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HSBC Holdings PLC06 March 2006 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One) |X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number 1-7436 HSBC USA Inc. (Exact name of registrant as specified in its charter) Maryland 13-2764867 (State of Incorporation) (I.R.S. Employer Identification No.) 452 Fifth Avenue, New York, New York 10018(Address of principal executive offices) (Zip Code) (716) 841-2424 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Name of Each Exchange on Which Registered ------------------- ----------------------------------------- Depositary Shares (each representing a one-fourth share of New York Stock Exchange Adjustable Rate Cumulative Preferred Stock, Series D) $2.8575 Cumulative Preferred Stock New York Stock Exchange Floating Rate Non-Cumulative Preferred Stock, Series F New York Stock ExchangeDepositary Shares (each representing a one-fortieth share of New York Stock Exchange Floating Rate Non-Cumulative Preferred Stock, Series G) 7% Subordinated Notes due 2006 New York Stock Exchange 8.375% Debentures due 2007 New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, asdefined in Rule 405 of the Securities Act. Yes |X| No |_| Indicate by check mark if the registrant is not required to file reportspursuant to Section 13 or Section 15(d) of the Act. Yes |_| No |X| Indicate by check mark whether the registrant (1) had filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes |X| No |_| Indicate by check mark if disclosure of delinquent filers pursuant to Item 405of Regulation S-K is not contained herein, and will not be contained, to thebest of registrant's knowledge, in definitive proxy or information statementsincorporated by reference in Part III of the Form 10-K or any amendment to thisForm 10-K. |X| Indicate by check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer. See definition of "acceleratedfiler and a large accelerated filer" in Rule 12b-2 of the Exchange Act. (Checkone): Large accelerated filer |_| Accelerated filer |_| Non-accelerated filer |X| Indicate by check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Act). Yes |_| No |X| At February 28, 2006, all voting stock (706 shares of Common Stock $5 par value)is owned by an indirect wholly owned subsidiary of HSBC Holdings plc. DOCUMENTS INCORPORATED BY REFERENCE None================================================================================ HSBC USA Inc. Form 10-K TABLE OF CONTENTS Part I------------------------------------------------------------------------------------------------------------------------ Page Item 1. Business History ................................................................................... 4 Description of Operations and Business Segments ........................................... 4 2005 Developments and Trends .............................................................. 6 Geographic Distribution of Assets and Earnings ............................................ 8 Regulation, Supervision and Capital ....................................................... 8 Competition ............................................................................... 11 Corporate Governance ...................................................................... 11 Cautionary Statement on Forward-Looking Statements ........................................ 12 Statistical Disclosure by Bank Holding Companies: Average Balance Sheets and Interest Earned and Paid ................................... 79 Changes in Interest Income and Expense Attributable to Changes in Rate and Volume .............................................................................. 30 Securities Portfolios ................................................................. 99 Loans Outstanding: Composition and Maturities ........................................................ 27 Risk Elements in the Loan Portfolio ............................................... 53-55, 104 Summary of Loan Loss Experience ....................................................... 56 Deposits .............................................................................. 109 Short-Term Borrowings ................................................................. 110Item 1A. Risk Factors .................................................................................. 13Item 1B. Unresolved Staff Comments ..................................................................... 14Item 2. Properties .................................................................................... 14Item 3. Legal Proceedings ............................................................................. 14Item 4. Submission of Matters to a Vote of Security Holders ........................................... 14 Part II------------------------------------------------------------------------------------------------------------------------ Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters ..................... 14Item 6. Selected Financial Data ....................................................................... 15Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Executive Overview ........................................................................ 16 Basis of Reporting ........................................................................ 17 Critical Accounting Policies .............................................................. 22 Balance Sheet Review ...................................................................... 26 Results of Operations ..................................................................... 30 Business Segments ......................................................................... 46 Credit Quality ............................................................................ 53 Off-Balance Sheet Arrangements and Contractual Obligations ................................ 59 Risk Management ........................................................................... 62 Glossary of Terms ......................................................................... 77Item 7A. Quantitative and Qualitative Disclosures About Market Risk .................................... 78Item 8. Financial Statements and Supplementary Data ................................................... 81Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure .......... 142Item 9A. Controls and Procedures ....................................................................... 142 2 Part III------------------------------------------------------------------------------------------------------------------------ Page Item 10. Directors and Executive Officers of the Registrant ............................................ 143Item 11. Executive Compensation ........................................................................ 147Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Matters ............ 152Item 13. Certain Relationships and Related Transactions ................................................ 153Item 14. Principal Accounting Fees and Services ........................................................ 153 Part IV------------------------------------------------------------------------------------------------------------------------ Item 15. Exhibits and Financial Statement Schedules .................................................... 154 3 P A R T I-------------------------------------------------------------------------------- Item 1. Business-------------------------------------------------------------------------------- History HSBC USA Inc., incorporated under the laws of Maryland, is a New York Statebased bank holding company registered under the Bank Holding Company Act of1956, as amended. HSBC USA Inc. and its subsidiaries are collectively referredto as "HUSI". HUSI's origin was in Buffalo, New York in 1850 as The Marine TrustCompany, which later became Marine Midland Banks, Inc. (Marine). In 1980, TheHongkong and Shanghai Banking Corporation Limited (now HSBC Holdings plc,hereinafter referred to as "HSBC") acquired 51% of the common stock of Marineand the remaining 49% of common stock in 1987. In December 1999, HSBC acquiredRepublic New York Corporation (Republic) and merged it with HUSI. At the mergerdate, Republic and HUSI had total assets of approximately $47 billion and $43billion respectively. Through its affiliation with HSBC, HUSI offers its customers access to globalmarkets and services. In turn, HUSI plays a role in the delivery and processingof other HSBC products. HSBC is one of the largest banking and financialservices organizations in the world. Headquartered in London, England, HSBC'sinternational network comprises over 9,800 offices in 77 countries andterritories in Europe, the Asia-Pacific region, North America, South America,the Middle East and Africa. Effective January 1, 2004, HSBC created a new North American organizationalstructure with HSBC North America Holdings Inc. (HNAH) as the top-tier UnitedStates (U.S.) bank holding company. At December 31, 2005, HNAH was among the 10largest U.S. bank holding companies ranked by assets. HUSI routinely conductstransactions with other principal subsidiaries of HNAH, which include: o HSBC Bank Canada (HBCA), a Canadian banking subsidiary; o HSBC Finance Corporation (formerly Household International, Inc.), a consumer finance company; o HSBC Markets (USA) Inc. (HMUS), a holding company for investment banking and markets subsidiaries; and o HSBC Technology & Services (USA) Inc. (HTSU), a provider of information technology services. Description of Operations and Business Segments At December 31, 2005, HUSI had total assets of approximately $154 billion andapproximately 12,000 full and part time employees. HUSI is among the 15 largestbank holding companies in the United States (U.S.) ranked by assets. Through itsprincipal commercial banking subsidiary, HSBC Bank USA, National Association(HBUS), HUSI offers its three million customers a full range of commercialbanking products and services. Its customers include individuals, including highnet worth individuals, small businesses, corporations, institutions andgovernments. HBUS also engages in mortgage banking, and is an internationaldealer in derivative instruments denominated in U.S. dollars and othercurrencies, focusing on structuring of transactions to meet clients' needs aswell as for proprietary purposes. With total assets of $151 billion at December 31, 2005, HBUS is among the topten banks in the U.S. HBUS's main office is in Delaware, and its domesticoperations are primarily in New York State. It also has banking branch officesand/or representative offices in Florida, California, New Jersey, Delaware,Pennsylvania, Washington, Oregon, Massachusetts and Washington, D.C. In additionto its domestic offices, HBUS maintains foreign branch offices, subsidiariesand/or representative offices in the Caribbean, Europe, Asia, Latin America,Australia and Canada. HUSI has five distinct business segments that it utilizes for managementreporting and analysis purposes. The segments are based upon customer groupings,as well as products and services offered. The segments are described in thefollowing paragraphs. Analysis of financial results for HUSI's business segmentsbegins on page 46 of this Form 10-K. 4 The Personal Financial Services (PFS) Segment This segment provides a broad range of financial products and services includinginstallment and revolving term loans, deposits, branch services, mutual funds,investments and insurance. These products are marketed to individuals primarilythrough the branch banking network and increasingly through e-banking channels.Residential mortgage lending provides loan financing through direct retail andwholesale origination channels. Mortgage loans are originated through a networkof brokers, wholesale agents and retail origination offices. Servicing isperformed for the individual mortgage holder or on a contractual basis formortgages owned by third parties. The PFS segment continues to include MasterCard(1)/Visa(2) credit cardreceivables acquired on a daily basis, related to account relationships whichHUSI sold to HSBC Finance Corporation in 2004. The Consumer Finance (CF) Segment Effective for the first quarter of 2005, HUSI formed a new business segment,Consumer Finance (CF), which was reported as a component of PFS in priorperiods. The CF segment includes point of sale and other lending activitiesprimarily to meet the financial needs of individuals. Specifically, operatingactivity within the CF segment relates to various consumer loans, private labelcredit card receivables, and retained interests in securitized receivable trustspurchased from HSBC Finance Corporation, as well as consumer loans purchasedfrom originating lenders pursuant to HSBC Finance Corporation correspondent loanprograms. The Commercial Banking (CMB) Segment This segment provides loan and deposit products to small businesses andmiddle-market corporations including specialized products such as real estatefinancing. Various credit and trade related products such as standby facilities,performance guarantees and acceptances are also offered. These products andservices are offered through multiple delivery systems, including the branchbanking network. The Corporate, Investment Banking and Markets (CIBM) Segment This segment is comprised of Corporate/Institutional Banking (CIB) andInvestment Banking and Markets (IBM). CIB provides deposit and lending productsto large and multi-national corporations and banks. U.S. dollar clearingservices are offered for domestic and international wire transfer transactions.Credit and trade related products such as standby facilities, performanceguarantees and acceptances are also provided by CIB to large corporate entities.The IBM component includes treasury and traded markets. The treasury functionmaintains overall responsibility for the investment and borrowing of funds toensure liquidity, manage interest rate risk and capital at risk. Traded marketsencompasses the trading and sale of foreign exchange, banknotes, derivatives,precious metals, securities and emerging markets instruments, both domesticallyand internationally. The Private Banking (PB) Segment This segment offers a full range of services for high net worth domestic andforeign individuals including deposit, lending, trading, trust, branch services,mutual funds, insurance and investment management. Other Segment This segment includes equity investments in Wells Fargo HSBC Trade Bank N.A. andHSBC Republic Bank (Suisse) S.A. ----------(1) MasterCard is a registered trademark of MasterCard International,Incorporated. (2) Visa is a registered trademark of Visa USA, Inc. 5 2005 Developments and Trends 2005 Operations HUSI's 2005 net income of $976 million reflected a decrease of $282 million(22%) from the prior year. Analysis of the components of net income begins onpage 30 of this Form 10-K. Total assets increased $13 billion (9%) during 2005. Analysis of balance sheetgrowth and funding begins on page 26 of this Form 10-K. Credit Quality Issues HUSI's loan portfolio is comprised of consumer loans, which are primarilyincluded within the PFS and CF business segments, and commercial loans that areincluded within the CMB and CIBM segments. Increased provisions for credit losses during 2005 are primarily due tosignificant increases in consumer loan balances, most notably the private labelportfolio balances acquired from HSBC Finance Corporation in December 2004.Commercial loan credit quality has been exceptionally strong throughout 2004 and2005 with net charge offs and provisions well below historical levels. In August 2005, Hurricane Katrina (Katrina) caused destruction and loss toindividuals, businesses and public infrastructure. As of December 31, 2005, HUSIhad $232 million of consumer receivables outstanding with customers living inthe Federal Emergency Management Agency (FEMA) designated Individual Assistancedisaster areas(1). An incremental provision for credit losses of $10 million wasrecorded in the second half of 2005 for Katrina, which represents HUSI's bestestimate of Katrina's impact on the loan portfolio. Future net charge offs inthe CF business segment related to Katrina are not expected to be material.Various programs were initiated to assist customers affected by the disaster,including extended payment arrangements and interest and fee waivers for up to90 days or more for certain products depending on customer circumstances. Theseinterest and fee waivers totaled $7 million during 2005. Effective October 1, 2005, new bankruptcy legislation was enacted, resulting ina spike in bankruptcy filings for HUSI in the fourth quarter of the year. 2005results include an incremental provision for credit losses of $5 millionattributable to bankruptcy reform. The CF business segment does not expect amaterial increase in net charge offs in 2006 as a result of the enactment ofthis new legislation. Further analysis of credit quality begins on page 53 of this Form 10-K. Loan Trends Loan mix improved in 2005 with more emphasis being placed on higher yieldingcredit card receivables, small business loans, middle market loans andcommercial real estate loans. There also was an initiative to reduce residentialmortgage loans held for investment purposes. In December 2004, HUSI acquired approximately $12 billion of private labelreceivables and other loans from HSBC Finance Corporation at fair value, withoutrecourse. By agreement, HUSI is purchasing additional receivables generatedunder current and future private label credit card accounts at fair value on adaily basis. During 2005, underlying customer balances included within the private labelportfolio have revolved, and new relationships have been added, bringing thetotal private label portfolio balance to $15 billion at December 31, 2005.Losses before income tax expense of $233 million were realized from thisportfolio for the year ended December 31, 2005. Results in 2005 have beennegatively impacted by significant amortization of the premium paid for thesereceivables. ----------(1) Customers in the Individual Assistance Counties, as definedby FEMA on the list last updated and published on September 9, 2005 6 Further analysis regarding this acquired portfolio is included in the analysisof HUSI's CF segment, beginning on page 48 of this Form 10-K. Transactions with HSBC Finance Corporation and Other HSBC Affiliates In March 2003, HSBC completed its acquisition of Household International, Inc.In December 2004, Household International, Inc. changed its legal name to HSBCFinance Corporation. 