HSBC Holdings Regulatory News (HSBA)

6 Mar 2006 18:25

HSBC Holdings PLC06 March 2006 PART 3 88 Foreign Currency Translation The accounts of HUSI's foreign operations are measured using local currency asthe functional currency. Assets and liabilities are translated into UnitedStates dollars at the rate of exchange in effect on the balance sheet date.Income and expenses are translated at average monthly exchange rates. Netexchange gains or losses resulting from such translation are included in commonshareholder's equity as a component of accumulated other comprehensive income.Foreign currency denominated transactions in other than the local functionalcurrency are translated using the period end exchange rate with any foreigncurrency transaction gain or loss recognized currently in income. Resale and Repurchase Agreements HUSI purchases securities under agreements to resell (resale agreements) andsells securities under agreements to repurchase (repurchase agreements). Resaleagreements and repurchase agreements are generally accounted for as securedlending and secured borrowing transactions respectively. The amounts advanced under resale agreements and the amounts borrowed underrepurchase agreements are carried on the consolidated balance sheet at theamount advanced or borrowed, plus accrued interest to date. Interest earned onresale agreements is reported as interest income. Interest paid on repurchaseagreements is reported as interest expense. HUSI offsets resale and repurchaseagreements executed with the same counterparty under legally enforceable nettingagreements that meet the applicable netting criteria as permitted by U.S. GAAP. Repurchase agreements may require HUSI to deposit cash or other collateral withthe lender. In connection with resale agreements, it is the policy of HUSI toobtain possession of collateral, which may include the securities purchased,with market value in excess of the principal amount loaned. The market value ofthe collateral subject to the resale and repurchase agreements is regularlymonitored, and additional collateral is obtained or provided when appropriate,to ensure appropriate collateral coverage of these secured financingtransactions. Securities Debt securities that HUSI has the ability and intent to hold to maturity arereported at cost, adjusted for amortization of premiums and accretion ofdiscounts which are recognized as adjustments to yield over the expected livesof the related securities. Securities acquired principally for the purpose ofselling them in the near term are classified as trading assets and reported atfair value, with unrealized gains and losses included in earnings. Investmentsin Federal Home Loan Bank and Federal Reserve Bank stock are reported at cost inother assets. All other securities are classified as available for sale andcarried at fair value, with unrealized gains and losses, net of related incometaxes, recorded as adjustments to common shareholder's equity as a component ofaccumulated other comprehensive income. The fair value of securities is based on current market quotations whereavailable, or internal valuation models that approximate market pricing. Thevalidity of internal pricing models is regularly substantiated by reference toactual market prices realized upon sale or liquidation of these instruments. Realized gains and losses on sales of securities not classified as tradingassets are computed on a specific identified cost basis and are reported inother revenues as security gains, net. Adjustments to fair value of tradingassets, as well as gains and losses on the sale of such securities, are reportedin other revenues as trading revenues. HUSI regularly evaluates its securitiesto identify losses in fair value that are considered other than temporary. Anydecline in the fair value of investments which is deemed to be other thantemporary is charged against current earnings in other revenues and a new costbasis is established for the security. Loans Loans are stated at their amortized cost, which represents the principal amountoutstanding, net of unearned income, charge offs, unamortized purchase premiumor discount, unamortized nonrefundable fees and related direct loan originationcosts and purchase accounting fair value adjustments. Loans are further reducedby the allowance for credit losses. 89 Loans held for sale are carried at the lower of aggregate cost or market valueand continue to be reported as loans in the consolidated balance sheet. Premiumsand discounts, purchase accounting fair value adjustments and deferred fees andorigination costs are recognized as adjustments to yield over the life of therelated receivables. Interest income is recorded based on methods that result inlevel rates of return over the terms of the loans. Restructured loans are loans for which the original contractual terms have beenpermanently modified to provide for terms that are less than HUSI would bewilling to accept for new loans with comparable risk because of deterioration inthe borrower's financial condition. Interest on these loans is accrued at therenegotiated rates. Loan Charge Off Policies and Practices Commercial loan balances are charged off at the time all or a portion of thebalance is deemed uncollectible. Consumer loan charge off policies, which vary by product, are summarized below. Residential Mortgage Loans Carrying values in excess of net realizable value are charged off at or beforethe time foreclosure is completed or when settlement is reached with theborrower. If foreclosure is not pursued, and there is no reasonable expectationfor recovery, the account is generally charged off no later than the end of themonth in which the account becomes six months contractually delinquent. Auto Finance Carrying values in excess of net realizable value are generally charged off nolater than the month in which the account becomes four months contractuallydelinquent. MasterCard/Visa and Private Label Credit Card Loans Loan balances are generally charged off by the end of the month in which theaccount becomes six months contractually delinquent. Other Consumer Loans Loan balances are generally charged off during the month following the month inwhich the account becomes four months contractually delinquent. Nonaccruing Loan Policies and Practices HUSI's nonaccruing loan policies vary by product and are summarized below. Commercial Commercial loans are categorized as nonaccruing when, in the opinion ofmanagement, reasonable doubt exists with respect to the ultimate collectibilityof interest or principal based on certain factors including period of time pastdue and adequacy of collateral. At the time a loan is classified as nonaccruing,any accrued interest recorded on the loan is generally reversed and chargedagainst income. Interest income on these loans is subsequently recognized onlyto the extent of cash received or until the loan is placed on accrual status. Inthose instances where there is doubt as to collectibility of principal, anyinterest payments received are applied to principal. Loans are not reclassifiedas accruing until interest and principal payments are brought current and futurepayments are reasonably assured. 90 Consumer Residential mortgage loans are generally designated as nonaccruing whencontractually delinquent for more than three months. Credit card receivables andother consumer loans generally accrue interest until charge off. Loan Fees and Costs Nonrefundable fees and related direct costs associated with the origination ofloans are deferred and netted against outstanding loan balances. Theamortization of net deferred fees, which include points on real estate securedloans and costs, is recognized in interest income, generally by the interestmethod, based on the estimated lives of the related loans. MasterCard/Visaannual fees, net of direct lending costs, are deferred and amortized on astraight-line basis over one year. Nonrefundable fees related to lendingactivities other than direct loan origination are recognized as other revenuesover the period in which the related service is provided. This includes feesassociated with the issuance of loan commitments where the likelihood of thecommitment being exercised is considered remote. In the event of the exercise ofthe commitment, the remaining unamortized fee is recognized in interest incomeover the loan term using the interest method. Other credit-related fees, such asstandby letter of credit fees, loan syndication and agency fees are recognizedas other operating income over the period the related service is performed. Allowance for Credit Losses HUSI maintains an allowance for credit losses that is, in the judgment ofmanagement, adequate to absorb estimated probable losses of principal, interestand fees inherent in its commercial and consumer loan portfolios. The adequacyof the allowance for credit losses is assessed within the context of appropriateU.S. GAAP guidance, and is based, in part, upon an evaluation of various factorsincluding: o an analysis of individual exposures where applicable; o current and historical loss experience; o changes in the overall size and composition of the portfolio; and o specific adverse situations and general economic conditions. HUSI also considers key ratios such as reserves to nonperforming loans andreserves as a percentage of net charge offs in developing its loss reserveestimate. Loss estimates are reviewed periodically and adjustments are reportedin earnings when they become known. These estimates are influenced by factorsoutside of the control of HUSI management, such as consumer payment patterns andeconomic conditions, and there is uncertainty inherent in these estimates,making it reasonably possible that they could change. For commercial and select consumer loan assets, HUSI conducts a periodicassessment on a loan-by-loan basis of losses it believes to be inherent in theloan portfolio. When it is deemed probable, based upon known facts andcircumstances, that full contractual interest and principal on an individualloan will not be collected in accordance with its contractual terms, the loan isconsidered impaired. An impairment reserve is established based upon the presentvalue of expected future cash flows, discounted at the loan's original effectiveinterest rate, or as a practical expedient, at the loan's observable marketprice or the fair value of the collateral if the loan is collateral dependent.Generally, impaired loans include loans in nonaccruing status, loans which havebeen assigned a specific allowance for credit losses, loans which have beenpartially charged off, and loans designated as troubled debt restructures.Problem commercial loans are assigned various criticized facility grades underthe allowance for credit losses methodology. Formula-based reserves are also established against commercial loans when, basedupon an analysis of relevant data, it is probable that a loss has been incurredand the amount of that loss can be reasonably estimated, even though an actualloss has yet to be identified. A separate reserve for credit losses associatedwith off-balance sheet exposures including letters of credit, guarantees toextend credit and financial guarantees is also maintained and included in otherliabilities, which incorporates estimates of the probability that customerswill actually draw upon off-balance sheet obligations. This estimationmethodology uses the probability of default from the customer rating assigned toeach counterparty, the "Loss Given Default" rating assigned to each transactionor facility based on the collateral securing the transaction, and the measure ofexposure based on the transaction. These reserves are determined by reference tocontinuously monitored and updated historical loss rates or factors, which arederived from a migration analysis considering net charge off experience by loanand industry type in relation to internal credit grading. 91 Probable losses for pools of homogeneous consumer loans are generally estimatedusing a roll rate migration analysis that estimates the probability that a loanwill progress through the various stages of delinquency, and ultimately chargeoff. This analysis considers delinquency status, loss experience and severityand takes into consideration whether loans are in bankruptcy, have beenrestructured, or are subject to forbearance, an external debt management plan,hardship, modification, extension or deferment. The allowance for credit losseson consumer receivables also takes into consideration the loss severity expectedbased on the underlying collateral, if any, for the loan in the event ofdefault. In addition, loss estimates on consumer receivables are maintained toreflect HUSI's judgment of portfolio risk factors, which may not be fullyreflected in the statistical roll rate calculation. Risk factors considered inestablishing loss reserves on consumer loans include recent growth, product mix,bankruptcy trends, geographic concentrations, economic conditions, portfolioseasoning, account management policies and practices and current levels ofcharge offs and delinquencies. Properties and Equipment, Net Properties and equipment are recorded at cost, net of accumulated depreciationand amortization. Depreciation is provided on a straight-line basis over theestimated useful lives of the assets which generally range from 3 to 40 years.Leasehold improvements are amortized over the lesser of the economic useful lifeof the improvement or the term of the lease. Costs of maintenance and repairsare expensed as incurred. Repossessed Collateral Real estate owned is valued at the lower of cost or fair value less estimatedcosts to sell. These values are periodically reviewed and reduced, if necessary.Costs of holding real estate and related gains and losses on disposition arecredited or charged to operations as incurred as a component of operatingexpense. Repossessed vehicles, net of loss reserves when applicable, arerecorded at the lower of the estimated fair market value or the outstandingreceivable balance. Mortgage Servicing Rights HUSI recognizes the right to service mortgages as a separate and distinct assetat the time the loans are sold, or at the time the rights are acquired.Servicing rights are then amortized in proportion to net servicing income andcarried on the balance sheet in other assets at the lower of their initialcarrying value, adjusted for amortization, or fair value. As interest rates decline, prepayments generally accelerate, thereby reducingfuture net servicing cash flows from the mortgage portfolio. The carrying valueof the mortgage servicing rights (MSRs) is periodically evaluated for impairmentbased on the difference between the carrying value of such rights and theircurrent fair value. If the carrying value of the servicing rights exceeds fairvalue, the asset is deemed impaired and, if deemed temporary, impairment isrecognized by recording a balance sheet valuation reserve with a correspondingcharge to income. If deemed permanent, impairment is recorded as a reduction tothe MSRs and valuation reserve balances. For purposes of measuring impairment,MSRs are stratified based upon interest rates and whether such rates are fixedor variable and other loan characteristics. Fair value is determined based uponthe application of pricing valuation models incorporating portfolio specificprepayment assumptions. The reasonableness of these pricing models isperiodically substantiated by reference to independent broker price quotationsand industry surveys. 