FORM 6-K
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Report of Foreign Private Issuer
Pursuant to Rule 13a - 16 or 15d - 16 of
the Securities Exchange Act of 1934
For the month of March, 2006
HSBC Holdings plc
42nd Floor, 8 Canada
Square, London E14 5HQ, England
(Indicate by check mark whether the registrant files or will file annual
reports under cover of Form 20-F or Form 40-F).
Form 20-F X Form 40-F ......
(Indicate by check mark whether the registrant by furnishing the information
contained in this Form is also thereby furnishing the information to the
Commission pursuant to Rule 12g3-2(b) under the Securities Exchange Act of
1934).
Yes....... No X
(If "Yes" is marked, indicate below the file number assigned to the registrant
in connection with Rule 12g3-2(b): 82- ..............)
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 2005
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934
For the transition period from ______ to ______
Commission file number 1-7436
HSBC USA Inc.
(Exact name of registrant as specified in its charter)
Maryland 13-2764867
(State of Incorporation) (I.R.S. Employer Identification No.)
452 Fifth Avenue, New York, New York 10018
(Address of principal executive offices) (Zip Code)
(716) 841-2424
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
------------------- -----------------------------------------
Depositary Shares (each representing a one-fourth share of New York Stock Exchange
Adjustable Rate Cumulative Preferred Stock, Series D)
$2.8575 Cumulative Preferred Stock New York Stock Exchange
Floating Rate Non-Cumulative Preferred Stock, Series F New York Stock Exchange
Depositary Shares (each representing a one-fortieth share of New York Stock Exchange
Floating Rate Non-Cumulative Preferred Stock, Series G)
7% Subordinated Notes due 2006 New York Stock Exchange
8.375% Debentures due 2007 New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act.
Yes |X| No |_|
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act.
Yes |_| No |X|
Indicate by check mark whether the registrant (1) had filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of the Form 10-K or any amendment to this
Form 10-K. |X|
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer. See definition of "accelerated
filer and a large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer |_| Accelerated filer |_|
Non-accelerated filer |X|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act).
Yes |_| No |X|
At February 28, 2006, all voting stock (706 shares of Common Stock $5 par value)
is owned by an indirect wholly owned subsidiary of HSBC Holdings plc.
DOCUMENTS INCORPORATED BY REFERENCE
None
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HSBC USA Inc.
Form 10-K
TABLE OF CONTENTS
Part I
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Page
Item 1. Business
History ................................................................................... 4
Description of Operations and Business Segments ........................................... 4
2005 Developments and Trends .............................................................. 6
Geographic Distribution of Assets and Earnings ............................................ 8
Regulation, Supervision and Capital ....................................................... 8
Competition ............................................................................... 11
Corporate Governance ...................................................................... 11
Cautionary Statement on Forward-Looking Statements ........................................ 12
Statistical Disclosure by Bank Holding Companies:
Average Balance Sheets and Interest Earned and Paid ................................... 79
Changes in Interest Income and Expense Attributable to Changes in Rate and
Volume .............................................................................. 30
Securities Portfolios ................................................................. 99
Loans Outstanding:
Composition and Maturities ........................................................ 27
Risk Elements in the Loan Portfolio ............................................... 53-55, 104
Summary of Loan Loss Experience ....................................................... 56
Deposits .............................................................................. 109
Short-Term Borrowings ................................................................. 110
Item 1A. Risk Factors .................................................................................. 13
Item 1B. Unresolved Staff Comments ..................................................................... 14
Item 2. Properties .................................................................................... 14
Item 3. Legal Proceedings ............................................................................. 14
Item 4. Submission of Matters to a Vote of Security Holders ........................................... 14
Part II
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Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters ..................... 14
Item 6. Selected Financial Data ....................................................................... 15
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Executive Overview ........................................................................ 16
Basis of Reporting ........................................................................ 17
Critical Accounting Policies .............................................................. 22
Balance Sheet Review ...................................................................... 26
Results of Operations ..................................................................... 30
Business Segments ......................................................................... 46
Credit Quality ............................................................................ 53
Off-Balance Sheet Arrangements and Contractual Obligations ................................ 59
Risk Management ........................................................................... 62
Glossary of Terms ......................................................................... 77
Item 7A. Quantitative and Qualitative Disclosures About Market Risk .................................... 78
Item 8. Financial Statements and Supplementary Data ................................................... 81
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure .......... 142
Item 9A. Controls and Procedures ....................................................................... 142
2
Part III
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Page
Item 10. Directors and Executive Officers of the Registrant ............................................ 143
Item 11. Executive Compensation ........................................................................ 147
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Matters ............ 152
Item 13. Certain Relationships and Related Transactions ................................................ 153
Item 14. Principal Accounting Fees and Services ........................................................ 153
Part IV
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Item 15. Exhibits and Financial Statement Schedules .................................................... 154
3
P A R T I
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Item 1. Business
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History
HSBC USA Inc., incorporated under the laws of Maryland, is a New York State
based bank holding company registered under the Bank Holding Company Act of
1956, as amended. HSBC USA Inc. and its subsidiaries are collectively referred
to as "HUSI". HUSI's origin was in Buffalo, New York in 1850 as The Marine Trust
Company, which later became Marine Midland Banks, Inc. (Marine). In 1980, The
Hongkong and Shanghai Banking Corporation Limited (now HSBC Holdings plc,
hereinafter referred to as "HSBC") acquired 51% of the common stock of Marine
and the remaining 49% of common stock in 1987. In December 1999, HSBC acquired
Republic New York Corporation (Republic) and merged it with HUSI. At the merger
date, Republic and HUSI had total assets of approximately $47 billion and $43
billion respectively.
Through its affiliation with HSBC, HUSI offers its customers access to global
markets and services. In turn, HUSI plays a role in the delivery and processing
of other HSBC products. HSBC is one of the largest banking and financial
services organizations in the world. Headquartered in London, England, HSBC's
international network comprises over 9,800 offices in 77 countries and
territories in Europe, the Asia-Pacific region, North America, South America,
the Middle East and Africa.
Effective January 1, 2004, HSBC created a new North American organizational
structure with HSBC North America Holdings Inc. (HNAH) as the top-tier United
States (U.S.) bank holding company. At December 31, 2005, HNAH was among the 10
largest U.S. bank holding companies ranked by assets. HUSI routinely conducts
transactions with other principal subsidiaries of HNAH, which include:
o HSBC Bank Canada (HBCA), a Canadian banking subsidiary;
o HSBC Finance Corporation (formerly Household International, Inc.), a
consumer finance company;
o HSBC Markets (USA) Inc. (HMUS), a holding company for investment banking
and markets subsidiaries; and
o HSBC Technology & Services (USA) Inc. (HTSU), a provider of information
technology services.
Description of Operations and Business Segments
At December 31, 2005, HUSI had total assets of approximately $154 billion and
approximately 12,000 full and part time employees. HUSI is among the 15 largest
bank holding companies in the United States (U.S.) ranked by assets. Through its
principal commercial banking subsidiary, HSBC Bank USA, National Association
(HBUS), HUSI offers its three million customers a full range of commercial
banking products and services. Its customers include individuals, including high
net worth individuals, small businesses, corporations, institutions and
governments. HBUS also engages in mortgage banking, and is an international
dealer in derivative instruments denominated in U.S. dollars and other
currencies, focusing on structuring of transactions to meet clients' needs as
well as for proprietary purposes.
With total assets of $151 billion at December 31, 2005, HBUS is among the top
ten banks in the U.S. HBUS's main office is in Delaware, and its domestic
operations are primarily in New York State. It also has banking branch offices
and/or representative offices in Florida, California, New Jersey, Delaware,
Pennsylvania, Washington, Oregon, Massachusetts and Washington, D.C. In addition
to its domestic offices, HBUS maintains foreign branch offices, subsidiaries
and/or representative offices in the Caribbean, Europe, Asia, Latin America,
Australia and Canada.
HUSI has five distinct business segments that it utilizes for management
reporting and analysis purposes. The segments are based upon customer groupings,
as well as products and services offered. The segments are described in the
following paragraphs. Analysis of financial results for HUSI's business segments
begins on page 46 of this Form 10-K.
4
The Personal Financial Services (PFS) Segment
This segment provides a broad range of financial products and services including
installment and revolving term loans, deposits, branch services, mutual funds,
investments and insurance. These products are marketed to individuals primarily
through the branch banking network and increasingly through e-banking channels.
Residential mortgage lending provides loan financing through direct retail and
wholesale origination channels. Mortgage loans are originated through a network
of brokers, wholesale agents and retail origination offices. Servicing is
performed for the individual mortgage holder or on a contractual basis for
mortgages owned by third parties.
The PFS segment continues to include MasterCard(1)/Visa(2) credit card
receivables acquired on a daily basis, related to account relationships which
HUSI sold to HSBC Finance Corporation in 2004.
The Consumer Finance (CF) Segment
Effective for the first quarter of 2005, HUSI formed a new business segment,
Consumer Finance (CF), which was reported as a component of PFS in prior
periods. The CF segment includes point of sale and other lending activities
primarily to meet the financial needs of individuals. Specifically, operating
activity within the CF segment relates to various consumer loans, private label
credit card receivables, and retained interests in securitized receivable trusts
purchased from HSBC Finance Corporation, as well as consumer loans purchased
from originating lenders pursuant to HSBC Finance Corporation correspondent loan
programs.
The Commercial Banking (CMB) Segment
This segment provides loan and deposit products to small businesses and
middle-market corporations including specialized products such as real estate
financing. Various credit and trade related products such as standby facilities,
performance guarantees and acceptances are also offered. These products and
services are offered through multiple delivery systems, including the branch
banking network.
The Corporate, Investment Banking and Markets (CIBM) Segment
This segment is comprised of Corporate/Institutional Banking (CIB) and
Investment Banking and Markets (IBM). CIB provides deposit and lending products
to large and multi-national corporations and banks. U.S. dollar clearing
services are offered for domestic and international wire transfer transactions.
Credit and trade related products such as standby facilities, performance
guarantees and acceptances are also provided by CIB to large corporate entities.
The IBM component includes treasury and traded markets. The treasury function
maintains overall responsibility for the investment and borrowing of funds to
ensure liquidity, manage interest rate risk and capital at risk. Traded markets
encompasses the trading and sale of foreign exchange, banknotes, derivatives,
precious metals, securities and emerging markets instruments, both domestically
and internationally.
The Private Banking (PB) Segment
This segment offers a full range of services for high net worth domestic and
foreign individuals including deposit, lending, trading, trust, branch services,
mutual funds, insurance and investment management.
Other Segment
This segment includes equity investments in Wells Fargo HSBC Trade Bank N.A. and
HSBC Republic Bank (Suisse) S.A.
----------
(1) MasterCard is a registered trademark of MasterCard International,
Incorporated.
(2) Visa is a registered trademark of Visa USA, Inc.
5
2005 Developments and Trends
2005 Operations
HUSI's 2005 net income of $976 million reflected a decrease of $282 million
(22%) from the prior year. Analysis of the components of net income begins on
page 30 of this Form 10-K.
Total assets increased $13 billion (9%) during 2005. Analysis of balance sheet
growth and funding begins on page 26 of this Form 10-K.
Credit Quality Issues
HUSI's loan portfolio is comprised of consumer loans, which are primarily
included within the PFS and CF business segments, and commercial loans that are
included within the CMB and CIBM segments.
Increased provisions for credit losses during 2005 are primarily due to
significant increases in consumer loan balances, most notably the private label
portfolio balances acquired from HSBC Finance Corporation in December 2004.
Commercial loan credit quality has been exceptionally strong throughout 2004 and
2005 with net charge offs and provisions well below historical levels.
