debt securities .. 10 (1) 153 56 (18) 910 Foreign debt securities ......... 6 (1) 191 11 (2) 227 ---------- ---------- ------------- ---------- ---------- ------------- Securities available for sale ... 944 $ (158) $ 6,529 845 $ (205) $ 8,141 ========== ========== ============= ========== ========== =============Securities held to maturity: U.S. Treasury ................... -- $ -- $ -- -- $ -- $ -- U.S. Government sponsored enterprises (1) .............. 23 * 15 22 (17) 389 U.S. Government agency issued or guaranteed ......... 49 * 21 169 (2) 35 Obligations of U.S. states and political subdivisions ....... 1 * * 9 * 4 Other domestic debt securities .. 2 * 22 4 (2) 33 Foreign debt securities ......... 2 * 51 -- -- -- ---------- ---------- ------------- ---------- ---------- ------------- Securities held to maturity ..... 77 $ * $ 109 204 $ (21) $ 461 ========== ========== ============= ========== ========== ============= (1) Includes primarily mortgaged-backed securities issued by FNMA and FHLMC. * Less than $500 thousand. 113 ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year --------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair ValueDecember 31, 2005 Securities Losses of Investment Securities Losses of Investment------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury ................... 7 $ (4) $ 619 -- $ -- $ -- U.S. Government sponsored enterprises (1) .............. 560 (176) 7,313 46 (75) 1,434 U.S. Government agency issued or guaranteed ......... 288 (22) 1,346 82 (26) 434 Obligations of U.S. states and political subdivisions ....... 61 (5) 436 -- -- -- Asset backed securities ......... 22 (4) 464 31 * 23 Other domestic debt securities .. 6 (14) 1,089 7 (1) 34 Foreign debt securities ......... 17 (5) 336 1 * 25 ---------- ---------- ------------- ---------- ---------- ------------- Securities available for sale ... 961 $ (230) $ 11,603 167 $ (102) $ 1,950 ========== ========== ============= ========== ========== =============Securities held to maturity: U.S. Treasury ................... 3 $ * $ 83 -- $ -- $ -- U.S. Government sponsored enterprises (1) .............. 28 (14) 397 3 (7) 41 U.S. Government agency issued or guaranteed ......... 181 (1) 34 -- -- -- Obligations of U.S. states and political subdivisions ....... 2 * * 10 * 4 Other domestic debt securities 4 * 33 2 (1) 5 Foreign debt securities ......... 2 * 51 -- -- -- ---------- ---------- ------------- ---------- ---------- ------------- Securities held to maturity ..... 220 $ (15) $ 598 15 $ (8) $ 50 ========== ========== ============= ========== ========== ============= (1) Includes primarily mortgage-backed securities issued by FNMA and FHLMC. * Less than $500 thousand. Gross unrealized losses have increased within the available for sale securitiesportfolio during 2006, due to changes in interest rates. Since substantially allof these securities are high credit grade (i.e., AAA or AA), and HUSI has theability and intent to hold these securities until maturity or a market pricerecovery, they are not considered to be other than temporarily impaired. 114 The following table summarizes realized gains and losses on investmentsecurities transactions attributable to available for sale and held to maturitysecurities. Amounts in the table include net realized (losses) gains of $(11)million and $8 million reported in residential mortgage banking revenue in theconsolidated statement of income for 2005 and 2004, respectively. ----------------------------------------------------------------------------------- Net Gross Gross Realized Realized Realized GainsYear Ended December 31 Gains (Losses) (Losses)----------------------------------------------------------------------------------- (in millions) 2006Securities available for sale .................... $ 34 $ (6) $ 28Securities held to maturity: Maturities, calls and mandatory redemptions ... 1 -- 1 -------- -------- -------- $ 35 $ (6) $ 29 ======== ======== ======== 2005Securities available for sale .................... $ 107 $ (13) $ 94Securities held to maturity: Maturities, calls and mandatory redemptions ... 1 -- 1 -------- -------- -------- $ 108 $ (13) $ 95 ======== ======== ======== 2004Securities available for sale .................... $ 100 $ (8) $ 92Securities held to maturity: Maturities, calls and mandatory redemptions ... 1 -- 1 -------- -------- -------- $ 101 $ (8) $ 93 ======== ======== ======== The amortized cost and fair values of securities available for sale andsecurities held to maturity at December 31, 2006, by contractual maturity aresummarized in the following table. Expected maturities differ from contractualmaturities because borrowers have the right to prepay obligations withoutprepayment penalties in certain cases. Available for sale amounts exclude equitysecurities with a fair value of $786 million ($775 million cost) that do nothave stated maturities. 115 The following table also reflects the distribution of maturities of debtsecurities held at December 31, 2006, together with the approximate taxableequivalent yield of the portfolio. The yields shown are calculated by dividingannual interest income, including the accretion of discounts and theamortization of premiums, by the amortized cost of securities outstanding atDecember 31, 2006. Yields on tax-exempt obligations have been computed on ataxable equivalent basis using applicable statutory tax rates. ------------------------------------------------------------------------------------------------------------------------ Within After One After Five After One But Within But Within TenTaxable Year Five Years Ten Years YearsEquivalent ---------------- ----------------- ------------------ ------------------Basis Amount Yield Amount Yield Amount Yield Amount Yield------------------------------------------------------------------------------------------------------------------------ ($ in millions) Available for sale: U.S. Treasury ..................... $ 225 4.09% $ 1,187 4.41% $ 123 4.38% $ -- --% U.S. Government sponsored enterprises ..................... 50 2.63 582 3.56 852 4.76 9,198 4.89 U.S. Government agency issued or guaranteed ...................... * 7.00 320 6.07 35 5.21 3,438 4.92 Obligations of U.S. states and political subdivisions ...... -- -- -- -- 6 5.34 509 5.03 Asset backed securities ........... 1 5.96 329 3.95 159 4.92 89 5.33 Other domestic debt securities .... 21 5.96 63 4.23 44 5.02 1,215 5.14 Foreign debt securities ........... 152 6.57 200 5.79 242 6.08 266 7.62 ------- ------- -------- --------Total amortized cost ................ $ 449 4.86% $ 2,681 4.47% $ 1,461 4.98% $ 14,715 4.97% ======= ======= ======== ========Total fair value .................... $ 448 $ 2,656 $ 1,429 $ 14,464 ======= ======= ======== ======== Held to maturity: U.S. Treasury ..................... $ -- --% $ -- --% $ -- --% $ -- --% U.S. Government sponsored enterprises ..................... 3 7.00 8 7.34 93 6.10 1,741 5.90 U.S. Government agency issued or guaranteed ...................... 1 7.10 9 6.97 4 8.65 570 6.49 Obligations of U.S. states and political subdivisions .......... 14 6.95 46 5.82 45 5.00 220 5.16 Other domestic debt securities .... -- -- -- -- -- -- 167 5.80 Foreign debt securities ........... 51 3.22 -- -- -- -- -- -- ------- ------- -------- --------Total amortized cost ................ $ 69 4.16% $ 63 6.19% $ 142 5.83% $ 2,698 5.96% ======= ======= ======== ========Total fair value .................... $ 69 $ 66 $ 149 $ 2,756 ======= ======= ======== ======== * Less than $500 thousand. Investments in Federal Home Loan Bank (FHLB) stock, Federal Reserve Bank (FRB)stock, and MasterCard Class B securities of $360 million, $306 million and $57million, respectively, were included in other assets at December 31, 2006.Investments in FHLB and FRB stock of $360 million and $292 million,respectively, were included in other assets at December 31, 2005. 116 Note 7. Loans-------------------------------------------------------------------------------- A distribution of the loan portfolio, including loans held for sale, issummarized in the following table. ----------------------------------------------------------------------------------------------------------------- 2006 2005 ------------------------------- -------------------------------- Total Held for Sale Total Held for Sale Loans Included in Total Loans Included in Total----------------------------------------------------------------------------------------------------------------- (in millions) Commercial: Construction and other real estate ..... $ 8,918 $ 102 $ 9,122 $ 68 Other commercial ....................... 20,564 -- 18,596 -- ---------- ----------------- ----------- ----------------- 29,482 102 27,718 68 ---------- ----------------- ----------- ----------------- Consumer: Residential mortgage ................... 39,808 4,227 43,986 4,107 Credit card receivables ................ 18,260 -- 15,514 -- Other consumer loans ................... 2,687 394 3,124 390 ---------- ----------------- ----------- ----------------- 60,755 4,621 62,624 4,497 ---------- ----------------- ----------- -----------------Total loans ............................... $ 90,237 $ 4,723 $ 90,342 $ 4,565 ========== ================= =========== ================= In December 2004, HUSI acquired a $12 billion private label loan portfolio fromHSBC Finance Corporation. The portfolio consisted of approximately $11 billionof private label credit card receivables and $1 billion of other consumer andcommercial loans. The customer relationships were retained by HSBC FinanceCorporation. By agreement, HUSI is purchasing additional credit card receivablesgenerated from customer accounts at fair value on a daily basis. During 2006 and2005, underlying customer balances included within the private label portfoliohave revolved, and new relationships have been added, bringing the total privatelabel credit card portfolio balance to approximately $17 billion at December 31,2006. Higher quality nonconforming residential mortgage loans were acquired fromoriginating lenders pursuant to HSBC Finance Corporation correspondent loanprograms from December 2003 until September 2005. Purchases of these loans werediscontinued as a result of strategic balance sheet initiatives to enhanceHUSI's liquidity position and to address interest rate risk. Residential mortgage loan originations generally declined during 2006 and 2005due to a rising interest rate environment. In addition, originations of variousadjustable rate residential mortgage loan products that would have been retainedon the balance sheet prior to 2005 were being sold in the secondary marketbeginning in 2005 and throughout 2006, also as a result of strategic balancesheet initiatives to enhance liquidity and to address interest rate risk. Thesefactors contributed to the overall decrease in residential mortgage loans during2006. HUSI has loans outstanding to certain executive officers and directors. Theloans were made on substantially the same terms, including interest rates andcollateral, as those prevailing at the same time for comparable transactionswith other persons and do not involve more than normal risk of collectibility.The aggregate amount of such loans did not exceed 5% of shareholders' equity atDecember 31, 2006 and 2005. 