92 HUSI uses certain derivative financial instruments including options andinterest rate swaps to protect against the decline in economic value of MSRs.These instruments have not been designated as qualifying hedges in accordancewith U.S. GAAP guidelines and are therefore recorded as trading instruments thatare marked to market through earnings. Goodwill Goodwill, representing the excess of purchase price over the fair value of netidentifiable assets acquired, results from purchase business combinations.Goodwill is not amortized, but is reviewed for impairment annually usingdiscounted cash flows. Impairment may be reviewed earlier if circumstancesindicate that the carrying amount may not be recoverable. HUSI considerssignificant and long-term changes in industry and economic conditions to beprimary indicators of potential impairment. Receivables Sold and Serviced with Limited Recourse and Securitization Revenue Certain private label credit card receivables have been securitized and sold toinvestors with limited recourse. Recourse is limited to HUSI's rights to futurecash flow and any subordinated interest that HUSI may retain. Upon sale, thereceivables are removed from the balance sheet and a gain on sale is recognizedfor the difference between the carrying value of the receivables and theadjusted sales proceeds. The adjusted sales proceeds include cash received andthe present value estimate of future cash flows to be received over the lives ofthe sold receivables. Future cash flows are based on estimates of prepayments,the impact of interest rate movements on yields of receivables and securitiesissued, delinquency of receivables sold, servicing fees and other factors. Theresulting gain is also adjusted by a provision for estimated probable lossesunder the recourse provision. This provision, and the related reserve forreceivables serviced with limited recourse, are established at the time of saleto cover all probable credit losses over the life of the receivables sold basedon historical experience and estimates of expected future performance. Themethodologies vary depending upon the type of receivables sold, using eitherhistorical net charge off rates applied to the expected balances to be receivedover the remaining life of the receivable or a historical static pool analysis.The reserves are reviewed periodically by evaluating the estimated future cashflows of each securitized pool to ensure that there is sufficient remaining cashflow to cover estimated future credit losses. Any changes to the estimates forthe reserve for receivables serviced with limited recourse are made in theperiod they become known. Gains on sales net of recourse provisions, servicingincome and excess spread relating to securitized receivables are reported in theaccompanying consolidated statements of income as securitization revenue. In connection with these transactions, HUSI records an interest-only stripreceivable, representing HUSI's contractual right to receive interest and othercash flows from the securitization trusts. HUSI's interest-only stripreceivables are reported at fair value using discounted cash flow estimates as aseparate component of receivables net of HUSI's estimate of probable lossesunder the recourse provisions. Cash flow estimates include estimates ofprepayments, the impact of interest rate movements on yields of receivables andsecurities issued, delinquency of receivables sold, servicing fees and estimatedprobable losses under the recourse provisions. Unrealized gains and losses arerecorded as adjustments to common shareholder's equity in accumulated othercomprehensive income, net of income taxes. The interest-only strip receivablesare reviewed for impairment quarterly or earlier if events indicate that thecarrying value may not be recovered. Any decline in the fair value of theinterest-only strip receivable which is deemed to be other than temporary ischarged against current earnings. HUSI has also, in certain cases, retained other subordinated interests in thesesecuritizations. Neither the interest-only strip receivables nor the othersubordinated interests are in the form of securities. Prior to the third quarter of 2004, public private label credit cardtransactions were structured as sales to revolving trusts that requirereplenishments to support previously issued securities. Receivables of theseasset types will continue to be sold to these trusts until their revolvingperiod ends, the last of which is expected to occur in 2008. Beginning in thethird quarter of 2004, it is intended that all new collateralized fundingtransactions be structured as secured financings. 93 HUSI has also continued to replenish, at reduced levels, certain non-publicprivate label securities issued to conduits in order to manage liquidity. Income Taxes HNAH files a consolidated federal income tax return, which includes HUSI. Deferred tax assets and liabilities are recognized for the estimated future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases, as well as the estimated future tax consequences attributable to netoperating loss and tax credit carryforwards. These deferred tax assets andliabilities are measured using the tax rates and laws that are expected to be ineffect. A valuation allowance is established if, based on available evidence, itis more likely than not that some portion or all of the deferred tax asset willnot be realized. Foreign taxes paid are applied as credits to reduce federalincome taxes payable, unless utilization of the credit is limited. Derivative Financial Instruments Derivative financial instruments are recognized on the balance sheet at theirfair value. On the date a derivative contract is entered into, HUSI designatesit as either: o a qualifying hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge); o a qualifying hedge of the variability of cash flows to be received or paid related to a recognized asset, liability or forecasted transaction (cash flow hedge); or o as a trading position. Changes in the fair value of a derivative that has been designated and qualifiesas a fair value hedge, along with the changes in the fair value of the hedgedasset or liability that is attributable to the hedged risk (including losses orgains on firm commitments), are recorded in current period earnings. Changes inthe fair value of a derivative that has been designated and qualifies as a cashflow hedge, to the extent effective as a hedge, are recorded in accumulatedother comprehensive income and reclassified into earnings in the period duringwhich the hedged item affects earnings. Ineffectiveness is reflected in currentearnings. Changes in the fair value of derivatives held for trading purposes arereported in current period earnings. At the inception of each hedge, HUSI formally documents all relationshipsbetween hedging instruments and hedged items, as well as its risk managementobjective and strategy for undertaking various hedge transactions, the nature ofthe hedged risk, and how hedge effectiveness and ineffectiveness will bemeasured. This process includes linking all derivatives that are designated asfair value or cash flow hedges to specific assets and liabilities on the balancesheet or to specific firm commitments or forecasted transactions. HUSI alsoformally assesses, both at inception and on a recurring basis, whether thederivatives that are used in hedging transactions are highly effective inoffsetting changes in fair values or cash flows of hedged items and whether theyare expected to continue to be highly effective in future periods. Thisassessment is conducted using statistical regression analysis. For interest rateswaps that meet the criteria whereby no ineffectiveness can be assumed inaccordance with U.S. GAAP guidance, no ongoing assessment is required. Earnings volatility may result from the on-going mark to market of certaineconomically viable derivative contracts that do not satisfy the hedgingrequirements of U.S. GAAP guidance, as well as from the hedge ineffectivenessassociated with the qualifying contracts. 94 Embedded Derivatives HUSI may acquire or originate a financial instrument that contains a derivativeinstrument "embedded" within it. Upon origination or acquisition of any suchinstrument, HUSI assesses whether the economic characteristics of the embeddedderivative are clearly and closely related to the economic characteristics ofthe principal component of the financial instrument (i.e., the host contract)and whether a separate instrument with the same terms as the embedded instrumentwould meet the definition of a derivative instrument. When it is determined that: (1) the embedded derivative possesses economiccharacteristics that are not clearly and closely related to the economiccharacteristics of the host contract; and (2) a separate instrument with thesame terms would qualify as a derivative instrument, the embedded derivative isseparated from the host contract, carried at fair value, and designated atrading instrument. If these conditions are not met, the derivative is notseparated from the host contract. Any gain recognized at inception related tothe derivative is effectively embedded in the debt host contract and isrecognized over the life of the debt instrument. Hedge Discontinuation If it is determined that a derivative is not highly effective as a hedge, orthat in the future it ceases to be a highly effective hedge, HUSI discontinueshedge accounting as of the beginning of the quarter in which such determinationwas made. HUSI discontinues hedge accounting prospectively when: o the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item (including firm commitments or forecasted transactions); o the derivative expires or is sold, terminated, or exercised; o it is unlikely that a forecasted transaction will occur; o the hedged firm commitment no longer meets the definition of a firm commitment; or o the designation of the derivative as a hedging instrument is no longer appropriate. When hedge accounting is discontinued because it is determined that thederivative no longer qualifies as an effective fair value or cash flow hedge,the derivative will continue to be carried on the balance sheet at its fairvalue. In the case of a fair value hedge of a recognized asset or liability, as long asthe hedged item continues to exist on the balance sheet, the hedged item will nolonger be adjusted for changes in fair value. The basis adjustment that hadpreviously been recorded to the hedged item during the period from thedesignation date to the hedge discontinuation date is amortized over theremaining life of the hedged item as an adjustment to the yield. In the case of a cash flow hedge of a recognized asset or liability, as long asthe hedged item continues to exist on the balance sheet, the effective portionof the changes in fair value of the hedging derivative will no longer bereclassified into other comprehensive income. The balance applicable to thediscontinued hedging relationship will be amortized into earnings over theremaining life of the hedged item. If the hedged item was a firm commitment orforecasted transaction that is not expected to occur, any amounts recorded onthe balance sheet related to the hedged item, including any amounts recorded inother comprehensive income, are reclassified to current period earnings. In the case of either a fair value hedge or a cash flow hedge, if the previouslyhedged item is sold or extinguished, the basis adjustment to the underlyingasset or liability or any remaining unamortized other comprehensive incomebalance will be reclassified to current period earnings. In all other situations in which hedge accounting is discontinued, thederivative will be carried at its fair value on the balance sheet, with changesin its fair value recognized in current period earnings unless redesignated as aqualifying hedge. 95 Day One Revenue Recognition HUSI recognizes gain or loss at the inception of derivative transactions onlywhen the fair value of the transaction can be verified to market transactions orif all significant pricing model assumptions can be verified to observablemarket data. The net realized gains recorded in trading assets associated withthese transactions is offset by a reserve until the transaction can be verifiedto observable market data. Stock-Based Compensation HUSI uses the fair value method of accounting for stock awards granted toemployees under various stock option and employee stock purchase plans. Stockcompensation costs are recognized prospectively for all new awards granted underthese plans. Compensation expense relating to share options is calculated usinga binomial lattice methodology that is based on the underlying assumptions ofthe Black-Scholes option pricing model and is charged to expense over thevesting period, generally three to five years. Compensation expense relating torestricted stock rights (RSRs) is based upon the market value of the RSRs on thedate of grant and is charged to earnings over the vesting period of the RSRs,generally three to five years. Transactions with Related Parties In the normal course of business, HUSI enters into transactions with HSBC andits subsidiaries. These transactions include funding arrangements,administrative and operational support, and other miscellaneous services. Allmaterial related party balances and transactions among various direct andindirect subsidiaries of HUSI are eliminated in consolidation. All materialrelated party transactions between HUSI and other HSBC subsidiaries are reportedin Note 20 beginning on page 122 of these consolidated financial statements. New Accounting Pronouncements In December 2004, the Financial Accounting Standards Board (FASB) issued theStatement of Financial Accounting Standards No. 123 (Revised), Share-BasedPayment (SFAS 123R). SFAS 123R requires public entities to measure the cost ofstock-based compensation based on the grant date fair value of the award, aswell as other disclosure requirements. On March 28, 2005, the Securities andExchange Commission (SEC) issued Staff Accounting Bulletin 107 which amended thecompliance date to allow public companies to comply with the provisions of SFAS123R at the beginning of their next fiscal year that begins after June 15, 2005.The adoption of SFAS 123R is not expected to have a significant effect onoperating results or cash flows. In May 2005, the FASB issued Statement of Financial Accounting Standards No.154, Accounting Changes and Error Corrections: a replacement of APB Opinion No.20 (APB 20) and FASB Statement 3 (SFAS 154) which requires companies to applyvoluntary changes in accounting principles retrospectively whenever it ispracticable. The retrospective application requirement replaces APB 20'srequirement to recognize most voluntary changes in accounting principle byincluding the cumulative effect of the change in net income during the periodthe change occurs. Retrospective application will be the required transitionmethod for new accounting pronouncements in the event that a newly-issuedpronouncement does not specify transition guidance. SFAS 154 is effective foraccounting changes made in fiscal years beginning after December 15, 2005. In November 2005, the FASB issued Staff Position Nos. FAS 115-1 and FAS 124-1,The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments (FSP 115-1 and FSP 124-1), in response to Emerging Issues Task Force03-1, The Meaning of Other-Than-Temporary Impairment and Its Application toCertain Investments (EITF 03-1). FSP 115-1 and FSP 124-1 provide guidanceregarding the determination as to when an investment is considered impaired,whether that impairment is other-than-temporary, and the measurement of animpairment loss. FSP 115-1 and FSP 124-1 also include accounting considerationssubsequent to the recognition of an other-than-temporary impairment and requirescertain disclosures about unrealized losses that 96 have not been recognized as other than temporary impairments. These requirementsare effective for annual reporting periods beginning after December 15, 2005.Adoption of the impairment guidance contained in FSP 115-1 and FSP 124-1 is notexpected to have a material impact on HUSI's financial position or results ofoperations. In February 2006, the FASB issued Statement of Financial Accounting StandardsNo. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155). SFAS155 permits fair value measurement for any hybrid financial instrument thatcontains an embedded derivative that would otherwise require bifurcation andseparate accounting. An irrevocable election may be made at inception to measuresuch a hybrid financial instrument at fair value, with changes in fair valuerecognized through income. Such an election needs to be supported by concurrentdocumentation. SFAS 155 is effective for fiscal years beginning after September15, 2006, with early adoption permitted. HUSI is currently considering theimpact that adoption will have on its consolidated results and financialposition. In August 2005, the FASB issued an exposure draft for a proposed Statement ofFinancial Accounting Standards entitled, Accounting for Servicing of FinancialAssets (the proposed SFAS). The proposed SFAS would amend previously issuedguidance with respect to accounting for separately recognized loan servicingrights. Under the proposed SFAS, all servicing rights would initially bemeasured at fair value, if practicable. For each class of servicing rights, anentity would be permitted to choose either of the following methods: (a) amortize servicing assets or liabilities in proportion to and over the period of estimated net servicing income or net servicing loss. This method would require an assessment of servicing assets or liabilities for impairment based on fair value at each reporting date; or (b) report servicing assets or liabilities at fair value at each reporting date and report changes in fair value in earnings in the period in which the changes occur. Transition provisions of the proposed SFAS permit a one-time reclassification ofavailable for sale securities used to offset changes in the economic value ofMSRs to trading securities, without calling into question the treatment of thosesecurities under Statement of Financial Accounting Standards No. 115, Accountingfor Certain Investments in Debt and Equity Securities (SFAS 115). Thisreclassification would be permitted upon initial adoption of the proposed SFASas of the beginning of the fiscal year of adoption. If issued in the form of theproposed SFAS, HUSI plans to early adopt its provisions as of January 1, 2006and recognize residential mortgage servicing rights (MSRs) at fair value. Theeffect of measuring existing MSRs at fair value and reclassifying available forsale securities to trading securities will be accounted for as a cumulativeeffect adjustment to retained earnings. Adoption of this proposed SFAS is notexpected to have a material effect on HUSI's consolidated results or financialposition. In January 2006, the FASB issued an exposure draft for a proposed SFAS, The FairValue Option for Financial Assets and Financial Liabilities, Including anAmendment of FASB Statement No. 115 (the proposed SFAS). Under this proposedSFAS, an entity may irrevocably elect fair value as the initial and subsequentmeasurement attribute for certain financial assets and financial liabilities,with changes in fair value recognized in earnings as those changes occur. If thefinal SFAS is issued in this form, HUSI plans to make the election for certaincategories of financial instruments. 