In August 2005, Hurricane Katrina (Katrina) caused destruction and loss to
individuals, businesses and public infrastructure. As of December 31, 2005, HUSI
had $232 million of consumer receivables outstanding with customers living in
the Federal Emergency Management Agency (FEMA) designated Individual Assistance
disaster areas(1). An incremental provision for credit losses of $10 million was
recorded in the second half of 2005 for Katrina, which represents HUSI's best
estimate of Katrina's impact on the loan portfolio. Future net charge offs in
the CF business segment related to Katrina are not expected to be material.
Various programs were initiated to assist customers affected by the disaster,
including extended payment arrangements and interest and fee waivers for up to
90 days or more for certain products depending on customer circumstances. These
interest and fee waivers totaled $7 million during 2005.
Effective October 1, 2005, new bankruptcy legislation was enacted, resulting in
a spike in bankruptcy filings for HUSI in the fourth quarter of the year. 2005
results include an incremental provision for credit losses of $5 million
attributable to bankruptcy reform. The CF business segment does not expect a
material increase in net charge offs in 2006 as a result of the enactment of
this new legislation.
Further analysis of credit quality begins on page 53 of this Form 10-K.
Loan Trends
Loan mix improved in 2005 with more emphasis being placed on higher yielding
credit card receivables, small business loans, middle market loans and
commercial real estate loans. There also was an initiative to reduce residential
mortgage loans held for investment purposes.
In December 2004, HUSI acquired approximately $12 billion of private label
receivables and other loans from HSBC Finance Corporation at fair value, without
recourse. By agreement, HUSI is purchasing additional receivables generated
under current and future private label credit card 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 $15 billion at December 31, 2005.
Losses before income tax expense of $233 million were realized from this
portfolio for the year ended December 31, 2005. Results in 2005 have been
negatively impacted by significant amortization of the premium paid for these
receivables.
----------
(1) Customers in the Individual Assistance Counties, as defined
by FEMA on the list last updated and published on September 9, 2005
6
Further analysis regarding this acquired portfolio is included in the analysis
of HUSI's CF segment, beginning on page 48 of this Form 10-K.
Transactions with HSBC Finance Corporation and Other HSBC Affiliates
In March 2003, HSBC completed its acquisition of Household International, Inc.
In December 2004, Household International, Inc. changed its legal name to HSBC
Finance Corporation. 2005 was highlighted by continued cooperation between HUSI
and HSBC Finance Corporation to identify synergies in products and processes.
Synergies have been achieved in loan origination and servicing, card processing,
IT contingency rationalization, purchasing, call center cooperation, the shared
use of HSBC's service centers, and the consolidation of certain administrative
functions. In addition, HSBC Finance Corporation's credit scoring and
data-mining technology has been made available to HUSI. HUSI and HSBC Finance
Corporation will continue to work cooperatively on product offerings and
back-office operations.
Since the end of 2003, HUSI has routinely purchased credit card receivables,
residential mortgage loans and other loans from HSBC Finance Corporation, and
from originating lenders pursuant to HSBC Finance Corporation correspondent loan
programs. In most cases, HSBC Finance Corporation retained the right to service
these portfolios. Acquisitions of residential mortgage loans were discontinued
in 2005. Fees charged by HSBC Finance Corporation for loan origination and
servicing expenses, which are primarily recorded in the CF segment, have
increased significantly due to increased private label receivables and other
loans acquired from HSBC Finance Corporation and from their correspondents.
HNAH's technology services in North America were centralized by the creation of
a new subsidiary, HSBC Technology & Services (USA) Inc. (HTSU), effective
January 1, 2004. HUSI's technology services employees, as well as technology
services employees from other HSBC affiliates in the United States, were
transferred to HTSU. Technology related assets and software purchased subsequent
to January 1, 2004 are generally purchased and owned by HTSU. Pursuant to a
master service level agreement, HTSU charges HUSI for technology services and
software development. Fees charged by HTSU to HUSI for technology services
expenses have increased in 2005, as HUSI continued to upgrade its automated
technology environment.
HUSI obtains certain underwriting, broker-dealer and administrative support
services from HSBC and various other affiliates. Fees charged by these
affiliates for treasury and traded markets services provided to HUSI's CIBM
segment have increased in 2005 due primarily to business expansion initiatives.
Details of these and other transactions with HSBC affiliates are presented in
Note 20 of the consolidated financial statements beginning on page 122 of this
Form 10-K.
Deposit Strategy and Growth
Beginning in 2004, the deposit strategy for HUSI's retail network included a
shifting emphasis toward building deposits over a three to five year period,
across multiple markets and segments, utilizing multiple delivery systems.
Specifically, the following were initiated:
o full deployment of new personal and business checking and savings
products;
o emphasis on more competitive pricing with the introduction of high
yielding products, including online savings accounts, which grew
significantly late in 2005;
o retail branch expansion into new geographic markets;
o improving delivery systems, including use of internet capabilities;
o refining targeting of the affluent consumer population;
o maintaining strong customer relationships; and
o increasing deposits from, and improving retention of, existing customers.
HUSI experienced a successful rollout of its deposit strategy during 2005
resulting in increased deposits of $12 billion during the year.
7
Other Matters
During 2005, HUSI incorporated a new nationally chartered bank, HSBC Trust
Company (Delaware), National Association, whose operations are limited to trust
activities. This new bank, which received its charter on July 1, 2005 had an
immaterial impact on HUSI's consolidated balance sheet and results of operations
for 2005.
Geographic Distribution of Assets and Earnings
HUSI's foreign operations represented less than 6% of HUSI's consolidated total
assets at December 31, 2005 and 2004, and less than 7% of consolidated income
before income tax expense for 2005, 2004 and 2003.
Regulation, Supervision and Capital
Through June 30, 2004, HUSI and HBUS were supervised and routinely examined by
the State of New York Banking Department and the Board of Governors of the
Federal Reserve System (the Federal Reserve). Effective July 1, 2004, HBUS
became a nationally chartered bank and is primarily supervised by the Office of
the Comptroller of the Currency (OCC). HUSI, as a bank holding company,
continues to be supervised by the Federal Reserve. HUSI and HBUS are subject to
banking laws and regulations which place various restrictions on and
requirements regarding their operations and administration, including the
establishment and maintenance of branch offices, capital and reserve
requirements, deposits and borrowings, investment and lending activities,
payment of dividends and numerous other matters. The Federal Reserve Act
restricts certain transactions between banks and their nonbank affiliates. Since
the deposits of HBUS are insured by the Federal Deposit Insurance Corporation
(FDIC), HBUS is subject to relevant FDIC regulations.
HBUS is required to maintain noninterest bearing cash reserves with the Federal
Reserve Bank, which averaged $709 million in 2005 and $730 million in 2004.
HUSI and HBUS are subject to various regulatory capital requirements
administered by federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory actions, and possibly additional
discretionary actions by regulators. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, specific capital guidelines
must be met that involve quantitative measures of assets, liabilities, and
certain off-balance sheet items as calculated under regulatory accounting
practices. The capital amounts and classifications are also subject to
qualitative judgments by the regulators about components, risk weightings and
other factors.
HUSI's capital resources are summarized on page 29 of this Form 10-K.
Quantitative measures established by regulation to ensure capital adequacy
require the maintenance of minimum amounts and ratios of total and Tier 1
capital (as defined in banking regulations). Capital amounts and ratios for HUSI
and HBUS are summarized in Note 18 of the consolidated financial statements on
page 119 of this Form 10-K. To be categorized as "well capitalized", a banking
institution must have the minimum ratios reflected in the table included in Note
18 and must not be subject to a directive, order or written agreement to meet
and maintain specific capital levels.
From time to time, bank regulators propose amendments to or issue
interpretations of risk-based capital guidelines. Such proposals or
interpretations could, upon implementation, affect reported capital ratios and
net risk weighted assets. A new capital adequacy framework, which has been
proposed by U.S. regulators for implementation by January 1, 2009, is further
described under "Basel Capital Standards".
8
HBUS is subject to risk-based assessments from the FDIC, the U.S. Government
agency that insures deposits in HBUS to a maximum of $100,000 per domestic
depositor. Depository institutions subject to assessment are categorized based
on capital ratios and other factors, with those in the highest rated categories
paying no assessments. Because of its standing as a "well-capitalized",
financially sound institution, HBUS has not been assessed by the FDIC in the
past three years.
The Deposit Insurance Funds Act (DIFA) of 1996 authorized the Financing
Corporation (FICO), a U.S. Government corporation, to collect funds from FDIC
insured institutions to pay interest on FICO bonds. The FICO assessment rate in
effect at December 31, 2005 was 1.34 percent of assessable deposits. The FICO
assessment rate is adjusted quarterly. HBUS is subject to a quarterly FICO
premium.
The USA Patriot Act (the Patriot Act), effective October 26, 2001, imposed
significant record keeping and customer identity requirements, expanded the
government's powers to freeze or confiscate assets and increased the available
penalties that may be assessed against financial institutions for violation of
the requirements of the Patriot Act intended to detect and deter money
laundering. The Patriot Act required the U.S. Treasury Secretary to develop and
adopt final regulations with regard to the anti-money laundering compliance
obligations on financial institutions (a term which includes insured U.S.
depository institutions, U.S. branches and agencies of foreign banks, U.S.
broker-dealers and numerous other entities). The U.S. Treasury Secretary
delegated certain authority to a bureau of the U.S. Treasury Department known as
the Financial Crimes Enforcement Network (FinCEN).
Many of the anti-money laundering compliance requirements of the Patriot Act, as
implemented by FinCEN, are generally consistent with the anti-money laundering
compliance obligations that applied to HBUS under the Bank Secrecy Act and
applicable Federal Reserve Board regulations before the Patriot Act was adopted.
These include requirements to adopt and implement an anti-money laundering
program, report suspicious transactions and implement due diligence procedures
for certain correspondent and private banking accounts. Certain other specific
requirements under the Patriot Act involve compliance obligations. The Patriot
Act and other recent events have resulted in heightened scrutiny of Bank Secrecy
Act and anti-money laundering compliance programs by the federal and state bank
regulators. On April 30, 2003, HBUS entered into a written agreement with the
Federal Reserve Bank of New York and the New York State Banking Department to
enhance its compliance with anti-money laundering requirements. Due to the
change in primary regulators in 2004, this agreement is now subject to
enforcement by the OCC. In response to this agreement, HBUS has increased
compliance staff and has implemented certain improvements in its compliance,
reporting, and review systems and procedures. On February 6, 2006, the OCC
determined that HBUS had satisfied the requirements of the written agreement and
therefore terminated the agreement.
Basel Capital Standards
The Basel Committee on Banking Supervision (the Basel Committee) published its
revised minimum capital adequacy framework (Basel II) in June 2004. Since its
publication, the U.S. regulators, including the Federal Reserve and the OCC,
have been working to adopt the framework as the mandatory minimum capital
standard for approximately 10 to 12 of the largest U.S. banks. As a banking
subsidiary of HNAH, HUSI has been designated as a mandatory bank by the U.S.
regulators and is required to adopt Basel II.
In October 2004, the U.S. regulators asked the mandatory banks and several
others to voluntarily participate in a Quantitative Impact Study (the QIS). The
purpose of the QIS was to measure the change in minimum regulatory capital
requirements for each bank using the current Basel I standard compared to the
proposed regulation under Basel II. The results of the QIS, published in the
second quarter of 2005, indicated that, on average, the minimum capital
requirement of participating banks decreased by approximately 13%. In addition,
the results were widely dispersed and lacked comparative consistency among the
participating banks.