2005 was highlighted by continued cooperation between HUSIand HSBC Finance Corporation to identify synergies in products and processes.Synergies have been achieved in loan origination and servicing, card processing,IT contingency rationalization, purchasing, call center cooperation, the shareduse of HSBC's service centers, and the consolidation of certain administrativefunctions. In addition, HSBC Finance Corporation's credit scoring anddata-mining technology has been made available to HUSI. HUSI and HSBC FinanceCorporation will continue to work cooperatively on product offerings andback-office operations. Since the end of 2003, HUSI has routinely purchased credit card receivables,residential mortgage loans and other loans from HSBC Finance Corporation, andfrom originating lenders pursuant to HSBC Finance Corporation correspondent loanprograms. In most cases, HSBC Finance Corporation retained the right to servicethese portfolios. Acquisitions of residential mortgage loans were discontinuedin 2005. Fees charged by HSBC Finance Corporation for loan origination andservicing expenses, which are primarily recorded in the CF segment, haveincreased significantly due to increased private label receivables and otherloans acquired from HSBC Finance Corporation and from their correspondents. HNAH's technology services in North America were centralized by the creation ofa new subsidiary, HSBC Technology & Services (USA) Inc. (HTSU), effectiveJanuary 1, 2004. HUSI's technology services employees, as well as technologyservices employees from other HSBC affiliates in the United States, weretransferred to HTSU. Technology related assets and software purchased subsequentto January 1, 2004 are generally purchased and owned by HTSU. Pursuant to amaster service level agreement, HTSU charges HUSI for technology services andsoftware development. Fees charged by HTSU to HUSI for technology servicesexpenses have increased in 2005, as HUSI continued to upgrade its automatedtechnology environment. HUSI obtains certain underwriting, broker-dealer and administrative supportservices from HSBC and various other affiliates. Fees charged by theseaffiliates for treasury and traded markets services provided to HUSI's CIBMsegment have increased in 2005 due primarily to business expansion initiatives. Details of these and other transactions with HSBC affiliates are presented inNote 20 of the consolidated financial statements beginning on page 122 of thisForm 10-K. Deposit Strategy and Growth Beginning in 2004, the deposit strategy for HUSI's retail network included ashifting emphasis toward building deposits over a three to five year period,across multiple markets and segments, utilizing multiple delivery systems.Specifically, the following were initiated: o full deployment of new personal and business checking and savings products; o emphasis on more competitive pricing with the introduction of high yielding products, including online savings accounts, which grew significantly late in 2005; o retail branch expansion into new geographic markets; o improving delivery systems, including use of internet capabilities; o refining targeting of the affluent consumer population; o maintaining strong customer relationships; and o increasing deposits from, and improving retention of, existing customers. HUSI experienced a successful rollout of its deposit strategy during 2005resulting in increased deposits of $12 billion during the year. 7 Other Matters During 2005, HUSI incorporated a new nationally chartered bank, HSBC TrustCompany (Delaware), National Association, whose operations are limited to trustactivities. This new bank, which received its charter on July 1, 2005 had animmaterial impact on HUSI's consolidated balance sheet and results of operationsfor 2005. Geographic Distribution of Assets and Earnings HUSI's foreign operations represented less than 6% of HUSI's consolidated totalassets at December 31, 2005 and 2004, and less than 7% of consolidated incomebefore income tax expense for 2005, 2004 and 2003. Regulation, Supervision and Capital Through June 30, 2004, HUSI and HBUS were supervised and routinely examined bythe State of New York Banking Department and the Board of Governors of theFederal Reserve System (the Federal Reserve). Effective July 1, 2004, HBUSbecame a nationally chartered bank and is primarily supervised by the Office ofthe Comptroller of the Currency (OCC). HUSI, as a bank holding company,continues to be supervised by the Federal Reserve. HUSI and HBUS are subject tobanking laws and regulations which place various restrictions on andrequirements regarding their operations and administration, including theestablishment and maintenance of branch offices, capital and reserverequirements, deposits and borrowings, investment and lending activities,payment of dividends and numerous other matters. The Federal Reserve Actrestricts certain transactions between banks and their nonbank affiliates. Sincethe deposits of HBUS are insured by the Federal Deposit Insurance Corporation(FDIC), HBUS is subject to relevant FDIC regulations. HBUS is required to maintain noninterest bearing cash reserves with the FederalReserve Bank, which averaged $709 million in 2005 and $730 million in 2004. HUSI and HBUS are subject to various regulatory capital requirementsadministered by federal banking agencies. Failure to meet minimum capitalrequirements can initiate certain mandatory actions, and possibly additionaldiscretionary actions by regulators. Under capital adequacy guidelines and theregulatory framework for prompt corrective action, specific capital guidelinesmust be met that involve quantitative measures of assets, liabilities, andcertain off-balance sheet items as calculated under regulatory accountingpractices. The capital amounts and classifications are also subject toqualitative judgments by the regulators about components, risk weightings andother factors. HUSI's capital resources are summarized on page 29 of this Form 10-K. Quantitative measures established by regulation to ensure capital adequacyrequire the maintenance of minimum amounts and ratios of total and Tier 1capital (as defined in banking regulations). Capital amounts and ratios for HUSIand HBUS are summarized in Note 18 of the consolidated financial statements onpage 119 of this Form 10-K. To be categorized as "well capitalized", a bankinginstitution must have the minimum ratios reflected in the table included in Note18 and must not be subject to a directive, order or written agreement to meetand maintain specific capital levels. From time to time, bank regulators propose amendments to or issueinterpretations of risk-based capital guidelines. Such proposals orinterpretations could, upon implementation, affect reported capital ratios andnet risk weighted assets. A new capital adequacy framework, which has beenproposed by U.S. regulators for implementation by January 1, 2009, is furtherdescribed under "Basel Capital Standards". 8 HBUS is subject to risk-based assessments from the FDIC, the U.S. Governmentagency that insures deposits in HBUS to a maximum of $100,000 per domesticdepositor. Depository institutions subject to assessment are categorized basedon capital ratios and other factors, with those in the highest rated categoriespaying no assessments. Because of its standing as a "well-capitalized",financially sound institution, HBUS has not been assessed by the FDIC in thepast three years. The Deposit Insurance Funds Act (DIFA) of 1996 authorized the FinancingCorporation (FICO), a U.S. Government corporation, to collect funds from FDICinsured institutions to pay interest on FICO bonds. The FICO assessment rate ineffect at December 31, 2005 was 1.34 percent of assessable deposits. The FICOassessment rate is adjusted quarterly. HBUS is subject to a quarterly FICOpremium. The USA Patriot Act (the Patriot Act), effective October 26, 2001, imposedsignificant record keeping and customer identity requirements, expanded thegovernment's powers to freeze or confiscate assets and increased the availablepenalties that may be assessed against financial institutions for violation ofthe requirements of the Patriot Act intended to detect and deter moneylaundering. The Patriot Act required the U.S. Treasury Secretary to develop andadopt final regulations with regard to the anti-money laundering complianceobligations on financial institutions (a term which includes insured U.S.depository institutions, U.S. branches and agencies of foreign banks, U.S.broker-dealers and numerous other entities). The U.S. Treasury Secretarydelegated certain authority to a bureau of the U.S. Treasury Department known asthe Financial Crimes Enforcement Network (FinCEN). Many of the anti-money laundering compliance requirements of the Patriot Act, asimplemented by FinCEN, are generally consistent with the anti-money launderingcompliance obligations that applied to HBUS under the Bank Secrecy Act andapplicable Federal Reserve Board regulations before the Patriot Act was adopted.These include requirements to adopt and implement an anti-money launderingprogram, report suspicious transactions and implement due diligence proceduresfor certain correspondent and private banking accounts. Certain other specificrequirements under the Patriot Act involve compliance obligations. The PatriotAct and other recent events have resulted in heightened scrutiny of Bank SecrecyAct and anti-money laundering compliance programs by the federal and state bankregulators. On April 30, 2003, HBUS entered into a written agreement with theFederal Reserve Bank of New York and the New York State Banking Department toenhance its compliance with anti-money laundering requirements. Due to thechange in primary regulators in 2004, this agreement is now subject toenforcement by the OCC. In response to this agreement, HBUS has increasedcompliance staff and has implemented certain improvements in its compliance,reporting, and review systems and procedures. On February 6, 2006, the OCCdetermined that HBUS had satisfied the requirements of the written agreement andtherefore terminated the agreement. Basel Capital Standards The Basel Committee on Banking Supervision (the Basel Committee) published itsrevised minimum capital adequacy framework (Basel II) in June 2004. Since itspublication, the U.S. regulators, including the Federal Reserve and the OCC,have been working to adopt the framework as the mandatory minimum capitalstandard for approximately 10 to 12 of the largest U.S. banks. As a bankingsubsidiary of HNAH, HUSI has been designated as a mandatory bank by the U.S.regulators and is required to adopt Basel II. In October 2004, the U.S. regulators asked the mandatory banks and severalothers to voluntarily participate in a Quantitative Impact Study (the QIS). Thepurpose of the QIS was to measure the change in minimum regulatory capitalrequirements for each bank using the current Basel I standard compared to theproposed regulation under Basel II. The results of the QIS, published in thesecond quarter of 2005, indicated that, on average, the minimum capitalrequirement of participating banks decreased by approximately 13%. In addition,the results were widely dispersed and lacked comparative consistency among theparticipating banks. 9 The original date to publish the new rules was mid-year 2005 for implementationon January 1, 2008. Subsequently, the U.S. regulators agreed that additionaltime was needed to better understand the QIS results and to amend, if necessary,the new rules accordingly. Consequently, they decided in April 2005 to delay thepublication of the new rules until the first quarter 2006. The regulators alsoagreed to analyze the results in light of industry concerns from smaller,non-mandatory banks that the new regulation would create advantages resultingfrom lower capital requirements for the few banks adopting Basel II. Thecombined effect of needing to amend the new rules for mandatory banks and theneed to address the issues raised by non-mandatory banks led to the decision inSeptember 2005, to delay the implementation date for Basel II by one year toJanuary 1, 2009. In October 2005, the U.S. regulators published a proposal to replace the currentrules under Basel I with a more risk sensitive framework (Basel IA) that wouldapply to all non-mandatory banks. The U.S. regulators have advised that the newrules for Basel IA and Basel II would be issued at approximately the same timein 2006. Despite the timing changes made by U.S. regulators, HUSI must be prepared toimplement Basel II according to the original schedule on January 1, 2008 to meetthe requirements of HSBC's principal regulator, the Financial Services Authorityin the United Kingdom. Sarbanes-Oxley Act of 2002, Section 404 Compliance As an SEC registrant of public debt and preferred shares, HUSI is required tocomply with the Sarbanes-Oxley Act of 2002 (the SarBox Act). Section 404 of theSarBox Act (Section 404) requires registrants and their auditors to assess andreport on internal controls over financial reporting on an annual basis. As aforeign registrant, HSBC is required to comply with Section 404 beginning in thefiscal year ending December 31, 2006. As a subsidiary of a foreign registrant,HUSI will support HSBC with its Section 404 compliance. Under the SEC's currentrules for non-accelerated filers, HUSI will be required to comply with Section404 for the fiscal year ending December 31, 2007. HUSI has adopted the internal control framework established by the Committee ofSponsoring Organizations of the Treadway Commission (COSO) to complete itsmanagement assessment of the effectiveness of internal controls over financialreporting in compliance with Section 404. Certain other financial reporting riskassessment factors have also been included to ensure adequate coverage ofsafeguarding of assets and anti-fraud risks. 10 Competition The Gramm-Leach-Bliley Act of 1999 (GLB Act), effective March 11, 2000,eliminated many of the regulatory restrictions on providing financial services.The GLB Act allows for financial institutions and other providers of financialproducts to enter into combinations that permit a single organization to offer acomplete line of financial products and services. Therefore, HUSI and itssubsidiaries face intense competition in all of the markets they serve,competing with both other financial institutions and non-banking institutionssuch as insurance companies, major retailers, brokerage firms and investmentcompanies. Following the enactment of the GLB Act, HUSI elected to be treated as afinancial holding company (FHC). As an FHC, HUSI's activities in the U.S. havebeen expanded enabling it to offer a more complete line of products andservices. HUSI's ability to engage in expanded financial activities as an FHCdepends upon its meeting certain criteria, including requirements that its U.S.depository institution subsidiary, HBUS, its forty percent owned subsidiary,Wells Fargo HSBC Trade Bank N.A., and its nationally chartered trust bank, HSBCTrust Company (Delaware), National Association, be well capitalized and wellmanaged, and that they have achieved at least a satisfactory record of meetingcommunity credit needs during their most recent examination pursuant to theCommunity Reinvestment Act. In general, an FHC would be required, upon notice bythe Federal Reserve Board, to enter into an agreement to correct any deficiencyin the requirements necessary to maintain its FHC election. Until suchdeficiencies are corrected, the Federal Reserve Board may impose limitations onthe conduct or activities of an FHC or any of its affiliates as it deemsappropriate. If such deficiencies are not corrected in a timely manner, theFederal Reserve Board may require an FHC to divest its control of any subsidiarydepository institution or to cease to engage in certain financial activities. Asof December 31, 2005, no known deficiencies exist, and HUSI is not subject tolimitations or penalties relative to its status as an FHC. Corporate Governance HUSI is committed to high standards of corporate governance. In February 2006,HUSI's Board of Directors adopted Governance Standards which, together with thecharters of committees of the Board of Directors, provide the framework for thecorporate governance of HUSI. As of December 31, 2005, HUSI's Board of Directorshad three primary committees to assist with corporate oversightresponsibilities. o Audit Committee - This committee's primary duties are to: (1) monitor the integrity of HUSI's financial reporting and risk management processes and systems of internal controls regarding finance, accounting, and legal compliance; (2) monitor the independence and performance of HUSI's internal and independent auditor; and (3) provide an avenue of communication among the independent auditor, management, the internal auditors, and the Board of Directors. o Human Resources Committee - This committee's primary duties are to: (1) review and make recommendations with respect to the appointment and compensation of such officers and employees as the Board by resolution shall from time to time determine, including incentive compensation programs; (2) review the organization's compensation philosophy; and (3) provide general oversight of management regarding human resources strategy and policy, major organizational changes, major human resources initiatives, executive management development and succession planning, and diversity initiatives. o Fiduciary Committee - This committee's primary duty is to supervise the fiduciary activities of the organization which includes evaluation of the following: (1) proper exercise of fiduciary powers; (2) adequacy of management, staffing, systems and facilities; (3) adequacy of ethical standards, strategic plans, policies and control procedures; (4) investment performance; (5) adequacy of risk management and compliance programs; and (6) regulatory examination and internal and external audit reports. 