97 Note 3. Acquisitions and Divestitures-------------------------------------------------------------------------------- 2005 There were no material business acquisitions or divestitures during 2005. 2004 On December 29, 2004, HUSI purchased approximately $12 billion of private labelloans, primarily credit card receivables, from HSBC Finance Corporation at fairvalue. HSBC Finance Corporation retained the customer relationships associatedwith these balances. This portfolio acquisition resulted in creation of theConsumer Finance business segment in 2005. See Note 23 beginning page 132 ofthis Form 10-K for a summary of HUSI's results by business segment. On June 1, 2004, HUSI transferred a wholly owned domestic brokerage subsidiaryto HMUS at fair value. The transaction did not have a material impact on HUSI'soperations for 2005 or 2004. On July 31, 2004, HUSI transferred most of its Panamanian branch operations toan HSBC affiliate at fair value. The transaction did not have a material impacton HUSI's operations for 2005 or 2004. On February 29, 2004, HUSI sold its banking subsidiary in Uruguay to an HSBCaffiliate at fair value. The transaction did not have a material impact onHUSI's operations for 2005 or 2004. Note 4. Trading Assets and Liabilities-------------------------------------------------------------------------------- Trading assets and liabilities are summarized in the following table. --------------------------------------------------------------------------------December 31, 2005 2004-------------------------------------------------------------------------------- (in millions)Trading assets: U.S. Treasury .................................. $ 148 $ 181 U.S. Government agency ......................... 1,238 677 Asset backed securities ........................ 1,981 1,144 Corporate bonds ................................ 2,786 1,771 Other securities ............................... 4,626 3,263 Precious metals ................................ 2,286 3,172 Fair value of derivatives ...................... 8,155 9,607 -------- -------- $ 21,220 $ 19,815 ======== ========Trading account liabilities: Securities sold, not yet purchased ............. $ 1,808 $ 951 Payables for precious metals ................... 1,161 1,134 Fair value of derivatives ...................... 7,741 10,035 -------- -------- $ 10,710 $ 12,120 ======== ======== 98 Note 5. Securities-------------------------------------------------------------------------------- At December 31, 2005 and 2004, HUSI held no securities of any single issuer(excluding the U.S. Treasury and U.S. Government agencies) with a book valuethat exceeded 10% of shareholders' equity. The amortized cost and fair value of the available for sale and held to maturitysecurities portfolios are summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ Gross Gross Amortized Unrealized Unrealized FairDecember 31, 2005 Cost Gains Losses Value------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Treasury ....................................... $ 711 $ -- $ (4) $ 707 U.S. Government sponsored enterprises (1) ........... 10,850 25 (251) 10,624 U.S. Government agency issued or guaranteed ......... 2,466 10 (48) 2,428 Obligations of U.S. states and political subdivisions 487 -- (5) 482 Asset backed securities ............................. 1,165 2 (4) 1,163 Other domestic debt securities ...................... 1,700 6 (15) 1,691 Foreign debt securities ............................. 611 8 (5) 614 Equity securities ................................... 49 6 -- 55 ---------- ---------- ---------- ---------- Securities available for sale ....................... $ 18,039 $ 57 $ (332) $ 17,764 ========== ========== ========== ========== Securities held to maturity: U.S. Treasury ....................................... $ 83 $ -- $ -- $ 83 U.S. Government sponsored enterprises (1) ........... 1,860 57 (21) 1,896 U.S. Government agency issued or guaranteed ......... 644 31 (1) 674 Obligations of U.S. states and political subdivisions 369 25 -- 394 Other domestic debt securities ...................... 164 1 (1) 164 Foreign debt securities ............................. 51 -- -- 51 ---------- ---------- ---------- ---------- Securities held to maturity ......................... $ 3,171 $ 114 $ (23) $ 3,262 ========== ========== ========== ========== (1) Includes primarily mortgage backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). ------------------------------------------------------------------------------------------------------------------------ Gross Gross Amortized Unrealized Unrealized FairDecember 31, 2004 Cost Gains Losses Value------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Treasury ....................................... $ 203 $ -- $ (3) $ 200 U.S. Government sponsored enterprises (1) ........... 8,136 47 (90) 8,093 U.S. Government agency issued or guaranteed ......... 2,236 28 (29) 2,235 Asset backed securities ............................. 1,122 3 (1) 1,124 Other domestic debt securities ...................... 1,783 10 (2) 1,791 Foreign debt securities ............................. 1,090 15 (2) 1,103 Equity securities ................................... 64 49 (4) 109 ---------- ---------- ---------- ---------- Securities available for sale ....................... $ 14,634 $ 152 $ (131) $ 14,655 ========== ========== ========== ========== Securities held to maturity: U.S. Treasury ....................................... $ 122 $ -- $ -- $ 122 U.S. Government sponsored enterprises (1) ........... 2,202 92 (11) 2,283 U.S. Government agency issued or guaranteed ......... 716 40 (2) 754 Obligations of U.S. states and political subdivisions 465 37 -- 502 Other domestic debt securities ...................... 231 6 (1) 236 Foreign debt securities ............................. 145 -- -- 145 ---------- ---------- ---------- ---------- Securities held to maturity ......................... $ 3,881 $ 175 $ (14) $ 4,042 ========== ========== ========== ========== (1) Includes primarily mortgage backed securities issued by FNMA and FHLMC. 99 A summary of gross unrealized losses and related fair values, classified as tothe length of time the losses have existed, is presented in the following table. --------------------------------------------------------------------------------------------------------------------- One Year or Less Greater Than One Year --------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair ValueDecember 31, 2005 Securities Losses of Investment Securities Losses of Investment--------------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Government sponsored enterprises (1) ......... 560 $ (176) $ 7,313 46 $ (75) $ 1,434 U.S. Government agency issued or guaranteed .... 288 (22) 1,346 82 (26) 434 All other securities ...... 113 (32) 2,944 39 (1) 82 -------- -------- -------- -------- -------- -------- Securities available for sale 961 $ (230) $ 11,603 167 $ (102) $ 1,950 ======== ======== ======== ======== ======== ======== Securities held to maturity: U.S. Government sponsored enterprises (1) ......... 28 $ (14) $ 397 3 $ (7) $ 41 U.S. Government agency issued or guaranteed .... 181 (1) 34 -- -- -- All other securities ...... 11 -- 167 12 (1) 9 -------- -------- -------- -------- -------- -------- Securities held to maturity 220 $ (15) $ 598 15 $ (8) $ 50 ======== ======== ======== ======== ======== ======== (1) Includes primarily mortgage-backed securities issued by FNMA and FHLMC. -------------------------------------------------------------------------------------------------------------------- One Year or Less Greater Than One Year --------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair ValueDecember 31, 2004 Securities Losses of Investment Securities Losses of Investment--------------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Government sponsored enterprises (1) ......... 78 $ (36) $ 3,118 51 $ (54) $ 1,344 U.S. Government agency issued or guaranteed .... 62 (11) 646 115 (18) 532 All other securities ...... 32 (9) 687 21 (3) 103 -------- -------- -------- -------- -------- -------- Securities available for sale 172 $ (56) $ 4,451 187 $ (75) $ 1,979 ======== ======== ======== ======== ======== ======== Securities held to maturity: U.S. Government sponsored enterprises (1) ......... 8 $ (2) $ 163 12 $ (9) $ 247 U.S. Government agency issued or guaranteed .... 4 (1) 27 3 (1) 34 All other securities ...... 7 (1) 5 -- -- -- -------- -------- -------- -------- -------- -------- Securities held to maturity 19 $ (4) $ 195 15 $ (10) $ 281 ======== ======== ======== ======== ======== ======== (1) Includes primarily mortgage-backed securities issued by FNMA and FHLMC. Gross unrealized losses have generally increased within the available for salesecurities and held to maturity securities portfolios during 2005, due to risingshort-term and medium-term interest rates. Since substantially all of thesesecurities are high credit grade (i.e., AAA or AA), and HUSI has the intent tohold these securities until maturity or a market price recovery, they are notconsidered to be other than temporarily impaired. 100 The following table summarizes realized gains and losses on investmentsecurities transactions attributable to available for sale and held to maturitysecurities. Amounts in the table include net realized gains (losses) of $(11)million, $8 million and $22 million reported in residential mortgage bankingrevenue in the consolidated statement of income for 2005, 2004 and 2003respectively. -------------------------------------------------------------------------------------------------------------------- Net Gross Gross Realized Realized Realized GainsYear Ended December 31 Gains (Losses) (Losses)-------------------------------------------------------------------------------------------------------------------- (in millions) 2005Securities available for sale .................................. $ 107 $ (13) $ 94Securities held to maturity: Maturities, calls and mandatory redemptions ................ 1 -- 1 ---------- ---------- ----------- $ 108 $ (13) $ 95 ========== ========== =========== 2004Securities available for sale .................................. $ 100 $ (8) $ 92Securities held to maturity: Maturities, calls and mandatory redemptions ................ 1 -- 1 ---------- ---------- ----------- $ 101 $ (8) $ 93 ========== ========== =========== 2003Securities available for sale .................................. $ 81 $ (11) $ 70 ========== ========== =========== 101 The amortized cost and fair values of securities available for sale andsecurities held to maturity at December 31, 2005, by contractual maturity aresummarized in the following table. Expected maturities differ from contractualmaturities because borrowers have the right to prepay obligations withoutprepayment penalties in certain cases. Available for sale amounts exclude $49million cost ($55 million fair value) of equity securities that do not havematurities. The following table also reflects the distribution of maturities of debtsecurities held at December 31, 2005, together with the approximate taxableequivalent yield of the portfolio. The yields shown are calculated by dividingannual interest income, including the accretion of discounts and theamortization of premiums, by the amortized cost of securities outstanding atDecember 31, 2005. Yields on tax-exempt obligations have been computed on ataxable equivalent basis using applicable statutory tax rates. ------------------------------------------------------------------------------------------------------------------------ Within After One After Five AfterTaxable One But Within But Within TenEquivalent Year Five Years Ten Years YearsBasis Amount Yield Amount Yield Amount Yield Amount Yield------------------------------------------------------------------------------------------------------------------------ (in millions) Available for sale: U.S. Treasury ...... $ -- --% $ 611 3.79% $ 100 4.25% $ -- --% U.S. Government sponsored enterprises 16 5.41 488 3.19 917 4.56 9,429 4.75 U.S. Government agency issued or guaranteed -- -- 60 4.17 35 5.07 2,371 4.36 Obligations of U.S. states and political subdivisions ..... -- -- -- -- -- -- 487 5.06 Asset backed securities -- -- 458 4.13 497 4.30 210 4.67 Other domestic debt securities ....... 27 4.89 70 4.73 64 4.67 1,539 4.96 Foreign debt securities 92 6.19 294 5.83 97 6.88 128 6.89 ------- ---- ------- ---- ------- ---- ------- ----Total amortized cost ..... $ 135 5.84% $ 1,981 4.07% $ 1,710 4.61% $14,164 4.74% ------- ---- ------- ---- ------- ---- ------- ----Total fair value ......... $ 141 $ 1,956 $ 1,679 $13,933 ======= ======= ======= ======= Held to maturity: U.S. Treasury ...... $ 83 3.47% $ -- --% $ -- --% $ -- --% U.S. Government sponsored enterprises 11 7.04 22 7.30 122 6.10 1,705 5.91 U.S. Government agency issued or guaranteed -- -- 20 6.97 2 7.68 622 6.58 Obligations of U.S. states and political subdivisions ..... 8 6.42 52 6.11 61 5.52 248 5.19 Other domestic debt securities ....... -- -- -- -- -- -- 164 5.80 Foreign debt securities 51 3.27 -- -- -- -- -- -- ------- ---- ------- ---- ------- ---- ------- ----Total amortized cost ..... $ 153 3.81% $ 94 6.56% $ 185 5.93% $ 2,739 5.99% ------- ---- ------- ---- ------- ---- ------- ----Total fair value ......... $ 153 $ 98 $ 197 $ 2,814 ======= ======= ======= ======= 102 Note 6. Loans-------------------------------------------------------------------------------- A distribution of the loan portfolio, including loans held for sale, issummarized in the following table. --------------------------------------------------------------------------------------------------------------------- December 31, 2005 December 31, 2004 --------------------------- --------------------------- Total Held for Sale Total Held for Sale--------------------------------------------------------------------------------------------------------------------- (in millions) Commercial: Construction and other real estate ........... $ 9,123 $ -- $ 8,281 $ -- Other commercial ............................. 18,598 -- 14,691 --Consumer: Residential mortgage ......................... 43,970 4,175 46,775 1,352 Credit card receivables ...................... 15,514 -- 12,078 -- Other consumer loans ......................... 3,137 390 3,122 402 ---------- ---------- ---------- ---------- $ 90,342 $ 4,565 $ 84,947 $ 1,754 ========== ========== ========== ========== On December 29, 2004, HUSI acquired a $12 billion private label loan portfoliofrom HSBC Finance Corporation. The portfolio consisted of approximately $11billion of private label credit card receivables and $1 billion of otherconsumer and commercial loans. By agreement, HUSI is purchasing additionalreceivables generated under current and future private label credit cardaccounts at fair value on a daily basis. During 2005, underlying customerbalances included within the private label portfolio have revolved, and newrelationships have been added, bringing the total private label credit cardportfolio balance to approximately $15 billion at December 31, 2005. During 2005, HUSI purchased $1.5 billion of residential mortgage loans fromoriginating lenders pursuant to HSBC Finance Corporation correspondent loanprograms. Purchases of residential mortgage loans from HSBC Finance Corporationwere discontinued effective September 1, 2005. Residential mortgage loan originations generally declined during 2005 due to arising interest rate environment. In addition, originations of variousadjustable rate residential mortgage loan products that would have been retainedon the balance sheet prior to 2005 were being sold in the secondary marketbeginning in 2005. These factors contributed to the overall decrease inresidential mortgage loans during 2005. In June 2005, HUSI began acquiring residential mortgage loans from unaffiliatedthird parties, with the intent of selling the loans to HMUS. The increase inheld for sale loans during 2005 directly resulted from this new activity. Thesale of these loans to HMUS are further described in Note 20 beginning on page122 of this Form 10-K. Commercial loans include certain bonds issued by the government of Venezuela aspart of debt renegotiations (Brady Bonds). HUSI's intent is to hold theseinstruments until maturity. The Brady Bonds are fully secured as to principal byzero-coupon U.S. Treasury securities with a face value equal to that of theunderlying bonds. The following table presents information regarding BradyBonds. --------------------------------------------------------------------------------December 31 2005 2004-------------------------------------------------------------------------------- (in millions)Balance at end of year: Face value ................................. $ 178 $ 178 Aggregate carrying value ................... 166 166 Aggregate fair value ....................... 