9
The original date to publish the new rules was mid-year 2005 for implementation
on January 1, 2008. Subsequently, the U.S. regulators agreed that additional
time was needed to better understand the QIS results and to amend, if necessary,
the new rules accordingly. Consequently, they decided in April 2005 to delay the
publication of the new rules until the first quarter 2006. The regulators also
agreed to analyze the results in light of industry concerns from smaller,
non-mandatory banks that the new regulation would create advantages resulting
from lower capital requirements for the few banks adopting Basel II. The
combined effect of needing to amend the new rules for mandatory banks and the
need to address the issues raised by non-mandatory banks led to the decision in
September 2005, to delay the implementation date for Basel II by one year to
January 1, 2009.
In October 2005, the U.S. regulators published a proposal to replace the current
rules under Basel I with a more risk sensitive framework (Basel IA) that would
apply to all non-mandatory banks. The U.S. regulators have advised that the new
rules for Basel IA and Basel II would be issued at approximately the same time
in 2006.
Despite the timing changes made by U.S. regulators, HUSI must be prepared to
implement Basel II according to the original schedule on January 1, 2008 to meet
the requirements of HSBC's principal regulator, the Financial Services Authority
in the United Kingdom.
Sarbanes-Oxley Act of 2002, Section 404 Compliance
As an SEC registrant of public debt and preferred shares, HUSI is required to
comply with the Sarbanes-Oxley Act of 2002 (the SarBox Act). Section 404 of the
SarBox Act (Section 404) requires registrants and their auditors to assess and
report on internal controls over financial reporting on an annual basis. As a
foreign registrant, HSBC is required to comply with Section 404 beginning in the
fiscal year ending December 31, 2006. As a subsidiary of a foreign registrant,
HUSI will support HSBC with its Section 404 compliance. Under the SEC's current
rules for non-accelerated filers, HUSI will be required to comply with Section
404 for the fiscal year ending December 31, 2007.
HUSI has adopted the internal control framework established by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO) to complete its
management assessment of the effectiveness of internal controls over financial
reporting in compliance with Section 404. Certain other financial reporting risk
assessment factors have also been included to ensure adequate coverage of
safeguarding of assets and anti-fraud risks.
10
Competition
The Gramm-Leach-Bliley Act of 1999 (GLB Act), effective March 11, 2000,
eliminated many of the regulatory restrictions on providing financial services.
The GLB Act allows for financial institutions and other providers of financial
products to enter into combinations that permit a single organization to offer a
complete line of financial products and services. Therefore, HUSI and its
subsidiaries face intense competition in all of the markets they serve,
competing with both other financial institutions and non-banking institutions
such as insurance companies, major retailers, brokerage firms and investment
companies.
Following the enactment of the GLB Act, HUSI elected to be treated as a
financial holding company (FHC). As an FHC, HUSI's activities in the U.S. have
been expanded enabling it to offer a more complete line of products and
services. HUSI's ability to engage in expanded financial activities as an FHC
depends upon its meeting certain criteria, including requirements that its U.S.
depository institution subsidiary, HBUS, its forty percent owned subsidiary,
Wells Fargo HSBC Trade Bank N.A., and its nationally chartered trust bank, HSBC
Trust Company (Delaware), National Association, be well capitalized and well
managed, and that they have achieved at least a satisfactory record of meeting
community credit needs during their most recent examination pursuant to the
Community Reinvestment Act. In general, an FHC would be required, upon notice by
the Federal Reserve Board, to enter into an agreement to correct any deficiency
in the requirements necessary to maintain its FHC election. Until such
deficiencies are corrected, the Federal Reserve Board may impose limitations on
the conduct or activities of an FHC or any of its affiliates as it deems
appropriate. If such deficiencies are not corrected in a timely manner, the
Federal Reserve Board may require an FHC to divest its control of any subsidiary
depository institution or to cease to engage in certain financial activities. As
of December 31, 2005, no known deficiencies exist, and HUSI is not subject to
limitations or penalties relative to its status as an FHC.
Corporate Governance
HUSI is committed to high standards of corporate governance. In February 2006,
HUSI's Board of Directors adopted Governance Standards which, together with the
charters of committees of the Board of Directors, provide the framework for the
corporate governance of HUSI. As of December 31, 2005, HUSI's Board of Directors
had three primary committees to assist with corporate oversight
responsibilities.
o Audit Committee - This committee's primary duties are to:
(1) monitor the integrity of HUSI's financial reporting and risk
management processes and systems of internal controls regarding
finance, accounting, and legal compliance;
(2) monitor the independence and performance of HUSI's internal and
independent auditor; and
(3) provide an avenue of communication among the independent auditor,
management, the internal auditors, and the Board of Directors.
o Human Resources Committee - This committee's primary duties are to:
(1) review and make recommendations with respect to the appointment and
compensation of such officers and employees as the Board by
resolution shall from time to time determine, including incentive
compensation programs;
(2) review the organization's compensation philosophy; and
(3) provide general oversight of management regarding human resources
strategy and policy, major organizational changes, major human
resources initiatives, executive management development and
succession planning, and diversity initiatives.
o Fiduciary Committee - This committee's primary duty is to supervise the
fiduciary activities of the organization which includes evaluation of the
following:
(1) proper exercise of fiduciary powers;
(2) adequacy of management, staffing, systems and facilities;
(3) adequacy of ethical standards, strategic plans, policies and control
procedures;
(4) investment performance;
(5) adequacy of risk management and compliance programs; and
(6) regulatory examination and internal and external audit reports.
11
In January 2006, the Board of Directors changed the name of the Human Resources
Committee to the Human Resources and Compensation Committee, and also
established a new committee:
o Nominating & Governance Committee - This committee's primary duties are to:
(1) identify director candidates and ensure that new directors receive
appropriate orientation;
(2) oversee the composition, structure, operation and evaluation of the
Board and its committees; and
(3) review and make recommendations regarding director compensation.
The annual report on Form 10-K, quarterly reports on Form 10-Q, and current
reports on Form 8-K, as filed with the Securities and Exchange Commission (the
SEC), are available on HUSI's website at www.us.hsbc.com.
Cautionary Statement on Forward-Looking Statements
Certain matters discussed throughout this Form 10-K constitute forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995. In addition, HUSI may make or approve certain statements in future filings
with the SEC, in press releases, or oral or written presentations by
representatives of HUSI that are not statements of historical fact and may also
constitute forward-looking statements. Words such as "may", "will", "should",
"would", "could", "believe", "do not believe", "no reason to believe",
"intends", "expects", "estimates", "targeted", "plans", "anticipates", "goal"
and similar expressions are intended to identify forward-looking statements but
should not be considered as the only means through which these statements may be
made. These matters or statements will relate to future financial condition,
results of operations, plans, objectives, performance or business developments
and will involve known and unknown risks, uncertainties and other factors that
may cause HUSI's actual results, performance or achievements to be materially
different from that which was expressed or implied by such forward-looking
statements. Forward-looking statements are based on current views and
assumptions and speak only as of the date they are made. HUSI undertakes no
obligation to update any forward-looking statement to reflect subsequent
circumstances or events.
12
Item 1A. Risk Factors
--------------------------------------------------------------------------------
The important factors, many of which are out of HUSI's control, which could
affect actual results and could cause results to vary materially from those
expressed in public statements or documents are:
o changes in laws and regulations, including attempts by local, state and
national regulatory agencies or offices or legislative bodies to control
alleged "predatory" or discriminatory lending practices through broad or
targeted initiatives aimed at lenders operating in consumer lending
markets, including with respect to tax refund anticipation loans;
o increased competition from well-capitalized companies or lenders with
access to government sponsored organizations which may impact the terms,
rates, costs or profits historically included in the loan products that
HUSI offers or purchases;
o changes in accounting or credit policies, practices or standards, as they
may be internally modified from time to time or changes as may be required
by regulatory agencies or the Financial Accounting Standards Board;
o changes to operational practices from time to time such as determinations
to acquire or sell private label credit card receivables, residential
mortgage and other loans, to structure more collateralized funding as
secured financings, or changes to HUSI's customer account management
policies and practices and risk management/collection practices;
o changes in overall economic conditions, including the interest rate
environment in which HUSI operates, the capital markets in which HUSI
funds its operations, the market values of consumer owned real estate
throughout the United States, recession, employment and currency
fluctuations;
o consumer perception of the availability of credit, including price
competition in the market segments which HUSI targets and the
ramifications or ease of filing for personal bankruptcy;
o the effectiveness of models or programs to predict loan delinquency or
loss and initiatives to improve collections in all business areas, and
changes HUSI may make from time to time in these models, programs and
initiatives;
o changes in management's estimates of probable losses inherent in HUSI's
loan portfolios;
o continued consumer acceptance of HUSI's distribution systems and demand
for HUSI's loan or insurance products;
o changes associated with, as well as the difficulty in, integrating
systems, operational functions and cultures, as applicable, of any
organization or portfolio acquired by HUSI;
o a reduction of HUSI's debt ratings by any of the nationally recognized
statistical rating organizations that rate these instruments to a level
that is below HUSI's current ratings;
o amendments to, and interpretations of risk-based capital guidelines and
reporting instructions;
o the impact of raising the required minimum payments on credit card
accounts;
o the costs, effects and outcomes of regulatory reviews or litigation
relating to any nonprime loan receivables or the business practices or
policies of any of HUSI's business units, including, but not limited to,
additional compliance requirements;
o increased funding costs resulting from instability in the capital markets
and risk tolerance of fixed income investors;
o the costs, effects and outcomes of any litigation matter that is
determined adversely to HUSI or its subsidiaries;
o the ability to attract and retain qualified personnel to support the
underwriting, servicing, collection and sales functions of HUSI's
businesses;
o failure to obtain expected funding from HSBC subsidiaries and clients;
o the impact of natural and other catastrophic disasters or the ability to
collect on receivables in affected areas; and
o the inability of HUSI to manage any or all of the foregoing risks as well
as anticipated.
13
Item 1B. Unresolved Staff Comments
--------------------------------------------------------------------------------
None.
Item 2. Properties
--------------------------------------------------------------------------------
The principal executive offices of HUSI are located at 452 Fifth Avenue, New
York, New York 10018, which is owned by HBUS. The main office of HBUS is located
at 1105 N. Market Street, Wilmington, Delaware 19801. The principal executive
offices of HBUS are located at One HSBC Center, Buffalo, New York 14203, in a
building under a long-term lease. HBUS has more than 380 other banking offices
in New York State located in 44 counties, fifteen branches in Florida, eleven
branches in California, four branches in New Jersey, two branches in
Pennsylvania and one branch each in Oregon, Washington State, Delaware and
Washington D.C. Approximately 34% of these offices are located in buildings
owned by HBUS and the remaining are located in leased quarters. In addition,
there are branch offices and locations for other activities occupied under
various types of ownership and leaseholds in states other than New York, none of
which are materially important to the respective activities. HBUS also owns
properties in: Montevideo, Uruguay; Punta del Este, Uruguay; and Buenos Aires,
Argentina.
Item 3. Legal Proceedings
--------------------------------------------------------------------------------
HUSI's legal proceedings are summarized in Note 24 of the consolidated financial
statements on page 134 of this Form 10-K.
Item 4. Submission of Matters to a Vote of Security Holders
--------------------------------------------------------------------------------
Not applicable.
PART II
--------------------------------------------------------------------------------
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters
--------------------------------------------------------------------------------
All 706 shares of HUSI's outstanding stock are owned by HSBC North America Inc.
(HNAI), an indirect subsidiary of HSBC. Consequently, there is no public market
in HUSI's common stock.