117 Loans Held for Sale Beginning in June 2005, loans held for sale include residential mortgage loansacquired from unaffiliated third parties and from HSBC Finance Corporation, withthe intent of selling the loans to HMUS. Loans held for sale to HMUS increased$244 million in 2006 to $3.1 billion at December 31, 2006. Loans held for sale are recorded at the lower of aggregate cost or market value.Aggregate cost exceeded market value at December 31, 2006 and December 31, 2005.Changes in the valuation allowance utilized to adjust loans held for sale tomarket value are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- 2006 2005 ------------------------------------ ------------------------------------ Valuation Allowance Related to Valuation Allowance Related to ------------------------------ ------------------------------ Loans Held Other Loans Held Other for Sale Loans Held for Sale Loans HeldYear Ended December 31 to HMUS for Sale Total to HMUS for Sale Total----------------------------------------------------------------------------------------------------------------------- (in millions) Balance at beginning of period ......... $ (11) $ (15) $ (26) $ -- $ (4) $ (4)(Increased) decreased allowance for net reductions in market value ... (133) 12 (121) (32) (11) (43)Releases of valuation allowance for loans sold ....................... 109 -- 109 21 -- 21 ---------- ---------- -------- ---------- ---------- --------Balance at end of period ............... $ (35) $ (3) $ (38) $ (11) $ (15) $ (26) ========== ========== ======== ========== ========== ======== Loans held for sale to HMUS are subject to interest rate risk, in that theirvalue will change as a result of changes in the interest rate environment.Interest rate risk is mitigated through an active economic hedging program tooffset changes in value of the loans held for sale. Trading related revenuesrelated to this economic hedging program, which includes net interest income andtrading revenues were $132 million and $36 million for 2006 and 2005,respectively. 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 enters into a variety of transactions in the normalcourse of business that involve both on- and off-balance sheet credit risk.Principal among these activities is lending to various commercial,institutional, governmental and individual customers. HUSI participates inlending activity throughout the United States and internationally. In general,HUSI controls the varying degrees of credit risk involved in on- and off-balancesheet transactions through specific credit policies. These policies andprocedures provide for a strict approval, monitoring and reporting process. Itis HUSI's policy to require collateral when it is deemed appropriate. Varyingdegrees and types of collateral are secured depending upon management's creditevaluation. As with any nonconforming and non-prime loan products, HUSI utilizes highunderwriting standards and prices these loans in a manner that is appropriate tocompensate for higher risk. Certain residential mortgage loans have high loan-to-value (LTV) ratios and nomortgage insurance, which could result in potential inability to recover theentire investment in loans involving foreclosed or damaged properties. HUSI also offers interest-only residential mortgage loans. These interest-onlyloans allow customers to pay only the accruing interest for a period of time,which results in lower payments during the initial loan period. Depending on acustomer's financial situation, the subsequent increase in the required paymentattributable to loan principal could affect a customer's ability to repay theloan at some future date when the interest rate resets and/or principal paymentsare required. 118 Outstanding balances of high LTV and interest-only loans are summarized in thefollowing table. ------------------------------------------------------------------------------------------------December 31 2006 2005------------------------------------------------------------------------------------------------ (in millions) Residential mortgage loans with high LTV and no mortgage insurance ... $ 2,717 $ 3,510Interest-only residential mortgage loans ............................. 7,537 8,713 ---------- ---------Total ................................................................ $ 10,254 $ 12,223 ========== ========= Concentrations of first and second liens within the residential mortgage loanportfolio are summarized in the following table. Amounts in the table excludeloans held for sale. ------------------------------------------------------------------------------------------------December 31 2006 2005------------------------------------------------------------------------------------------------ (in millions) Closed end: First lien ........................................................ $ 31,876 $ 36,389 Second lien ....................................................... 474 193Revolving: Second lien ....................................................... 3,231 3,297 ---------- ---------Total ................................................................ $ 35,581 $ 39,879 ========== ========= HUSI also offers adjustable rate residential mortgage loans which allow it toadjust pricing on the loan in line with market movements. At December 31, 2006,HUSI had approximately $21.2 billion in adjustable rate residential mortgageloans. In 2007, approximately $2.5 billion of adjustable rate residentialmortgage loans will experience their first interest rate reset. In 2008,approximately $3.6 billion of adjustable rate residential mortgage loans willexperience their first interest rate reset. As interest rates have risen overthe last three years, many adjustable rate loans are expected to require asignificantly higher monthly payment following their first adjustment. Acustomer's financial situation at the time of the interest rate reset couldaffect the customer's ability to repay the loan after the adjustment. Regional exposure at December 31, 2006 for certain loan portfolios is summarizedin the following table. -------------------------------------------------------------------------------------------------- Commercial Residential Credit Construction and Other Mortgage CardDecember 31, 2006 Real Estate Loans Loans Receivables-------------------------------------------------------------------------------------------------- New York State ............................. 53% 24% 6%North Central United States ................ 5 12 24North Eastern United States ................ 7 12 14Southern United States ..................... 17 24 31Western United States ...................... 18 28 25 ----- ----- ----Total ...................................... 100% 100% 100% ===== ===== ==== Sale of Brady Bonds At December 31, 2005, commercial loans included certain bonds issued by thegovernment of Venezuela as part of debt renegotiations (Brady Bonds) with a facevalue of $178 million, and a recorded carrying value of $165 million. During thesecond quarter of 2006, the Venezuelan government redeemed all Brady Bonds heldby HUSI at their face value resulting in a gain of $13 million, which wasrecorded in other revenues. 119 Credit Quality Statistics Nonaccruing loans information is summarized in the following table. ------------------------------------------------------------------------------------------------------- 2006 2005------------------------------------------------------------------------------------------------------- (in millions) Nonaccruing loans Balance at end of period: Commercial: Construction and other real estate ................................. $ 33 $ 15 Other commercial ................................................... 69 70 --------- --------- Total commercial ................................................... 102 85 --------- --------- Consumer: Residential mortgages .............................................. 182 138 Credit card receivables ............................................ 1 -- Other consumer loans ............................................... -- -- --------- --------- Total consumer loans ............................................... 183 138 --------- --------- Total nonaccruing loans .................................................. $ 285 $ 223 ========= ========= Interest income on nonaccruing loans is summarized in the following table. ------------------------------------------------------------------------------------------------------Year Ended December 31 2006 2005 2004------------------------------------------------------------------------------------------------------ (in millions) Interest income on nonaccruing loans: Amount which would have been recorded had the associated loans been current in accordance with their original terms ....... $ 21 $ 25 $ 23 Amount actually recorded ...................................... 8 12 17 Additional credit quality statistics are summarized in the following table. ------------------------------------------------------------------------------------------------------December 31 2006 2005------------------------------------------------------------------------------------------------------ (in millions) Accruing loans contractually past due 90 days or more as to principal or interest: Total commercial ........................................................... $ 22 $ 19 --------- -------- Consumer: Residential mortgages ................................................... 11 27 Credit card receivables ................................................. 339 248 Other consumer loans .................................................... 16 17 --------- -------- Total consumer loans .................................................... 366 292 --------- -------- Total accruing loans contractually past due 90 days or more ................ $ 388 $ 311 ========= ======== Impaired loans: Balance at end of period ................................................... $ 100 $ 90 Amount with impairment reserve ............................................. 35 27 Impairment reserve ......................................................... 13 10 Other real estate and owned assets: Balance at end of period ................................................... $ 53 $ 35 120 Note 8. Allowance for Credit Losses-------------------------------------------------------------------------------- An analysis of the allowance for credit losses is presented in the followingtable. ----------------------------------------------------------------------------------------------------- 2006 2005 2004----------------------------------------------------------------------------------------------------- (in millions) Balance at beginning of year ................................. $ 846 $ 788 $ 399Provision charged (credited) to income ....................... 823 674 (17)Charge offs .................................................. (1,012) (871) (157)Recoveries ................................................... 248 255 78Allowance related to acquisitions and (dispositions), net .... (8) -- 485 ---------- --------- ---------Balance at end of year ....................................... $ 897 $ 846 $ 788 ========== ========= =========Non--United States transfer risk reserves included in the allowance for credit losses ................................ $ -- $ 4 $ 14 ========== ========= ========= On December 29, 2004, HUSI acquired approximately $12 billion of private labelloans from HSBC Finance Corporation, including an allowance for credit lossesassociated with the purchased loans. Note 9. Securitizations and Secured Financings-------------------------------------------------------------------------------- On December 29, 2004, HUSI acquired a domestic private label loan portfolio fromHSBC Finance Corporation, without recourse, which included a consumer privatelabel credit card portfolio, securitized receivables related to this portfolio,and retained interest assets related to these securitizations. These credit cardsecuritization transactions were structured to receive sale treatment under U.S.GAAP. In a securitization, a designated pool of receivables is removed from thebalance sheet and transferred to an unaffiliated revolving trust. Thisunaffiliated trust is a qualifying special purpose entity (QSPE) as defined bySFAS 140 and, therefore, is not consolidated. The QSPE funds its purchase ofreceivables through the issuance of securities to investors, entitling them toreceive specified cash flows during the life of the securities. The securitiesare collateralized by the underlying receivables transferred to the QSPE. Theserevolving securitization trusts require replenishment of receivables to supportpreviously issued securities. Replenishments for the revolving securitizationtrusts were $3.6 billion and $8.7 billion in 2006 and 2005, respectively. In the third quarter of 2006, the last remaining securitization trust agreementrelated to the private label portfolio acquired from HSBC Finance Corporation in2004 was amended. As a result, the securitization trust no longer qualifies forsale treatment and the transaction is now recorded as a secured financingtransaction. At the transaction date, all outstanding investments, credit cardreceivables and liabilities related to the trust were recorded on HUSI'sconsolidated balance sheet. All new collateralized funding transactions have been structured as securedfinancings under U.S. GAAP since the third quarter of 2004. In a securedfinancing, a designated pool of receivables are conveyed to a wholly ownedlimited purpose subsidiary, which in turn transfers receivables to a trust thatsells interests to investors. Repayment of the debt issued by the trust issecured by the receivables transferred. The receivables and the underlying debtof the trust remain on HUSI's balance sheet. HUSI does not recognize a gain in asecured financing transaction. Because the receivables and debt remain on thebalance sheet, revenues and expenses are reported consistently with the ownedbalance sheet portfolio. There have been no new secured financings in 2006. 121 HUSI's securitized receivables and secured financings are summarized in thefollowing table. -----------------------------------------------------------------------------------------------------------------------Year ended December 31 2006 2005----------------------------------------------------------------------------------------------------------------------- (in millions) Securitized private label receivables at period end .............................. $ -- $ 1,343 ============ ============Secured financings in long-term debt: Balance at period end ......................................................... $ 2,134 $ 1,500 ============ ============ Private label credit card receivables and investment securities collateralizing secured financings at period end ........................................... $ 2,439 $ 1,824 ============ ============ Note 10. Properties and Equipment, Net-------------------------------------------------------------------------------- The composition of properties and equipment, net of accumulated depreciation, issummarized in the following table. ----------------------------------------------------------------------------------------------------------------------- DepreciableDecember 31 Life (Years) 2006 2005----------------------------------------------------------------------------------------------------------------------- ($ in millions) Land ......................................................... -- $ 79 $ 92Buildings .................................................... 5-40 754 688Furniture and equipment ...................................... 3-7 519 503 ------------ ------------Total ........................................................ 1,352 1,283Less: accumulated depreciation ............................... (812) (745) ------------ ------------Properties and equipment, net ................................ $ 540 $ 538 ============ ============ Depreciation expense during the year ......................... $ 79 $ 85 ============ ============ Note 11. Intangible Assets, Net-------------------------------------------------------------------------------- The following table summarizes the composition of intangible assets. -----------------------------------------------------------------------------------------------------------------------December 31 2006 2005----------------------------------------------------------------------------------------------------------------------- (in millions) Mortgage servicing rights ........................................................ $ 474 $ 418Other ............................................................................ 47 45 ------------ ------------Intangible assets, net ........................................................... $ 521 $ 463 ============ ============ Mortgage Servicing Rights (MSRs) HUSI has one class of MSRs arising from sales of residential mortgage loans.HUSI recognizes the right to service mortgage loans as a separate and distinctasset at the time the loans are sold. HUSI receives a fee for servicing therelated residential mortgage loans. Effective January 1, 2006, HUSI adopted SFAS 156 electing to measure this oneclass of MSRs at fair value. Upon adoption, HUSI recorded a cumulative effectadjustment to beginning retained earnings of less than $1 million, representingthe difference between the fair value and the carrying amount of MSRs as of thedate of adoption. MSRs are subject to prepayment and interest rate risk, in that their value willfluctuate as a result of changes in the interest rate environment. Interest raterisk is mitigated through an active economic hedging program that usessecurities and derivatives to offset changes in the fair value of MSRs. Sincethe hedging program involves trading activity, risk is quantified and managedusing a number of risk assessment techniques, which are addressed in more detailunder Market Risk Management beginning on page 80 of this Form 10-K. 122 With the adoption of SFAS 156, HUSI also made an irrevocable election toreclassify securities used to offset changes in economic value of MSRs fromavailable for sale to trading assets, effective January 1, 2006. At December 31,2005, these securities had a book value of $115 million and a fair value of $111million. The accumulated unrealized loss recorded in accumulated othercomprehensive income of $4 million was reversed effective January 1, 2006, withthe offsetting amount recorded as a cumulative effect adjustment to retainedearnings. MSRs are initially measured at fair value at the time that the related loans aresold, and periodically remeasured using the fair value measurement method. Thismethod requires that MSRs be measured at fair value at each reporting date withchanges in fair value of the asset reflected in residential mortgage bankingrevenue in the period that the changes occur. Fair value is determined basedupon the application of valuation models and other inputs. The valuation modelsincorporate assumptions market participants would use in estimating future cashflows. These assumptions include expected prepayments, default rates andmarket-based option adjusted spreads. The reasonableness of these valuationmodels is periodically validated by reference to external independent brokervaluations and industry surveys. Fair value of MSRs is calculated using the following critical assumptions. ----------------------------------------------------------------------------------------------------------------------- December 31, December 31, 2006 2005----------------------------------------------------------------------------------------------------------------------- Annualized constant prepayment rate (CPR) ........................................ 20.80% 16.30%Constant discount rate ........................................................... 10.34% 12.07%Weighted average life ............................................................ 4.8 years 5.5 years The following table summarizes MSRs activity for the year ended December 31,2006, the reporting period since adoption of SFAS 156. -----------------------------------------------------------------------------------------------------------------------Year Ended December 31 2006----------------------------------------------------------------------------------------------------------------------- (in millions) Fair value of MSRs: Beginning balance ................................................................................... $ 418 Additions related to loan sales ..................................................................... 