11 In January 2006, the Board of Directors changed the name of the Human ResourcesCommittee to the Human Resources and Compensation Committee, and alsoestablished a new committee: o Nominating & Governance Committee - This committee's primary duties are to: (1) identify director candidates and ensure that new directors receive appropriate orientation; (2) oversee the composition, structure, operation and evaluation of the Board and its committees; and (3) review and make recommendations regarding director compensation. The annual report on Form 10-K, quarterly reports on Form 10-Q, and currentreports on Form 8-K, as filed with the Securities and Exchange Commission (theSEC), are available on HUSI's website at www.us.hsbc.com. Cautionary Statement on Forward-Looking Statements Certain matters discussed throughout this Form 10-K constitute forward-lookingstatements within the meaning of the Private Securities Litigation Reform Act of1995. In addition, HUSI may make or approve certain statements in future filingswith the SEC, in press releases, or oral or written presentations byrepresentatives of HUSI that are not statements of historical fact and may alsoconstitute forward-looking statements. Words such as "may", "will", "should","would", "could", "believe", "do not believe", "no reason to believe","intends", "expects", "estimates", "targeted", "plans", "anticipates", "goal"and similar expressions are intended to identify forward-looking statements butshould not be considered as the only means through which these statements may bemade. These matters or statements will relate to future financial condition,results of operations, plans, objectives, performance or business developmentsand will involve known and unknown risks, uncertainties and other factors thatmay cause HUSI's actual results, performance or achievements to be materiallydifferent from that which was expressed or implied by such forward-lookingstatements. Forward-looking statements are based on current views andassumptions and speak only as of the date they are made. HUSI undertakes noobligation to update any forward-looking statement to reflect subsequentcircumstances or events. 12 Item 1A. Risk Factors-------------------------------------------------------------------------------- The important factors, many of which are out of HUSI's control, which couldaffect actual results and could cause results to vary materially from thoseexpressed in public statements or documents are: o changes in laws and regulations, including attempts by local, state and national regulatory agencies or offices or legislative bodies to control alleged "predatory" or discriminatory lending practices through broad or targeted initiatives aimed at lenders operating in consumer lending markets, including with respect to tax refund anticipation loans; o increased competition from well-capitalized companies or lenders with access to government sponsored organizations which may impact the terms, rates, costs or profits historically included in the loan products that HUSI offers or purchases; o changes in accounting or credit policies, practices or standards, as they may be internally modified from time to time or changes as may be required by regulatory agencies or the Financial Accounting Standards Board; o changes to operational practices from time to time such as determinations to acquire or sell private label credit card receivables, residential mortgage and other loans, to structure more collateralized funding as secured financings, or changes to HUSI's customer account management policies and practices and risk management/collection practices; o changes in overall economic conditions, including the interest rate environment in which HUSI operates, the capital markets in which HUSI funds its operations, the market values of consumer owned real estate throughout the United States, recession, employment and currency fluctuations; o consumer perception of the availability of credit, including price competition in the market segments which HUSI targets and the ramifications or ease of filing for personal bankruptcy; o the effectiveness of models or programs to predict loan delinquency or loss and initiatives to improve collections in all business areas, and changes HUSI may make from time to time in these models, programs and initiatives; o changes in management's estimates of probable losses inherent in HUSI's loan portfolios; o continued consumer acceptance of HUSI's distribution systems and demand for HUSI's loan or insurance products; o changes associated with, as well as the difficulty in, integrating systems, operational functions and cultures, as applicable, of any organization or portfolio acquired by HUSI; o a reduction of HUSI's debt ratings by any of the nationally recognized statistical rating organizations that rate these instruments to a level that is below HUSI's current ratings; o amendments to, and interpretations of risk-based capital guidelines and reporting instructions; o the impact of raising the required minimum payments on credit card accounts; o the costs, effects and outcomes of regulatory reviews or litigation relating to any nonprime loan receivables or the business practices or policies of any of HUSI's business units, including, but not limited to, additional compliance requirements; o increased funding costs resulting from instability in the capital markets and risk tolerance of fixed income investors; o the costs, effects and outcomes of any litigation matter that is determined adversely to HUSI or its subsidiaries; o the ability to attract and retain qualified personnel to support the underwriting, servicing, collection and sales functions of HUSI's businesses; o failure to obtain expected funding from HSBC subsidiaries and clients; o the impact of natural and other catastrophic disasters or the ability to collect on receivables in affected areas; and o the inability of HUSI to manage any or all of the foregoing risks as well as anticipated. 13 Item 1B. Unresolved Staff Comments-------------------------------------------------------------------------------- None. Item 2. Properties-------------------------------------------------------------------------------- The principal executive offices of HUSI are located at 452 Fifth Avenue, NewYork, New York 10018, which is owned by HBUS. The main office of HBUS is locatedat 1105 N. Market Street, Wilmington, Delaware 19801. The principal executiveoffices of HBUS are located at One HSBC Center, Buffalo, New York 14203, in abuilding under a long-term lease. HBUS has more than 380 other banking officesin New York State located in 44 counties, fifteen branches in Florida, elevenbranches in California, four branches in New Jersey, two branches inPennsylvania and one branch each in Oregon, Washington State, Delaware andWashington D.C. Approximately 34% of these offices are located in buildingsowned by HBUS and the remaining are located in leased quarters. In addition,there are branch offices and locations for other activities occupied undervarious types of ownership and leaseholds in states other than New York, none ofwhich are materially important to the respective activities. HBUS also ownsproperties in: Montevideo, Uruguay; Punta del Este, Uruguay; and Buenos Aires,Argentina. Item 3. Legal Proceedings-------------------------------------------------------------------------------- HUSI's legal proceedings are summarized in Note 24 of the consolidated financialstatements on page 134 of this Form 10-K. Item 4. Submission of Matters to a Vote of Security Holders-------------------------------------------------------------------------------- Not applicable. PART II-------------------------------------------------------------------------------- Item 5. Market for the Registrant's Common Equity and Related StockholderMatters-------------------------------------------------------------------------------- All 706 shares of HUSI's outstanding stock are owned by HSBC North America Inc.(HNAI), an indirect subsidiary of HSBC. Consequently, there is no public marketin HUSI's common stock. 14 Item 6. Selected Financial Data-------------------------------------------------------------------------------- Year Ended December 31 2005 2004 2003 2002 2001----------------------------------------------------------------------------------------------------------------------- (in millions) Net interest income ................... $ 3,063 $ 2,741 $ 2,510 $ 2,376 $ 2,265 --------- --------- -------- -------- --------Trading revenues ...................... 395 288 291 130 255Residential mortgage banking revenue (expense) ........................... 64 (120) (102) 24 33Securities gains, net ................. 106 85 48 118 149Interest on tax settlement ............ -- 17 22 -- --Other income .......................... 1,346 1,049 895 787 659 --------- --------- -------- -------- --------Total other revenues .................. 1,911 1,319 1,154 1,059 1,096 --------- --------- -------- -------- --------Goodwill amortization ................. -- -- -- -- 176Princeton Note Matter ................. -- -- -- -- 575Other expenses ........................ 2,758 2,101 2,040 1,875 1,792Provision (credit) for credit losses .. 674 (17) 113 195 238 --------- --------- -------- -------- --------Income before income tax expense and cumulative effect of accounting change 1,542 1,976 1,511 1,365 580Income tax expense .................... 566 718 570 510 226 --------- --------- -------- -------- --------Income before cumulative effect of accounting change ................... 976 1,258 941 855 354 --------- --------- -------- -------- --------Cumulative effect of accounting change - implementation of SFAS 133, net of tax ................ -- -- -- -- (1) --------- --------- -------- -------- --------Net income ............................ $ 976 $ 1,258 $ 941 $ 855 $ 353 ========= ========= ======== ======== ======== Adjusted net income (1) ............... $ 976 $ 1,258 $ 941 $ 855 $ 529 ========= ========= ======== ======== ======== Balances at year end:Loans: Commercial loans ................ $ 27,721 $ 22,972 $ 18,654 $ 19,917 $ 19,910 Residential mortgages ........... 43,970 46,775 26,637 20,713 17,807 Credit card receivables ......... 15,514 12,078 1,161 1,138 1,185 Other consumer loans ............ 3,137 3,122 2,022 1,868 2,021 --------- --------- -------- -------- -------- Total loans ..................... 90,342 84,947 48,474 43,636 40,923 Allowance for credit losses ..... (846) (788) (399) (493) (506) --------- --------- -------- -------- -------- Loans, net of allowance ......... 89,496 84,159 48,075 43,143 40,417Total assets .......................... 153,859 141,050 95,562 89,426 87,114Total tangible assets ................. 151,120 138,310 92,736 86,544 84,218Total deposits ........................ 91,815 79,981 63,955 59,830 57,330Short-term borrowings ................. 7,049 9,874 6,782 7,392 9,202Long-term debt ........................ 27,959 23,839 3,814 3,675 3,668Total common shareholder's equity ..... 10,278 10,366 6,962 6,897 6,549Tangible common shareholder's equity .. 7,562 7,611 4,022 3,737 3,535Total shareholders' equity ............ 11,594 10,866 7,462 7,397 7,049 Selected financial ratios:Total shareholders' equity to total assets 7.54% 7.70% 7.81% 8.27% 8.09%Tangible common shareholder's equity to total tangible assets ............ 5.00 5.50 4.34 4.32 4.20Rate of return on average (2): Total assets .................... .66 1.12 1.02 .97 .41 Total common shareholder's equity .......................... 8.78 16.35 13.06 12.42 4.80Net interest margin to average (2): Earning assets .................. 2.26 2.70 3.07 3.03 2.94 Total assets .................... 2.09 2.46 2.76 2.74 2.66Average total shareholders' equity to average total assets (2) ............ 7.85 7.18 8.20 8.20 8.50Cost/income ratio (2) ................. 55.44 51.73 55.65 54.59 52.94 (1) With the adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets on January 1, 2002, HUSI is no longer required to amortize goodwill, but rather evaluate goodwill for impairment annually. Accordingly, for fiscal year ended 2001, goodwill amortization has been excluded from the adjusted amounts for consistency purposes. (2) Selected financial ratios are defined in the Glossary of Terms beginning on page 77 of this Form 10-K. 15 Item 7. Management's Discussion and Analysis of Financial Condition and Resultsof Operations-------------------------------------------------------------------------------- Executive Overview-------------------------------------------------------------------------------- HUSI's 2005 net income of $976 million reflected a decrease of $282 million(22%) from the prior year. Income before income tax expense decreased $434million (22%), primarily due to: o decreased net interest margin, due mainly to the impact of $451 million of amortization of initial premium paid for the private label portfolio acquired from HSBC Finance Corporation in December 2004, as included within the CF business segment, and to the effect of a flattening yield curve on balance sheet management income within the CIBM business segment; and o significant non-recurring revenue items recorded for 2005 ($59 million of gains from sales of properties and businesses; and a $48 million gain from sale of an equity investment) were less than non-recurring items recorded for 2004 ($99 million gain from sale of credit card relationships to HSBC Finance Corporation; $45 million gain from sale of investment in NYCE; and $17 million interest income on an IRS refund). Excluding the impact of the items noted above, 2005 was highlighted by increasesin income before income tax expense in the PFS, CF, CMB and PB segments, due to: o successful rollout during 2005 of an enhanced deposit growth strategy; o significant expansion of residential mortgage, other consumer and commercial loan portfolios in 2004 and 2005; o positive impact on earnings, excluding the impact of the premium amortization noted above, of the private label receivable portfolio acquired in December 2004, and from additional private label receivables acquired in 2005; and o increased trading revenues, increased gains on sales of securities and increased fee income included in the CIBM business segment. Further analysis of business segments begins on page 46 of this Form 10-K. 16 Basis of Reporting-------------------------------------------------------------------------------- HUSI's consolidated financial statements are prepared in accordance withaccounting principles generally accepted in the United States (U.S. GAAP). International Financial Reporting Standards (IFRS) Because HSBC reports results in accordance with IFRS and IFRS results are usedby HSBC in measuring and rewarding performance of employees, HUSI managementalso separately monitors net income under IFRS (a non-U.S. GAAP financialmeasure). The following table reconciles HUSI's net income on a U.S. GAAP basisto net income on an IFRS basis. --------------------------------------------------------------------------------Year Ended December 31 2005-------------------------------------------------------------------------------- (in millions)Net income - U.S. GAAP basis ................................. $ 976Adjustments, net of tax: Derivatives and hedge accounting ....................... 18 Securitizations ........................................ 2 Loan origination ....................................... (7) Loan impairment ........................................ (11) Stock-based compensation ............................... (16) Property ............................................... (46) Other .................................................. 16 -----Net income - IFRS basis ...................................... $ 932 ===== Differences between U.S. GAAP and IFRS are as follows: Derivatives and hedge accounting IFRS o Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values are obtained from quoted market prices in active markets, or by using valuation techniques, including recent market transactions, where an active market does not exist. Valuation techniques include discounted cash flow models and option pricing models as appropriate. All derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. o In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (i.e. the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (i.e. without modification or repackaging) or based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading profit or loss on inception of the derivative. If observable market data are not available, the initial increase in fair value indicated by the valuation model, but based on unobservable inputs, is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis, or recognized in the income statement when the inputs become observable, or when the transaction is closed out. o Certain derivatives embedded in other financial instruments, such as the conversion option in a convertible bond, are treated as separate derivatives when their economic characteristics and risks are not clearly and closely related to those of the host contract, the terms of the embedded derivative are the same as those of a stand-alone derivative, and the combined contract is not designated at fair value through profit and loss. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. o Derivative assets and liabilities on different transactions are only netted if the transactions are with the same counterparty, a legal right of set-off exists, and the cash flows are intended to be settled on a net basis. 17 o The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument, and if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. Where derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. Hedge accounting: o It is HSBC's policy to document, at the inception of a hedging relationship, the relationship between the hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking the hedge. Such policies also require documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. Interest on designated qualifying hedges is included in "Net interest income". Fair value hedge: o Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair value of the asset or liability or group thereof that are attributable to the hedged risk. o If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item for which the effective interest method is used is amortized to the income statement over the residual period to maturity. Cash flow hedge: - The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement. - Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect profit or loss. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability. - When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. Net investment hedge: - Hedges of net investments in foreign operations are accounted for similarly to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation. Hedge effectiveness testing: - To qualify for hedge accounting, IAS 39 requires that at the inception of the hedge and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness). Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis. - The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. The method an HSBC entity adopts for assessing hedge effectiveness will depend on its risk management strategy. 18 - For fair value hedge relationships, HSBC entities utilize the cumulative dollar offset method or regression analysis as effectiveness testing methodologies. For cash flow hedge relationships, HSBC entities utilize the change in variable cash flow method or the cumulative dollar offset method using the hypothetical derivative approach. - For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For actual effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective. Derivatives that do not qualify for hedge accounting: - All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement. These gains and losses are reported in "Trading income", except where derivatives are managed in conjunction with financial instruments designated at fair value, in which case gains and losses are reported in "Net income from financial instruments designated at fair value". U.S. GAAP o The accounting under SFAS 133 "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39 as described above (from January 1, 2005). o The requirements of SFAS 133 have been effective from January 1, 2001. o SFAS 133 permits the "shortcut method" of hedge effectiveness testing for certain transactions. Under this method, it may be assumed, at inception of the hedge, there is no ineffectiveness in the hedging of interest rate risk with an interest rate swap provided specific criteria are met. o Certain issued structured notes are classified as trading liabilities under IFRS, but not under U.S. GAAP. Under IFRS, these notes will be held at fair value, with changes in fair value reflected in the income statement. Under U.S. GAAP, if the embedded derivative is not "clearly and closely related" to the host contract, the embedded derivative will be bifurcated and held at fair value, the host contract will be held at amortized cost, and changes in both will be reflected in the income statement. If the embedded derivative is "clearly and closely related" to the host contract, the issued note will be held at amortized cost in its entirety, with changes in the amortized cost reflected in the income statement. o Under U.S. GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. These contracts do not meet the requirements for set off under IAS 32 and hence are presented gross on the balance sheet under IFRS. Securitizations IFRS o The recognition of securitized assets is governed by a three-step process. The process may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows have been transferred to a third party, those securitized assets should be derecognized. - If the rights to the cash flows are retained but there is a contractual obligation to pay the cash flows to another party, the securitized assets should be derecognized if certain conditions are met, for example, where there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If it is determined that some significant risks and rewards of ownership have been transferred, but some significant risks and rewards have also been retained, it must be determined whether or not control has been retained. If it has not been retained, the asset should be derecognized. If control has been retained, an entity shall continue to recognize the asset to the extent of its continuing involvement. U.S. GAAP o SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over those securitized assets. o Control has been surrendered over transferred assets if and only if all of the following conditions are met: - The transferred assets have been put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. 19 o Where HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the special purpose entity, HSBC recognizes this interest at fair value on sale of the assets. Loan origination IFRS o Certain loan fee income and incremental directly attributable loan origination costs are amortized to the profit and loss account over the life of the loan as part of the effective interest method calculation under IAS 39. U.S. GAAP o Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the profit and loss account over the life of the loan as an adjustment to interest income (SFAS 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) Loan impairment IFRS o Where there is evidence of impairment, based on statistical models using historic loss rates adjusted for economic conditions, portfolios of loans are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate and includes reasonably estimable recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. U.S. GAAP o Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery of these amounts, the loans are written off in full, or to recoverable value where collateral exists. The delinquency status, for example, the number of days payment is overdue, where write-off occurs is applied consistently across similar loan products as described in HSBC's credit guidelines. Where local regulators mandate the delinquency status at which write-off must occur for different retail products and these reasonably reflect estimable recoveries on individual loans, this basis of measuring impairment is reflected in U.S. GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. Stock-based compensation IFRS o IFRS 2 "Share-based Payment" requires that where annual bonuses are paid in restricted shares, whereby the employee must remain with HSBC for a fixed period in order to receive the shares, the award is expensed over that period. U.S. GAAP o In its U.S. GAAP reporting, under SFAS 123 "Accounting for Stock Based Compensation", HSBC has interpreted the service period as being the period to which the bonus relates. o For 2005 bonuses, awarded in early 2006, HSBC will follow SFAS 123 (revised 2004) "Share-Based Payment" ("SFAS 123R"). SFAS 123R is consistent with IFRS 2, requiring restricted bonuses be expensed over the period the employee must remain with HSBC. However, SFAS 123R only applies to awards made after the date of adoption, which HSBC has elected as July 1, 2005. 20 Property IFRS o Under the transition rules of IFRS 1, HSBC has elected to freeze the value of its properties at their January 1, 2004 valuations. These are the "deemed cost" of properties under IFRS and will not be revalued in the future. Properties held at historical or deemed cost are depreciated except for freehold land and leasehold land greater than 500 years. Investment properties are not depreciated. o Investment properties are recognized at current market value with gains or losses recognized in net income for the period. U.S. GAAP o U.S. GAAP does not permit revaluations of property, including investment property, although it requires recognition of asset impairment. Any realized surplus or deficit is, therefore, reflected in income on disposal of the property. Depreciation is charged on all properties based on cost. Other Other includes differences relating to pension expense and other insignificantitems. 21 Critical Accounting Policies-------------------------------------------------------------------------------- HUSI's consolidated financial statements are prepared in accordance withaccounting principles generally accepted in the United States. The significantaccounting policies used in the preparation of HUSI's consolidated financialstatements are more fully described in Note 2 to the accompanying consolidatedfinancial statements beginning on page 88 of this Form 10-K. Certain critical accounting policies, which affect the reported amounts ofassets, liabilities, revenues and expenses, are complex and involve significantjudgment by management, including the use of estimates and assumptions. As aresult, changes in estimates, assumptions or operational policies couldsignificantly affect HUSI's financial position or results of operations. Theaccounting estimates are based upon historical experience and on various otherassumptions that are believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities. Actual results may differ from these estimates underdifferent assumptions, customer account management policies and practices, riskmanagement/collection practices, or conditions as discussed below. Of the significant accounting policies used in the preparation of HUSI'sconsolidated financial statements, the items discussed below involve criticalaccounting estimates and a high degree of judgment and complexity. Allowance for Credit Losses HUSI lends money and provides various credit facilities to others, resulting inrisk that borrowers may not repay amounts owed when they become contractuallydue. Consequently, an allowance for credit losses is maintained at a level thatis considered adequate to cover estimates of probable losses of principal,interest and fees in the existing portfolio. Allowance estimates are reviewedperiodically, and adjustments are reflected through the provision for creditlosses in the period when they become known. The accounting estimate relating tothe allowance for credit losses is a "critical accounting estimate" for thefollowing reasons: o changes in such estimates could significantly impact the allowance for credit losses and the provision for credit losses; o estimates related to the reserve for credit losses require consideration of future delinquency and charge off trends, which are uncertain and require a high degree of judgment; and o the allowance for credit losses is influenced by factors outside of HUSI's control. Customer payment patterns, economic conditions, bankruptcy trends and changes in laws and regulations all have an impact on the estimates. HUSI's allowance for credit losses is regularly assessed for adequacy through adetailed review of the loan portfolio. The allowance is comprised of two balancesheet components: o the allowance for credit losses, which is carried as a reduction to loans on the balance sheet and includes reserves for anticipated losses associated with all loans and leases outstanding; and o the reserve for off-balance sheet risk, which is recorded in other liabilities and includes probable and reasonably estimable losses arising from off-balance sheet arrangements such as letters of credit and commitments to lend that have not yet been drawn by customers. 22 Both types of reserves include amounts calculated for specific individual loanbalances and for collective loan portfolios depending on the nature of theexposure and the manner in which risks inherent in that exposure are managed. o All commercial loans that exceed five hundred thousand dollars are evaluated individually for impairment. When a loan is found to be "impaired", a specific reserve is calculated. Reserves against impaired loans are determined primarily by an analysis of discounted expected cash flows expected by HUSI with reference to independent valuations of underlying loan collateral and also considering secondary market prices for distressed debt where appropriate. o Loans which are not individually evaluated for impairment are pooled into homogeneous categories of loans and evaluated to determine if it is deemed probable, based on historical data, that a loss has been realized even though it has not yet been manifested in a specific loan. For retail receivables, HUSI uses roll rate methodology (statistical analysis ofhistorical trends used to estimate the probability of continued delinquency,ultimate charge off, and amount of consequential loss assessed at each timeperiod for which payments are overdue) to support the estimation of inherentlosses. The results of these models are reviewed by management in conjunctionwith changes in risk selection, changes in underwriting policies, national andlocal economic trends, trends in bankruptcy, loss severity and recoveries, andmonths of loss coverage. The resulting loss coverage ratio varies by portfoliobased on inherent risk and regulatory guidance. Roll rates are regularly updatedand benchmarked against actual outcomes to ensure that they remain appropriate. In 2004, HUSI implemented a new methodology to support the estimation of lossesinherent in pools of homogeneous commercial loans, leases and off-balance sheetrisk. These measures have been under development at HUSI for over three years tosupport more advanced credit risk management, estimation of credit economiccapital, enhanced portfolio management and the requirements of the Baselframework. This new methodology uses the probability of default from thecustomer rating assigned to each counterparty, the "Loss Given Default" ratingassigned to each transaction or facility based on the collateral securing thetransaction, and the measure of exposure based on the transaction. A suite ofmodels, tools and templates was developed using quantitative and statisticaltechniques, which are combined with expert judgment to support the assessment ofeach transaction. They were developed using HUSI's internal data andsupplemented by data from external sources which was judged to be consistentwith HUSI's internal credit standards. As some of the requirements under Baseldiffer from interpretations of U.S. GAAP requirements for the measurement ofinherent losses in homogeneous pools of loans, these measures are modified tomeet accounting standards. These advanced measures are applied to thehomogeneous credit pools to estimate the reserves required. The results from the advanced commercial analysis, retail roll rate analysis andthe specific/impairment reserving process is reviewed each quarter by a CreditReserve Committee co-chaired by the Chief Financial Officer and Chief CreditOfficer. This committee also considers other observable factors, both internalto HUSI and external in the general economy, to ensure that the estimatesprovided by the various models adequately include all known information at eachreporting period. The Credit Reserve Committee may add to or reduce a generalunallocated allowance to account for any observable factor not considered in thevarious models, for small portfolios or period ending manual entries notconsidered in a model and to recognize modeling imperfections. The creditreserves and the results of the Credit Reserve Committee are reviewed withHUSI's Credit Risk Management Committee and the Board of Directors' AuditCommittee each quarter. HUSI recognizes however that there is a high degree of subjectivity andimprecision inherent in the process of estimating losses utilizing historicaldata. Accordingly, a discretionary component of the allowance for credit lossesfor unspecified potential losses inherent in the loan portfolios is providedbased upon an evaluation of certain critical factors including the impact of thenational economic cycle, migration of loans within non-criticized loanportfolios, and loan portfolio concentration. Additional credit quality related analysis begins on page 53 of this Form 10-K.HUSI's approach toward credit risk management begins on page 64 of this Form10-K. 23 Goodwill Goodwill is not subject to amortization but is tested for possible impairment atleast annually or more frequently if events or changes in circumstances indicatethat the asset might be impaired. Impairment testing requires that the fairvalue of each reporting unit be compared to its carrying amount, including thegoodwill. Significant and long-term changes in industry and economic conditionsare considered to be primary indicators of potential impairment. Impairment testing of goodwill is a "critical accounting estimate" due to thegoodwill balance and the significant judgment required