14
Item 6. Selected Financial Data
--------------------------------------------------------------------------------
Year Ended December 31 2005 2004 2003 2002 2001
-----------------------------------------------------------------------------------------------------------------------
(in millions)
Net interest income ................... $ 3,063 $ 2,741 $ 2,510 $ 2,376 $ 2,265
--------- --------- -------- -------- --------
Trading revenues ...................... 395 288 291 130 255
Residential mortgage banking revenue
(expense) ........................... 64 (120) (102) 24 33
Securities gains, net ................. 106 85 48 118 149
Interest on tax settlement ............ -- 17 22 -- --
Other income .......................... 1,346 1,049 895 787 659
--------- --------- -------- -------- --------
Total other revenues .................. 1,911 1,319 1,154 1,059 1,096
--------- --------- -------- -------- --------
Goodwill amortization ................. -- -- -- -- 176
Princeton Note Matter ................. -- -- -- -- 575
Other expenses ........................ 2,758 2,101 2,040 1,875 1,792
Provision (credit) for credit losses .. 674 (17) 113 195 238
--------- --------- -------- -------- --------
Income before income tax expense and
cumulative effect of accounting change 1,542 1,976 1,511 1,365 580
Income tax expense .................... 566 718 570 510 226
--------- --------- -------- -------- --------
Income before cumulative effect of
accounting change ................... 976 1,258 941 855 354
--------- --------- -------- -------- --------
Cumulative effect of accounting
change - implementation of
SFAS 133, net of tax ................ -- -- -- -- (1)
--------- --------- -------- -------- --------
Net income ............................ $ 976 $ 1,258 $ 941 $ 855 $ 353
========= ========= ======== ======== ========
Adjusted net income (1) ............... $ 976 $ 1,258 $ 941 $ 855 $ 529
========= ========= ======== ======== ========
Balances at year end:
Loans:
Commercial loans ................ $ 27,721 $ 22,972 $ 18,654 $ 19,917 $ 19,910
Residential mortgages ........... 43,970 46,775 26,637 20,713 17,807
Credit card receivables ......... 15,514 12,078 1,161 1,138 1,185
Other consumer loans ............ 3,137 3,122 2,022 1,868 2,021
--------- --------- -------- -------- --------
Total loans ..................... 90,342 84,947 48,474 43,636 40,923
Allowance for credit losses ..... (846) (788) (399) (493) (506)
--------- --------- -------- -------- --------
Loans, net of allowance ......... 89,496 84,159 48,075 43,143 40,417
Total assets .......................... 153,859 141,050 95,562 89,426 87,114
Total tangible assets ................. 151,120 138,310 92,736 86,544 84,218
Total deposits ........................ 91,815 79,981 63,955 59,830 57,330
Short-term borrowings ................. 7,049 9,874 6,782 7,392 9,202
Long-term debt ........................ 27,959 23,839 3,814 3,675 3,668
Total common shareholder's equity ..... 10,278 10,366 6,962 6,897 6,549
Tangible common shareholder's equity .. 7,562 7,611 4,022 3,737 3,535
Total shareholders' equity ............ 11,594 10,866 7,462 7,397 7,049
Selected financial ratios:
Total shareholders' equity to total assets 7.54% 7.70% 7.81% 8.27% 8.09%
Tangible common shareholder's equity
to total tangible assets ............ 5.00 5.50 4.34 4.32 4.20
Rate of return on average (2):
Total assets .................... .66 1.12 1.02 .97 .41
Total common shareholder's
equity .......................... 8.78 16.35 13.06 12.42 4.80
Net interest margin to average (2):
Earning assets .................. 2.26 2.70 3.07 3.03 2.94
Total assets .................... 2.09 2.46 2.76 2.74 2.66
Average total shareholders' equity to
average total assets (2) ............ 7.85 7.18 8.20 8.20 8.50
Cost/income ratio (2) ................. 55.44 51.73 55.65 54.59 52.94
(1) With the adoption of Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets on January 1, 2002, HUSI is no longer
required to amortize goodwill, but rather evaluate goodwill for impairment
annually. Accordingly, for fiscal year ended 2001, goodwill amortization
has been excluded from the adjusted amounts for consistency purposes.
(2) Selected financial ratios are defined in the Glossary of Terms beginning
on page 77 of this Form 10-K.
15
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
--------------------------------------------------------------------------------
Executive Overview
--------------------------------------------------------------------------------
HUSI's 2005 net income of $976 million reflected a decrease of $282 million
(22%) from the prior year. Income before income tax expense decreased $434
million (22%), primarily due to:
o decreased net interest margin, due mainly to the impact of $451 million of
amortization of initial premium paid for the private label portfolio
acquired from HSBC Finance Corporation in December 2004, as included
within the CF business segment, and to the effect of a flattening yield
curve on balance sheet management income within the CIBM business segment;
and
o significant non-recurring revenue items recorded for 2005 ($59 million of
gains from sales of properties and businesses; and a $48 million gain from
sale of an equity investment) were less than non-recurring items recorded
for 2004 ($99 million gain from sale of credit card relationships to HSBC
Finance Corporation; $45 million gain from sale of investment in NYCE; and
$17 million interest income on an IRS refund).
Excluding the impact of the items noted above, 2005 was highlighted by increases
in income before income tax expense in the PFS, CF, CMB and PB segments, due to:
o successful rollout during 2005 of an enhanced deposit growth strategy;
o significant expansion of residential mortgage, other consumer and
commercial loan portfolios in 2004 and 2005;
o positive impact on earnings, excluding the impact of the premium
amortization noted above, of the private label receivable portfolio
acquired in December 2004, and from additional private label receivables
acquired in 2005; and
o increased trading revenues, increased gains on sales of securities and
increased fee income included in the CIBM business segment.
Further analysis of business segments begins on page 46 of this Form 10-K.
16
Basis of Reporting
--------------------------------------------------------------------------------
HUSI's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States (U.S. GAAP).
International Financial Reporting Standards (IFRS)
Because HSBC reports results in accordance with IFRS and IFRS results are used
by HSBC in measuring and rewarding performance of employees, HUSI management
also separately monitors net income under IFRS (a non-U.S. GAAP financial
measure). The following table reconciles HUSI's net income on a U.S. GAAP basis
to net income on an IFRS basis.
--------------------------------------------------------------------------------
Year Ended December 31 2005
--------------------------------------------------------------------------------
(in millions)
Net income - U.S. GAAP basis ................................. $ 976
Adjustments, net of tax:
Derivatives and hedge accounting ....................... 18
Securitizations ........................................ 2
Loan origination ....................................... (7)
Loan impairment ........................................ (11)
Stock-based compensation ............................... (16)
Property ............................................... (46)
Other .................................................. 16
-----
Net income - IFRS basis ...................................... $ 932
=====
Differences between U.S. GAAP and IFRS are as follows:
Derivatives and hedge accounting
IFRS
o Derivatives are recognized initially, and are subsequently remeasured, at
fair value. Fair values are obtained from quoted market prices in active
markets, or by using valuation techniques, including recent market
transactions, where an active market does not exist. Valuation techniques
include discounted cash flow models and option pricing models as
appropriate. All derivatives are classified as assets when their fair
value is positive, or as liabilities when their fair value is negative.
o In the normal course of business, the fair value of a derivative on
initial recognition is considered to be the transaction price (i.e. the
fair value of the consideration given or received). However, in certain
circumstances the fair value of an instrument will be evidenced by
comparison with other observable current market transactions in the same
instrument (i.e. without modification or repackaging) or based on a
valuation technique whose variables include only data from observable
markets, including interest rate yield curves, option volatilities and
currency rates. When such evidence exists, HSBC recognizes a trading
profit or loss on inception of the derivative. If observable market data
are not available, the initial increase in fair value indicated by the
valuation model, but based on unobservable inputs, is not recognized
immediately in the income statement but is recognized over the life of the
transaction on an appropriate basis, or recognized in the income statement
when the inputs become observable, or when the transaction is closed out.
o Certain derivatives embedded in other financial instruments, such as the
conversion option in a convertible bond, are treated as separate
derivatives when their economic characteristics and risks are not clearly
and closely related to those of the host contract, the terms of the
embedded derivative are the same as those of a stand-alone derivative, and
the combined contract is not designated at fair value through profit and
loss. These embedded derivatives are measured at fair value with changes
in fair value recognized in the income statement.
o Derivative assets and liabilities on different transactions are only
netted if the transactions are with the same counterparty, a legal right
of set-off exists, and the cash flows are intended to be settled on a net
basis.
17
o The method of recognizing the resulting fair value gains or losses depends
on whether the derivative is held for trading, or is designated as a
hedging instrument, and if so, the nature of the risk being hedged. All
gains and losses from changes in the fair value of derivatives held for
trading are recognized in the income statement. Where derivatives are
designated as hedges, HSBC classifies them as either: (i) hedges of the
change in fair value of recognized assets or liabilities or firm
commitments ("fair value hedge"); (ii) hedges of the variability in highly
probable future cash flows attributable to a recognized asset or
liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges
of net investments in a foreign operation ("net investment hedge"). Hedge
accounting is applied to derivatives designated as hedging instruments in
a fair value, cash flow or net investment hedge provided certain criteria
are met.
Hedge accounting:
o It is HSBC's policy to document, at the inception of a hedging
relationship, the relationship between the hedging instruments and hedged
items, as well as its risk management objective and strategy for
undertaking the hedge. Such policies also require documentation of the
assessment, both at hedge inception and on an ongoing basis, of whether
the derivatives that are used in hedging transactions are highly effective
in offsetting changes in fair values or cash flows of hedged items
attributable to the hedged risks. Interest on designated qualifying hedges
is included in "Net interest income".
Fair value hedge:
o Changes in the fair value of derivatives that are designated and qualify
as fair value hedging instruments are recorded in the income statement,
together with changes in the fair value of the asset or liability or group
thereof that are attributable to the hedged risk.
o If the hedging relationship no longer meets the criteria for hedge
accounting, the cumulative adjustment to the carrying amount of a hedged
item for which the effective interest method is used is amortized to the
income statement over the residual period to maturity.
Cash flow hedge:
- The effective portion of changes in the fair value of derivatives
that are designated and qualify as cash flow hedges are recognized
in equity. Any gain or loss relating to an ineffective portion is
recognized immediately in the income statement.
- Amounts accumulated in equity are recycled to the income statement
in the periods in which the hedged item will affect profit or loss.
However, when the forecast transaction that is hedged results in the
recognition of a non-financial asset or a non-financial liability,
the gains and losses previously deferred in equity are transferred
from equity and included in the initial measurement of the cost of
the asset or liability.
- When a hedging instrument expires or is sold, or when a hedge no
longer meets the criteria for hedge accounting, any cumulative gain
or loss existing in equity at that time remains in equity until the
forecast transaction is ultimately recognized in the income
statement. When a forecast transaction is no longer expected to
occur, the cumulative gain or loss that was reported in equity is
immediately transferred to the income statement.
Net investment hedge:
- Hedges of net investments in foreign operations are accounted for
similarly to cash flow hedges. Any gain or loss on the hedging
instrument relating to the effective portion of the hedge is
recognized in equity; the gain or loss relating to the ineffective
portion is recognized immediately in the income statement. Gains and
losses accumulated in equity are included in the income statement on
the disposal of the foreign operation.
Hedge effectiveness testing:
- To qualify for hedge accounting, IAS 39 requires that at the
inception of the hedge and throughout its life, each hedge must be
expected to be highly effective (prospective effectiveness). Actual
effectiveness (retrospective effectiveness) must also be
demonstrated on an ongoing basis.
- The documentation of each hedging relationship sets out how the
effectiveness of the hedge is assessed. The method an HSBC entity
adopts for assessing hedge effectiveness will depend on its risk
management strategy.