100 Changes in fair value due to: Change in valuation inputs or assumptions used in the valuation models ........................... 43 Realization of cash flows ........................................................................ (87) ------------ Ending balance ...................................................................................... $ 474 ============ 123 The following table summarizes activity for MSRs and the related valuationallowance for the year ended December 31, 2005 and December 31, 2004, which wasprior to the adoption of SFAS 156. ----------------------------------------------------------------------------------------------------------------------- 2005 2004----------------------------------------------------------------------------------------------------------------------- (in millions) MSRs, net of accumulated amortization: Balance, January 1 ............................................................ $ 416 $ 526 Additions related to loan sales ............................................... 136 62 Net MSRs acquisitions (sales) ................................................. -- (54) Permanent impairment charges .................................................. (21) (15) Amortization .................................................................. (74) (103) ------------ ------------ Balance, December 31 .......................................................... 457 416 ------------ ------------ Valuation allowance for MSRs: Balance, January 1 ............................................................ (107) (23) Temporary impairment (provision) recovery ..................................... 47 (102) Permanent impairment charges .................................................. 21 15 Release of allowance related to MSRs sold ..................................... -- 3 ------------ ------------ Balance, December 31 .......................................................... (39) (107) ------------ ------------ MSRs, net of accumulated amortization and valuation allowance at December 31 ..... $ 418 $ 309 ============ ============ Information regarding residential mortgage loans serviced for others, which arenot included in the consolidated balance sheet, is summarized in the followingtable. -----------------------------------------------------------------------------------------------------------------------Year Ended December 31 2006 2005----------------------------------------------------------------------------------------------------------------------- (in millions) Outstanding principal balances at period end ..................................... $ 34,736 $ 31,961 ============ ============ Custodial balances maintained and included in noninterest bearing deposits at period end .................................................................... $ 647 $ 628 ============ ============ Servicing fee income recorded in residential mortgage banking revenue during the period ........................................................................ $ 100 $ 76 ============ ============ Other Intangible Assets Other intangible assets include favorable lease arrangements and customer lists.The weighted-average amortization period for these intangible assets is 87months at December 31, 2006. Total amortization expense was approximately $6million for 2006 and 2005. Scheduled amortization is approximately $6 millionper year for 2007 through 2011. 124 Note 12. Goodwill-------------------------------------------------------------------------------- During the second quarter of 2006, HUSI completed its annual impairment test ofgoodwill. In order to conform its testing date with that of HSBC and other HSBCaffiliates, HUSI changed its accounting policy for the impairment testing dateand completed an additional impairment test of goodwill in the third quarter. Atboth testing dates, HUSI determined that the fair value of each of the reportingunits exceeded its carrying value. As a result, no impairment loss was requiredto be recognized. In subsequent years, the annual impairment test of goodwillwill continue to be completed at July 1. During the year ended December 31,2006, there were no material events or transactions which warrantedconsideration for their impact on recorded book values assigned to goodwill. The following table presents a summary of changes in goodwill. -----------------------------------------------------------------------------------------------------------------------Year ended December 31 2006 2005----------------------------------------------------------------------------------------------------------------------- (in millions) Balance at beginning of year ..................................................... $ 2,694 $ 2,697Purchase accounting adjustment ................................................... 22 --Reductions related to branch disposals ........................................... -- (3) ------------ ------------Balance at the end of the year ................................................... $ 2,716 $ 2,694 ============ ============ During 2006, a deferred tax asset related to a previous acquisition was adjustedagainst the related goodwill balance, resulting in the purchase accountingadjustment noted in the table above. Note 13. Deposits-------------------------------------------------------------------------------- The aggregate amounts of time deposit accounts (primarily certificates ofdeposits) each with a minimum of $100,000 included in domestic office depositswere approximately $19 billion and $23 billion at December 31, 2006 and 2005,respectively. Certain domestic deposits meet the definition of a hybridfinancial instrument as defined in SFAS 155. As a result, deposits totaling $1.3billion at December 31, 2006 are being carried at fair value with all changes infair value recorded to profit and loss. The scheduled maturities of all timedeposits at December 31, 2006 is summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Domestic Foreign Offices Offices Total----------------------------------------------------------------------------------------------------------------------- (in millions) 2007: 0-90 days ................................................. $ 13,927 $ 9,262 $ 23,189 91-180 days ............................................... 5,039 328 5,367 181-365 days .............................................. 4,312 242 4,554 ----------- ------------ ------------ 23,278 9,832 33,1102008 ......................................................... 1,528 20 1,5482009 ......................................................... 144 8 1522010 ......................................................... 125 -- 1252011 ......................................................... 75 -- 75Later years .................................................. 279 -- 279 ----------- ------------ ------------ $ 25,429 $ 9,860 $ 35,289 =========== ============ ============ Overdraft deposits reclassified to loans were approximately $1,727 million and$1,291 million at December 31, 2006 and 2005, respectively. 125 Note 14. Short-Term Borrowings-------------------------------------------------------------------------------- The following table summarizes the components of short-term borrowings. AtDecember 31, 2006 and 2005, there were no categories of short-term borrowingsthat exceeded 30% of total shareholders' equity. --------------------------------------------------------------------------------December 31 2006 2005-------------------------------------------------------------------------------- (in millions)Federal funds purchased (day to day) .................. $ 77 $ 57Securities sold under repurchase agreements ........... 1,328 1,273Commercial paper ...................................... 2,414 2,620Precious metals ....................................... 1,146 1,812Other ................................................. 108 605 --------- ---------Total short-term borrowings ........................... $ 5,073 $ 6,367 ========= ========= In July 2006, HUSI's unused $2 billion line of credit from HSBC FinanceCorporation expired and was not renewed. At December 31, 2006, HUSI had an unused line of credit from HSBC of $2 billion.This line of credit does not require compensating balance arrangements andcommitment fees are not significant. The interest rate is comparable to thirdparty rates for a line of credit with similar terms. At December 31, 2006, HUSI had an unused line of credit from its parent, HSBCNorth America Inc., of $150 million. The interest rate is comparable to thirdparty rates for a line of credit with similar terms. As a member of the New York Federal Home Loan Bank (FHLB), HUSI has a securedborrowing facility, which is collateralized by residential mortgage loans. AtDecember 31, 2006 and 2005, the facility included $5 billion of borrowingsincluded in long-term debt (see Note 15). The facility also allows access tofurther short-term borrowings based upon the amount of residential mortgageloans pledged as collateral with the FHLB, which were undrawn as of December 31,2006 and 2005. 126 Note 15. Long-Term Debt-------------------------------------------------------------------------------- The composition of long-term debt is presented in the following table. Interestrates on floating rate notes are determined periodically by formulas based oncertain money market rates or, in certain instances, by minimum interest ratesas specified in the agreements governing the issues. Interest rates in effect atDecember 31, 2006 are shown in parentheses. --------------------------------------------------------------------------------------------------------------December 31 2006 2005-------------------------------------------------------------------------------------------------------------- (in millions) Issued by HUSI or its subsidiaries other than HBUS:Non-subordinated debt: Medium-Term Floating Rate Notes due 2007-2011 (5.14% - 5.38%) .................... $ 53 $ -- 8.375% Debentures due 2007 ....................................................... 100 101 Floating Rate Extendible Notes due 2008-2011 (5.35%) ............................. 1,499 1,497 --------- --------- 1,652 1,598Subordinated debt: 7% Subordinated Notes due 2006 ................................................... -- 300 Fixed Rate Subordinated Notes due 2008-2097 (5.88% - 9.70%) ...................... 1,496 1,501 Perpetual Capital Notes (5.69%) .................................................. 