178 177 HUSI has loans outstanding to certain executive officers and directors. Theloans were made on substantially the same terms, including interest rates andcollateral, as those prevailing at the same time for comparable transactionswith other persons and do not involve more than normal risk of collectibility.The aggregate amount of such loans did not exceed 5% of shareholders' equity atDecember 31, 2005 and 2004. 103 Credit Quality Statistics The following table presents a summary of credit quality statistics. ------------------------------------------------------------------------------------------------------------------------ 2005 2004 2003 2002 2001------------------------------------------------------------------------------------------------------------------------ (in millions) Nonaccruing loans Balance at end of period: Commercial: Construction and other real estate.. $ 15 $ 33 $ 30 $ 29 $ 28 Other commercial ................... 70 117 233 242 252 ------ ------ ------ ------ ------ Total commercial ................... 85 150 263 271 280 ------ ------ ------ ------ ------ Consumer: Residential mortgages .............. 156 113 78 88 96 Credit card receivables ............ -- -- 22 27 28 Other consumer loans ............... -- 1 3 1 13 ------ ------ ------ ------ ------ Total consumer loans ............... 156 114 103 116 137 ------ ------ ------ ------ ------ Total nonaccruing loans .................. $ 241 $ 264 $ 366 $ 387 $ 417 ====== ====== ====== ====== ====== As a percent of loans: Commercial: Construction and other real estate . .16% .40% .43% .46% .47% Other commercial ................... .38 .80 2.00 1.78 1.80 ------ ------ ------ ------ ------ Total commercial ................... .31 .65 1.41 1.36 1.41 ------ ------ ------ ------ ------ Consumer: Residential mortgages .............. .35 .24 .29 .42 .54 Credit card receivables ............ -- -- 1.89 2.37 2.36 Other consumer loans ............... -- .03 .15 .05 .64 ------ ------ ------ ------ ------ Total consumer loans ............... .25 .18 .35 .49 .65 ------ ------ ------ ------ ------ Total .................................... .27% .31% .76% .89% 1.02% ====== ====== ====== ====== ====== Interest income on nonaccruing loans (Year ended December 31): Amount which would have been recorded had the associated loans been current in accordance with their original terms ... $ 25 $ 23 $ 28 $ 37 $ 31 Amount actually recorded ................. 12 17 12 9 19 Accruing loans contractually past due 90 days or more as to principal or interest: Total commercial ......................... $ 19 $ 13 $ 25 $ 36 $ 12 ------ ------ ------ ------ ------ Consumer: Residential mortgages .............. 27 1 1 2 1 Credit card receivables ............ 248 223 -- -- -- Other consumer loans ............... 17 22 11 3 9 ------ ------ ------ ------ ------ Total consumer loans ............... 292 246 12 5 10 ------ ------ ------ ------ ------ Total accruing loans contractually past due 90 days or more .................... $ 311 $ 259 $ 37 $ 41 $ 22 ====== ====== ====== ====== ====== Criticized assets (balance at end of period): Special mention .......................... $ 706 $ 784 $ 618 $1,099 $1,146 Substandard .............................. 721 590 682 996 946 Doubtful ................................. 25 46 128 115 108 ------ ------ ------ ------ ------ Total .................................... $1,452 $1,420 $1,428 $2,210 $2,200 ====== ====== ====== ====== ====== Impaired loans: Balance at end of period .............. $ 90 $ 236 $ 267 $ 288 $ 243 Amount with impairment reserve ........ 27 210 179 170 151 Impairment reserve .................... 10 18 86 89 83 Other real estate and owned assets: Balance at end of period ................. $ 35 $ 15 $ 17 $ 17 $ 18 Ratio of total nonaccruing loans, other real estate and owned assets to total assets ................................. .18% .20% .40% .45% .50% 104 Note 7. Allowance for Credit Losses-------------------------------------------------------------------------------- An analysis of the allowance for credit losses is presented in the followingtable. ------------------------------------------------------------------------------------------------------------------------ 2005 2004 2003------------------------------------------------------------------------------------------------------------------------ (in millions) Balance at beginning of year ............................................... $ 788 $ 399 $ 493Allowance related to acquisitions and (dispositions), net .................. -- 485 (15)Charge offs ................................................................ 871 157 243Recoveries ................................................................. 255 78 51 ------- ------- ------- Net charge offs ...................................................... 616 79 192 ------- ------- -------Provision (credited) charged to income ..................................... 674 (17) 113 ------- ------- -------Balance at end of year ..................................................... $ 846 $ 788 $ 399 ======= ======= ======= On December 29, 2004, HUSI acquired approximately $12 billion of private labelloans from HSBC Finance Corporation, including an allowance for credit losses ofapproximately $505 million associated with the purchased loans. The 2005provision for credit losses and levels of allowance for credit losses reflectthe impact of the acquisition of private label receivables, as well as theimpact of other loans and receivables growth during 2005. Additionally, theprovision for 2005 and overall allowance levels at December 31, 2005 includetotal incremental provisions of $10 million relating to Hurricane Katrina and $5million relating to new bankruptcy legislation. Included in the December 31, 2005 and December 31, 2004 allowances for creditlosses are approximately $4 million and $14 million respectively, of non-UnitedStates transfer risk reserves. Note 8. Asset Securitizations-------------------------------------------------------------------------------- On December 29, 2004, HUSI acquired a domestic private label loan portfolio fromHSBC Finance Corporation, without recourse, which included a consumer privatelabel credit card portfolio, securitized receivables related to this portfolio,and retained interest assets related to these securitizations. HUSI purchasedall retained interests associated with these securitizations. Structure of Credit Card Securitizations These credit card securitization transactions are structured to receive saletreatment under Statement of Financial Accounting Standards No. 140, Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities, a replacement of FASB Statement No. 125, (SFAS 140). In asecuritization, a designated pool of private label credit card receivables isremoved from the balance sheet and transferred to an unaffiliated trust. Thisunaffiliated trust is a qualifying special purpose entity (QSPE) as defined bySFAS 140 and, therefore, is not consolidated. The QSPE funds its receivablepurchase through the issuance of securities to investors, entitling them toreceive specified cash flows during the life of the securities. The securitiesare collateralized by the underlying receivables transferred to the QSPE. To help ensure that adequate funds are available to meet the cash needs of theQSPE, various forms of interests in securitized assets may be retained includinginterest-only strip receivables, over collateralization, subordinated tranches,interest in accrued interest and fees, or other retained interests which providecredit enhancement to investors. Interest-only strip receivables are rights tofuture cash flows arising from the securitized receivables after the investorsreceive their contractual return, and are recorded at fair value, net of relatedloss reserves. Investors and the securitization trusts have only limitedrecourse to HUSI's assets for failure of debtors to pay. That recourse islimited to the rights to future cash flows and other subordinated interest thatHUSI may retain. Cash flows related to the interest-only strip receivables arecollected over the life of the underlying securitized receivables. 105 HUSI's retained securitization interests are not in the form of securities andare included in other assets on the consolidated balance sheet. The compositionof these retained interests is summarized in the following table. ------------------------------------------------------------------------------------------------------------------------December 31 2005 2004------------------------------------------------------------------------------------------------------------------------ (in millions) Retained interests reported in other assets: Interest-only strip receivables .................................................... $ 15 $ 50 Over collateralization ............................................................. 74 126 Subordinated tranches .............................................................. -- 163 Subordinated interest in accrued interest and fees ................................. 18 37 ------- ------- Total retained interests ........................................................... $ 107 $ 376 ======= ======= Under IFRS HUSI's securitizations are treated as secured financings. In order toalign accounting treatment with that of HSBC, all new collateralized fundingtransactions are structured as secured financings. However, because existingpublic private label credit card transactions were structured as sales torevolving trusts that require replenishments of receivables to supportpreviously issued securities, receivables will continue to be sold to thesetrusts until the revolving periods end, the last of which is expected to occurin 2007. In a secured financing, a designated pool of receivables are conveyed to awholly owned limited purpose subsidiary, which in turn transfers receivables toa trust that sells interests to investors. Repayment of the debt issued by thetrust is secured by the receivables transferred. The transactions are structuredas secured financings under SFAS 140. Therefore, the receivables and theunderlying debt of the trust remain on HUSI's balance sheet. HUSI does notrecognize a gain in a secured financing transaction. Because the receivables anddebt remain on the balance sheet, revenues and expenses are reported consistentwith the owned balance sheet portfolio. As of December 31, 2005, securedfinancings of $1.5 billion were secured by $2.2 billion of private label creditcard receivables. Securitization revenue primarily includes servicing revenue and excess spreadassociated with the current and prior period securitization of loans withlimited recourse structured as sales. Interest-only strip receivables, net of the related losses and excluding themark to market adjustment recorded in accumulated other comprehensive incomedecreased by $46 million in 2005. Credit card revolving securitization trusts are established at fixed levels andrequire frequent sales of new loan balances into the trust to replace loans asthey run off. These replenishments totaled $8.7 billion in 2005. Cash flows received from credit card revolving securitization trusts were asfollows. ------------------------------------------------------------------------------------------------------------------------Year Ended December 31 2005------------------------------------------------------------------------------------------------------------------------ (in millions) Servicing fees received .................................................................................. $ 50Other cash flow received on retained interests (1) ....................................................... 109 (1) Includes all cash flows from interest-only strip receivables, excluding servicing fees. 106 At December 31, 2005, the sensitivity of the current fair value of theinterest-only strip receivables to immediate unfavorable 10% and 20% changes inassumptions was tested, resulting in insignificant impacts on the carryingvalue. Static pool credit losses are calculated by summing actual and projected futurecredit losses and dividing them by the original balance of each pool of asset.Due to the short term revolving nature of credit card balances, theweighted-average percentage of static pool credit losses is not considered to bematerially different from the weighted-average charge off assumptions used indetermining the fair value of interest-only strip receivables. Total receivables and two-month-and over contractual delinquencies for theprivate label credit card portfolio are summarized in the following table: --------------------------------------------------------------------------------------------------------------------- December 31, 2005 December 31, 2004 -------------------------- -------------------------- Loans Delinquent Loans Delinquent Outstanding Loans Outstanding Loans--------------------------------------------------------------------------------------------------------------------- (in millions) Managed private label credit card receivables ........... $ 15,698 2.37% $ 14,425 2.66%Receivables securitized and serviced with limited recourse ...................................... (1,343) 2.53 (3,490) 2.44 ---------- ---------- ---------- ---------- Owned private label credit card receivables ............. $ 14,355 2.36% $ 10,935 2.73% ========== ========== ========== ========== Average loan balances and net charge offs for the private label credit cardportfolio are presented in the following table. Since the portfolio waspurchased on December 29, 2004, average balances are not available as ofDecember 31, 2004. Net charge offs were minimal for the period in which HUSIowned the portfolio in 2004. ------------------------------------------------------------------------------------------------------------------ Average NetDecember 31, 2005 Loans Charge Offs------------------------------------------------------------------------------------------------------------------ (in millions) Managed private label credit card receivables................................. $ 14,532 3.85%Receivables securitized and serviced with limited recourse ................... (2,194) 4.94 ---------- --------- Owned private label credit card receivables .................................. $ 12,338 3.65% ========== ========= Note 9. Properties and Equipment, Net-------------------------------------------------------------------------------- The composition of properties and equipment, net of accumulated depreciation andamortization, is summarized in the following table. -------------------------------------------------------------------------------------------------------------------- DepreciableDecember 31 Life (Years) 2005 2004-------------------------------------------------------------------------------------------------------------------- (in millions) Land -- $ 92 $ 99Buildings ......................................................... 5-40 688 711Furniture and equipment ........................................... 3-7 503 483 --------- ---------Total ............................................................. 1,283 1,293 --------- ---------Less: accumulated depreciation and amortization ................... (745) (699) --------- ---------Properties and equipment, net ..................................... $ 538 $ 594 ========= ========= Depreciation and amortization expense was approximately $85 million and $98million in 2005 and 2004 respectively. 107 Note 10. Intangible Assets, Net-------------------------------------------------------------------------------- The following table summarizes the composition of intangible assets. ------------------------------------------------------------------------------------------------------------------------December 31 2005 2004------------------------------------------------------------------------------------------------------------------------ (in millions) Mortgage servicing rights, net of accumulated amortization and valuation allowance ............ $ 418 $ 309Other ......................................................................................... 45 43 ------- -------Intangible assets, net ........................................................................ $ 463 $ 352 ======= ======= Mortgage Servicing Rights (MSRs) HUSI recognizes the right to service mortgages as a separate and distinct assetat the time the related loans are sold, or at the time the MSRs are purchased.MSRs are amortized in proportion to net servicing income and carried on thebalance sheet at the lower of their initial carrying value, adjusted foramortization, or fair value. Fair value is based on the present value of future cash flows which, at December31, 2005, was calculated using a constant prepayment rate (CPR) of 16.3%annualized, a constant discount rate of 12.07%, and a weighted average life of5.5 years. The following table summarizes activity for MSRs and the related valuationallowance. ----------------------------------------------------------------------------------------------------------------------- 2005 2004 2003----------------------------------------------------------------------------------------------------------------------- (in millions) MSRs, net of accumulated amortization: Balance, January 1 ......................................................... $ 416 $ 526 $ 395 Additions related to loan sales ............................................ 