18
- For fair value hedge relationships, HSBC entities utilize the
cumulative dollar offset method or regression analysis as
effectiveness testing methodologies. For cash flow hedge
relationships, HSBC entities utilize the change in variable cash
flow method or the cumulative dollar offset method using the
hypothetical derivative approach.
- For prospective effectiveness, the hedging instrument must be
expected to be highly effective in achieving offsetting changes in
fair value or cash flows attributable to the hedged risk during the
period for which the hedge is designated. For actual effectiveness,
the changes in fair value or cash flows must offset each other in
the range of 80 per cent to 125 per cent for the hedge to be deemed
effective.
Derivatives that do not qualify for hedge accounting:
- All gains and losses from changes in the fair value of any
derivatives that do not qualify for hedge accounting are recognized
immediately in the income statement. These gains and losses are
reported in "Trading income", except where derivatives are managed
in conjunction with financial instruments designated at fair value,
in which case gains and losses are reported in "Net income from
financial instruments designated at fair value".
U.S. GAAP
o The accounting under SFAS 133 "Accounting for Derivative Instruments and
Hedging Activities" is generally consistent with that under IAS 39 as
described above (from January 1, 2005).
o The requirements of SFAS 133 have been effective from January 1, 2001.
o SFAS 133 permits the "shortcut method" of hedge effectiveness testing for
certain transactions. Under this method, it may be assumed, at inception
of the hedge, there is no ineffectiveness in the hedging of interest rate
risk with an interest rate swap provided specific criteria are met.
o Certain issued structured notes are classified as trading liabilities
under IFRS, but not under U.S. GAAP. Under IFRS, these notes will be held
at fair value, with changes in fair value reflected in the income
statement. Under U.S. GAAP, if the embedded derivative is not "clearly and
closely related" to the host contract, the embedded derivative will be
bifurcated and held at fair value, the host contract will be held at
amortized cost, and changes in both will be reflected in the income
statement. If the embedded derivative is "clearly and closely related" to
the host contract, the issued note will be held at amortized cost in its
entirety, with changes in the amortized cost reflected in the income
statement.
o Under U.S. GAAP, derivatives receivable and payable with the same
counterparty may be reported net on the balance sheet when there is an
executed ISDA Master Netting Arrangement covering enforceable
jurisdictions. These contracts do not meet the requirements for set off
under IAS 32 and hence are presented gross on the balance sheet under
IFRS.
Securitizations
IFRS
o The recognition of securitized assets is governed by a three-step process.
The process may be applied to the whole asset, or a part of an asset:
- If the rights to the cash flows have been transferred to a third
party, those securitized assets should be derecognized.
- If the rights to the cash flows are retained but there is a
contractual obligation to pay the cash flows to another party, the
securitized assets should be derecognized if certain conditions are
met, for example, where there is no obligation to pay amounts to the
eventual recipient unless an equivalent amount is collected from the
original asset.
- If it is determined that some significant risks and rewards of
ownership have been transferred, but some significant risks and
rewards have also been retained, it must be determined whether or
not control has been retained. If it has not been retained, the
asset should be derecognized. If control has been retained, an
entity shall continue to recognize the asset to the extent of its
continuing involvement.
U.S. GAAP
o SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and
Extinguishments of Liabilities" requires that receivables that are sold to
a special purpose entity and securitized can only be derecognized and a
gain or loss on sale recognized if the originator has surrendered control
over those securitized assets.
o Control has been surrendered over transferred assets if and only if all of
the following conditions are met:
- The transferred assets have been put presumptively beyond the reach
of the transferor and its creditors, even in bankruptcy or other
receivership.
- Each holder of interests in the transferee (i.e. holder of issued
notes) has the right to pledge or exchange their beneficial
interests, and no condition constrains this right and provides more
than a trivial benefit to the transferor.
- The transferor does not maintain effective control over the assets
through either an agreement that obligates the transferor to
repurchase or to redeem them before their maturity or through the
ability to unilaterally cause the holder to return specific assets,
other than through a clean-up call.
- If these conditions are not met the securitized assets should
continue to be consolidated.
19
o Where HSBC retains an interest in the securitized assets, such as a
servicing right or the right to residual cash flows from the special
purpose entity, HSBC recognizes this interest at fair value on sale of the
assets.
Loan origination
IFRS
o Certain loan fee income and incremental directly attributable loan
origination costs are amortized to the profit and loss account over the
life of the loan as part of the effective interest method calculation
under IAS 39.
U.S. GAAP
o Certain loan fee income and direct but not necessarily incremental loan
origination costs, including an apportionment of overheads, are amortized
to the profit and loss account over the life of the loan as an adjustment
to interest income (SFAS 91 "Accounting for Nonrefundable Fees and Costs
Associated with Originating or Acquiring Loans and Initial Direct Costs of
Leases".)
Loan impairment
IFRS
o Where there is evidence of impairment, based on statistical models using
historic loss rates adjusted for economic conditions, portfolios of loans
are written down to their net recoverable amount. The net recoverable
amount is the present value of the estimated future recoveries discounted
at the portfolio's original effective interest rate and includes
reasonably estimable recoveries on loans individually identified for
write-off pursuant to HSBC's credit guidelines.
U.S. GAAP
o Where the delinquency status of loans in a portfolio is such that there is
no realistic prospect of recovery of these amounts, the loans are written
off in full, or to recoverable value where collateral exists. The
delinquency status, for example, the number of days payment is overdue,
where write-off occurs is applied consistently across similar loan
products as described in HSBC's credit guidelines. Where local regulators
mandate the delinquency status at which write-off must occur for different
retail products and these reasonably reflect estimable recoveries on
individual loans, this basis of measuring impairment is reflected in U.S.
GAAP accounting. Cash recoveries relating to pools of such written-off
loans, if any, are reported as loan recoveries upon collection.
Stock-based compensation
IFRS
o IFRS 2 "Share-based Payment" requires that where annual bonuses are paid
in restricted shares, whereby the employee must remain with HSBC for a
fixed period in order to receive the shares, the award is expensed over
that period.
U.S. GAAP
o In its U.S. GAAP reporting, under SFAS 123 "Accounting for Stock Based
Compensation", HSBC has interpreted the service period as being the period
to which the bonus relates.
o For 2005 bonuses, awarded in early 2006, HSBC will follow SFAS 123
(revised 2004) "Share-Based Payment" ("SFAS 123R"). SFAS 123R is
consistent with IFRS 2, requiring restricted bonuses be expensed over the
period the employee must remain with HSBC. However, SFAS 123R only applies
to awards made after the date of adoption, which HSBC has elected as July
1, 2005.
20
Property
IFRS
o Under the transition rules of IFRS 1, HSBC has elected to freeze the value
of its properties at their January 1, 2004 valuations. These are the
"deemed cost" of properties under IFRS and will not be revalued in the
future. Properties held at historical or deemed cost are depreciated
except for freehold land and leasehold land greater than 500 years.
Investment properties are not depreciated.
o Investment properties are recognized at current market value with gains or
losses recognized in net income for the period.
U.S. GAAP
o U.S. GAAP does not permit revaluations of property, including investment
property, although it requires recognition of asset impairment. Any
realized surplus or deficit is, therefore, reflected in income on disposal
of the property. Depreciation is charged on all properties based on cost.
Other
Other includes differences relating to pension expense and other insignificant
items.
21
Critical Accounting Policies
--------------------------------------------------------------------------------
HUSI's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States. The significant
accounting policies used in the preparation of HUSI's consolidated financial
statements are more fully described in Note 2 to the accompanying consolidated
financial statements beginning on page 88 of this Form 10-K.
Certain critical accounting policies, which affect the reported amounts of
assets, liabilities, revenues and expenses, are complex and involve significant
judgment by management, including the use of estimates and assumptions. As a
result, changes in estimates, assumptions or operational policies could
significantly affect HUSI's financial position or results of operations. The
accounting estimates are based upon historical experience and on various other
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities. Actual results may differ from these estimates under
different assumptions, customer account management policies and practices, risk
management/collection practices, or conditions as discussed below.
Of the significant accounting policies used in the preparation of HUSI's
consolidated financial statements, the items discussed below involve critical
accounting estimates and a high degree of judgment and complexity.
Allowance for Credit Losses
HUSI lends money and provides various credit facilities to others, resulting in
risk that borrowers may not repay amounts owed when they become contractually
due. Consequently, an allowance for credit losses is maintained at a level that
is considered adequate to cover estimates of probable losses of principal,
interest and fees in the existing portfolio. Allowance estimates are reviewed
periodically, and adjustments are reflected through the provision for credit
losses in the period when they become known. The accounting estimate relating to
the allowance for credit losses is a "critical accounting estimate" for the
following reasons:
o changes in such estimates could significantly impact the allowance for
credit losses and the provision for credit losses;
o estimates related to the reserve for credit losses require consideration
of future delinquency and charge off trends, which are uncertain and
require a high degree of judgment; and
o the allowance for credit losses is influenced by factors outside of HUSI's
control. Customer payment patterns, economic conditions, bankruptcy trends
and changes in laws and regulations all have an impact on the estimates.
HUSI's allowance for credit losses is regularly assessed for adequacy through a
detailed review of the loan portfolio. The allowance is comprised of two balance
sheet components:
o the allowance for credit losses, which is carried as a reduction to loans
on the balance sheet and includes reserves for anticipated losses
associated with all loans and leases outstanding; and
o the reserve for off-balance sheet risk, which is recorded in other
liabilities and includes probable and reasonably estimable losses arising
from off-balance sheet arrangements such as letters of credit and
commitments to lend that have not yet been drawn by customers.
22
Both types of reserves include amounts calculated for specific individual loan
balances and for collective loan portfolios depending on the nature of the
exposure and the manner in which risks inherent in that exposure are managed.
o All commercial loans that exceed five hundred thousand dollars are
evaluated individually for impairment. When a loan is found to be
"impaired", a specific reserve is calculated. Reserves against impaired
loans are determined primarily by an analysis of discounted expected cash
flows expected by HUSI with reference to independent valuations of
underlying loan collateral and also considering secondary market prices
for distressed debt where appropriate.
o Loans which are not individually evaluated for impairment are pooled into
homogeneous categories of loans and evaluated to determine if it is deemed
probable, based on historical data, that a loss has been realized even
though it has not yet been manifested in a specific loan.
For retail receivables, HUSI uses roll rate methodology (statistical analysis of
historical trends used to estimate the probability of continued delinquency,
ultimate charge off, and amount of consequential loss assessed at each time
period for which payments are overdue) to support the estimation of inherent
losses. The results of these models are reviewed by management in conjunction
with changes in risk selection, changes in underwriting policies, national and
local economic trends, trends in bankruptcy, loss severity and recoveries, and
months of loss coverage. The resulting loss coverage ratio varies by portfolio
based on inherent risk and regulatory guidance. Roll rates are regularly updated
and benchmarked against actual outcomes to ensure that they remain appropriate.
In 2004, HUSI implemented a new methodology to support the estimation of losses
inherent in pools of homogeneous commercial loans, leases and off-balance sheet
risk. These measures have been under development at HUSI for over three years to
support more advanced credit risk management, estimation of credit economic
capital, enhanced portfolio management and the requirements of the Basel
framework. This new methodology uses the probability of default from the
customer rating assigned to each counterparty, the "Loss Given Default" rating
assigned to each transaction or facility based on the collateral securing the
transaction, and the measure of exposure based on the transaction. A suite of
models, tools and templates was developed using quantitative and statistical
techniques, which are combined with expert judgment to support the assessment of
each transaction. They were developed using HUSI's internal data and
supplemented by data from external sources which was judged to be consistent
with HUSI's internal credit standards. As some of the requirements under Basel
differ from interpretations of U.S. GAAP requirements for the measurement of
inherent losses in homogeneous pools of loans, these measures are modified to
meet accounting standards. These advanced measures are applied to the
homogeneous credit pools to estimate the reserves required.