in the use of discountedcash flow models to determine fair value. Discounted cash flow models includesuch variables as revenue growth rates, expense trends, interest rates andterminal values. Based on an evaluation of key data and market factors,management's judgment is required to select the specific variables to beincorporated into the models. Additionally, the estimated fair value can besignificantly impacted by the cost of capital used to discount future cashflows. The cost of capital percentage is generally derived from an appropriatecapital asset pricing model, which itself depends on a number of financial andeconomic variables which are established on the basis of management's judgment.When management's judgment is that the anticipated cash flows have decreasedand/or the cost of capital has increased, the effect will be a lower estimate offair value. If the fair value is determined to be lower than the carrying value,an impairment charge will be recorded and net income will be negativelyimpacted. Reporting units were identified based upon an analysis of each of HUSI'sindividual operating segments. Goodwill was allocated to the carrying value ofeach reporting unit based on its relative fair value. See Business Segmentsbeginning on page 46 of this Form 10-K for an allocation of recorded book valueof goodwill by segment. HUSI has established April 30 of each year as the date for conducting its annualgoodwill impairment assessment. At April 30, 2005, there were no individualreporting units with a fair value less than carrying value, including goodwill.The fair value calculations were tested for sensitivity to reflect reasonablevariations, including: (1) keeping all other variables constant and assuming nofuture expense savings are achieved; and (2) keeping other variables constantwhile cutting projected revenue growth rates in half. In both of these casesthere was no impairment identified in any reporting unit. Mortgage Servicing Rights (MSRs) HUSI recognizes the right to service mortgage loans as a separate and distinctasset at the time the loans are sold. Servicing rights are then amortized inproportion to net servicing income and carried on the balance sheet at the lowerof their initial carrying value, adjusted for amortization, or fair value. As interest rates decline, prepayments generally accelerate, thereby reducingfuture net servicing cash flows from the serviced mortgage loan portfolio. Thecarrying value of the MSRs is periodically evaluated for impairment based on thedifference between the carrying value of such rights and their current fairvalue. For purposes of measuring impairment, MSRs are stratified based uponinterest rates and whether such rates are fixed or variable and other loancharacteristics. Fair value is determined based upon the application of pricingvaluation models incorporating portfolio specific prepayment assumptions. Theestimate of fair value is considered to be a "critical accounting estimate"because the assumptions used in the valuation models involve a high degree ofsubjectivity that is dependent on future interest rate movements. Thereasonableness of these pricing models is periodically substantiated byreference to external independent broker valuations and industry surveys. 24 Valuation of Derivative Instruments and Derivative Income Derivative instruments are utilized as part of HUSI's risk management strategyto protect the value of certain assets and liabilities and future cash flowsagainst adverse interest rate and foreign exchange rate movements. Allderivatives are recognized on the balance sheet at fair value. The valuation ofderivative instruments is a critical accounting estimate because most are valuedusing discounted cash flow modeling techniques in lieu of market value quotes.Discounted cash flow modeling techniques require the use of estimates regardingthe amount and timing of future cash flows, which are susceptible to significantchange in future periods based on changes in market rates. The assumptions usedin the cash flow projection models are based on forward yield curves which arealso susceptible to changes as market conditions change. The results of thesevaluations are regularly reviewed for reasonableness by comparison to aninternal determination of fair value or third party quotes. Significant changesin the fair value can result in equity and earnings volatility as follows: o changes in the fair value of a derivative that has been designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability (including losses or gains on firm commitments), are recorded in current period earnings; o changes in the fair value of a derivative that has been designated and qualifies as a cash flow hedge are recorded in other comprehensive income to the extent of its effectiveness, until earnings are impacted by the variability of cash flows from the hedged item; and o changes in the fair value of derivatives held for trading purposes are reported in current period earnings. Derivatives designated as effective hedges may be tested for effectiveness underthe long haul method. For these transactions, assessments are made, at theinception of the hedge and on a recurring basis, whether the derivative used inthe hedging transaction has been and is expected to continue to be highlyeffective in offsetting changes in fair values or cash flows of the hedged item.This assessment is conducted using statistical regression analysis. If it isdetermined as a result of this assessment that a derivative is not expected tobe a highly effective hedge or that it has ceased to be a highly effectivehedge, hedge accounting is discontinued as of the beginning of the quarter inwhich such determination was made. The assessment of the effectiveness of thederivatives used in hedging transactions is considered to be a "criticalaccounting estimate" due to the use of statistical regression analysis in makingthis determination. Similar to discounted cash flow modeling techniques,statistical regression analysis also requires the use of estimates regarding theamount and timing of future cash flows, which are susceptible to significantchanges in future periods based on changes in market rates. Statisticalregression analysis also involves the use of additional assumptions includingthe determination of the period over which the analysis should occur as well asselecting a convention for the treatment of credit spreads in the analysis. The outcome of the statistical regression analysis serves as the foundation fordetermining whether or not the derivative is highly effective as a hedginginstrument. This can result in earnings volatility as the mark to market onderivatives which do not qualify as effective hedges and the ineffectivenessassociated with qualifying hedges are recorded in current period earnings. For more information about HUSI's policies regarding the use of derivativeinstruments, see Note 2 to the accompanying consolidated financial statementsbeginning on page 94 of this Form 10-K. 25 Balance Sheet Review-------------------------------------------------------------------------------- Overview HUSI utilizes deposits and borrowings from various sources to fund balance sheetgrowth, to meet cash and capital needs, and to fund investments in subsidiaries.Balance sheet growth and funding sources are summarized in the following table. -------------------------------------------------------------------------------------------------------------------- Increase (Decrease) During The Year Ended December 31 ------------------------------------------------- 2005 2004 ---------------------- --------------------- Amount % Amount %-------------------------------------------------------------------------------------------------------------------- (in millions) Balance sheet growth: Loans .................................................. $ 5,395 6 $ 36,473 75 Short-term investments (1) ............................. 3,426 40 2,761 47 Trading assets ......................................... 1,405 7 5,169 35 Securities and other assets ............................ 2,583 9 1,085 4 -------- -------- -------- -------- $ 12,809 9 $ 45,488 48 ======== ======== ======== ========Funding sources: Total deposits ......................................... $ 11,834 15 $ 16,026 25 Long-term debt ......................................... 4,120 17 20,025 525 All other liabilities and shareholders' equity ......... (3,145) (8) 9,437 34 -------- -------- -------- -------- $ 12,809 9 $ 45,488 48 ======== ======== ======== ======== (1) Includes cash and due from banks, interest bearing deposits with banks and Federal funds sold and securities purchased under resale agreements. Average Assets and Liabilities Average earning assets and interest bearing liabilities increased duringcalendar year 2005, as compared with 2004, primarily due to: o increased average residential mortgage loan balances from held portfolio growth in 2004; o increased average credit card and other loan balances associated with the private label receivable portfolio acquired in December 2004; o increased average commercial loan and deposit balances resulting from targeted growth in small business and middle-market commercial customers; and o increased average deposits, long-term debt and short-term borrowings balances, which were the primary funding sources for asset growth during 2004. 26 Loans Outstanding The following table summarizes balances for major loan categories. Othercommercial loans includes $1,901 million, $1,378 million, and $246 million ofloans and advances to HSBC affiliates at December 31, 2005, 2004 and 2003respectively. ------------------------------------------------------------------------------------------------------------------------December 31 2005 2004 2003 2002 2001------------------------------------------------------------------------------------------------------------------------ (in millions) Commercial: Construction and other real estate ......... $ 9,123 $ 8,281 $ 7,024 $ 6,313 $ 5,920 Other commercial ........................... 18,598 14,691 11,630 13,604 13,990Consumer: Residential mortgage loans ................. 43,970 46,775 26,637 20,713 17,807 Credit card receivables .................... 15,514 12,078 1,161 1,138 1,185 Other consumer loans ....................... 3,137 3,122 2,022 1,868 2,021 --------- --------- --------- --------- ---------Total loans ...................................... $ 90,342 $ 84,947 $ 48,474 $ 43,636 $ 40,923 ========= ========= ========= ========= ========= Increased loans during 2005 were attributable to: o increased commercial loan balances resulting from continuation of specific programs initiated in 2004 to target growth in small business, middle market and real estate commercial lending portfolios; and o increased private label credit card receivables, due partially to the addition of new private label relationships to the portfolio, and partially to decreasing balances required to be maintained in off-balance sheet securitized receivable trusts. Increased loans during 2004 were attributable to: o acquisition of a $12 billion private label loan portfolio from HSBC Finance Corporation in December 2004, which consisted primarily of credit card receivables; o increased residential mortgage loan balances resulting from purchases of approximately $4 billion of loans from HSBC Finance Corporation and from originating lenders pursuant to an HSBC Finance Corporation correspondent loan program and from continued growth in the held mortgage loan portfolio; and o increased commercial loan balances resulting from specific programs initiated during the year to target growth in middle market, commercial real estate and small business lending portfolios. Commercial Loan Maturities and Sensitivity to Changes in Interest Rates The contractual maturity and interest sensitivity of total commercial loans atDecember 31, 2005 is summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ One Over One Over Year Through Five TotalDecember 31, 2005 or Less Five Years Years Loans------------------------------------------------------------------------------------------------------------------------ (in millions) Commercial: Construction and other real estate ............... $ 2,470 $ 4,946 $ 1,707 $ 9,123 Other commercial ................................. 11,695 5,739 1,164 18,598 --------- --------- --------- ---------Total .................................................. $ 14,165 $ 10,685 $ 2,871 $ 27,721 ========= ========= ========= ========= Loans with fixed interest rates ........................ $ 6,334 $ 2,167 $ 1,295 $ 9,796Loans having variable interest rates ................... 7,831 8,518 1,576 17,925 --------- --------- --------- ---------Total .................................................. $ 14,165 $ 10,685 $ 2,871 $ 27,721 ========= ========= ========= ========= 27 Deposits The following table summarizes balances for major depositor categories. ------------------------------------------------------------------------------------------------------------------------December 31 2005 2004 2003 2002 2001------------------------------------------------------------------------------------------------------------------------ (in millions) Individuals, partnerships and corporations ....... $ 76,438 $ 65,312 $ 53,959 $ 51,470 $ 50,852Domestic and foreign banks ....................... 12,871 12,759 7,580 7,114 4,646U.S. government and states and political subdivisions ................................... 1,566 1,493 1,464 855 1,169Foreign governments and official institutions ................................... 940 417 952 391 663 --------- --------- --------- --------- ---------Total deposits ................................... $ 91,815 $ 79,981 $ 63,955 $ 59,830 $ 57,330 ========= ========= ========= ========= ========= Deposits were a primary source of funding for balance sheet growth during 2005and 2004. Total deposits increased 15% and 25% in 2005 and 2004 respectively,resulting from: o successful rollout of new deposit products, including online savings accounts; o enhanced marketing efforts for the HSBC brand and for new and existing products in particular; and o improved systems and processes for identifying new customers and for delivering products to new and existing customers. Long-Term Debt and Other Borrowings HBUS has a $20 billion Global Bank Note Program, which provides for issuance ofsubordinated and senior global notes. Long-term debt issuances during 2005 and2004 were primarily from this program. Borrowings from the Global Bank NoteProgram totaled $1 billion and $14 billion for 2005 and 2004 respectively.Additional information regarding HUSI's long-term debt is presented in Note 14of the consolidated financial statements, beginning on page 111 of this Form10-K. HUSI had borrowings from the Federal Home Loan Bank (FHLB) of $5 billion atDecember 31, 2005 and 2004, and had access to a potential secured borrowingfacility as a member of the FHLB. In addition, HUSI had deposits and otherborrowings from HSBC affiliates of approximately $11 billion at December 31,2005 and 2004. Preferred Stock In April 2005, HUSI issued Floating Rate Non-Cumulative Preferred Stock, SeriesF with a stated value of $25 per share. In October 2005, HUSI issued FloatingRate Non-Cumulative Preferred Stock, Series G with a stated value of $1,000 pershare. Total proceeds of these two issues, net of issuance costs, were $869million. In December 2005, HUSI redeemed all issued shares of $1.8125 CumulativePreferred Stock, Series E at their stated value of $25 per share, resulting intotal cash outlay of $75 million. 28 Capital Resources A summary of changes in common shareholder's equity is presented in thefollowing table. ------------------------------------------------------------------------------------------------------------------------ 2005 2004 2003------------------------------------------------------------------------------------------------------------------------ (in millions) Balance, January 1 ............................................ $ 10,366 $ 6,962 $ 6,896Increases (decreases) due to: Net income .............................................. 976 1,258 941 Dividends paid to common shareholder .................... (675) (125) (690) Dividends paid to preferred shareholders ................ (46) (23) (22) Change in other comprehensive income .................... (43) (97) (134) Capital contributions from parent (1) ................... 3 2,411 15 Reductions of capital surplus ........................... (303) (20) (44) ---------- ---------- ---------- Total net (decrease) increase ........................... (88) 3,404 66 ---------- ---------- ----------Balance, December 31 .......................................... $ 10,278 $ 10,366 $ 6,962 ========== ========== ========== (1) Capital contributions from parent include amounts related to an HSBC stock option plan in which almost all of HUSI's employees are eligible to participate ($3 million, $11 million and $15 million for 2005, 2004 and 2003 respectively). Year end common shareholder's equity ratios are presented in the followingtable. ------------------------------------------------------------------------------------------------------------------------Year Ended December 31 2005 2004 2003------------------------------------------------------------------------------------------------------------------------ Common shareholder's equity to total assets.................... 6.68% 7.35% 7.28%Tangible common shareholder's equity to total tangible assets . 