136 62 283 Net MSRs acquisitions (sales) .............................................. -- (54) 51 Permanent impairment charges ............................................... (21) (15) (44) Amortization ............................................................... (74) (103) (159) ------- ------- ------- Balance, December 31 ....................................................... 457 416 526 ------- ------- ------- Valuation allowance for MSRs: Balance, January 1 ......................................................... (107) (23) (40) Temporary impairment (provision) recovery .................................. 47 (102) (27) Permanent impairment charges ............................................... 21 15 44 Release of allowance related to MSRs sold .................................. -- 3 -- ------- ------- ------- Balance, December 31 ....................................................... (39) (107) (23) ------- ------- ------- MSRs, net of accumulated amortization and valuation allowance at December 31 ....................................................... $ 418 $ 309 $ 503 ======= ======= ======= Residential mortgage loans serviced for others are not included in theaccompanying consolidated balance sheets. The outstanding principal balances ofthese loans were $32 billion and $28 billion at December 31, 2005 and 2004respectively. Custodial balances maintained in connection with the foregoingloan servicing, and included in noninterest bearing deposits in domesticoffices, were approximately $628 million and $546 million at December 31, 2005and 2004 respectively. Normal amortization for the current MSRs portfolios is expected to beapproximately $73 million for the year ending December 31, 2006, declininggradually to approximately $36 million for the year ending December 31, 2010.Actual levels of amortization could increase or decrease depending upon changesin interest rates and loan prepayment activity. Actual levels of amortizationare also dependent upon future levels of MSRs recorded. 108 Other Intangible Assets Other intangible assets primarily includes favorable lease arrangements, whichresulted from various business acquisitions. Scheduled amortization willapproximate $5 million per year for 2006 through 2010. Note 11. Goodwill-------------------------------------------------------------------------------- During the second quarter of 2005, HUSI completed its annual impairment test ofgoodwill and determined that the fair value of each of the reporting unitsexceeded its carrying value. As a result, no impairment loss was required to berecognized. During 2005, HUSI sold certain branches, which resulted in insignificantdecreases in goodwill. During 2004, HUSI sold or transferred certain domestic and foreign operations toaffiliated HSBC entities, resulting in reductions of goodwill of approximately$80 million. Note 12. Deposits-------------------------------------------------------------------------------- The aggregate amount of time deposit accounts (primarily certificates ofdeposits) each with a minimum of $100,000 included in domestic office depositswere approximately $23 billion and $19 billion at December 31, 2005 and 2004respectively. The scheduled maturities of all time deposits at December 31, 2005follows. -------------------------------------------------------------------------------- Domestic Foreign Offices Offices Total-------------------------------------------------------------------------------- (in millions)2006: 0-90 days ................ $11,662 $10,797 $22,459 91-180 days .............. 6,814 156 6,970 181-365 days ............. 5,117 118 5,235 ------- ------- ------- 23,593 11,071 34,6642007 ........................... 3,187 3 3,1902008 ........................... 1,355 5 1,3602009 ........................... 176 -- 1762010 ........................... 103 -- 103Later years .................... 330 -- 330 ------- ------- ------- $28,744 $11,079 $39,823 ======= ======= ======= Overdraft deposits reclassified to loans were approximately $1,291 million and$370 million at December 31, 2005 and 2004 respectively. 109 Note 13. Short-Term Borrowings-------------------------------------------------------------------------------- Selected information for short-term borrowings is summarized in the followingtable. Average interest rates during each year are computed by dividing totalinterest expense by the average amount borrowed. ------------------------------------------------------------------------------------------------------------------------ 2005 2004 2003 ----------------------- -------------------- --------------------- Amount Rate Amount Rate Amount Rate------------------------------------------------------------------------------------------------------------------------ (in millions) Federal funds purchased (day to day): At December 31 ........................ $ 57 3.86% $ 2,152 2.31% $ 1,718 .95% Average during year ................... 720 3.12 958 1.30 915 1.11 Maximum month-end balance ............. 580 2,612 2,563Securities sold under repurchase agreements: At December 31 ........................ 1,273 4.39 1,733 2.69 357 1.45 Average during year ................... 1,362 3.99 1,008 3.38 638 1.97 Maximum month-end balance ............. 1,594 2,597 1,475Commercial paper: At December 31 ........................ 2,620 4.28 1,879 2.22 1,730 1.08 Average during year ................... 2,673 3.32 1,735 1.40 1,406 1.21 Maximum month-end balance ............. 3,185 1,911 1,730Precious metals: At December 31 ........................ 2,494 .49 3,163 .41 2,808 .78 Average during year ................... 2,644 .47 3,017 .42 3,437 .33 Maximum month-end balance ............. 2,997 3,338 3,735All other short-term borrowings: At December 31 ........................ 605 3.67 947 2.76 169 .97 Average during year ................... 1,828 3.87 766 3.93 1,044 1.53 Maximum month-end balance ............. 5,026 2,187 2,103 At December 31, 2005, HUSI had an unused $2 billion line of credit from HSBCFinance Corporation. The interest rate is comparable to third party rates for aline of credit with similar terms. At December 31, 2005, HUSI had an unused line of credit from HSBC of $2 billion.This line of credit does not require compensating balance arrangements andcommitment fees are not significant. Interest rates are comparable to thirdparty rates for lines of credit with similar terms. At December 31, 2005, HUSI had an unused line of credit from HNAI of $150million. The interest rate is comparable to third party rates for a line ofcredit with similar terms. As a member of the New York Federal Home Loan Bank (FHLB), HUSI has a securedborrowing facility which is collateralized by residential mortgage loan assets.At December 31, 2005, the facility included $5 billion of borrowings included inlong-term debt (see Note 14 on page 111). The facility also allows access tofurther short-term borrowings based upon the amount of residential mortgageloans pledged as collateral with the FHLB, which were undrawn as of December 31,2005. 110 Note 14. Long-Term Debt-------------------------------------------------------------------------------- The composition of long-term debt is presented in the following table. Interestrates on floating rate notes are determined periodically by formulas based oncertain money market rates or, in certain instances, by minimum interest ratesas specified in the agreements governing the issues. Interest rates in effect atDecember 31, 2005 are shown in parentheses. -----------------------------------------------------------------------------------------------------------------------December 31 2005 2004----------------------------------------------------------------------------------------------------------------------- (in millions) Issued or acquired by HUSI or its subsidiaries other than HBUS:Non-subordinated debt: 8.375% Debentures due 2007 ........................................................ $ 101 $ 101 Floating Rate Extendible Notes due 2007-2011 (4.35%) .............................. 1,497 -- --------- --------- 1,598 101Subordinated debt: 7% Subordinated Notes due 2006 .................................................... 300 300 Fixed Rate Subordinated Notes due 2008-2097 (5.88% - 9.70%) ....................... 1,501 1,522 Perpetual Capital Notes (4.15%) ................................................... 126 125 Junior Subordinated Debentures due 2026-2032 (7.53% - 8.38%) ...................... 1,070 1,061 --------- --------- 2,997 3,008 --------- --------- Total issued or acquired by HUSI or its subsidiaries other than HBUS .................... 4,595 3,109 --------- --------- Issued or acquired by HBUS or its subsidiaries:Non-subordinated debt:Global Bank Note Program: Medium-Term Floating Rate Notes due 2006-2040 (4.21% - 4.70%) ..................... 1,544 890 Fixed Rate Senior Global Bank Notes due 2006-2009 (2.75% - 3.88%) ................. 1,940 1,977 Floating Rate Senior Global Bank Notes due 2006-2009 (4.14% - 4.62%) .............. 8,890 8,884 Floating Rate Non-USD Global Bank Notes due 2008-2009 (2.34% - 2.50%) ............. 1,191 1,362 Floating Rate/Fixed Rate Senior Notes due 2012 (5.02%) ............................ 25 -- --------- --------- 13,590 13,113Federal Home Loan Bank of New York (FHLB) advances: Fixed Rate FHLB advances due 2006-2033 (2.01% - 7.24%) ............................ 8 12 Floating Rate FHLB advances due 2006-2008 (4.05% - 4.49%) ......................... 5,000 5,000 --------- --------- 5,008 5,012 Private Label Credit Card Secured Financing due 2006-2007 (4.45% - 4.66%) ............... 1,500 -- Other: 3.99% Non-USD Senior Debt due 2044 ................................................ 481 557 Other ............................................................................. 41 48 --------- --------- 522 605 --------- --------- Total non-subordinated debt ............................................................. 20,620 18,730 --------- --------- Subordinated debt:Global Bank Note Program: Fixed Rate Global Bank Notes due 2014-2035 (4.63% - 5.88%) ........................ 2,725 1,980 --------- --------- Total issued or acquired by HBUS or its subsidiaries .................................... 23,345 20,710 --------- --------- Obligations under capital leases ........................................................ 19 20 --------- --------- Total long-term debt .................................................................... $ 27,959 $ 23,839 ========= ========= 111 The table excludes $1,550 million of debt issued by HBUS or its subsidiariespayable to HUSI. Of this amount, the earliest note is due to mature in November2006 and the latest note is due to mature in 2097. Debt Issued by HUSI or its Subsidiaries other than HBUS In August 2005, HUSI filed an S-3 Shelf Registration Statement (the 2005 shelf)with the Securities and Exchange Commission (SEC) in the amount of $2.0 billion.A 2002 shelf registration, with a remaining amount of approximately $300million, was closed out and combined into the 2005 shelf to create one shelf inthe aggregate amount of $2.3 billion. The 2005 shelf enables HUSI to issuesenior debt securities, subordinated debt securities, preferred stock anddepositary shares. The $1.5 billion Floating Rate Extendible Notes were issued by HUSI in November2005 under the 2005 shelf. These senior debt securities require the noteholdersto decide each month whether or not to extend the maturity date of their notesby one month beyond the initial maturity date of December 15, 2006. In no eventwill the maturity of the notes be extended beyond December 15, 2011, the finalmaturity date. If on any election date a noteholder decides not to extend thematurity of all or any portion of the principal amount of his notes, the noteswill mature on the previously elected maturity date, which will be the maturitydate that is twelve months from the current election date. On the December 2005election date, all noteholders elected to extend the maturity date of theirnotes to January 15, 2007. The notes are not subject to redemption by HUSI priorto the final maturity date. Interest is payable on the notes in arrears on the15th day of each month, commencing December 15, 2005 and ending on the finalmaturity date. The interest rate will be determined by reference to theone-month LIBOR, plus or minus the applicable spread for that particularinterest period. The spread for each interest period ranges from minus 2 basispoints for the interest period ending December 15, 2006 to plus 3 basis pointsfor the interest period ending December 15, 2011. Certain statutory business trusts (issuer trusts) that issued guaranteedmandatorily redeemable securities (Capital Securities) were consideredconsolidated subsidiaries of HUSI. Capital Securities issued by these trusts tothird party investors, along with common securities of the trusts (CommonSecurities) issued to HUSI, were invested in Junior Subordinated Debentures ofHUSI. Prior to HUSI's adoption of FIN 46 at December 31, 2003, the CapitalSecurities were included in long-term debt on HUSI's consolidated balance sheetand the Common Securities and Junior Subordinated Debentures were eliminated inconsolidation. Upon adoption of FIN 46, HUSI deconsolidated the issuer trusts.As a result, the Junior Subordinated Debentures issued by HUSI to the trusts arereflected in total long-term debt on HUSI's consolidated balance sheet atDecember 31, 2005 and 2004. Debt Issued by HBUS or its Subsidiaries In June 2004, HBUS finalized a $10 billion Global Bank Note Program, whichprovided for issuance of subordinated and senior global notes. In September2004, this program was replaced by a $20 billion Global Bank Note Program. Thefollowing debt issuances were made under the Global Bank Note Program in 2005. o In June 2005, HBUS issued the $25 million Floating Rate/Fixed Rate Senior Notes due 2012. Interest on the notes is paid quarterly commencing September 29, 2005. For each interest payment period in the period from (and including) June 29, 2005 to (but excluding) the interest payment date falling on June 29, 2007, the interest rate is determined by reference to the three month LIBOR plus 0.50% per annum. For each interest payment period in the period from (and including) June 29, 2007 to (but excluding) the stated maturity date of June 29, 2012, the interest rate is 4.95% per annum. HBUS may redeem the notes, in whole but not in part, on June 29, 2007. o In August 2005, HBUS issued $750 million 5.625% Subordinated Notes due 2035. Interest is paid semiannually on February 15 and August 15 of each year, commencing February 15, 2006 and ending on the stated maturity date of August 15, 2035 at the rate of 5.625% per annum. These notes may not be redeemed by HBUS. 112 In October 2005, HUSI entered into a private label credit card secured financingtransaction in the amount of $1.5 billion. A designated pool of consumer privatelabel credit card receivables were conveyed to a wholly owned limited purposesubsidiary, which in turn transferred the receivables to a trust that soldinterests to investors. Since the transaction was structured as a securedfinancing under Statement of Financial Accounting Standards No. 140, Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities, (SFAS 140), the receivables and the underlying debt of the trustremain on HUSI's balance sheet. Repayment of the debt issued by the trust issecured by the receivables transferred to the trust. At December 31, 2005, the$1.5 billion of debt was secured by $2.2 billion of private label credit cardreceivables. As payments on the receivables are collected, funds are transferredto the trustee and new receivables are added to the trust to maintain the agreedupon level of collateral. Contractual scheduled maturities for total long-term debt over the next fiveyears are as follows. -------------------------------------------------------------------------------- (in millions)2006 ......................................................... $ 6,7162007 ......................................................... 7,6392008 ......................................................... 3,1252009 ......................................................... 4,4352010 ......................................................... 