The results from the advanced commercial analysis, retail roll rate analysis and
the specific/impairment reserving process is reviewed each quarter by a Credit
Reserve Committee co-chaired by the Chief Financial Officer and Chief Credit
Officer. This committee also considers other observable factors, both internal
to HUSI and external in the general economy, to ensure that the estimates
provided by the various models adequately include all known information at each
reporting period. The Credit Reserve Committee may add to or reduce a general
unallocated allowance to account for any observable factor not considered in the
various models, for small portfolios or period ending manual entries not
considered in a model and to recognize modeling imperfections. The credit
reserves and the results of the Credit Reserve Committee are reviewed with
HUSI's Credit Risk Management Committee and the Board of Directors' Audit
Committee each quarter.
HUSI recognizes however that there is a high degree of subjectivity and
imprecision inherent in the process of estimating losses utilizing historical
data. Accordingly, a discretionary component of the allowance for credit losses
for unspecified potential losses inherent in the loan portfolios is provided
based upon an evaluation of certain critical factors including the impact of the
national economic cycle, migration of loans within non-criticized loan
portfolios, and loan portfolio concentration.
Additional credit quality related analysis begins on page 53 of this Form 10-K.
HUSI's approach toward credit risk management begins on page 64 of this Form
10-K.
23
Goodwill
Goodwill is not subject to amortization but is tested for possible impairment at
least annually or more frequently if events or changes in circumstances indicate
that the asset might be impaired. Impairment testing requires that the fair
value of each reporting unit be compared to its carrying amount, including the
goodwill. Significant and long-term changes in industry and economic conditions
are considered to be primary indicators of potential impairment.
Impairment testing of goodwill is a "critical accounting estimate" due to the
goodwill balance and the significant judgment required in the use of discounted
cash flow models to determine fair value. Discounted cash flow models include
such variables as revenue growth rates, expense trends, interest rates and
terminal values. Based on an evaluation of key data and market factors,
management's judgment is required to select the specific variables to be
incorporated into the models. Additionally, the estimated fair value can be
significantly impacted by the cost of capital used to discount future cash
flows. The cost of capital percentage is generally derived from an appropriate
capital asset pricing model, which itself depends on a number of financial and
economic variables which are established on the basis of management's judgment.
When management's judgment is that the anticipated cash flows have decreased
and/or the cost of capital has increased, the effect will be a lower estimate of
fair value. If the fair value is determined to be lower than the carrying value,
an impairment charge will be recorded and net income will be negatively
impacted.
Reporting units were identified based upon an analysis of each of HUSI's
individual operating segments. Goodwill was allocated to the carrying value of
each reporting unit based on its relative fair value. See Business Segments
beginning on page 46 of this Form 10-K for an allocation of recorded book value
of goodwill by segment.
HUSI has established April 30 of each year as the date for conducting its annual
goodwill impairment assessment. At April 30, 2005, there were no individual
reporting units with a fair value less than carrying value, including goodwill.
The fair value calculations were tested for sensitivity to reflect reasonable
variations, including: (1) keeping all other variables constant and assuming no
future expense savings are achieved; and (2) keeping other variables constant
while cutting projected revenue growth rates in half. In both of these cases
there was no impairment identified in any reporting unit.
Mortgage Servicing Rights (MSRs)
HUSI recognizes the right to service mortgage loans as a separate and distinct
asset at the time the loans are sold. Servicing rights are then amortized in
proportion to net servicing income and carried on the balance sheet at the lower
of their initial carrying value, adjusted for amortization, or fair value.
As interest rates decline, prepayments generally accelerate, thereby reducing
future net servicing cash flows from the serviced mortgage loan portfolio. The
carrying value of the MSRs is periodically evaluated for impairment based on the
difference between the carrying value of such rights and their current fair
value. For purposes of measuring impairment, MSRs are stratified based upon
interest rates and whether such rates are fixed or variable and other loan
characteristics. Fair value is determined based upon the application of pricing
valuation models incorporating portfolio specific prepayment assumptions. The
estimate of fair value is considered to be a "critical accounting estimate"
because the assumptions used in the valuation models involve a high degree of
subjectivity that is dependent on future interest rate movements. The
reasonableness of these pricing models is periodically substantiated by
reference to external independent broker valuations and industry surveys.
24
Valuation of Derivative Instruments and Derivative Income
Derivative instruments are utilized as part of HUSI's risk management strategy
to protect the value of certain assets and liabilities and future cash flows
against adverse interest rate and foreign exchange rate movements. All
derivatives are recognized on the balance sheet at fair value. The valuation of
derivative instruments is a critical accounting estimate because most are valued
using discounted cash flow modeling techniques in lieu of market value quotes.
Discounted cash flow modeling techniques require the use of estimates regarding
the amount and timing of future cash flows, which are susceptible to significant
change in future periods based on changes in market rates. The assumptions used
in the cash flow projection models are based on forward yield curves which are
also susceptible to changes as market conditions change. The results of these
valuations are regularly reviewed for reasonableness by comparison to an
internal determination of fair value or third party quotes. Significant changes
in the fair value can result in equity and earnings volatility as follows:
o changes in the fair value of a derivative that has been designated and
qualifies as a fair value hedge, along with the changes in the fair value
of the hedged asset or liability (including losses or gains on firm
commitments), are recorded in current period earnings;
o changes in the fair value of a derivative that has been designated and
qualifies as a cash flow hedge are recorded in other comprehensive income
to the extent of its effectiveness, until earnings are impacted by the
variability of cash flows from the hedged item; and
o changes in the fair value of derivatives held for trading purposes are
reported in current period earnings.
Derivatives designated as effective hedges may be tested for effectiveness under
the long haul method. For these transactions, assessments are made, at the
inception of the hedge and on a recurring basis, whether the derivative used in
the hedging transaction has been and is expected to continue to be highly
effective in offsetting changes in fair values or cash flows of the hedged item.
This assessment is conducted using statistical regression analysis. If it is
determined as a result of this assessment that a derivative is not expected to
be a highly effective hedge or that it has ceased to be a highly effective
hedge, hedge accounting is discontinued as of the beginning of the quarter in
which such determination was made. The assessment of the effectiveness of the
derivatives used in hedging transactions is considered to be a "critical
accounting estimate" due to the use of statistical regression analysis in making
this determination. Similar to discounted cash flow modeling techniques,
statistical regression analysis also requires the use of estimates regarding the
amount and timing of future cash flows, which are susceptible to significant
changes in future periods based on changes in market rates. Statistical
regression analysis also involves the use of additional assumptions including
the determination of the period over which the analysis should occur as well as
selecting a convention for the treatment of credit spreads in the analysis.
The outcome of the statistical regression analysis serves as the foundation for
determining whether or not the derivative is highly effective as a hedging
instrument. This can result in earnings volatility as the mark to market on
derivatives which do not qualify as effective hedges and the ineffectiveness
associated with qualifying hedges are recorded in current period earnings.
For more information about HUSI's policies regarding the use of derivative
instruments, see Note 2 to the accompanying consolidated financial statements
beginning on page 94 of this Form 10-K.
25
Balance Sheet Review
--------------------------------------------------------------------------------
Overview
HUSI utilizes deposits and borrowings from various sources to fund balance sheet
growth, to meet cash and capital needs, and to fund investments in subsidiaries.
Balance sheet growth and funding sources are summarized in the following table.
--------------------------------------------------------------------------------------------------------------------
Increase (Decrease)
During The Year Ended December 31
-------------------------------------------------
2005 2004
---------------------- ---------------------
Amount % Amount %
--------------------------------------------------------------------------------------------------------------------
(in millions)
Balance sheet growth:
Loans .................................................. $ 5,395 6 $ 36,473 75
Short-term investments (1) ............................. 3,426 40 2,761 47
Trading assets ......................................... 1,405 7 5,169 35
Securities and other assets ............................ 2,583 9 1,085 4
-------- -------- -------- --------
$ 12,809 9 $ 45,488 48
======== ======== ======== ========
Funding sources:
Total deposits ......................................... $ 11,834 15 $ 16,026 25
Long-term debt ......................................... 4,120 17 20,025 525
All other liabilities and shareholders' equity ......... (3,145) (8) 9,437 34
-------- -------- -------- --------
$ 12,809 9 $ 45,488 48
======== ======== ======== ========
(1) Includes cash and due from banks, interest bearing deposits with banks and
Federal funds sold and securities purchased under resale agreements.
Average Assets and Liabilities
Average earning assets and interest bearing liabilities increased during
calendar year 2005, as compared with 2004, primarily due to:
o increased average residential mortgage loan balances from held portfolio
growth in 2004;
o increased average credit card and other loan balances associated with the
private label receivable portfolio acquired in December 2004;
o increased average commercial loan and deposit balances resulting from
targeted growth in small business and middle-market commercial customers;
and
o increased average deposits, long-term debt and short-term borrowings
balances, which were the primary funding sources for asset growth during
2004.
26
Loans Outstanding
The following table summarizes balances for major loan categories. Other
commercial loans includes $1,901 million, $1,378 million, and $246 million of
loans and advances to HSBC affiliates at December 31, 2005, 2004 and 2003
respectively.
------------------------------------------------------------------------------------------------------------------------
December 31 2005 2004 2003 2002 2001
------------------------------------------------------------------------------------------------------------------------
(in millions)
Commercial:
Construction and other real estate ......... $ 9,123 $ 8,281 $ 7,024 $ 6,313 $ 5,920
Other commercial ........................... 18,598 14,691 11,630 13,604 13,990
Consumer:
Residential mortgage loans ................. 43,970 46,775 26,637 20,713 17,807
Credit card receivables .................... 15,514 12,078 1,161 1,138 1,185
Other consumer loans ....................... 3,137 3,122 2,022 1,868 2,021
--------- --------- --------- --------- ---------
Total loans ...................................... $ 90,342 $ 84,947 $ 48,474 $ 43,636 $ 40,923
========= ========= ========= ========= =========
Increased loans during 2005 were attributable to:
o increased commercial loan balances resulting from continuation of specific
programs initiated in 2004 to target growth in small business, middle
market and real estate commercial lending portfolios; and
o increased private label credit card receivables, due partially to the
addition of new private label relationships to the portfolio, and
partially to decreasing balances required to be maintained in off-balance
sheet securitized receivable trusts.
Increased loans during 2004 were attributable to:
o acquisition of a $12 billion private label loan portfolio from HSBC
Finance Corporation in December 2004, which consisted primarily of credit
card receivables;
o increased residential mortgage loan balances resulting from purchases of
approximately $4 billion of loans from HSBC Finance Corporation and from
originating lenders pursuant to an HSBC Finance Corporation correspondent
loan program and from continued growth in the held mortgage loan
portfolio; and
o increased commercial loan balances resulting from specific programs
initiated during the year to target growth in middle market, commercial
real estate and small business lending portfolios.
Commercial Loan Maturities and Sensitivity to Changes in Interest Rates
The contractual maturity and interest sensitivity of total commercial loans at
December 31, 2005 is summarized in the following table.
------------------------------------------------------------------------------------------------------------------------
One Over One Over
Year Through Five Total
December 31, 2005 or Less Five Years Years Loans
------------------------------------------------------------------------------------------------------------------------
(in millions)
Commercial:
Construction and other real estate ............... $ 2,470 $ 4,946 $ 1,707 $ 9,123
Other commercial ................................. 11,695 5,739 1,164 18,598
--------- --------- --------- ---------
Total .................................................. $ 14,165 $ 10,685 $ 2,871 $ 27,721
========= ========= ========= =========
Loans with fixed interest rates ........................ $ 6,334 $ 2,167 $ 1,295 $ 9,796
Loans having variable interest rates ................... 7,831 8,518 1,576 17,925
--------- --------- --------- ---------
Total .................................................. $ 14,165 $ 10,685 $ 2,871 $ 27,721
========= ========= ========= =========
27
Deposits
The following table summarizes balances for major depositor categories.