5.00 5.50 4.34 HUSI periodically pays dividends to its parent company, HNAI. Dividends paid toHNAI were significantly reduced in 2004 in order to conserve funds for theDecember 2004 acquisition of private label receivables and loans from HSBCFinance Corporation. The capital contributions from parent in 2004 includes $2.4billion received to provide additional funding for the private label portfolioacquisition. Effective January 1, 2005, the separate U.S. defined benefit pension plans weremerged into a single defined benefit pension plan which facilitates thedevelopment of a unified employee benefit policy and unified employee benefitplan administration for HSBC affiliates operating in the U.S. As a result,HUSI's prepaid pension asset of $482 million, and a related deferred taxliability of $203 million, were transferred to HNAH. The net transfer amount of$279 million is recorded as a reduction of capital surplus. HUSI and HBUS are required to meet minimum capital requirements by theirprincipal regulators. Risk-based capital amounts and ratios are presented onpage 119 of this Form 10-K. 29 Results of Operations-------------------------------------------------------------------------------- Net Interest Income-------------------------------------------------------------------------------- Net interest income is the total interest income on earning assets less thetotal interest expense on deposits and borrowed funds. In the discussion thatfollows, interest income and rates are presented and analyzed on a taxableequivalent basis to permit comparisons of yields on tax-exempt and taxableassets. An analysis of consolidated average balances and interest rates on ataxable equivalent basis is presented on pages 79 of this Form 10-K. The following table presents changes in the components of net interest incomeaccording to "volume" and "rate". ------------------------------------------------------------------------------------------------------------------------ 2005 Compared to 2004 2004 Compared to 2003 Increase/(Decrease) Increase/(Decrease)Year Ended December 31 2005 Volume Rate 2004 Volume Rate 2003------------------------------------------------------------------------------------------------------------------------ (in millions)Interest income: Interest bearing deposits with banks $ 120 $ 24 $ 55 $ 41 $ 13 $ 3 $ 25Federal funds sold and securities purchased under resale agreements 191 15 102 74 2 17 55Trading assets ................... 275 44 66 165 30 (2) 137Securities ....................... 899 38 (24) 885 (40) 17 908Loans: Commercial ...................... 1,233 190 212 831 (7) (93) 931 Consumer: Residential mortgages ....... 2,321 491 (1) 1,831 792 (139) 1,178 Credit cards ................ 812 749 (44) 107 10 (15) 112 Other consumer .............. 264 94 27 143 25 (11) 129 ------ ------- ----- ------ ----- ----- ------ Total consumer ............. 3,397 1,334 (18) 2,081 827 (165) 1,419Other interest ................... 32 4 10 18 2 (4) 20 ------ ------- ----- ------ ----- ----- ------Total interest income ............ 6,147 1,649 403 4,095 827 (227) 3,495 ------ ------- ----- ------ ----- ----- ------Interest expense:Deposits in domestic offices: Savings deposits .............. 318 9 130 179 17 (27) 189 Other time deposits ........... 822 257 200 365 121 21 223Deposits in foreign offices: Foreign banks deposits ........ 277 22 148 107 58 2 47 Other time and savings ........ 354 (7) 187 174 (18) (15) 207Short-term borrowings ............ 276 36 108 132 5 36 91Long-term debt ................... 1,019 619 20 380 247 (73) 206 ------ ------- ----- ------ ----- ----- ------Total interest expense ........... 3,066 936 793 1,337 430 (56) 963 ------ ------- ----- ------ ----- ----- ------Net interest income - taxable equivalent basis ....... 3,081 $ 713 $(390) 2,758 $ 397 $(171) 2,532 ======= ===== ===== =====Tax equivalent adjustment ........ 18 17 22 ------ ------ ------Net interest income - non taxable equivalent basis ... $3,063 $2,741 $2,510 ====== ====== ====== 30 2005 Compared to 2004 Overview Net interest income increased $322 million (12%) in 2005, as compared with 2004. The net interest margin declined from 2.46% in 2004 to 2.09% in 2005. Thefollowing factors contributed to the overall decrease in net interest margin: o amortization of premiums paid to acquire private label credit card receivables; o a reduction in balance sheet management income in CIBM, due largely to a flat yield curve; o average balances of residential mortgage loans have increased significantly in 2005, without an increase in the yield on these loans despite the rising interest rate environment; and o average balances and rates paid on wholesale liabilities increased in 2005. These balances provided funding for the higher average assets. Analysis of various components of net interest income follows. Interest Income - Loans Total interest income on loans increased $1.7 billion (59%) in 2005. Averagetotal loan balances increased 46% for 2005, resulting primarily from a full yearimpact of significant increases in residential mortgage loans held forinvestment and credit card receivables portfolios during 2004. Commercial Loans Interest income from commercial loans increased $402 million (48%) in 2005.Average commercial loan balances increased by 21% during the year. The averageyield earned on commercial loans also increased due to increases in HBUS's primelending rate during 2005. Significant resources have been dedicated to expansion of various commerciallending businesses and regional offices. Targeted growth in small business,middle market and real estate lending portfolios, which began in 2004, hascontinued to increase loan balances in 2005. HUSI plans for continued growth in2006, and will continue to build upon its status as one of the top smallbusiness lenders in New York State. Residential Mortgage Loans Interest income earned from residential mortgage loans increased $490 million(27%) in 2005. HUSI significantly expanded the volume of adjustable rateresidential mortgage loans originated throughout 2004, which were retained onthe balance sheet. As a result, average residential mortgage loans heldincreased by approximately 27% during 2005. Since the beginning of 2004, approximately $5.5 billion of residential mortgageshave been purchased from HSBC Finance Corporation and from originating lenderspursuant to an HSBC Finance Corporation correspondent loan program. Purchasesfrom these correspondents were discontinued effective September 1, 2005.Originations of residential mortgage loans have decreased in 2005 as comparedwith 2004, due to the contracting national originations market. In the first half of 2005, consumers continued to take advantage of lower couponadjustable rate products, resulting in lower overall average yields. However,the average yield earned on residential mortgage loans gradually rose during2005, following the general rise in interest rates, resulting in an annual yieldthat was comparable to 2004. 31 Credit Card Receivables Interest earned from credit card receivables increased $705 million (659%) in2005. Average credit card receivable balances were $12 billion higher for 2005. In December 2004, HUSI acquired $12 billion of private label receivables andother loans from HSBC Finance Corporation. Total premiums paid for thesereceivables, which are being amortized against interest income over theestimated life of the related receivables, totaled $639 million. Total 2005amortization of the initial premium was $432 million. During 2005, underlying customer balances included within the private labelportfolio have revolved, and new relationships have been added. In addition,decreased balances were required to be maintained in off-balance sheetsecuritized receivable trusts during 2005. As a result, total private labelreceivables increased to $15 billion at December 31, 2005. By agreement, newreceivables generated from these private label relationships are being acquiredfrom HSBC Finance Corporation on a daily basis. Total premiums paid, which arebeing amortized against interest income over the estimated life of the relatedreceivables, totaled $411 million for 2005. Total 2005 amortization associatedwith these premiums was $283 million. During 2004, HUSI sold certain MasterCard/Visa credit card relationships to HSBCFinance Corporation. HUSI purchases receivables associated with theseMasterCard/Visa relationships from HSBC Finance Corporation on a daily basis.Total premiums paid for these new receivables, which are being amortized againstinterest income over the estimated life of the related receivables, totaled $34million. Total 2005 amortization associated with these premiums was $32 million. The average yields for credit card receivables and total loans were reduced in2005 as a result of amortization of premiums paid for various credit cardportfolios, as follows: ---------------------------------------------------------------------------------------------------------Year Ended December 31, 2005 Amount Rate--------------------------------------------------------------------------------------------------------- (in millions) Credit card receivables:Interest income, before premium amortization ..................... $ 1,559 12.04%Premium amortization ............................................. (747) (6.00) ----------- -----------Interest income, adjusted for premium amortization ............... $ 812 6.04% =========== =========== Total loans:Interest income, before premium amortization ..................... $ 5,377 6.15%Premium amortization ............................................. (747) (.88) ----------- -----------Interest income, adjusted for premium amortization ............... $ 4,630 5.27% =========== =========== HUSI continues to purchase additional private label and MasterCard/Visa creditcard receivables on a daily basis from HSBC Finance Corporation, which continuesto own the customer relationships. Amortization of the initial premium paid toHSBC Finance Corporation was heavily front loaded into 2005, with approximatelytwo-thirds of the premium being amortized by year-end. Premium amortization istherefore expected to decrease in 2006, due to significantly reducedamortization of the initial premium. Other Consumer Loans Interest earned from various other consumer lending programs increased $121million (85%) in 2005. Average loan balances increased by 59% during the year,primarily due to consumer loans purchased from originating lenders pursuant toHSBC Finance Corporation correspondent loan programs. The average yield earnedon consumer loans also increased due to the rising short-term interest rateenvironment. 32 Interest Income - Short-Term Investments Short-term investments include interest bearing deposits with banks and Federalfunds sold and securities purchased under resale agreements. Fluctuations inshort-term investments directly result from the relationship between HUSI'sexcess liquidity position and its funding needs at any given point in time. Interest income from short-term investments increased $195 million (170%) in2005. Average short-term investment balances grew by 26% in 2005, while averagerates earned also increased significantly, primarily due to increases in thefederal funds rate throughout 2004 and 2005. Interest Expense - Deposits Total interest expense on interest bearing deposits increased $946 million(115%) in 2005. Interest expense increased for both domestic and foreigndeposits. Average interest bearing deposits increased by 17% in 2005. Depositswere a major source of funding for balance sheet growth in 2004 and 2005.Average interest rates paid to these customers also increased significantly, dueto increases in short-term interest rates and the introduction of morecompetitively priced consumer and commercial products. An overview of deposit growth initiatives is provided on page 7 of this Form10-K. Interest Expense - Short-Term Borrowings Interest expense on short-term borrowings increased $144 million (109%) in 2005.Average short-term borrowings balances increased by 23% in 2005, while theaverage interest rate paid also increased significantly, due primarily toincreases in the federal funds rate throughout 2004 and 2005. Interest Expense - Long-Term Debt Interest expense on long-term debt increased $639 million (168%) in 2005.Average long-term debt balances increased by 155% in 2005, due primarily to newdebt issued during the second half of 2004 and throughout 2005 to fund balancesheet growth. 2004 Compared to 2003 Net interest income increased approximately $231 million (9%) in 2004, comparedwith 2003. Increased average loan balances, primarily residential mortgageloans, were partially offset by increased long-term debt and deposit balances,and by a reduction in the net interest rate spread during 2005. Residential mortgage interest income increased approximately $653 million (55%)in 2004, compared with 2003. Average residential mortgages increasedapproximately $16 billion (74%) in 2004. The low interest rate environment of2003 and 2004 continued to stimulate consumers to refinance mortgages andpurchase residential property. In addition, HUSI continued to purchaseresidential mortgage loans from HSBC Finance Corporation and from originatinglenders pursuant to HSBC Finance Corporation correspondent loan programs. HUSIgenerally sells higher fixed rate residential mortgages under Federal loanprograms, and retains low adjustable rate mortgages on the balance sheet. Theincrease in variable rate mortgages relative to the entire residential mortgageportfolio has caused a decline in average residential mortgage interest rates ofapproximately 60 basis points for 2004. 33 Commercial loan interest income decreased approximately $100 million (11%) in2004. Average commercial loans decreased approximately $.1 billion (1%).Targeted growth in middle-market, commercial real estate and small businesslending portfolios increased commercial loan balances in 2004. However, during2002 and 2003, certain equipment finance, commercial finance and U.S. factoringbusinesses were exited or restructured resulting in office closings and sales ofcustomer relationships. In addition, certain receivables associated with thesebusinesses were retained, but have decreased throughout 2003 and 2004 asbalances have run off. These transactions more than offset the positive impactof 2004 loan growth on interest income. Interest expense associated with time deposits in domestic and foreign officesincreased a combined $159 million (24%) in 2004. An increase in average timedeposit balances of approximately $10 billion (19%), coupled with an increase inthe average rate paid on time deposits, were the primary drivers of the overallinterest expense increase. Interest expense on short-term borrowings increased approximately $41 million(45%) in 2004, due primarily to increases in the federal funds borrowing rateduring the year. Interest expense on long-term debt increased approximately $174 million (84%) in2004. Debt issued from HUSI's expanded global notes program and advances fromthe Federal Home Loan Bank with maturities greater than one year were primaryfunding sources for the purchase of $12 billion of private label receivablesfrom HSBC Finance Corporation in December 2004, thus increasing averagelong-term debt balances by approximately $6 billion (158%) during the year. Theaverage rate paid on long-term debt decreased significantly during 2004, due torates on new debt which were lower than rates on debt that existed in 2003. 34 Other Revenues-------------------------------------------------------------------------------- The components of other revenues are summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ 2005 Compared to 2004 Compared to 2004 2003 Increase/(Decrease) Increase/(Decrease) -------------------- ---------------------Year Ended December 31 2005 2004 2003 Amount % Amount %------------------------------------------------------------------------------------------------------------------------ (in millions) Trust income ................. $ 87 $ 95 $ 94 $ (8) (8) $ 1 1 Service charges: HSBC affiliate income .. 15 17 16 (2) (12) 1 6 Other service charges .. 195 196 196 (1) (1) -- -- ------- ------- ------- ------- ------- ------- ------- Total service charges .. 210 213 212 (3) (1) 1 1 ------- ------- ------- ------- ------- ------- ------- Other fees and commissions: Letter of credit fees .. 70 70 71 -- -- (1) (1) Credit card fees ....... 323 82 76 241 294 6 8 Wealth and tax advisory services 60 45 39 15 33 6 15 HSBC affiliate income .. 71 27 26 44 163 1 4 Other fee-based income, net of referral fees ........ 174 201 234 (27) (13) (33) (14) ------- ------- ------- ------- ------- ------- ------- Total other fees and commissions .......... 698 425 446 273 64 (21) (5) ------- ------- ------- ------- ------- ------- ------- Securitization revenue ....... 114 -- -- 114 -- -- -- Other income: Insurance .............. 48 63 65 (15) (24) (2) (3) HSBC affiliate income .. 44 103 16 (59) (57) 87 544 Interest on tax settlement -- 17 22 (17) (100) (5) (23) Gains on sale of property and other financial assets 67 65 16 2 3 49 306 Other .................. 78 85 46 (7) (8) 39 85 ------- ------- ------- ------- ------- ------- ------- Total other income ..... 237 333 165 (96) (29) 168 102 ------- ------- ------- ------- ------- ------- ------- Residential mortgage banking revenue (expense) .......... 64 (120) (102) 184 153 (18) (18)Trading revenues ............. 395 288 291 107 37 (3) (1)Securities gains, net ........ 