302 Note 15. Derivative Instruments and Hedging Activities-------------------------------------------------------------------------------- HUSI is party to various derivative financial instruments as an end user (1) forasset and liability management purposes; (2) in order to offset the riskassociated with changes in the value of various assets and liabilities accountedfor in the trading account; (3) to protect against changes in value of itsmortgage servicing rights portfolio; and (4) for trading in its own account. HUSI is also an international dealer in derivative instruments denominated inU.S. dollars and other currencies which include futures, forwards, swaps andoptions related to interest rates, foreign exchange rates, equity indices,commodity prices and credit, focusing on structuring of transactions to meetclients' needs. Fair Value Hedges Specifically, interest rate swaps that call for the receipt of a variable marketrate and the payment of a fixed rate are utilized under fair value strategies tohedge the risk associated with changes in the risk free rate component of thevalue of certain fixed rate investment securities. Interest rate swaps that callfor the receipt of a fixed rate and payment of a variable market rate areutilized to hedge the risk associated with changes in the risk free ratecomponent of certain fixed rate debt obligations. Where the critical terms of the hedge instrument are identical at hedgeinception, the short-cut method of accounting is utilized. As a result, noretrospective or prospective assessment of effectiveness is required and nohedge ineffectiveness is recognized. However, in instances where the short-cutmethod of accounting cannot be applied, the regression and cumulative dollaroffset methods are utilized in order to satisfy the retrospective andprospective assessment of hedge effectiveness for SFAS 133. HUSI recognized net gains (losses) of approximately $2 million, $(3) million and$(8) million for the years ended December 31, 2005, 2004 and 2003 respectively,(reported as other income in the consolidated statement of income), whichrepresented the ineffective portion of all fair value hedges. Only the timevalue component of these derivative contracts has been excluded from theassessment of hedge effectiveness. 113 Cash Flow Hedges Similarly, interest rate swaps and futures contracts that call for the paymentof a fixed rate are utilized under the cash flow strategy to hedge theforecasted repricing of certain deposit liabilities. In order to initiallyqualify for hedge accounting, assessment of hedge effectiveness is demonstratedon a prospective basis utilizing the regression method. In order to satisfy theretrospective assessment of hedge effectiveness, the cumulative dollar offsetmethod is utilized and ineffectiveness is recorded to the income statement on amonthly basis. HUSI recognized net gains (losses) of approximately $1 million, $(1) million and$3 million for the years ended December 31, 2005, 2004 and 2003 respectively,(reported as a component of other income in the consolidated statement ofincome), which represented the total ineffectiveness of all cash flow hedges.Only the time value component of these derivative contracts has been excludedfrom the assessment of hedge effectiveness. Gains or losses on derivative contracts that are reclassified from accumulatedother comprehensive income to current period earnings pursuant to this strategy,are included in interest expense on deposit liabilities during the periods thatnet income is impacted by the underlying liabilities. As of December 31, 2005,approximately $14 million of deferred net gains on derivative instrumentsaccumulated in other comprehensive income are expected to be included inearnings during 2006. Trading and Other Activities HUSI enters into certain derivative contracts for purely trading purposes inorder to realize profits from short-term movements in interest rates, commodityprices, foreign exchange rates and credit spreads. In addition, certainderivative contracts are accounted for on a full mark to market basis throughcurrent earnings even though they were acquired for the purpose of protectingthe economic value of certain assets and liabilities. Notional Values of Derivative Contracts The following table summarizes the notional values of derivative contracts. --------------------------------------------------------------------------------December 31 2005 2004-------------------------------------------------------------------------------- (in millions)Interest rate: Futures and forwards ..................... $ 106,826 $ 79,830 Swaps .................................... 1,674,091 1,219,657 Options written .......................... 199,676 105,582 Options purchased ........................ 217,095 90,635 ---------- ---------- 2,197,688 1,495,704 ---------- ----------Foreign exchange: Swaps, futures and forwards .............. 308,264 234,424 Options written .......................... 40,213 42,719 Options purchased ........................ 40,959 43,200 Spot ..................................... 21,099 21,927 ---------- ---------- 410,535 342,270 ---------- ----------Commodities, equities and precious metals: Swaps, futures and forwards .............. 48,702 40,876 Options written .......................... 14,378 10,648 Options purchased ........................ 16,127 11,729 ---------- ---------- 79,207 63,253 ---------- ---------- Credit derivatives ............................. 391,814 135,937 ---------- ---------- Total .......................................... $3,079,244 $2,037,164 ========== ========== 114 Credit and Market Risks Associated with Derivative Contracts Credit (or repayment) risk in derivative instruments is minimized by enteringinto transactions with high quality counterparties including other HSBCentities. Counterparties include financial institutions, government agencies,both foreign and domestic, corporations, funds (mutual funds, hedge funds,etc.), insurance companies and private clients. These counterparties are subjectto regular credit review by the credit risk management department. Mostderivative contracts are governed by an International Swaps and DerivativesAssociation Master Agreement. Depending on the type of counterparty and thelevel of expected activity, bilateral collateral arrangements may be required aswell. The total risk in a derivative contract is a function of a number of variables,such as: o whether counterparties exchange notional principal; o volatility of interest rates, currencies, equity or corporate reference entity used as the basis for determining contract payments; o maturity and liquidity of contracts; o credit worthiness of the counterparties in the transaction; and o existence and value of collateral received from counterparties to secure exposures. The following table presents credit risk exposure and net fair value associatedwith derivative contracts. In the table, current credit risk exposure is therecorded fair value of derivative receivables, which represents revaluationgains from the marking to market of derivative contracts held for tradingpurposes, for all counterparties with an International Swaps and DerivativesAssociation Master Agreement in place. Future credit risk exposure in the following table is measured using rulescontained in the risk-based capital guidelines published by U.S. bankingregulatory agencies. The risk exposure calculated in accordance with therisk-based capital guidelines potentially overstates actual credit exposure,because: o the risk-based capital guidelines ignore collateral that may have been received from counterparties to secure exposures; and o the risk-based capital guidelines compute exposures over the life of derivative contracts. However, many contracts contain provisions that allow a bank to close out the transaction if the counterparty fails to post required collateral. As a result, these contracts have potential future exposures that are often much smaller than the future exposures derived from the risk-based capital guidelines. The net credit risk exposure amount in the following table does not reflect theimpact of bilateral netting (i.e., netting with a single counterparty when abilateral netting agreement is in place). However, the risk-based capitalguidelines recognize that bilateral netting agreements reduce credit risk andtherefore allow for reductions of risk-weighted assets when netting requirementshave been met. In addition, risk-based capital rules require that nettedexposures of various counterparties be assigned risk-weightings, which result inrisk-weighted amounts for regulatory capital purposes that are a fraction of theoriginal netted exposures. -------------------------------------------------------------------------------December 31 2005 2004------------------------------------------------------------------------------- (in millions)Risk associated with derivative contracts:Current credit risk exposure ..................... $ 8,155 $ 9,607Future credit risk exposure ...................... 61,548 29,538 -------- --------Total risk exposure .............................. 69,703 39,145Less: collateral held against exposure ........... (1,850) (4,091) -------- --------Net credit risk exposure ......................... $ 67,853 $ 35,054 ======== ======== 115 The table below summarizes the risk profile of the counterparties of HUSI's onbalance sheet exposure to derivative contracts, net of cash and other highlyliquid collateral. -------------------------------------------------------------------------------- Percent of Current Credit Risk Exposure, Net of Collateral ------------------------------ Rating equivalent at December 31 2005 2004--------------------------------------------------------------------------------AAA to AA- .................................... 28% 32%A+ to A- ...................................... 39 47BBB+ to BBB- .................................. 22 11BB+ to B- ..................................... 4 6CCC+ and below ................................ 7 4 ------ ------Total ......................................... 100% 100% ====== ====== Market risk is the adverse effect that a change in interest rates, currency, orimplied volatility rates has on the value of a financial instrument. HUSImanages the market risk associated with interest rate and foreign exchangecontracts by establishing and monitoring limits as to the types and degree ofrisk that may be undertaken. HUSI also manages the market risk associated withthe trading derivatives through hedging strategies that correlate the rates,price and spread movements. HUSI measures this risk daily by using Value at Risk(VAR) and other methodologies. HUSI's Asset and Liability Policy Committee is responsible for monitoring anddefining the scope and nature of various strategies utilized to manage interestrate risk that are developed through its analysis of data from financialsimulation models and other internal and industry sources. The resulting hedgestrategies are then incorporated into HUSI's overall interest rate riskmanagement and trading strategies. Note 16. Income Taxes-------------------------------------------------------------------------------- Total income taxes were allocated as follows. ------------------------------------------------------------------------------------------------------------------------Year Ended December 31 2005 2004 2003------------------------------------------------------------------------------------------------------------------------ (in millions) To income before income taxes ................................................... $ 566 $ 718 $ 570To shareholders' equity as tax charge (benefit): Net unrealized gains (losses) on securities available for sale ............ (111) (20) (99) Unrealized gain (loss) on derivatives classified as cash flow hedges ...... 78 (30) 6 Unrealized gains on interest-only strip receivables ....................... 4 -- -- Foreign currency translation, net ......................................... (4) 4 16 ------- ------- ------- $ 533 $ 672 $ 493 ======= ======= ======= The components of income tax expense follow. ------------------------------------------------------------------------------------------------------------------------Year Ended December 31 2005 2004 2003------------------------------------------------------------------------------------------------------------------------ (in millions) Current: Federal ................................................................... $ 484 $ 455 $ 365 State and local ........................................................... 90 150 48 Foreign ................................................................... 7 17 24 ------- ------- -------Total current ................................................................... 581 622 437Deferred, primarily federal ..................................................... (15) 96 133 ------- ------- -------Total income tax expense ........................................................ $ 566 $ 718 $ 570 ======= ======= ======= 116 The following table is an analysis of the difference between effective ratesbased on the total income tax provision attributable to pretax income and thestatutory U.S. Federal income tax rate. ----------------------------------------------------------------------------------------------------------------Year Ended December 31 2005 2004 2003---------------------------------------------------------------------------------------------------------------- Statutory rate ..................................................... 35.0% 35.0% 35.0%Increase (decrease) due to: State and local income taxes ................................. 4.2 5.6 3.1 Goodwill ..................................................... -- -- .9 Release of tax reserves ...................................... (.3) (2.9) -- Tax exempt interest income ................................... (.7) (.5) (.8) Low income housing and miscellaneous other tax credits ....... (1.4) (.5) (.5) Other items .................................................. (.1) (.4) -- -------- -------- --------Effective income tax rate .......................................... 36.7% 36.3% 37.7% ======== ======== ======== The components of the net deferred tax position are presented in the followingtable. ----------------------------------------------------------------------------------------------------------------December 31 2005 2004---------------------------------------------------------------------------------------------------------------- (in millions) Deferred tax assets: Allowance for credit losses ................................................ $ 322 $ 308 Benefit accruals ........................................................... 96 97 Accrued expenses not currently deductible .................................. 55 47 Unrealized gains on securities available for sale .......................... 100 (11) Net purchase discount on acquired companies ................................ 39 40 Premium on purchased receivables ........................................... 12 44 -------- -------- Total deferred tax assets ............................................... 624 525 -------- --------Less deferred tax liabilities: Lease financing income accrued ............................................. 13 26 Investment securities ...................................................... 90 12 Accrued pension cost ....................................................... (3) 197 Accrued income on foreign bonds ............................................ 10 10 Deferred gain recognition .................................................. 31 40 Depreciation and amortization .............................................. 24 41 Interest and discount income ............................................... 227 230 Deferred fees/costs ........................................................ 87 106 Mortgage servicing rights .................................................. 137 116 Other ...................................................................... 6 21 -------- -------- Total deferred tax liabilities .......................................... 622 799 -------- -------- Net deferred tax asset (liability) ...................................... $ 2 $ (274) ======== ======== In the preceding table, the reduction in deferred tax liability related toaccrued pension cost resulted from the transfer of sponsorship of HUSI's definedbenefit pension plan to HNAH, effective January 1, 2005. See Note 22 beginningon page 127 of this Form 10-K for further information. Realization of deferred tax assets is contingent upon the generation of futuretaxable income or the existence of sufficient taxable income within thecarryback period. Based upon the level of historical taxable income and thescheduled reversal of the deferred tax liabilities over the periods in which thedeferred tax assets are deductible, management believes that it is more likelythan not HUSI would realize the benefits of these deductible differences. 117 Note 17. Preferred Stock-------------------------------------------------------------------------------- The following table presents information related to the issues of preferredstock outstanding. ---------------------------------------------------------------------------------------------------------------------- Amount Shares Dividend Outstanding Outstanding Rate -------------------------December 31 2005 2005 2005 2004---------------------------------------------------------------------------------------------------------------------- (in millions) Floating Rate Non-Cumulative Preferred Stock, Series F ($25 stated value) ................................... 20,700,000 4.319% $ 517 $ --14,950,000 Depositary Shares each representing a one-fortieth interest in a share of Floating Rate Non- Cumulative Preferred Stock, Series G ($1,000 stated value) 373,750 4.918 374 --6,000,000 Depositary shares each representing a one-fourth interest in a share of Adjustable Rate Cumulative Preferred Stock, Series D ($100 stated value) .................................. 1,500,000 4.500 150 150$2.8575 Cumulative Preferred Stock ($50 stated value) .. 3,000,000 5.715 150 150Dutch Auction Rate Transferable Securities(TM)Preferred Stock (DARTS): Series A ($100,000 stated value) ................. 625 2.988 63 63 Series B ($100,000 stated value) ................. 625 2.983 62 62CTUS Inc. Preferred Stock .............................. 