127 126 Junior Subordinated Debentures due 2026-2032 (7.53% - 8.38%) ..................... 1,061 1,070 --------- --------- 2,684 2,997 --------- --------- Total issued by HUSI or its subsidiaries other than HBUS ............................ 4,336 4,595 --------- --------- Issued or acquired by HBUS or its subsidiaries:Non-subordinated debt:Global Bank Note Program: Medium-Term Floating Rate Notes due 2007-2040 (5.14% - 5.63%) .................... 2,108 1,544 3.875% Fixed Rate Senior Global Bank Notes due 2009 .............................. 1,943 1,940 5.43% Fixed Rate Senior Global Bank Notes due 2009 ............................... 20 -- Floating Rate Senior Global Bank Notes due 2007-2009 (5.42% - 5.49%) ............. 4,646 8,890 Floating Rate Non-USD Global Bank Notes due 2008-2009 (3.54% - 3.56%) ............ 1,328 1,191 Floating Rate/Fixed Rate Senior Notes due 2012 (5.86%) ........................... 25 25 --------- --------- 10,070 13,590Federal Home Loan Bank of New York (FHLB) advances: Fixed Rate FHLB advances due 2007-2033 (2.01% - 7.24%) ........................... 10 8 Floating Rate FHLB advances due 2007-2036 (5.36% - 5.38%) ........................ 5,000 5,000 --------- --------- 5,010 5,008 Private Label Credit Card Secured Financing due 2007-2008 (5.49% - 6.52%), refer to Note 9 ........................................................................... 2,134 1,500 Precious Metal Leases due 2007-2014 (0.10%-1.70%) ................................... 729 683 Obligations of consolidated Variable Interest Entities due 2010-2035 (5.26% - 5.96%), refer to Note 27 ................................................................. 2,542 954 Other: 5.99% Fixed Rate Note due 2011 ................................................... 350 -- Floating Rate Note due 2011 (5.86%) .............................................. 4 -- 6.60% Fixed Rate Note due 2021 ................................................... 858 -- 3.99% Non-USD Senior Debt due 2044 ............................................... 530 481 Other ............................................................................ 34 40 --------- --------- 1,776 521 --------- ---------Total non-subordinated debt ......................................................... 22,261 22,256 --------- --------- Subordinated debt: 4.625% Global Subordinated Notes due 2014 ........................................ 995 994Global Bank Note Program: Fixed Rate Global Bank Notes due 2034-2035 (5.63% - 5.88%) ....................... 1,643 1,731 --------- ---------Total subordinated debt ............................................................. 2,638 2,725 --------- --------- Total issued or acquired by HBUS or its subsidiaries ................................ 24,899 24,981 --------- --------- Obligations under capital leases .................................................... 17 19 --------- --------- Total long-term debt ................................................................ $ 29,252 $ 29,595 ========= ========= 127 The table excludes $1,250 million of debt issued by HBUS or its subsidiariespayable to HUSI. Of this amount, the earliest note is due to mature in October2008 and the latest note is due to mature in 2097. Debt Issued by HUSI or its Subsidiaries other than HBUS In April 2006, HUSI filed an S-3 Shelf Registration Statement (the 2006 shelf)with the Securities and Exchange Commission. Under the 2006 shelf, HUSI mayissue debt securities or preferred stock, either separately or represented bydepositary shares, warrants, purchase contracts and units comprised of anycombination of one or more of the aforementioned securities. The 2006 shelf,which has no dollar limit, replaced a shelf filed in 2005 in the amount of $2.3billion. The Medium-Term Floating Rate Notes due 2007-2011 were issued under the2006 shelf. The $1.5 billion Floating Rate Extendible Notes were issued by HUSI in November2005. These senior debt securities require the noteholders to decide each monthwhether or not to extend the maturity date of their notes by one month beyondthe initial maturity date of December 15, 2006. In no event will the maturity ofthe notes be extended beyond December 15, 2011, the final maturity date. If onany election date a noteholder decides not to extend the maturity of all or anyportion of the principal amount of his notes, the notes will mature on thepreviously elected maturity date, which will be the maturity date that is twelvemonths from the current election date. On the December 2006 election date, allnoteholders elected to extend the maturity date of their notes to January 15,2008. The notes are not subject to redemption by HUSI prior to the finalmaturity date. Interest is payable on the notes in arrears on the 15th day ofeach month, commencing December 15, 2005 and ending on the final maturity date.The interest rate will be determined by reference to the one-month LIBOR, plusor minus the applicable spread for that particular interest period. The spreadfor each interest period ranges from minus 2 basis points for the interestperiod ending December 15, 2006 to plus 3 basis points for the interest periodending December 15, 2011. Debt Issued by HBUS or its Subsidiaries In December 2006, HBUS increased the size of its Global Bank Note Program from$20 billion to $40 billion. The Global Bank Note Program provides for theissuance of fixed rate and floating rate, senior and subordinated notes. Thefollowing debt issues were made under this program in 2006 and 2005. o In November 2006, HBUS issued the $20 million 5.43% Senior Notes due 2009. Interest is paid semiannually on May 20 and November 20 of each year, commencing on May 20, 2007 and ending on the stated maturity date of November 20, 2009. HBUS may redeem the notes, in whole but not in part, on November 20, 2007. o Certain Medium-Term Floating Rate Notes issued in 2006 meet the definition of hybrid financial instruments under SFAS 155, which was adopted in 2006 (see Note 2). Medium-Term Floating Rate Notes totaling $900 million at December 31, 2006 are being carried at fair value. o In June 2005, HBUS issued the $25 million Floating Rate/Fixed Rate Senior Notes due 2012. Interest on the notes is paid quarterly commencing September 29, 2005. For each interest payment period in the period from (and including) June 29, 2005 to (but excluding) the interest payment date falling on June 29, 2007, the interest rate is determined by reference to the three month LIBOR plus 0.50% per annum. For each interest payment period in the period from (and including) June 29, 2007 to (but excluding) the stated maturity date of June 29, 2012, the interest rate is 4.95% per annum. HBUS may redeem the notes, in whole but not in part, on June 29, 2007. o In August 2005, HBUS issued $750 million 5.625% Subordinated Notes due 2035. Interest is paid semiannually on February 15 and August 15 of each year, commencing February 15, 2006 and ending on the stated maturity date of August 15, 2035. These notes may not be redeemed by HBUS. Other includes certain notes totaling $1.2 billion at December 31, 2006, whichresulted from a 2006 structured financing transaction. 128 As of December 31, 2006, the contractual scheduled maturities for totallong-term debt over the next five years are as follows. -------------------------------------------------------------------------------- (in millions)2007 ........................................................... $ 7,4672008 ........................................................... 4,0702009 ........................................................... 4,4762010 ........................................................... 1,0682011 ........................................................... 2,144 Note 16. Derivative Instruments and Hedging Activities-------------------------------------------------------------------------------- HUSI is party to various derivative financial instruments as an end user (1) forasset and liability management purposes; (2) in order to offset the riskassociated with changes in the value of various assets and liabilities accountedfor in the trading account; (3) to protect against changes in value of itsmortgage servicing rights portfolio; and (4) for trading in its own account. HUSI is also an international dealer in derivative instruments denominated inU.S. dollars and other currencies which include futures, forwards, swaps andoptions related to interest rates, foreign exchange rates, equity indices,commodity prices and credit, focusing on structuring of transactions to meetclients' needs. Fair Value Hedges Specifically, interest rate swaps that call for the receipt of a variable marketrate and the payment of a fixed rate are utilized under fair value strategies tohedge the risk associated with changes in the risk free rate component of thevalue of certain fixed rate investment securities. Interest rate swaps that callfor the receipt of a fixed rate and payment of a variable market rate areutilized to hedge the risk associated with changes in the risk free ratecomponent of certain fixed rate debt obligations. The regression method isutilized in order to satisfy the retrospective and prospective assessment ofhedge effectiveness for SFAS 133. HUSI recognized net gains (losses) of approximately $10 million, $2 million and$(3) million for the years ended December 31, 2006, 2005 and 2004, respectively,(reported as other income in the consolidated statement of income), whichrepresented the ineffective portion of all fair value hedges. Only the timevalue component of these derivative contracts has been excluded from theassessment of hedge effectiveness. For the years ended December 31, 2006 and 2005, $5 million and $7 million ofgains related to the basis adjustment of terminated and/or redesignated fairvalue hedge relationships were amortized to earnings. During 2007, HUSI expectsto amortize $6 million of remaining gains to earnings resulting from theseterminated and/or redesignated fair value hedges. Cash Flow Hedges Similarly, interest rate swaps and futures contracts that call for the paymentof a fixed rate are utilized under the cash flow strategy to hedge theforecasted repricing of certain deposit liabilities. In order to satisfy theretrospective and prospective assessment of hedge effectiveness for SFAS 133,the regression method is utilized. Ineffectiveness is recorded to the statementof income on a monthly basis. The total ineffectiveness of all cash flow hedges was less than $1 million foreach of the years ended December 31, 2006, 2005 and 2004. Only the time valuecomponent of these derivative contracts has been excluded from the assessment ofhedge effectiveness. 