106 85 48 21 25 37 77 ------- ------- ------- ------- ------- ------- -------Total other revenues ......... $ 1,911 $ 1,319 $ 1,154 $ 592 45 $ 165 14 ======= ======= ======= ======= ======= ======= ======= 35 2005 Compared to 2004 Trust Income The 2005 reduction of trust income resulted from the sale of HUSI's personaltrust business, previously a component of the PB business segment, in the firstquarter of 2005. Other Fees and Commissions Increased credit card fees in 2005 resulted from acquisition of private labelcredit card receivables from HSBC Finance Corporation in December 2004 andthroughout 2005. In June 2004, HUSI transferred an investment brokerage subsidiary to HMUS. Feesreceived from brokerage customers prior to the transfer date are reported asother fee-based income in the preceding table, while fees received pursuant toan ongoing arrangement with HMUS since the transfer date are reported as HSBCaffiliate income. Therefore, for 2005, HSBC affiliate income increased, whileother fee-based income decreased. Securitization Revenue Securitization revenue is comprised of servicing revenue and excess servicingspread resulting directly from the purchase of residual interests in securitizedprivate label credit card receivables from HSBC Finance Corporation in December2004. The securitized trusts require replenishments of receivables to supportpreviously issued securities. Receivables will continue to be sold to thesetrusts until their revolving periods end, the last of which is expected to occurin 2008. There have been no new securitization transactions during 2005.Additional information regarding securitization activities is presented in Note8 of the consolidated financial statements beginning on page 105 of this Form10-K. Other Income HSBC affiliate income for 2005 was primarily attributable to the followingactivity: o effective October 2004, HBUS became the originating lender for HSBC Finance Corporation's Taxpayer Financial Services business. During 2005, mainly in the first quarter of the year, HUSI recorded $19 million of gains on the sale of refund anticipation loans to HSBC Finance Corporation; and o in June 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties and subsequently selling these loans to HMUS. Since the inception of this program, HUSI has acquired approximately $5 billion of residential mortgage loans, which it subsequently sold to HMUS for total gains of approximately $18 million. HSBC affiliate income for 2004 included a gain of $99 million related to thesale of certain credit card relationships to HSBC Finance Corporation. In July 2004, HUSI recorded a $17 million refund of interest previously paid tothe Internal Revenue Service related to a prior year tax audit. Gains on sale of property and other financial assets primarily include thefollowing significant activity and/or transactions for 2005 and 2004: 2005 o $17 million gain from the sale of property in July 2005; o $26 million gain from the sale of property in May 2005; and o $16 million of gains from the sales of various branches and from the sale of a portion of HUSI's personal trust business during 2005. 36 2004 o $45 million gain on the sale of an investment in NYCE Corporation in July 2004. Other includes the following significant activity and/or transactions for 2005: o in June 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties and subsequently selling these acquired loans to HMUS (refer to HSBC affiliate income on the preceding page). At December 31, 2005, HUSI had approximately $2.9 billion of residential mortgage loans held for sale related to this program on its consolidated balance sheet, which are reported at the lower of cost or market value. Cumulative net mark to market losses of $32 million related to this program were included in other income for 2005; and o various miscellaneous revenues increased as a direct result of the private label receivable portfolio purchased from HSBC Finance Corporation in December 2004, and from other private label portfolios acquired from unrelated third parties during 2005. 2004 Compared to 2003 Other Fees and Commissions The overall decrease in other fee-based income during 2004 was attributable tothe June 2004 transfer of a brokerage subsidiary of HUSI to an HSBC affiliate.Income received directly from customers, which was reported as other fee-basedincome prior to the transfer, was replaced by lower net referral fees receivedfrom HSBC affiliates. Other Income The 2004 increase in other income was primarily the result of the followingsignificant non-recurring transactions and/or other activities: o HUSI sold certain consumer credit card relationships to HSBC Finance Corporation at a gain of approximately $99 million, which was recorded as HSBC affiliate income; o HUSI sold its non-marketable minority investment in NYCE Corporation for a gain of approximately $45 million. HUSI had held its investment since 1985 and was obligated to sell its investment by the majority shareholder in accordance with the terms of the shareholder agreement; o HUSI recorded higher earnings from a foreign equity investment, resulting in an increase in other income of approximately $13 million in 2004, as compared with 2003; and o various bank branches and other properties were sold during 2004, with combined gains on sale of approximately $9 million being recorded as other income. 37 Residential Mortgage Banking Revenue The following table presents the components of residential mortgage bankingrevenue. Net interest income includes interest earned on assets and paid onliabilities of the residential mortgage banking business as well as anallocation of the funding benefit or cost associated with these balances. Thenet interest income component of the table is included in net interest income inthe consolidated statement of income and reflects actual interest earned, net ofinterest expense and corporate transfer pricing cost of funds. Effective January 2005, HUSI enhanced its funds transfer pricing methodology tobetter approximate current external market pricing and valuation, resulting inadditional internal charges to the residential mortgage banking business,included in the PFS segment, from CIBM. For comparability purposes, prior yearamounts in the following table have also been restated for this change inmethodology, which decreased net interest income for 2004 and 2003 byapproximately $206 million and $112 million respectively. ------------------------------------------------------------------------------------------------------------------------ 2005 Compared to 2004 Compared to 2004 2003 Increase/(Decrease) Increase/(Decrease) -------------------- --------------------Year Ended December 31 2005 2004 2003 Amount % Amount %------------------------------------------------------------------------------------------------------------------------ (in millions) Net interest income ................. $ 447 $ 461 $ 318 $ (14) (3) $ 143 45 ------ ------ ------ ------ ------ ------ ------ Servicing related income (expense): Servicing fee income .......... 75 78 72 (3) (4) 6 8 MSRs amortization ............. (73) (101) (158) 28 28 57 36 MSRs temporary impairment (provision) recovery ........ 47 (102) (27) 149 146 (75) (278) Trading - Derivative instruments used to offset changes in value of MSRs ..................... 2 8 (135) (6) (75) 143 106 (Losses) gains on sales of available for sale securities ......... (11) 8 22 (19) (238) (14) (64) ------ ------ ------ ------ ------ ------ ------Total net servicing related income (expense) ......................... 40 (109) (226) 149 137 117 52 ------ ------ ------ ------ ------ ------ ------ Originations and sales related income (expense): Gains (losses) on sales of mortgages 17 (4) 117 21 525 (121) (103) Trading - Forward loan sale commitments ....... (10) (2) 35 (8) (400) (37) (106) - Interest rate lock commitments ...... (4) (13) (40) 9 69 27 68 - Euro interest rate contracts ........ 1 -- -- 1 -- -- -- Fair value hedge activity (1) . -- (2) -- 2 100 (2) -- ------ ------ ------ ------ ------ ------ ------Total net originations and sales related income (expense) .................. 4 (21) 112 25 119 (133) (119) ------ ------ ------ ------ ------ ------ ------ Other mortgage income ............... 20 10 12 10 100 (2) (17) ------ ------ ------ ------ ------ ------ ------ Total residential mortgage banking revenue (expense) included in other revenues .......................... 64 (120) (102) 184 153 (18) (18) ------ ------ ------ ------ ------ ------ ------ Total residential mortgage banking related revenue ................... $ 511 $ 341 $ 216 $ 170 50 $ 125 58 ====== ====== ====== ====== ====== ====== ====== (1) Includes SFAS 133 qualifying fair value adjustments related to residential mortgage banking warehouse fair value hedging activity This was discontinued in 2005. 38 2005 Compared to 2004 The following strategic decisions and market factors affected residentialmortgage banking results for 2005: o HUSI increased the proportion of loans originated through its retail channels by leveraging the HSBC brand, branch network and customer base; o HUSI opted to decrease the volumes generated through HSBC Finance Corporation's network of residential mortgage loan correspondents, resulting in a decline in the volume of mortgages originated during the year; o HUSI sold a higher proportion of adjustable rate residential mortgage loans in 2005, which previously would have been held on the balance sheet. Residential mortgage loans originated with the intention to sell increased 41% in 2005, as compared with 2004; and o as interest rates rose in 2005, loan originations slowed in comparison to the prior year, resulting in reversal of a significant portion of the reserve for temporary MSRs impairment in 2005. Total loan originations declined 50% overall in 2005. Adjustable rate loans originated, as a percentage of all loans originated, fell from 67% in 2004 to 30% in 2005. Net Interest Income As a result of the strategies and market factors noted above, total residentialmortgage loans recorded on the consolidated balance sheet decreased 6% during2005. Despite the decrease in actual balances however, average residentialmortgage loans increased 27% in 2005 due to full year impact of significantportfolio growth in 2004, resulting in a significant increase in interest incomeduring the year. Decreased net interest income in 2005 was attributable to a narrowing ofinterest rate spreads on the core mortgage portfolio. Overall yields earned onresidential mortgage loans in 2005 were consistent with 2004. Servicing Related Income (Expense) Increased net servicing related income (expense) in 2005 was attributable todecreased MSRs amortization expense and to recoveries of temporary impairmentvaluation allowance during 2005, as compared with significant provisions forimpairment recorded in 2004. During 2005, interest rates generally rose and prepayments of residentialmortgages, mostly in the form of loan refinancings, decreased in comparison with2004 levels. Loan refinance activity represented 44% of total originations in2005, as compared with 50% in 2004. This led to lower amortization charges andthe subsequent release of temporary impairment provision on MSRs. HUSI maintains an available for sale securities portfolio that is used to offsetchanges in the economic value of MSRs. Net servicing related income amounts inthe table do not reflect unrealized losses, reported as a component of othercomprehensive income, or net interest income related to these securities. Additional analysis of MSRs activity is provided in Note 10 of the consolidatedfinancial statements beginning on page 108 of this Form 10-K. Additional commentary regarding risk management associated with the MSRs hedgingprogram is presented on page 72 of this Form 10-K. Origination and Sales Related Income (Expense) HUSI routinely sells residential mortgage loans to government sponsored entitiesand other private investors. The increase in originations and sales relatedincome for 2005 was attributable to a higher basis point gain on each individualloan sale as compared with 2004, as well as a higher volume of originated loansbeing sold during the year. 39 2004 Compared to 2003 Net Interest Income Increased net interest income in 2004 resulted from the significant increase inresidential mortgage loans during the year, primarily due to the followingfactors: o approximately $4 billion of residential mortgage loans were acquired from HSBC Finance Corporation and from originating lenders pursuant to an HSBC Finance Corporation correspondent loan program; and o increased origination volumes in the held loan portfolio. In 2004 HUSI generally retained variable rate mortgage loans in the held portfolio, while selling fixed rate loans to government sponsored entities and other private investors. Consumer demand for variable rate products increased significantly in 2004. Residential mortgage loan portfolio increases were partially offset by lowerinterest rate spreads on originated loans and by lower income on loans held forsale due to reduced levels of loans originated for sale. Servicing Related Income (Expense) Decreased net servicing related expense for full year 2004 resulted fromincreased servicing fee income, decreased MSRs amortization expense andincreased income associated with derivative instruments used to offset changesin the economic value of MSRs. These were partially offset by increases intemporary impairment reserves. Normal amortization of MSRs decreased $57 millionfor full year 2004. The recorded net book value of MSRs, as well as related amortization expense,are directly impacted by levels of residential mortgage prepayments. Higherlevels of prepayments generally increase amortization expense and decrease thenet book value of MSRs. Conversely, lower levels of prepayments generallydecrease amortization expense and increase the net book value of MSRs. During2004, prepayments of residential mortgages, mostly in the form of loanrefinancings, decreased in comparison with 2003 levels. 30 year fixed ratemortgage rates generally rose in the second quarter of 2004 from the low ratesexperienced in 2003, declined again through the third quarter, and leveled offin the fourth quarter. Loan refinance activity represented 50% of totaloriginations in 2004, as compared with 74% in 2003. The reduction inamortization is also partially due to lower MSRs balances in 2004, as comparedwith 2003. The positive impacts of amortization and trading revenue for 2004 were partiallyoffset by increases in the temporary impairment valuation allowance for theMSRs. The net servicing related expense amounts in the tables do not reflectapproximately $4 million of unrealized losses, recorded as other comprehensiveincome, on available for sale securities used to offset changes in the economicvalue of MSRs, or net interest income of $19 million on these securities. Originations and Sales Related Income (Expense) Originations and sales related income in 2004 reflects a small amount of netlosses realized on sales of residential mortgage loans, as compared with netgains of $117 million for 2003. Significantly lower volume of loans originatedwith the intention to sell in 2004 were coupled with lower gains recorded oneach sale transaction. During 2004, residential mortgages originated with theintention to sell declined 64% from 2003 levels, despite an overall increase inresidential mortgage loan originations. This was attributable to lower mortgagerefinancings and a larger proportion of adjustable rate mortgage originations in2004, which are generally held on HBUS's balance sheet. In the low interest rateenvironment that existed prior to 2004, customers tended to refinance with fixedrate loans, which are generally sold. As interest rates have risen during 2004,and refinancing activity has decreased, origination of fixed rate loansoriginated for sale also has decreased. General market conditions and industry factors affected the ability of lendersto recognize the same level of gains in 2004 compared to 2003. During 2003, themarket demand for residential mortgages far outweighed the supply of suchmortgages originated by lenders, which drove up pricing and associated gainsrecorded on the sales. 40 During 2004, due to lower mortgage refinancings and a contracting nationalmortgage originations market, the demand weakened relative to supply, which inturn returned pricing and net gains on sales of mortgages to more normal levels. Trading Revenues Trading revenues are generated by HUSI's participation in the foreign exchange,credit derivative and precious metal markets; from trading derivative contracts,including interest rate swaps and options; from trading securities; and as aresult of certain residential mortgage banking activities. The following table presents trading related revenues by business. The data inthe table includes net interest income earned on trading instruments, as well asan allocation of the funding benefit or cost associated with the tradingpositions. The trading related net interest income component is not included inother revenues, but is included in net interest income. Trading revenues relatedto the mortgage banking business are included in residential mortgage bankingrevenue. See analysis of residential mortgage banking revenue for details. ------------------------------------------------------------------------------------------------------------------------ 2005 Compared to 2004 Compared to 2004 2003 Increase/(Decrease) Increase/(Decrease) -------------------- --------------------Year Ended December 31 2005 2004 2003 Amount % Amount %------------------------------------------------------------------------------------------------------------------------ (in millions) Trading revenues ........ $ 395 $ 288 $ 291 $ 107 37 $ (3) (1)Net interest income ..... 5 76 81 (71) (93) (5) (6) ----- ----- ----- ----- ----- ----- -----Trading related revenues $ 400 $ 364 $ 372 $ 36 10 $ (8) (2) ===== ===== ===== ===== ===== ===== ===== Business: Derivatives ....... $ 166 $ 112 $ 125 $ 54 48 $ (13) (10) Treasury (primarily securities) ....... 50 37 65 13 35 (28) (43) Foreign exchange and banknotes ......... 134 143 102 (9) (6) 41 40 Precious metals ... 41 49 59 (8) (16) (10) (17) Other trading ..... 