100 -- --(1) --(1)$1.8125 Cumulative Preferred Stock, Series E ($25 stated value) ................................... -- 7.250 -- 75 --------- -------- $ 1,316 $ 500 ========= ======== (1) Less than $500 thousand In April 2005 HUSI issued $517.5 million of Floating Rate Non-CumulativePreferred Stock, Series F. Dividends on the Series F Preferred Stock arenon-cumulative and will be payable when and if declared by the board ofdirectors of HUSI quarterly on the first calendar day of January, April, Julyand October of each year. Dividends on the stated value per share are payablefor each dividend period at a rate equal to a floating rate per annum of .75%above three month LIBOR, but in no event will the rate be less than 3.5% perannum. The Series F Preferred Stock may be redeemed at the option of HUSI, inwhole or in part, on or after April 7, 2010 at a redemption price equal to $25per share, plus accrued and unpaid dividends for the then-current dividendperiod. In October 2005 HUSI issued $373.8 million of Floating Rate Non-CumulativePreferred Stock, Series G. Dividends on the Series G Preferred Stock arenon-cumulative and will be payable when and if declared by the board ofdirectors of HUSI quarterly on the first calendar day of January, April, Julyand October of each year. Dividends on the stated value per share are payablefor each dividend period at a rate equal to a floating rate per annum of .75%above three month LIBOR, but in no event will the rate be less than 4% perannum. The Series G Preferred Stock may be redeemed at the option of HUSI, inwhole or in part, on or after January 1, 2011 at a redemption price equal to$1,000 per share, plus accrued and unpaid dividends for the then-currentdividend period. The Adjustable Rate Cumulative Preferred Stock, Series D is redeemable, as awhole or in part, at the option of HUSI at $100 per share (or $25 per depositaryshare), plus accrued and unpaid dividends. The dividend rate is determinedquarterly, by reference to a formula based on certain benchmark market interestrates, but will not be less than 4 1/2% or more than 10 1/2% per annum for anyapplicable dividend period. The $2.8575 Cumulative Preferred Stock may be redeemed at the option of HUSI, inwhole or in part, on or after October 1, 2007 at $50 per share, plus accrued andunpaid dividends. Dividends are paid quarterly. DARTS of each series are redeemable at the option of HUSI, in whole or in part,on any dividend payment date, at $100,000 per share, plus accrued and unpaiddividends. Dividend rates for each dividend period are set pursuant to anauction procedure. The maximum applicable dividend rates on the shares of DARTSrange from 110% to 150% of the 60 day "AA" composite commercial paper rate. 118 HUSI acquired CTUS Inc., a unitary thrift holding company in 1997 from CTFinancial Services Inc. (the Seller). CTUS owned First Federal Savings and LoanAssociation of Rochester (First Federal). The acquisition agreement providedthat HUSI issue preferred shares to the Seller. The preferred shares providefor, and only for, a contingent dividend or redemption equal to the amount ofrecovery, net of taxes and costs, if any, by First Federal resulting from thepending action against the United States government alleging breaches by thegovernment of contractual obligations to First Federal following passage of theFinancial Institutions Reform, Recovery and Enforcement Act of 1989. HUSI issued100 preferred shares at a par value of $1.00 per share in connection with theacquisition. All shares of the $1.8125 Cumulative Preferred Stock, Series E were redeemed at$25 per share in December 2005. Note 18. Retained Earnings and Regulatory Capital Requirements-------------------------------------------------------------------------------- Bank dividends are a major source of funds for payment by HUSI of shareholderdividends and along with interest earned on investments, cover HUSI's operatingexpenses which consist primarily of interest on outstanding debt. The approvalof the Federal Reserve Board is required if the total of all dividends declaredby HBUS in any year exceeds the net profits for that year, combined with theretained profits for the two preceding years. Under a separate restriction,payment of dividends is prohibited in amounts greater than undivided profitsthen on hand, after deducting actual losses and bad debts. Bad debts are debtsdue and unpaid for a period of six months unless well secured, as defined, andin the process of collection. Under the more restrictive of the above rules HBUS can pay dividends to HUSI asof December 31, 2005 of approximately $2 billion, adjusted by the effect of itsnet income (loss) for 2006 up to the date of such dividend declaration. Capital amounts and ratios of HUSI and HBUS, calculated in accordance withbanking regulations, are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- 2005 2004 ---------------------------------------- ----------------------------------------- Capital Well-Capitalized Actual Capital Well-Capitalized ActualDecember 31 Amount Minimum Ratio Ratio Amount Minimum Ratio Ratio----------------------------------------------------------------------------------------------------------------------- (in millions) Total capital (to risk weighted assets): HUSI .............. $ 14,808 10.00% 12.53% $ 13,496 10.00% 12.53% HBUS .............. 14,464 10.00 12.32 13,270 10.00 12.46Tier 1 capital (to risk weighted assets): HUSI .............. 9,746 6.00 8.25 8,983 6.00 8.34 HBUS .............. 9,737 6.00 8.29 9,219 6.00 8.66Tier 1 capital (to average assets): HUSI .............. 9,746 3.00 6.51 8,983 3.00 7.20 HBUS .............. 9,737 5.00 6.61 9,219 5.00 7.51Tangible common equity (to risk weighted assets): HUSI .............. 7,562 6.40 7,611 7.07 HBUS .............. 9,778 8.33 9,249 8.70Risk weighted assets: HUSI .............. 118,145 107,696 HBUS .............. 117,382 106,470 119 The components of HUSI's risk-based capital are summarized in the followingtable. ------------------------------------------------------------------------------------------------------------------------December 31 2005 2004------------------------------------------------------------------------------------------------------------------------ (in millions) Tier 1 Capital: Common shareholder's equity ......................................................... $ 10,278 $ 10,366 Preferred stock ..................................................................... 1,191 375 Minority interest (primarily trust preferred securities) ............................ 1,038 1,029 Goodwill, identifiable intangibles and other direct deductions from capital ......... (2,782) (2,771) Other Tier 1 adjustments ............................................................ 21 (16) --------- --------- Tier 1 capital ...................................................................... 9,746 8,983 --------- --------- Tier 2 Capital: Long-term debt and other instruments qualifying as Tier 2 capital ................... 4,125 3,621 Qualifying aggregate allowance for credit losses .................................... 934 872 Other Tier 2 components ............................................................. 3 20 --------- --------- Tier 2 capital ...................................................................... 5,062 4,513 --------- --------- Total capital ............................................................................. $ 14,808 $ 13,496 ========= ========= 120 Note 19. Accumulated Other Comprehensive Income-------------------------------------------------------------------------------- Accumulated other comprehensive income includes certain items that are reporteddirectly within a separate component of shareholders' equity. The followingtable presents changes in accumulated other comprehensive income balances. ----------------------------------------------------------------------------------------------------------------------- 2005 2004 2003----------------------------------------------------------------------------------------------------------------------- (in millions) Unrealized gains (losses) on available for sale securities:Balance, January 1 .............................................................. $ 21 $ 61 $ 236 Increase (decrease) in fair value, net of taxes of $(71), $19 and $(75), in 2005, 2004 and 2003 respectively ......................................... (94) 14 (129) Net gains on sale of securities reclassified to net income, net of taxes of $(40), $(39) and $(25) in 2005, 2004 and 2003 respectively ............... (55) (54) (46) -------- -------- -------- Net change .................................................................... (149) (40) (175) -------- -------- --------Balance, December 31 ............................................................ (128) 21 61 -------- -------- -------- Unrealized gains (losses) on derivatives classified as cash flow hedges:Balance, January 1 .............................................................. (6) 52 41 Change in unrealized gain (loss), net of taxes of $78, $(30) and $11 in 2005, 2004 and 2003 respectively ......................................... 104 (58) 11 -------- -------- -------- Net change .................................................................... 104 (58) 11 -------- -------- --------Balance, December 31 ............................................................ 98 (6) 52 -------- -------- -------- Unrealized gains on interest-only strip receivables:Balance, January 1 .............................................................. -- -- -- Change in unrealized gains on interest-only strip receivables, net of taxes of $4 in 2005 .................................................. 7 -- -- -------- -------- -------- Net change .................................................................... 7 -- -- -------- -------- --------Balance, December 31 ............................................................ 7 -- -- -------- -------- -------- Foreign currency translation adjustments:Balance, January 1 .............................................................. 16 15 (15) Translation gains, net of taxes of $(4), $4 and $16 in 2005, 2004 and 2003 respectively ....................................................... (5) 1 30 -------- -------- -------- Net change .................................................................... (5) 1 30 -------- -------- --------Balance, December 31 ............................................................ 11 16 15 -------- -------- -------- Total accumulated other comprehensive income at December 31 ..................... $ (12) $ 31 $ 128 ======== ======== ======== 121 Note 20. Related Party Transactions-------------------------------------------------------------------------------- In the normal course of business, HUSI conducts transactions with HSBC and itsaffiliates (HSBC affiliates). These transactions occur at prevailing marketrates and terms. All extensions of credit by HUSI to other HSBC affiliates arelegally required to be secured by eligible collateral. The following tablepresents related party balances and the income and expense generated by relatedparty transactions. ------------------------------------------------------------------------------------------------------------------------December 31 2005 2004 2003------------------------------------------------------------------------------------------------------------------------ (in millions) Assets: Cash and due from banks ..................................... $ 121 $ 182 $ 73 Interest bearing deposits with banks ........................ 67 283 131 Federal funds sold and securities purchased under resale agreements ................................................ 111 47 25 Trading assets .............................................. 5,386 3,167 1,811 Loans ....................................................... 1,901 1,378 246 Other ....................................................... 78 126 32 -------- -------- -------- Total assets ................................................ $ 7,664 $ 5,183 $ 2,318 ======== ======== ======== Liabilities: Deposits .................................................... $ 10,131 $ 9,764 $ 7,513 Trading account liabilities ................................. 4,545 5,748 3,474 Short-term borrowings ....................................... 698 1,089 735 Other ....................................................... 106 28 38 -------- -------- -------- Total liabilities ........................................... $ 15,480 $ 16,629 $ 11,760 ======== ======== ======== ------------------------------------------------------------------------------------------------------------------------December 31 2005 2004 2003------------------------------------------------------------------------------------------------------------------------ (in millions) Interest income ................................................... $ 40 $ 20 $ 17Interest expense .................................................. 293 119 96Trading (losses) income ........................................... (2,543) (2,821) 428Other revenues .................................................... 130 147 58Support services from HSBC affiliates: Fees paid to HTSU for technology services ................... 216 172 -- Fees paid to HSBC Finance Corporation ....................... 415 35 -- Other fees, primarily treasury and traded markets services .. 288 213 160 Effective January 1, 2004, HUSI's technology services employees, as well astechnology services employees from other HSBC affiliates in the United States,were transferred to HTSU. In addition, all technology related assets andsoftware purchased subsequent to January 1, 2004 are generally purchased andowned by HTSU. Technology related assets owned by HUSI prior to January 1, 2004remain in place and were not transferred to HTSU. Pursuant to a master servicelevel agreement, HTSU charges HUSI for technology services and softwaredevelopment. 122 The following business transactions were conducted with HSBC Finance Corporationduring 2005. o HSBC Finance Corporation charges fees to HUSI for support services provided under various service level agreements, including loan origination and servicing as well as other operational and administrative support. o In December of 2004, approximately $12 billion of private label receivables and other loans were purchased from HSBC Finance Corporation. Retained interests in securitized private label credit card receivable pools of approximately $3 billion were also acquired. HSBC Finance Corporation retained the customer relationships and continues to service the loans. By agreement, HUSI is purchasing additional receivables generated under current and future private label accounts at fair value on a daily basis. During 2005, underlying customer balances included within the private label portfolio have revolved, and new relationships have been added, bringing the total private label portfolio balance to approximately $15 billion at December 31, 2005. Private label receivables were acquired from HSBC Finance Corporation at a total premium of $411 million during 2005. o During 2005, HUSI purchased approximately $1.5 billion of residential mortgage loans from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs. Total premiums paid to correspondents totaled $33 million, which is being amortized to interest income over the estimated life of the loans purchased. Purchases of residential mortgage loans from HSBC Finance Corporation correspondents were discontinued effective September 1, 2005. o In July of 2004, in order to centralize the servicing of credit card receivables within a common HSBC affiliate in the United States, certain consumer MasterCard/Visa credit card customer relationships of HUSI were sold to HSBC Finance Corporation. A $99 million gain on this transaction was reported by HUSI in other revenues in 2004. Receivable balances associated with these relationships were not sold as part of the transaction. New receivable balances generated by these relationships are purchased at fair value from HSBC Finance Corporation on a daily basis. During 2005, $2.1 billion of receivables associated with these relationships were purchased from HSBC Finance Corporation at a premium of approximately $34 million, which is being amortized to interest income over the estimated life of the receivables purchased. Servicing for these relationships was also transferred to HSBC Finance Corporation. o Effective October 1, 2004, HBUS is the originating lender for loans initiated for HSBC Finance Corporation's Taxpayer Financial Services business for clients of various third party tax preparers. By agreement, HBUS processes applications, funds and subsequently sells these loans to HSBC Finance Corporation. Approximately $24 billion of loans were originated by HBUS and immediately sold to HSBC Finance Corporation during 2005, primarily during the first two quarters, resulting in gains of approximately $19 million and fees paid to HSBC Finance Corporation of $4 million. o At December 31, 2005, HUSI had an unused $2 billion line of credit from HSBC Finance Corporation. The interest rate is comparable to third party rates for a line of credit with similar terms. o Trading losses for the year ended December 31, 2005 and 2004 respectively, primarily represent the mark to market of the intercompany components of interest rate and foreign currency derivative swap transactions entered into with HSBC Finance Corporation, which are substantially offset by the mark to market of related contracts entered into with third parties that are not reflected in the table. Specifically, HSBC Finance Corporation enters into these swap contracts with HUSI in order to hedge its interest rate positions. HUSI, within its Corporate, Investment Banking and Markets business, accounts for these transactions on a mark to market basis. 