129 Gains or losses on derivative contracts that are reclassified from accumulatedother comprehensive income to current period earnings pursuant to this strategy,are included in interest expense on deposit liabilities during the periods thatnet income is impacted by the underlying liabilities. As of December 31, 2006,approximately $7 million of deferred net gains on derivative instrumentsaccumulated in other comprehensive income are expected to be included inearnings during 2007. At December 31, 2006, the net unrealized loss on derivatives included inaccumulated other comprehensive income was $13 million, net of income taxes. Ofthis amount, the $64 million gain represents the effective portion of the netgains on derivatives that qualify as cash flow hedges, and the $77 million lossrelates to terminated and/or redesignated derivatives. For the years endedDecember 31, 2006 and 2005, respectively, $35 million and $34 million of gainsrelated to terminated and/or redesignated cash flow hedge relationships wereamortized to earnings from other comprehensive income. During 2007, HUSI expectsto amortize $11 million of remaining gains to earnings resulting from theseterminated and/or redesignated cash flow hedges. Trading and Other Activities HUSI enters into certain derivative contracts for purely trading purposes inorder to realize profits from short-term movements in interest rates, commodityprices, foreign exchange rates and credit spreads. In addition, certainderivative contracts are accounted for on a full mark to market basis throughcurrent earnings even though they were acquired for the purpose of protectingthe economic value of certain assets and liabilities. 130 Notional Values of Derivative Contracts The following table summarizes the notional values of derivative contracts. ------------------------------------------------------------------------------------------December 31 2006 2005------------------------------------------------------------------------------------------ (in millions)Interest rate: Futures and forwards .................................... $ 94,204 $ 106,826 Swaps ................................................... 1,906,688 1,674,091 Options written ......................................... 510,023 199,676 Options purchased ....................................... 544,026 217,095 ------------ ------------ 3,054,941 2,197,688 ------------ ------------Foreign exchange: Swaps, futures and forwards ............................. 394,621 308,264 Options written ......................................... 61,406 40,213 Options purchased ....................................... 63,795 40,959 Spot .................................................... 32,654 21,099 ------------ ------------ 552,476 410,535 ------------ ------------Commodities, equities and precious metals: Swaps, futures and forwards ............................. 43,620 48,702 Options written ......................................... 12,263 14,378 Options purchased ....................................... 16,115 16,127 ------------ ------------ 71,998 79,207 ------------ ------------ Credit derivatives ......................................... 816,422 391,814 ------------ ------------ Total ...................................................... $ 4,495,837 $ 3,079,244 ============ ============ The total notional amounts in the table above relate primarily to HUSI's tradingactivities. Notional amounts included in the table related to non-trading fairvalue, cash flow and economic hedging activities were $27 billion and $26billion at December 31, 2006 and 2005, respectively. Note 17. Income Taxes-------------------------------------------------------------------------------- Total income taxes were allocated as follows. ------------------------------------------------------------------------------------------------------Year Ended December 31 2006 2005 2004------------------------------------------------------------------------------------------------------ (in millions) To income before income taxes ........................................ $ 530 $ 566 $ 718To shareholders' equity as tax charge (benefit): Net unrealized losses on securities available for sale ............ (22) (111) (20) Unrealized (losses) gains on derivatives classified as cash flow hedges ............................................................ (106) 78 (30) Unrealized (losses) gains on interest-only strip receivables ...... (4) 4 -- Cumulative adjustment from adoption of new pension accounting pronouncement .................................................. (13) -- -- Foreign currency translation, net ................................. -- (4) 4 ------- ------- ------- $ 385 $ 533 $ 672 ======= ======= ======= The components of income tax expense follow. ------------------------------------------------------------------------------------------------------Year Ended December 31 2006 2005 2004------------------------------------------------------------------------------------------------------ (in millions) Current: Federal ........................................................... $ 466 $ 484 $ 455 State and local ................................................... 51 90 150 Foreign ........................................................... 18 7 17 ------- ------- -------Total current ........................................................ 535 581 622Deferred, primarily federal .......................................... (5) (15) 96 ------- ------- -------Total income tax expense ............................................. $ 530 $ 566 $ 718 ======= ======= ======= 131 The following table is an analysis of the difference between effective ratesbased on the total income tax provision attributable to pretax income and thestatutory U.S. Federal income tax rate. ------------------------------------------------------------------------------------------------------Year Ended December 31 2006 2005 2004------------------------------------------------------------------------------------------------------ Statutory rate ....................................................... 35.0% 35.0% 35.0%Increase (decrease) due to: State and local income taxes ...................................... 2.1 4.2 5.6 Release of tax reserves ........................................... (.7) (.3) (2.9) Tax exempt interest income ........................................ (.9) (.7) (.5) Low income housing and miscellaneous other tax credits ............ (1.8) (1.4) (.5) Other items ....................................................... .1 (.1) (.4) ------- -------- --------Effective income tax rate ............................................ 33.8% 36.7% 36.3% ======= ======== ======== The components of the net deferred tax position are presented in the followingtable. ------------------------------------------------------------------------------------------------------December 31 2006 2005------------------------------------------------------------------------------------------------------ (in millions) Deferred tax assets: Allowance for credit losses ................................................. $ 296 $ 322 Benefit accruals ............................................................ 100 96 Accrued expenses not currently deductible ................................... 80 55 Unrealized losses on securities available for sale .......................... 122 100 Net purchase discount on acquired companies ................................. (6) 39 Accrued pension cost ........................................................ 14 3 Premium on purchased receivables ............................................ 4 12 ------- ------- Total deferred tax assets ................................................ 610 627 ------- -------Less deferred tax liabilities: Lease financing income accrued .............................................. 7 13 Investment securities ....................................................... (20) 90 Accrued income on foreign bonds ............................................. -- 10 Deferred gain recognition ................................................... 34 31 Depreciation and amortization ............................................... 6 24 Interest and discount income ................................................ 168 227 Deferred fees/costs ......................................................... 97 87 Mortgage servicing rights ................................................... 177 137 Other ....................................................................... 40 6 ------- ------- Total deferred tax liabilities ........................................... 509 625 ------- ------- Net deferred tax asset ................................................... $ 101 $ 2 ======= ======= Realization of deferred tax assets is contingent upon the generation of futuretaxable income or the existence of sufficient taxable income within thecarryback period. Based upon the level of historical taxable income and thescheduled reversal of the deferred tax liabilities over the periods in which thedeferred tax assets are deductible, management believes that it is more likelythan not HUSI would realize the benefits of these deductible differences. In July 2006, the FASB issued FASB Interpretation No. 48, Accounting forUncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (FIN48). FIN 48 establishes threshold and measurement attributes for financialstatement recognition of tax positions taken or expected to be taken on a taxreturn. FIN 48 also provides guidance on derecognition, classification, interestand penalties, accounting in interim periods, disclosure and transition. FIN 48is effective for fiscal years beginning after December 15, 2006. The adoption ofFIN 48 will not have an impact on the financial results of HUSI. The adoption ofFIN 48 will result in the recognition of additional current tax liabilities andoffsetting deferred tax assets of $11 million. 132 Note 18. Preferred Stock-------------------------------------------------------------------------------- The following table presents information related to the issues of preferredstock outstanding. -------------------------------------------------------------------------------------------------------------------- Amount Shares Dividend Outstanding Outstanding Rate ------------------------December 31 2006 2006 2006 2005-------------------------------------------------------------------------------------------------------------------- ($ in millions) Floating Rate Non-Cumulative Preferred Stock, Series F ($25 stated value) ........................................ 