------------------------------------------------------------------------------------------------------------------------
December 31 2005 2004 2003 2002 2001
------------------------------------------------------------------------------------------------------------------------
(in millions)
Individuals, partnerships and corporations ....... $ 76,438 $ 65,312 $ 53,959 $ 51,470 $ 50,852
Domestic and foreign banks ....................... 12,871 12,759 7,580 7,114 4,646
U.S. government and states and political
subdivisions ................................... 1,566 1,493 1,464 855 1,169
Foreign governments and official
institutions ................................... 940 417 952 391 663
--------- --------- --------- --------- ---------
Total deposits ................................... $ 91,815 $ 79,981 $ 63,955 $ 59,830 $ 57,330
========= ========= ========= ========= =========
Deposits were a primary source of funding for balance sheet growth during 2005
and 2004. Total deposits increased 15% and 25% in 2005 and 2004 respectively,
resulting from:
o successful rollout of new deposit products, including online savings
accounts;
o enhanced marketing efforts for the HSBC brand and for new and existing
products in particular; and
o improved systems and processes for identifying new customers and for
delivering products to new and existing customers.
Long-Term Debt and Other Borrowings
HBUS has a $20 billion Global Bank Note Program, which provides for issuance of
subordinated and senior global notes. Long-term debt issuances during 2005 and
2004 were primarily from this program. Borrowings from the Global Bank Note
Program totaled $1 billion and $14 billion for 2005 and 2004 respectively.
Additional information regarding HUSI's long-term debt is presented in Note 14
of the consolidated financial statements, beginning on page 111 of this Form
10-K.
HUSI had borrowings from the Federal Home Loan Bank (FHLB) of $5 billion at
December 31, 2005 and 2004, and had access to a potential secured borrowing
facility as a member of the FHLB. In addition, HUSI had deposits and other
borrowings from HSBC affiliates of approximately $11 billion at December 31,
2005 and 2004.
Preferred Stock
In April 2005, HUSI issued Floating Rate Non-Cumulative Preferred Stock, Series
F with a stated value of $25 per share. In October 2005, HUSI issued Floating
Rate Non-Cumulative Preferred Stock, Series G with a stated value of $1,000 per
share. Total proceeds of these two issues, net of issuance costs, were $869
million.
In December 2005, HUSI redeemed all issued shares of $1.8125 Cumulative
Preferred Stock, Series E at their stated value of $25 per share, resulting in
total cash outlay of $75 million.
28
Capital Resources
A summary of changes in common shareholder's equity is presented in the
following table.
------------------------------------------------------------------------------------------------------------------------
2005 2004 2003
------------------------------------------------------------------------------------------------------------------------
(in millions)
Balance, January 1 ............................................ $ 10,366 $ 6,962 $ 6,896
Increases (decreases) due to:
Net income .............................................. 976 1,258 941
Dividends paid to common shareholder .................... (675) (125) (690)
Dividends paid to preferred shareholders ................ (46) (23) (22)
Change in other comprehensive income .................... (43) (97) (134)
Capital contributions from parent (1) ................... 3 2,411 15
Reductions of capital surplus ........................... (303) (20) (44)
---------- ---------- ----------
Total net (decrease) increase ........................... (88) 3,404 66
---------- ---------- ----------
Balance, December 31 .......................................... $ 10,278 $ 10,366 $ 6,962
========== ========== ==========
(1) Capital contributions from parent include amounts related to an HSBC stock
option plan in which almost all of HUSI's employees are eligible to
participate ($3 million, $11 million and $15 million for 2005, 2004 and
2003 respectively).
Year end common shareholder's equity ratios are presented in the following
table.
------------------------------------------------------------------------------------------------------------------------
Year Ended December 31 2005 2004 2003
------------------------------------------------------------------------------------------------------------------------
Common shareholder's equity to total assets.................... 6.68% 7.35% 7.28%
Tangible common shareholder's equity to total tangible assets . 5.00 5.50 4.34
HUSI periodically pays dividends to its parent company, HNAI. Dividends paid to
HNAI were significantly reduced in 2004 in order to conserve funds for the
December 2004 acquisition of private label receivables and loans from HSBC
Finance Corporation. The capital contributions from parent in 2004 includes $2.4
billion received to provide additional funding for the private label portfolio
acquisition.
Effective January 1, 2005, the separate U.S. defined benefit pension plans were
merged into a single defined benefit pension plan which facilitates the
development of a unified employee benefit policy and unified employee benefit
plan administration for HSBC affiliates operating in the U.S. As a result,
HUSI's prepaid pension asset of $482 million, and a related deferred tax
liability of $203 million, were transferred to HNAH. The net transfer amount of
$279 million is recorded as a reduction of capital surplus.
HUSI and HBUS are required to meet minimum capital requirements by their
principal regulators. Risk-based capital amounts and ratios are presented on
page 119 of this Form 10-K.
29
Results of Operations
--------------------------------------------------------------------------------
Net Interest Income
--------------------------------------------------------------------------------
Net interest income is the total interest income on earning assets less the
total interest expense on deposits and borrowed funds. In the discussion that
follows, interest income and rates are presented and analyzed on a taxable
equivalent basis to permit comparisons of yields on tax-exempt and taxable
assets. An analysis of consolidated average balances and interest rates on a
taxable equivalent basis is presented on pages 79 of this Form 10-K.
The following table presents changes in the components of net interest income
according to "volume" and "rate".
------------------------------------------------------------------------------------------------------------------------
2005 Compared to 2004 2004 Compared to 2003
Increase/(Decrease) Increase/(Decrease)
Year Ended December 31 2005 Volume Rate 2004 Volume Rate 2003
------------------------------------------------------------------------------------------------------------------------
(in millions)
Interest income:
Interest bearing deposits with banks $ 120 $ 24 $ 55 $ 41 $ 13 $ 3 $ 25
Federal funds sold and securities
purchased under resale agreements 191 15 102 74 2 17 55
Trading assets ................... 275 44 66 165 30 (2) 137
Securities ....................... 899 38 (24) 885 (40) 17 908
Loans:
Commercial ...................... 1,233 190 212 831 (7) (93) 931
Consumer:
Residential mortgages ....... 2,321 491 (1) 1,831 792 (139) 1,178
Credit cards ................ 812 749 (44) 107 10 (15) 112
Other consumer .............. 264 94 27 143 25 (11) 129
------ ------- ----- ------ ----- ----- ------
Total consumer ............. 3,397 1,334 (18) 2,081 827 (165) 1,419
Other interest ................... 32 4 10 18 2 (4) 20
------ ------- ----- ------ ----- ----- ------
Total interest income ............ 6,147 1,649 403 4,095 827 (227) 3,495
------ ------- ----- ------ ----- ----- ------
Interest expense:
Deposits in domestic offices:
Savings deposits .............. 318 9 130 179 17 (27) 189
Other time deposits ........... 822 257 200 365 121 21 223
Deposits in foreign offices:
Foreign banks deposits ........ 277 22 148 107 58 2 47
Other time and savings ........ 354 (7) 187 174 (18) (15) 207
Short-term borrowings ............ 276 36 108 132 5 36 91
Long-term debt ................... 1,019 619 20 380 247 (73) 206
------ ------- ----- ------ ----- ----- ------
Total interest expense ........... 3,066 936 793 1,337 430 (56) 963
------ ------- ----- ------ ----- ----- ------
Net interest income -
taxable equivalent basis ....... 3,081 $ 713 $(390) 2,758 $ 397 $(171) 2,532
======= ===== ===== =====
Tax equivalent adjustment ........ 18 17 22
------ ------ ------
Net interest income -
non taxable equivalent basis ... $3,063 $2,741 $2,510
====== ====== ======
30
2005 Compared to 2004
Overview
Net interest income increased $322 million (12%) in 2005, as compared with 2004.
The net interest margin declined from 2.46% in 2004 to 2.09% in 2005. The
following factors contributed to the overall decrease in net interest margin:
o amortization of premiums paid to acquire private label credit card
receivables;
o a reduction in balance sheet management income in CIBM, due largely to a
flat yield curve;
o average balances of residential mortgage loans have increased
significantly in 2005, without an increase in the yield on these loans
despite the rising interest rate environment; and
o average balances and rates paid on wholesale liabilities increased in
2005. These balances provided funding for the higher average assets.
Analysis of various components of net interest income follows.
Interest Income - Loans
Total interest income on loans increased $1.7 billion (59%) in 2005. Average
total loan balances increased 46% for 2005, resulting primarily from a full year
impact of significant increases in residential mortgage loans held for
investment and credit card receivables portfolios during 2004.
Commercial Loans
Interest income from commercial loans increased $402 million (48%) in 2005.
Average commercial loan balances increased by 21% during the year. The average
yield earned on commercial loans also increased due to increases in HBUS's prime
lending rate during 2005.
Significant resources have been dedicated to expansion of various commercial
lending businesses and regional offices. Targeted growth in small business,
middle market and real estate lending portfolios, which began in 2004, has
continued to increase loan balances in 2005. HUSI plans for continued growth in
2006, and will continue to build upon its status as one of the top small
business lenders in New York State.
Residential Mortgage Loans
Interest income earned from residential mortgage loans increased $490 million
(27%) in 2005. HUSI significantly expanded the volume of adjustable rate
residential mortgage loans originated throughout 2004, which were retained on
the balance sheet. As a result, average residential mortgage loans held
increased by approximately 27% during 2005.
Since the beginning of 2004, approximately $5.5 billion of residential mortgages
have been purchased from HSBC Finance Corporation and from originating lenders
pursuant to an HSBC Finance Corporation correspondent loan program. Purchases
from these correspondents were discontinued effective September 1, 2005.
Originations of residential mortgage loans have decreased in 2005 as compared
with 2004, due to the contracting national originations market.
In the first half of 2005, consumers continued to take advantage of lower coupon
adjustable rate products, resulting in lower overall average yields. However,
the average yield earned on residential mortgage loans gradually rose during
2005, following the general rise in interest rates, resulting in an annual yield
that was comparable to 2004.
31
Credit Card Receivables
Interest earned from credit card receivables increased $705 million (659%) in
2005. Average credit card receivable balances were $12 billion higher for 2005.
In December 2004, HUSI acquired $12 billion of private label receivables and
other loans from HSBC Finance Corporation. Total premiums paid for these
receivables, which are being amortized against interest income over the
estimated life of the related receivables, totaled $639 million. Total 2005
amortization of the initial premium was $432 million.
During 2005, underlying customer balances included within the private label
portfolio have revolved, and new relationships have been added. In addition,
decreased balances were required to be maintained in off-balance sheet
securitized receivable trusts during 2005. As a result, total private label
receivables increased to $15 billion at December 31, 2005. By agreement, new
receivables generated from these private label relationships are being acquired
from HSBC Finance Corporation on a daily basis. Total premiums paid, which are
being amortized against interest income over the estimated life of the related
receivables, totaled $411 million for 2005. Total 2005 amortization associated
with these premiums was $283 million.
During 2004, HUSI sold certain MasterCard/Visa credit card relationships to HSBC
Finance Corporation. HUSI purchases receivables associated with these
MasterCard/Visa relationships from HSBC Finance Corporation on a daily basis.
Total premiums paid for these new receivables, which are being amortized against
interest income over the estimated life of the related receivables, totaled $34
million. Total 2005 amortization associated with these premiums was $32 million.