123 The following business transactions were conducted with HMUS during 2005. o HUSI utilizes HMUS for broker dealer, debt underwriting, customer referrals and for other treasury and traded markets related services, pursuant to service level agreements. Debt underwriting fees charged by HMUS are deferred as a reduction of long-term debt and amortized to interest expense over the life of the related debt. Customer referral fees paid to HMUS are netted against customer fee income, which is included in other fees and commissions. All other fees charged by HMUS are included in support services from HSBC affiliates. o In June 2005, HUSI began acquiring residential mortgage loans, excluding servicing, from unaffiliated third parties and subsequently selling these acquired loans to HMUS. HUSI maintains no ownership interest in the residential mortgage loans after sale. Since inception of this program, HUSI has acquired approximately $5 billion of residential mortgage loans, which it subsequently sold to HMUS for total gains on sale of approximately $18 million. At December 31, 2005, HUSI had an unused line of credit from HSBC of $2 billion.The interest rate is comparable to third party rates for a line of credit withsimilar terms. HUSI has extended loans and lines of credit to various other HSBC affiliatestotaling $1.4 billion, of which $167 million was outstanding at December 31,2005. Interest rates are comparable to third party rates for lines of creditwith similar terms. At December 31, 2005 and December 31, 2004, the aggregate notional amounts ofall derivative contracts with HSBC affiliates were approximately $570 billionand $302 billion respectively. The net credit risk exposure related to thesecontracts was approximately $5 billion and $2 billion at December 31, 2005 and2004 respectively. Employees of HUSI participate in one or more stock compensation plans sponsoredby HSBC. HUSI's share of the expense of the plans for the year ended 2005 and2004 was $51 million and $61 million respectively. HUSI's share of expense hasbeen reduced during 2005, resulting from a change in the amortization periodutilized for share-based compensation in the CIBM business segment. Adescription of these plans is included in Note 21 beginning on page 124 of thisForm 10-K. During 2004, HUSI received capital contributions of $2.4 billion from its directparent company, HNAI, in exchange for two shares of common stock. HUSI alsocontributed $2.4 billion to HBUS in exchange for two shares of common stock. HUSI periodically pays dividends to its parent company, HNAI. Dividends declaredin 2005 and 2004 were $675 million and $125 million respectively. Note 21. Stock Option Plans and Restricted Share Plans-------------------------------------------------------------------------------- Options have been granted to employees of HUSI under the HSBC Holdings GroupShare Option Plan (the Group Share Option Plan), the HSBC Holdings ExecutiveShare Option Scheme (the Executive Share Option Plan) and under the HSBCHoldings Savings-Related Share Option Plan (Sharesave). Since the shares andcontribution commitment have been granted directly by HSBC, the offset tocompensation expense was a credit to capital surplus, representing acontribution of capital from HSBC. 124 The following table presents information for each plan. Descriptions of eachplan follow the table. ---------------------------------------------------------------------------------------------------------------------December 31 2005 2004 2003--------------------------------------------------------------------------------------------------------------------- Group Share Option Plan: Total options granted ................................ -- 4,574,000 4,076,000 Fair value per option granted ........................ $ -- $ 2.83 $ 3.01 Total compensation expense recognized (in millions) .. $ 6 $ 10 $ 11 Significant assumptions used to calculate fair value: Risk free interest rate ........................... --% 4.90% 4.68% Expected life (years) ............................. -- 6.9 5 Expected volatility ............................... --% 25% 30% Sharesave (5 year vesting period): Total options granted ................................ 262,000 207,000 737,000 Fair value per option granted ........................ $ 3.78 $ 3.80 $ 3.29 Total compensation expense recognized (in millions) .. $ -- $ -- $ 1 Significant assumptions used to calculate fair value: Risk free interest rate ........................... 4.3% 5.0% 4.24% Expected life (years) ............................. 5 5 5 Expected volatility ............................... 20% 25% 30% Sharesave (3 year vesting period): Total options granted ................................ 510,000 407,000 910,000 Fair value per option granted ........................ $ 3.73 $ 3.44 $ 3.20 Total compensation expense recognized (in millions) .. $ 1 $ 1 $ 1 Significant assumptions used to calculate fair value: Risk free interest rate ........................... 4.3% 4.9% 4.01% Expected life (years) ............................. 3 3 3 Expected volatility ............................... 20% 25% 30% Restricted Share Plan: Total compensation expense recognized (in millions) .. $ 44 $ 50 $ 46 Executive Share Option Plan: Total compensation expense recognized (in millions) .. $ -- $ -- $ 1 Group Share Option Plan The Group Share Option Plan was a discretionary long-term incentive compensationplan available prior to 2005, to certain HUSI employees based on performancecriteria. Options were granted at market value and are normally exercisablebetween the third and tenth anniversaries of the date of grant, subject tovesting conditions. Fair values of Group Share Option Plan awards made in 2004, measured at the dateof grant, were calculated using a binomial lattice methodology that is based onthe underlying assumptions of the Black-Scholes option pricing model. Whenmodeling options with vesting dependent on attainment of certain performanceconditions over a period of time, these performance targets are incorporatedinto the model using Monte-Carlo simulation. The expected life of optionsdepends on the behavior of option holders, which is incorporated into the optionmodel consistent with historic observable data. The fair values are inherentlysubjective and uncertain due to the assumptions made and the limitations of themodel used. Prior to 2004, options were valued using a simpler methodology,which was also based on the Black-Scholes model. No options were granted under the Group Share Option Plan in 2005, since theplan was terminated by HSBC in May 2005. In lieu of options, employees nowreceive grants of HSBC Holdings ordinary shares subject to certain vestingconditions. All existing stock option grants under the Group Share Option Planremain in effect subject to the same conditions as before plan termination andcompensation expense continues to be recognized over the various grant vestingperiods. 125 Sharesave Sharesave is an employee share option plan that enables eligible employees toenter into savings contracts of either three or five year terms, with theability to decide at the end of the contract term, to either use theiraccumulated savings to purchase HSBC Holdings ordinary shares at a discountedoption price or have the savings plus interest repaid in cash. Employees cansave up to approximately $400 per month over all their Sharesave savingscontracts. The option price is determined at the beginning of the offeringperiod each plan year and represents a 20% discount from the average price inLondon of the HSBC Holdings ordinary shares over the five trading days precedingthe offering. The options are exercisable within six months following the thirdor fifth anniversary of the beginning of the relevant savings contract. The fair value of options granted under Sharesave was estimated as of the dateof grant using a third party option pricing model in 2005 and 2004, and theBlack-Scholes option pricing model in 2003. Restricted Share Plans Awards are granted to key individuals in the form of performance andnon-performance restricted shares. The awards are based on an individual'sdemonstrated performance and future potential. Performance related restrictedshares generally vest after three years from date of grant, based on HSBC'sTotal Shareholder Return (TSR) relative to a benchmark TSR during theperformance period. TSR is defined as the growth in share value and declareddividend income during the period and the benchmark is composed of HSBC's peergroup of financial institutions. If the performance conditions are met, theshares vest and are released to the recipients two years later. Non-performancerestricted shares are released to the recipients based on continued service,typically at the end of a three year vesting period. Executive Share Option Plan The Executive Share Option Plan was a discretionary long-term incentivecompensation plan available to certain HUSI employees, based on performancecriteria and potential, with grants usually made each year. Options were grantedat market value and were normally exercisable between the third and tenthanniversaries of the date of grant, subject to vesting conditions. No grantshave been made under this plan since the adoption of the Group Share Option Planin 2001, and no compensation expense has been recognized since 2003. 126 Note 22. Pension and Other Postretirement Benefits-------------------------------------------------------------------------------- Defined Benefit Pension Plans In November 2004, sponsorship of the defined benefit pension plan of HUSI andthe defined benefit pension plan of HSBC Finance Corporation was transferred toHNAH. Effective January 1, 2005, the two separate plans were combined into asingle HNAH defined benefit pension plan which facilitates the development of aunified employee benefit policy and unified employee benefit plan administrationfor HSBC companies operating in the U.S. As a result, the pension asset relatingto HUSI's defined benefit plan of $279 million, net of tax, was transferred toHNAH as a capital transaction in the first quarter of 2005. The components of pension expense for the defined benefit plan reflected inHUSI's consolidated statement of income, are shown in the table below. Thepension expense for the year ended December 31, 2005 reflects the portion of thepension expense of the combined HNAH pension plan which has been allocated toHUSI. ------------------------------------------------------------------------------------------------------------------Year Ended December 31 2005 2004 2003------------------------------------------------------------------------------------------------------------------ (in millions) Service cost-benefits earned during the period ................. $ 27 $ 31 $ 29Interest cost on projected benefit obligation .................. 62 69 64Expected return on assets ...................................... (89) (96) (87)Amortization of prior service cost ............................. 1 1 1Recognized losses .............................................. 5 26 32 -------- -------- --------Pension expense ................................................ $ 6 $ 31 $ 39 ======== ======== ======== The information and activity presented below as of and for the year endedDecember 31, 2005 relates to the post-merger HNAH defined benefit pension plan,unless noted otherwise. The information and activity presented as of December31, 2004 and December 31, 2003 and for the years then ended, reflect thepre-merger HUSI defined benefit pension plan balances and activity. The assumptions used in determining pension expense of the defined benefit planare as follows: ------------------------------------------------------------------------------------------------------------------ 2005 2004 2003------------------------------------------------------------------------------------------------------------------ (Post-merger) (Pre-merger) (Pre-merger) Discount rate .................................................. 6.00% 6.25% 6.75%Salary increase assumption ..................................... 3.75 3.75 3.75Expected long-term rate of return on plan assets ............... 8.33 8.00 8.75 HNAH retains both an unaffiliated third party and an HSBC affiliate to provideinvestment consulting services. Given the plan's current allocation of equityand fixed income securities and using investment return assumptions which arebased on long term historical data, the long term expected return for planassets is reasonable. The funded status of the defined benefit pension plan is shown below. Thecomponents shown below as of December 31, 2005 reflect the funded status of thepost-merger HNAH pension plan and not the interests of HUSI. ------------------------------------------------------------------------------------------------------------------December 31 2005 2004------------------------------------------------------------------------------------------------------------------ (Post-merger) (Pre-merger) (in millions) Funded status $ (146) $ 130Unrecognized net actuarial gain 502 348Unamortized prior service cost 3 4 ---------- ----------Prepaid pension cost $ 359 $ 482 ========== ========== 127 A reconciliation of beginning and ending balances of the fair value of planassets associated with the defined benefit pension plan is shown below. Theactivity shown for the year ended December 31, 2005 reflects the activity of themerged HNAH defined benefit pension plan. --------------------------------------------------------------------------------------------------------------------Year Ended December 31 2005 2004-------------------------------------------------------------------------------------------------------------------- (Post-merger) (Pre-merger) (in millions) Fair value of plan assets at beginning of year .................................... $ 1,304 $ 1,222Transfer in of assets from the former HSBC Finance Corporation Plan ............... 1,001 --Actual return on plan assets ...................................................... 169 120Benefits paid ..................................................................... (90) (38) --------- ---------Fair value of plan assets at end of year .......................................... $ 2,384 $ 1,304 ========= ========= HUSI does not currently anticipate making employer contributions to the definedbenefit plan in 2006. The allocation of the pension plan assets at December 31, 2005 and 2004 is asfollows: -------------------------------------------------------------------------------------------------------------------- Percentage of Plan Assets at December 31, ----------------------------- 2005 2004-------------------------------------------------------------------------------------------------------------------- (Post-merger) (Pre-merger) Equity securities ................................................................. 69% 61%Debt securities ................................................................... 31 36Other ............................................................................. -- 3 --------- ---------Total ............................................................................. 100% 100% ========= ========= There were no investments in HSBC ordinary shares or American depositary sharesat December 31, 2005 and 2004. The primary objective of the defined benefit pension plan is to provide eligibleemployees with regular pension benefits. Since the plans are governed by theEmployee Retirement Income Security Act of 1974 (ERISA), ERISA regulations serveas guidance for the management of plan assets. Consistent with prudent standardsof preservation of capital and maintenance of liquidity, the goals of the plansare to earn the highest possible rate of return consistent with the tolerancefor risk as determined by the investment committee in its role as a fiduciary.In carrying out these objectives, short-term fluctuations in the value of planassets are considered secondary to long-term investment results. A third partyis used to provide investment consulting services such as recommendations on thetype of funds to be invested in and monitoring the performance of fund managers.In order to achieve the return objectives of the plans, the plans arediversified to ensure that adverse results from one security or security classwill not have an unduly detrimental effect on the entire investment portfolio.Assets are diversified by type, characteristic and number of investments as wellas by investment style of management organization. Equity securities areinvested in large, mid and small capitalization domestic stocks as well asinternational stocks. This information is provided by RNS The company news service from the London Stock Exchange MORE TO FOLLOW