9 23 21 (14) (61) 2 10 ----- ----- ----- ----- ----- ----- -----Trading related revenues $ 400 $ 364 $ 372 $ 36 10 $ (8) (2) ===== ===== ===== ===== ===== ===== ===== 2005 Compared to 2004 Improved trading markets during the second half of 2005 offset the difficultmarkets encountered during the first half of the year. Overall, client andproprietary trading revenues increased during 2005 as a result of the followingfactors: o improved trading results from an expanded credit derivatives trading desk; o successful rollout of a new structured transactions business within the CIBM segment, which has increased derivatives related revenues in 2005; and o increased Treasury revenues associated with a new whole loan structuring business initiated during 2005. The yield curve continued to flatten during the 2005, which resulted insignificant decreases in interest rate spreads associated with various tradingassets. 2004 Compared to 2003 Derivatives and treasury revenue decreased in 2004, due primarily to a lowerinterest rate environment, which decreased customer activity and reducedproprietary gains. Increased foreign exchange revenues resulted from improved performance forforeign currency and banknotes trading activities. 2003 banknotes tradingresults were negatively impacted by the SARS scare and by the war in Iraq. 2004activity reflected a recovery of customer activity levels and improvedproprietary results. 41 Decreased precious metals trading revenue was primarily due to a significantdefault by a customer in Australia, which was partially offset by slightlyimproved results in other domestic and foreign locations. Securities Gains, Net The following table presents realized security gains and losses included in theconsolidated statement of income. ----------------------------------------------------------------------------------------------------------------- Gross Realized Gross Realized Net Realized Gains (Losses) Gains (Losses)----------------------------------------------------------------------------------------------------------------- (in millions) Year Ended December 31, 2005: Net gains included in: Residential mortgage banking revenue (expense) (1) .. $ -- $ (11) $ (11) Securities gains, net ............................... 108 (2) 106 ------- ------- ------- $ 108 $ (13) $ 95 ======= ======= =======Year Ended December 31, 2004: Net gains included in: Residential mortgage banking revenue (1) ............ $ 8 $ -- $ 8 Securities gains, net ............................... 93 (8) 85 ------- ------- ------- $ 101 $ (8) $ 93 ======= ======= =======Year Ended December 31, 2003: Net gains included in: Residential mortgage banking revenue (1) ............ $ 22 $ -- $ 22 Securities gains, net ............................... 59 (11) 48 ------- ------- ------- $ 81 $ (11) $ 70 ======= ======= ======= (1) Securities gains (losses) related to available for sale securities used to offset charges in the economic value of MSRs are included in residential mortgage banking revenue (expense). HUSI maintains various securities portfolios as part of its overall liquidity,balance sheet diversification and risk management strategy. The following tablesummarizes the net securities gains resulting from non-mortgage bankingactivities. -----------------------------------------------------------------------------------------------------------------Year Ended December 31 2005 2004 2003----------------------------------------------------------------------------------------------------------------- (in millions) Balance sheet diversity and reduction of risk ............. $ 33 $ 45 $ 34Reduction of Latin American exposure ...................... 22 30 18Sale of an equity investment to an HSBC affiliate (1) ..... 48 -- --Other ..................................................... 3 10 (4) ------- ------- -------Total securities gains, net ............................... $ 106 $ 85 $ 48 ======= ======= ======= (1) In June 2005, HUSI sold shares in a foreign equity fund to an HSBC affiliate for a gain of $48 million, which is recorded within the PB segment. 42 Operating Expenses ------------------------------------------------------------------------------------------------------------------------ 2005 Compared to 2004 Compared to 2004 2003 Increase/(Decrease) Increase/(Decrease) -------------------- ---------------------Year Ended December 31 2005 2004 2003 Amount % Amount %------------------------------------------------------------------------------------------------------------------------ (in millions) Salaries and employee benefits . $ 1,052 $ 947 $ 1,138 $ 105 11 $ (191) (17)Occupancy expense, net ......... 182 176 165 6 3 11 7Support services from HSBC affiliates: Fees paid to HTSU for technology services .... 216 172 -- 44 26 172 -- Fees paid to HSBC Finance Corporation for loan servicing and other administrative support 415 35 -- 380 1,086 35 -- Other fees, primarily treasury and traded markets services ............... 288 213 160 75 35 53 33 ------- ------- ------- ------- ------- ------- ------- 919 420 160 499 119 260 163 ------- ------- ------- ------- ------- ------- ------- Other expenses: Equipment and software ... 91 108 145 (17) (16) (37) (26) Marketing ................ 79 44 39 35 80 5 13 Outside services ......... 116 103 116 13 13 (13) (11) Professional fees ........ 67 55 69 12 22 (14) (20) Telecommunications ....... 19 17 42 2 12 (25) (60) Postage, printing and office supplies ........ 26 25 29 1 4 (4) (14) Insurance business ....... 19 22 30 (3) (14) (8) (27) Other .................... 188 184 107 4 2 77 72 ------- ------- ------- ------- ------- ------- ------- Total other expenses..... 605 558 577 47 8 (19) (3) ------- ------- ------- ------- ------- ------- -------Total operating expenses ....... $ 2,758 $ 2,101 $ 2,040 $ 657 31 $ 61 3 ======= ======= ======= ======= ======= ======= =======Personnel - average number ..... 11,275 11,416 13,486 (141) (1) (2,070) (15) 2005 Compared to 2004 Salaries and Employee Benefits Salaries expense increased $55 million (8%) in 2005. During the first half of2004, HUSI transferred its brokerage subsidiary and most of its branchoperations in Panama to other HSBC affiliates, resulting in a significantreduction in staffing levels and salaries. Excluding these subsidiary transfers,the average number of personnel associated with HUSI's remaining operationsincreased for 2005. Business expansion initiatives in various business segmentswere the primary drivers of increased staff counts and salaries expense. Inaddition, in March 2005, HSBC transferred a subsidiary to HUSI that providesaccounting and valuation services to hedge fund clients, which also increasedstaff counts and salaries expense. Employee benefits expenses increased $50 million (22%) in 2005, due to: o increased employer share of payroll taxes and other benefit costs associated with the overall staffing and salaries increases noted above; and o an increase in HUSI's employer matching of employee retirement savings contributions due to changes in matching program provisions which took effect during 2004. 43 Support Services from HSBC Affiliates Fees are charged by various HSBC affiliates for technology services, forunderwriting and broker-dealer services, for loan origination and servicing, andfor other operational and administrative support functions. Transactions withHSBC affiliates are described and summarized in Note 20 of the consolidatedfinancial statements beginning on page 122 of this Form 10-K. The overall increases in HSBC affiliate charges are due primarily to thefollowing activity: o fees charged by HSBC Finance Corporation for loan origination and servicing expenses increased significantly due to increased services related to the private label receivable portfolio and other loans acquired from HSBC Finance Corporation and from their correspondents in 2004 and 2005. Fees charged by HSBC Finance Corporation for various administrative services also increased as a result of specific initiatives to centralize administrative functions; o fees charged by HTSU for technology services expenses increased, as HUSI continues to upgrade its automated technology environment. Equipment and software costs included in other expenses have decreased in 2005, as these costs are now included in the charges by HTSU; and o fees charged by HMUS and other HSBC affiliates for treasury and traded markets services have also increased in 2005 due primarily to business expansion initiatives within the CIBM segment. Other Expenses Increased marketing and promotional expenses resulted from increased use ofcustomer mailings and various media channels to enhance perception of the HSBCbrand and to market expanded products and services, including rollout of theonline savings account product in late 2005. 2004 Compared to 2003 During 2003, certain equipment finance, commercial finance and U.S. factoringbusinesses were sold. In addition, during 2004, certain domestic and foreignoperations were sold or transferred to HSBC affiliates at fair value. Thesetransactions decreased various operating expense lines by an approximatecombined amount of $97 million in 2004. HSBC affiliate charges included amounts for information technology, loanorigination and servicing, administrative and other operational support. During2003 and into 2004, HSBC instituted certain organizational changes that resultedin employees and other aspects of operations being transferred to other HSBCaffiliates in North America. These other HSBC affiliates in turn charge forservices in accordance with service level agreements. These organizationalchanges have impacted the amounts recorded in various functional expensecategories included in operating expenses on the consolidated statement ofincome. Direct expenses recorded in "salaries and employee benefits" on theconsolidated statement of income for 2003 are now recorded in "other expenses"for 2004. In the preceding table, the increase in HSBC affiliate charges, aswell as the decreases for salaries and employee benefits, equipment andsoftware, telecommunications and outside services expenses primarily resultedfrom these organizational changes. Salaries and Employee Benefits The decrease in salaries and employee benefits in 2004 was primarily due to thetransfer of employees to HSBC affiliates, to sales of various commercial lendingbusiness units in 2003, and to the sales or transfers of various subsidiaries toaffiliated HSBC entities during 2004, as previously described. Additionaldecreases in salaries resulted from ongoing efforts to integrate and centralizeoperations of various departments with those of HSBC Finance Corporation. As aresult of the organizational changes and other efforts, the average number ofpersonnel employed directly by HUSI decreased 15% during 2004, as compared with2003. During 2003, severance costs of $48 million were recorded as a result ofvarious expense reduction, global resourcing, and HSBC Finance Corporationintegration efforts. These initiatives were generally completed in 2003,resulting in expense decreases in 2004. 44 Partially offsetting these salary decreases were increased expenses associatedwith expanded residential mortgage lending and CIBM operations. Support Services From HSBC Affiliates As previously noted, a significant number of employees were transferred to HSBCaffiliates during 2004. Fees charged by these entities in accordance withvarious service level agreements either began on January 1, 2004, or haveincreased during the year due to expansion of the services they provide. Totaltechnology related expenses, net of related salary line decreases, increasedduring 2004 as HUSI has continued to upgrade its automated technologyenvironment. Origination and servicing expenses have increased due to increasedservices provided by HSBC Finance Corporation related to residential mortgagesand other consumer loans. Other Expense The 2004 increase in other expense was primarily due to the following factors: o HUSI refined its methodology for calculating its reserve for off-balance sheet exposure, resulting in an increase in the provision for off-balance sheet exposure of approximately $53 million; and o in the fourth quarter of 2004, HUSI recorded a provision of approximately $26 million for U.S. withholding tax costs related to deficiencies in client tax documentation through a charge to other expense. Provision for Credit Losses-------------------------------------------------------------------------------- Provisions for credit losses are recorded to adjust the allowance for creditlosses to the level that management deems adequate to absorb losses inherent inthe loan and lease portfolio. Such provisions increased $691 million in 2005,due primarily to the following factors: o exceptionally strong credit quality in 2004, particularly within the commercial loan portfolio, resulted in a total net release of provisions of $17 million for the year; o increased 2005 provisions of $564 million related to the private label receivable portfolio acquired from HSBC Finance Corporation on December 31, 2004 and throughout 2005; o generally increased 2005 provisions for credit losses associated with increased average balances for commercial, residential mortgage and other consumer loan portfolios; and o incremental 2005 credit card provisions totaling $15 million for losses associated with Hurricane Katrina and for new bankruptcy legislation. Analysis of the loan portfolios is presented within the Balance Sheet Reviewsection beginning on page 26 of this Form 10-K. Analysis of credit qualityassociated with loan portfolios begins on page 53 of this Form 10-K. Income Taxes-------------------------------------------------------------------------------- Income tax expense decreased $152 million in 2005 due principally to a decreasein pretax income combined with an adjustment of prior years' state and local taxprovisions to reflect the actual tax liabilities per the returns filed and ahigher level of low income housing tax credits. Analysis of income tax expense,the effective tax rate, and the net deferred tax position is provided in Note 16of the consolidated financial statements beginning on page 116 of this Form10-K. 45 Business Segments-------------------------------------------------------------------------------- HUSI's business segments are described beginning on page 4 of this Form 10-K.Results for each segment are summarized in the following tables and commentary.Prior period disclosures previously reported for 2004 and 2003 have beenconformed herein to the presentation of current segments, including methodologychanges related to the transfer pricing of assets and liabilities. The net interest income component in the following tables reflect actualinterest earned/paid, net of value/cost of funds as determined by corporatetransfer pricing methodology. Effective January 2005, HUSI enhanced its fundstransfer pricing methodology to better approximate current external marketpricing and valuation, resulting in additional internal charges to theresidential mortgage banking business, included in the PFS segment, from theCIBM segment. For comparability purposes, 2004 and 2003 segment results werealso restated, which increased CIBM net interest income by approximately $206million and $112 million respectively, with the offsetting decreases to PFS netinterest income. Personal Financial Services (PFS) Additional resources and priority were focused on core retail banking businessesduring 2005. Investment in the retail branch network continues to be expandedand reallocated to ensure coverage of high potential growth geographic areas.Loan and deposit products offered to individuals were expanded in conjunctionwith increased marketing efforts. HUSI has also continued to leverage itsrelationship with HSBC Finance Corporation to increase consumer loan assets andearnings, to obtain loan origination and servicing, and to reduce overalloperating costs of various administrative services. The following table summarizes results for the PFS segment. ------------------------------------------------------------------------------------------------------------------------ 2005 Compared 2004 Compared To 2004 To 2003 Increase/(Decrease) Increase/(Decrease) -------------------- --------------------Year Ended December 31 2005 2004 2003 Amount % Amount %------------------------------------------------------------------------------------------------------------------------ (in millions) Net interest income ......... $ 1,203 $ 1,090 $ 1,081 $ 113 10 $ 9 1Other revenues ..... ........ 442 381 250 61 16 131 52 ------- ------- ------- ------- ------- ------- -------Total revenues .............. 1,645 1,471 1,331 174 12 140 11Operating expenses .......... 1,033 944 930 89 9 14 2 ------- ------- ------- ------- ------- ------- -------Working contribution ........ 612 527 401 85 16 126 31Provision for credit losses . 103 81 68 22 27 13 19 ------- ------- ------- ------- ------- ------- -------Income before income tax expense ................... $ 509 $ 446 $ 333 $ 63 14 $ 113 34 ======= ======= ======= ======= ======= ======= ======= Average assets .............. $49,084 $41,202 $28,601Average liabilities/equity .. 43,304 34,165 31,066Goodwill at December 31 ..... 1,167 1,167 1,223 2005 Compared to 2004 Increased net interest income for 2005 was due to: o significant growth in average consumer loan balances, particularly adjustable rate residential mortgage loans, combined with slightly higher average yields on these adjustable rate loans; o more favorable interest rate spreads on a growing personal deposits base during 2005; offset by o $32 million of amortization of premium paid for MasterCard/Visa credit card receivables acquired on a daily basis from HSBC Finance Corporation. 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