20,700,000 5.910% $ 517 $ 51714,950,000 Depositary Shares each representing a one-fortieth interest in a share of Floating Rate Non-Cumulative Preferred Stock, Series G ($1,000 stated value) ..................................... 373,750 5.910 374 37414,950,000 Depositary Shares each representing a one-fortieth interest in a share of 6.50% Non-Cumulative Preferred Stock, Series H ($1,000 stated value) ........... 373,750 6.500 374 --6,000,000 Depositary shares each representing a one-fourth interest in a share of Adjustable Rate Cumulative Preferred Stock, Series D ($100 stated value) ....................................... 1,500,000 4.500 150 150$2.8575 Cumulative Preferred Stock ($50 stated value) ........ 3,000,000 5.715 150 150Dutch Auction Rate Transferable Securities(TM) Preferred Stock (DARTS): Series A ($100,000 stated value) ....................... 625 4.154 63 63 Series B ($100,000 stated value) ....................... 625 4.215 62 62CTUS Inc. Preferred Stock .................................... 100 -- -- (1) -- (1) --------- --------- $ 1,690 $ 1,316 ========= =========(1) Less than $500 thousand Preferred Stock In May 2006, HUSI issued 14,950,000 depositary shares, each representingone-fortieth of a share of 6.50% Non-Cumulative Preferred Stock, Series H($1,000 stated value). Total issue proceeds, net of $9 million of underwritingfees and other expenses, were $365 million. When and if declared by HUSI's Boardof Directors, dividends of 6.50% per annum on the stated value per share will bepayable quarterly on the first calendar day of January, April, July and Octoberof each year. The Series H Preferred Stock may be redeemed at the option ofHUSI, in whole or in part, on or after July 1, 2011 at $1,000 per share, plusaccrued and unpaid dividends for the then-current dividend period. Dividends on the Floating Rate Non-Cumulative Series F Preferred Stock arenon-cumulative and will be payable when and if declared by the Board ofDirectors of HUSI quarterly on the first calendar day of January, April, Julyand October of each year. Dividends on the stated value per share are payablefor each dividend period at a rate equal to a floating rate per annum of .75%above three month LIBOR, but in no event will the rate be less than 3.5% perannum. The Series F Preferred Stock may be redeemed at the option of HUSI, inwhole or in part, on or after April 7, 2010 at a redemption price equal to $25per share, plus accrued and unpaid dividends for the then-current dividendperiod. Dividends on the Floating Rate Non-Cumulative Series G Preferred Stock arenon-cumulative and will be payable when and if declared by the Board ofDirectors of HUSI quarterly on the first calendar day of January, April, Julyand October of each year. Dividends on the stated value per share are payablefor each dividend period at a rate equal to a floating rate per annum of .75%above three month LIBOR, but in no event will the rate be less than 4% perannum. The Series G Preferred Stock may be redeemed at the option of HUSI, inwhole or in part, on or after January 1, 2011 at a redemption price equal to$1,000 per share, plus accrued and unpaid dividends for the then-currentdividend period. 133 The Adjustable Rate Cumulative Preferred Stock, Series D is redeemable, as awhole or in part, at the option of HUSI at $100 per share (or $25 per depositaryshare), plus accrued and unpaid dividends. The dividend rate is determinedquarterly, by reference to a formula based on certain benchmark market interestrates, but will not be less than 4 1/2% or more than 10 1/2% per annum for anyapplicable dividend period. The $2.8575 Cumulative Preferred Stock may be redeemed at the option of HUSI, inwhole or in part, on or after October 1, 2007 at $50 per share, plus accrued andunpaid dividends. Dividends are paid quarterly. DARTS of each series are redeemable at the option of HUSI, in whole or in part,on any dividend payment date, at $100,000 per share, plus accrued and unpaiddividends. Dividend rates for each dividend period are set pursuant to anauction procedure. The maximum applicable dividend rates on the shares of DARTSrange from 110% to 150% of the 60 day "AA" composite commercial paper rate. HUSI acquired CTUS Inc., a unitary thrift holding company in 1997 from CTFinancial Services Inc. (the Seller). CTUS owned First Federal Savings and LoanAssociation of Rochester (First Federal). The acquisition agreement providedthat HUSI issue preferred shares to the Seller. The preferred shares providefor, and only for, a contingent dividend or redemption equal to the amount ofrecovery, net of taxes and costs, if any, by First Federal resulting from thepending action against the United States government alleging breaches by thegovernment of contractual obligations to First Federal following passage of theFinancial Institutions Reform, Recovery and Enforcement Act of 1989. HUSI issued100 preferred shares at a par value of $1.00 per share in connection with theacquisition. 134 Note 19. Retained Earnings and Regulatory Capital Requirements-------------------------------------------------------------------------------- Bank dividends are a major source of funds for payment by HUSI of shareholderdividends and along with interest earned on investments, cover HUSI's operatingexpenses which consist primarily of interest on outstanding debt. The approvalof the OCC is required if the total of all dividends declared by HBUS in anyyear exceeds the net profits for that year, combined with the retained profitsfor the two preceding years. Under a separate restriction, payment of dividendsis prohibited in amounts greater than undivided profits then on hand, afterdeducting actual losses and bad debts. Bad debts are debts due and unpaid for aperiod of six months unless well secured, as defined, and in the process ofcollection. Under the more restrictive of the above rules, as of December 31, 2006, HBUS canpay dividends to HUSI of approximately $1.6 billion, adjusted by the effect ofits net income (loss) for 2007 up to the date of such dividend declaration. Additional information regarding regulation, supervision and capital for HUSIand HBUS begins on page 11 of this Form 10-K. Capital amounts and ratios of HUSI and HBUS, calculated in accordance withbanking regulations, are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- 2006 2005 ------------------------------------ -------------------------------------- Capital Well-Capitalized Actual Capital Well-Capitalized ActualDecember 31 Amount Minimum Ratio Ratio Amount Minimum Ratio Ratio----------------------------------------------------------------------------------------------------------------------- ($ in millions) Total capital (to risk weighted assets): HUSI ............................ $ 15,501 10.00% 12.58% $ 14,808 10.00% 12.53% HBUS ............................ 14,998 10.00 12.23 14,464 10.00 12.32Tier 1 capital (to risk weighted assets): HUSI ............................ 10,577 6.00 8.58 9,746 6.00 8.25 HBUS ............................ 10,278 6.00 8.38 9,737 6.00 8.29Tier 1 capital (to average assets): HUSI ............................ 10,577 3.00 6.36 9,746 3.00 6.51 HBUS ............................ 10,278 5.00 6.29 9,737 5.00 6.61Risk weighted assets: HUSI ............................ 123,262 118,145 HBUS ............................ 122,652 117,382 135 Note 20. Accumulated Other Comprehensive Income-------------------------------------------------------------------------------- Accumulated other comprehensive income includes certain items that are reporteddirectly within a separate component of shareholders' equity. The followingtable presents changes in accumulated other comprehensive income balances. ---------------------------------------------------------------------------------------------- 2006 2005 2004---------------------------------------------------------------------------------------------- (in millions) Unrealized (losses) gains on available for sale securities:Balance, January 1 ............................................. $ (128) $ 21 $ 61 Increase (decrease) in fair value, net of taxes of $10, $71 and $(19), in 2006, 2005 and 2004, respectively ........... (55) (94) 14 Net gains on sale of securities reclassified to net income, net of taxes of $12, $40 and $39 in 2006, 2005 and 2004, respectively .............................................. (16) (55) (54) ------- ------- ------ Net change .................................................. (71) (149) (40) ------- ------- ------Balance, December 31 ........................................... (199) (128) 21 ======= ======= ====== Unrealized (losses) gains on derivatives classified as cash flow hedges:Balance, January 1 ............................................. 98 (6) 52 Change in unrealized gain (loss) net of taxes of $106, $(78) and $30 in 2006, 2005 and 2004, respectively .............. (106) 104 (58) ------- ------- ------ Net change .................................................. (106) 104 (58) ------- ------- ------Balance, December 31 ........................................... (8) 98 (6) ======= ======= ====== Unrealized gains on interest-only strip receivables:Balance, January 1 ............................................. 7 -- -- Change in unrealized gains on interest-only strip receivables, net of taxes of $4 and $(4) in 2006 and 2005, respectively .............................................. (7) 7 -- ------- ------- ------ Net change .................................................. (7) 7 -- ------- ------- ------Balance, December 31 ........................................... -- 7 -- ======= ======= ====== Foreign currency translation adjustments:Balance, January 1 ............................................. 11 16 15 Translation gains, net of taxes of $4 and $(4) in 2005 and 2004, respectively ........................................ * (5) 1 ------- ------- ------ Net change .................................................. -- (5) 1 ------- ------- ------Balance, December 31 ........................................... 11 11 16 ======= ======= ====== Unfunded postretirement benefits liability:Balance, January 1 ............................................. -- -- -- Cumulative effect of change in accounting for pension and postretirement benefits, net of taxes of $13 in 2006 ...... (18) -- -- ------- ------- ------ Net change .................................................. (18) -- -- ------- ------- ------Balance, December 31 ........................................... (18) -- -- ======= ======= ====== Summary of accumulated other comprehensive (loss) income:Accumulated other comprehensive (loss) income, January 1 ....... (12) 31 128Other comprehensive loss, net of tax ........................... (184) (43) (97)Cumulative effect of change in accounting for pension and postretirement benefits, net of tax .......................... (18) -- -- ------- ------- ------Accumulated other comprehensive (loss) income, December 31 ..... $ (214) $ (12) $ 31 ======= ======= ====== * Less than $500 thousand. 136 Note 21. Related Party Transactions-------------------------------------------------------------------------------- In the normal course of business, HUSI conducts transactions with HSBC and itsaffiliates (HSBC affiliates). These transactions occur at prevailing marketrates and terms. All extensions of credit by HUSI to other HSBC affiliates arelegally required to be secured by eligible collateral. The following tablepresents related party balances and the income and expense generated by relatedparty transactions. ----------------------------------------------------------------------------------------------------December 31 2006 2005 2004---------------------------------------------------------------------------------------------------- (in millions) Assets: Cash and due from banks ..................................... $ 179 $ 121 $ 182 Interest bearing deposits with banks ........................ 59 67 283 Federal funds sold and securities purchased under resale agreements ................................................ 141 111 47 Trading assets .............................................. 6,895 5,386 3,167 Loans ....................................................... 1,042 1,901 1,378 Other ....................................................... 1,192 78 126 --------- --------- --------- Total assets ................................................ $ 9,508 $ 7,664 $ 5,183 ========= ========= ========= Liabilities: Deposits .................................................... $ 12,232 $ 10,131 $ 9,764 Trading liabilities ......................................... 6,473 4,545 5,748 Short-term borrowings ....................................... 464 698 1,089 Other ....................................................... 255 106 28 --------- --------- --------- Total liabilities ........................................... $ 19,424 $ 15,480 $ 16,629 ========= ========= ========= ----------------------------------------------------------------------------------------------------December 31 2006 2005 2004---------------------------------------------------------------------------------------------------- (in millions) Interest income ................................................ $ 51 $ 40 $ 20Interest expense ............................................... 408 293 119Other revenues: Gains on sales of loans to HMUS ............................. 106 18 -- Other HSBC affiliates income ................................ 102 112 147Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation ....................... 452 415 35 Fees paid to HMUS ........................................... 227 162 114 Fees paid to HSBC Technology & Services (USA) Inc. (HTSU) for technology services ................................... 235 216 172 Fees paid to other HSBC affiliates .......................... 162 126 99 137 Transactions Conducted with HSBC Finance Corporation Credit Card Receivables and Other Loan Transactions o In December 2004, HUSI acquired a private label receivable portfolio from HSBC Finance Corporation, which primarily included credit card receivables and retained interests associated with securitized credit card receivables. HSBC Finance Corporation retained and continues to service the customer relationships, for which they charged HUSI servicing fees of $367 million and $379 million for the year ended December 31, 2006 and 2005, respectively. In July 2004, HUSI sold certain MasterCard(1)/Visa(2) credit card relationships to HSBC Finance Corporation, but retained the receivable balances associated with these relationships. By agreement, HUSI is purchasing receivables generated by these private label and MasterCard/Visa customer relationships at fair value on a daily basis. Premiums paid are being amortized to interest income over the estimated life of the receivables purchased. Since the original private label receivables acquisition and MasterCard/Visa relationship sale, the underlying customer balances included within these portfolios have revolved, and new private label relationships have been added. Activity related to these portfolios is summarized in the following table. ----------------------------------------------------------------------------------------------------- Private Label MasterCard/Visa ----------------------- ---------------------For the year ended December 31 2006 2005 2006 2005----------------------------------------------------------------------------------------------------- (in millions) Receivables acquired from HSBC Finance Corporation: Balance at beginning of period .............. $ 14,355 $ 10,936 $ 1,159 $ 1,142 Receivables acquired ........................ 21,591 21,029 2,317 2,055 Customer payments, net charge offs and other activity ............................ (18,973) (17,610) (2,189) (2,038) --------- ---------- --------- --------- Balance at end of period .................... $ 16,973 $ 14,355 $ 1,287 $ 1,159 ========= ========== ========= ========= Premiums paid to HSBC Finance Corporation: Unamortized balance at beginning of period .. $ 320 $ 624 $ 12 $ 11 Premiums paid ............................... 367 411 39 34 Amortization ................................ (499) (715) (36) (33) --------- ---------- --------- --------- Unamortized balance at end of period ........ $ 188 $ 320 $ 15 $ 12 ========= ========== ========= ========= Other Transactions with HSBC Finance Corporation o Support services from HSBC affiliates include charges by HSBC Finance Corporation under various service level agreements for loan origination and servicing as well as other operational and administrative support. o HBUS is the originating lender for a federal income tax refund anticipation loan program for clients of various third party tax preparers, which is managed by HSBC Finance Corporation. By agreement, HBUS processes applications, funds and subsequently sells these loans to HSBC Finance Corporation. During 2006, primarily during the first quarter, approximately $16.1 billion of loans were originated by HBUS and sold to HSBC Finance Corporation, resulting in gains of approximately $22 million and fees paid to HSBC Finance Corporation of $4 million. For 2005, $15.1 billion of loans were sold to HSBC Finance Corporation, resulting in gains of $19 million and fees paid of $4 million. o In July 2006, HUSI's unused $2 billion line of credit with HSBC Finance Corporation expired and was not renewed. ----------(1) MasterCard is a registered trademark of MasterCard International, Incorporated. (2) Visa is a registered trademark of Visa USA, Inc. 138 Transactions Conducted with HMUS o HUSI utilizes HMUS for broker dealer, debt underwriting, customer referrals and for other treasury and traded markets related services, pursuant to service level agreements. Debt underwriting fees charged by HMUS are deferred as a reduction of long-term debt and amortized to interest expense over the life of the related debt. Preferred stock issuance costs charged by HMUS are recorded as a reduction of capital surplus. Customer referral fees paid to HMUS are netted against customer fee income, which is included in other fees and commissions. All other fees charged by HMUS are included in support services from HSBC affiliates. o In June 2005, HUSI began acquiring residential mortgage loans, excluding servicing, from unaffiliated third parties and subsequently selling these acquired loans to HMUS. HUSI maintains no ownership interest in the residential mortgage loans after sale. During 2006, HUSI sold $16 billion of loans to HMUS for total gains on sale of $106 million, which are included in other revenues. For 2005, HUSI sold approximately $2 billion of loans to HMUS for total gains on sale of $18 million. Refer to page 9 of this Form 10-K for further information regarding this program. Other Transactions with HSBC Affiliates At December 31, 2006, HUSI had an unused line of credit with HSBC of $2 billion. HUSI has extended loans and lines of credit to various other HSBC affiliatestotaling $1.4 billion, of which $172 million was outstanding at December 31,2006. HUSI routinely enters into derivative transactions with HSBC Finance Corporationand other HSBC affiliates as part of a global HSBC strategy to offset interestrate or other market risks associated with debt issues, derivative contracts orother financial transactions with unaffiliated third parties. At December 31,2006 and December 31, 2005, the aggregate notional amounts of all derivativecontracts with other HSBC affiliates were approximately $772 billion and $570billion, respectively. The net credit risk exposure (defined as the recordedfair value of derivative receivables) related to these contracts wasapproximately $7 billion and $5 billion at December 31, 2006 and 2005,respectively. HUSI, within its Corporate, Investment Banking and Marketsbusiness, accounts for these transactions on a mark to market basis, with thechange in value of contracts with HSBC affiliates substantially offset by thechange in value of related contracts entered into with unaffiliated thirdparties. Domestic employees of HUSI participate in a defined benefit pension plansponsored by HNAH. Additional information regarding pensions is provided in Note23 of these consolidated financial statements, beginning on page 142 of thisForm 10-K. Employees of HUSI participate in one or more stock compensation plans sponsoredby HSBC. HUSI's share of the expense of these plans on a pre-tax basis for theyear ended December 31, 2006 and 2005 was approximately $74 million and $51million, respectively. As of December 31, 2006, HUSI's share of compensationcost related to nonvested stock compensation plans was approximately $90million, which is expected to be recognized over a weighted-average period of1.6 years. A description of these stock compensation plans begins on page 140 ofthis Form 10-K. During 2005, HUSI sold shares in a foreign equity fund to an HSBC affiliate fora gain of $48 million. 139 This information is provided by RNS The company news service from the London Stock Exchange More to Follow