The average yields for credit card receivables and total loans were reduced in
2005 as a result of amortization of premiums paid for various credit card
portfolios, as follows:
---------------------------------------------------------------------------------------------------------
Year Ended December 31, 2005 Amount Rate
---------------------------------------------------------------------------------------------------------
(in millions)
Credit card receivables:
Interest income, before premium amortization ..................... $ 1,559 12.04%
Premium amortization ............................................. (747) (6.00)
----------- -----------
Interest income, adjusted for premium amortization ............... $ 812 6.04%
=========== ===========
Total loans:
Interest income, before premium amortization ..................... $ 5,377 6.15%
Premium amortization ............................................. (747) (.88)
----------- -----------
Interest income, adjusted for premium amortization ............... $ 4,630 5.27%
=========== ===========
HUSI continues to purchase additional private label and MasterCard/Visa credit
card receivables on a daily basis from HSBC Finance Corporation, which continues
to own the customer relationships. Amortization of the initial premium paid to
HSBC Finance Corporation was heavily front loaded into 2005, with approximately
two-thirds of the premium being amortized by year-end. Premium amortization is
therefore expected to decrease in 2006, due to significantly reduced
amortization of the initial premium.
Other Consumer Loans
Interest earned from various other consumer lending programs increased $121
million (85%) in 2005. Average loan balances increased by 59% during the year,
primarily due to consumer loans purchased from originating lenders pursuant to
HSBC Finance Corporation correspondent loan programs. The average yield earned
on consumer loans also increased due to the rising short-term interest rate
environment.
32
Interest Income - Short-Term Investments
Short-term investments include interest bearing deposits with banks and Federal
funds sold and securities purchased under resale agreements. Fluctuations in
short-term investments directly result from the relationship between HUSI's
excess liquidity position and its funding needs at any given point in time.
Interest income from short-term investments increased $195 million (170%) in
2005. Average short-term investment balances grew by 26% in 2005, while average
rates earned also increased significantly, primarily due to increases in the
federal funds rate throughout 2004 and 2005.
Interest Expense - Deposits
Total interest expense on interest bearing deposits increased $946 million
(115%) in 2005. Interest expense increased for both domestic and foreign
deposits. Average interest bearing deposits increased by 17% in 2005. Deposits
were a major source of funding for balance sheet growth in 2004 and 2005.
Average interest rates paid to these customers also increased significantly, due
to increases in short-term interest rates and the introduction of more
competitively priced consumer and commercial products.
An overview of deposit growth initiatives is provided on page 7 of this Form
10-K.
Interest Expense - Short-Term Borrowings
Interest expense on short-term borrowings increased $144 million (109%) in 2005.
Average short-term borrowings balances increased by 23% in 2005, while the
average interest rate paid also increased significantly, due primarily to
increases in the federal funds rate throughout 2004 and 2005.
Interest Expense - Long-Term Debt
Interest expense on long-term debt increased $639 million (168%) in 2005.
Average long-term debt balances increased by 155% in 2005, due primarily to new
debt issued during the second half of 2004 and throughout 2005 to fund balance
sheet growth.
2004 Compared to 2003
Net interest income increased approximately $231 million (9%) in 2004, compared
with 2003. Increased average loan balances, primarily residential mortgage
loans, were partially offset by increased long-term debt and deposit balances,
and by a reduction in the net interest rate spread during 2005.
Residential mortgage interest income increased approximately $653 million (55%)
in 2004, compared with 2003. Average residential mortgages increased
approximately $16 billion (74%) in 2004. The low interest rate environment of
2003 and 2004 continued to stimulate consumers to refinance mortgages and
purchase residential property. In addition, HUSI continued to purchase
residential mortgage loans from HSBC Finance Corporation and from originating
lenders pursuant to HSBC Finance Corporation correspondent loan programs. HUSI
generally sells higher fixed rate residential mortgages under Federal loan
programs, and retains low adjustable rate mortgages on the balance sheet. The
increase in variable rate mortgages relative to the entire residential mortgage
portfolio has caused a decline in average residential mortgage interest rates of
approximately 60 basis points for 2004.
33
Commercial loan interest income decreased approximately $100 million (11%) in
2004. Average commercial loans decreased approximately $.1 billion (1%).
Targeted growth in middle-market, commercial real estate and small business
lending portfolios increased commercial loan balances in 2004. However, during
2002 and 2003, certain equipment finance, commercial finance and U.S. factoring
businesses were exited or restructured resulting in office closings and sales of
customer relationships. In addition, certain receivables associated with these
businesses were retained, but have decreased throughout 2003 and 2004 as
balances have run off. These transactions more than offset the positive impact
of 2004 loan growth on interest income.
Interest expense associated with time deposits in domestic and foreign offices
increased a combined $159 million (24%) in 2004. An increase in average time
deposit balances of approximately $10 billion (19%), coupled with an increase in
the average rate paid on time deposits, were the primary drivers of the overall
interest expense increase.
Interest expense on short-term borrowings increased approximately $41 million
(45%) in 2004, due primarily to increases in the federal funds borrowing rate
during the year.
Interest expense on long-term debt increased approximately $174 million (84%) in
2004. Debt issued from HUSI's expanded global notes program and advances from
the Federal Home Loan Bank with maturities greater than one year were primary
funding sources for the purchase of $12 billion of private label receivables
from HSBC Finance Corporation in December 2004, thus increasing average
long-term debt balances by approximately $6 billion (158%) during the year. The
average rate paid on long-term debt decreased significantly during 2004, due to
rates on new debt which were lower than rates on debt that existed in 2003.
34
Other Revenues
--------------------------------------------------------------------------------
The components of other revenues are summarized in the following table.
------------------------------------------------------------------------------------------------------------------------
2005 Compared to 2004 Compared to
2004 2003
Increase/(Decrease) Increase/(Decrease)
-------------------- ---------------------
Year Ended December 31 2005 2004 2003 Amount % Amount %
------------------------------------------------------------------------------------------------------------------------
(in millions)
Trust income ................. $ 87 $ 95 $ 94 $ (8) (8) $ 1 1
Service charges:
HSBC affiliate income .. 15 17 16 (2) (12) 1 6
Other service charges .. 195 196 196 (1) (1) -- --
------- ------- ------- ------- ------- ------- -------
Total service charges .. 210 213 212 (3) (1) 1 1
------- ------- ------- ------- ------- ------- -------
Other fees and commissions:
Letter of credit fees .. 70 70 71 -- -- (1) (1)
Credit card fees ....... 323 82 76 241 294 6 8
Wealth and tax advisory services 60 45 39 15 33 6 15
HSBC affiliate income .. 71 27 26 44 163 1 4
Other fee-based income, net of
referral fees ........ 174 201 234 (27) (13) (33) (14)
------- ------- ------- ------- ------- ------- -------
Total other fees and
commissions .......... 698 425 446 273 64 (21) (5)
------- ------- ------- ------- ------- ------- -------
Securitization revenue ....... 114 -- -- 114 -- -- --
Other income:
Insurance .............. 48 63 65 (15) (24) (2) (3)
HSBC affiliate income .. 44 103 16 (59) (57) 87 544
Interest on tax settlement -- 17 22 (17) (100) (5) (23)
Gains on sale of property and
other financial assets 67 65 16 2 3 49 306
Other .................. 78 85 46 (7) (8) 39 85
------- ------- ------- ------- ------- ------- -------
Total other income ..... 237 333 165 (96) (29) 168 102
------- ------- ------- ------- ------- ------- -------
Residential mortgage banking
revenue (expense) .......... 64 (120) (102) 184 153 (18) (18)
Trading revenues ............. 395 288 291 107 37 (3) (1)
Securities gains, net ........ 106 85 48 21 25 37 77
------- ------- ------- ------- ------- ------- -------
Total other revenues ......... $ 1,911 $ 1,319 $ 1,154 $ 592 45 $ 165 14
======= ======= ======= ======= ======= ======= =======
35
2005 Compared to 2004
Trust Income
The 2005 reduction of trust income resulted from the sale of HUSI's personal
trust business, previously a component of the PB business segment, in the first
quarter of 2005.
Other Fees and Commissions
Increased credit card fees in 2005 resulted from acquisition of private label
credit card receivables from HSBC Finance Corporation in December 2004 and
throughout 2005.
In June 2004, HUSI transferred an investment brokerage subsidiary to HMUS. Fees
received from brokerage customers prior to the transfer date are reported as
other fee-based income in the preceding table, while fees received pursuant to
an ongoing arrangement with HMUS since the transfer date are reported as HSBC
affiliate income. Therefore, for 2005, HSBC affiliate income increased, while
other fee-based income decreased.
Securitization Revenue
Securitization revenue is comprised of servicing revenue and excess servicing
spread resulting directly from the purchase of residual interests in securitized
private label credit card receivables from HSBC Finance Corporation in December
2004. The securitized trusts require replenishments of receivables to support
previously issued securities. Receivables will continue to be sold to these
trusts until their revolving periods end, the last of which is expected to occur
in 2008. There have been no new securitization transactions during 2005.
Additional information regarding securitization activities is presented in Note
8 of the consolidated financial statements beginning on page 105 of this Form
10-K.
Other Income
HSBC affiliate income for 2005 was primarily attributable to the following
activity:
o effective October 2004, HBUS became the originating lender for HSBC
Finance Corporation's Taxpayer Financial Services business. During 2005,
mainly in the first quarter of the year, HUSI recorded $19 million of
gains on the sale of refund anticipation loans to HSBC Finance
Corporation; and
o in June 2005, HUSI began acquiring residential mortgage loans from
unaffiliated third parties and subsequently selling these loans to HMUS.
Since the inception of this program, HUSI has acquired approximately $5
billion of residential mortgage loans, which it subsequently sold to HMUS
for total gains of approximately $18 million.
HSBC affiliate income for 2004 included a gain of $99 million related to the
sale of certain credit card relationships to HSBC Finance Corporation.
In July 2004, HUSI recorded a $17 million refund of interest previously paid to
the Internal Revenue Service related to a prior year tax audit.
Gains on sale of property and other financial assets primarily include the
following significant activity and/or transactions for 2005 and 2004:
2005
o $17 million gain from the sale of property in July 2005;
o $26 million gain from the sale of property in May 2005; and
o $16 million of gains from the sales of various branches and from the sale
of a portion of HUSI's personal trust business during 2005.
36
2004
o $45 million gain on the sale of an investment in NYCE Corporation in July
2004.
Other includes the following significant activity and/or transactions for 2005:
o in June 2005, HUSI began acquiring residential mortgage loans from
unaffiliated third parties and subsequently selling these acquired loans
to HMUS (refer to HSBC affiliate income on the preceding page). At
December 31, 2005, HUSI had approximately $2.9 billion of residential
mortgage loans held for sale related to this program on its consolidated
balance sheet, which are reported at the lower of cost or market value.
Cumulative net mark to market losses of $32 million related to this
program were included in other income for 2005; and
o various miscellaneous revenues increased as a direct result of the private
label receivable portfolio purchased from HSBC Finance Corporation in
December 2004, and from other private label portfolios acquired from
unrelated third parties during 2005.
2004 Compared to 2003
Other Fees and Commissions
The overall decrease in other fee-based income during 2004 was attributable to
the June 2004 transfer of a brokerage subsidiary of HUSI to an HSBC affiliate.
Income received directly from customers, which was reported as other fee-based
income prior to the transfer, was replaced by lower net referral fees received
from HSBC affiliates.
Other Income
The 2004 increase in other income was primarily the result of the following
significant non-recurring transactions and/or other activities:
o HUSI sold certain consumer credit card relationships to HSBC Finance
Corporation at a gain of approximately $99 million, which was recorded as
HSBC affiliate income;
o HUSI sold its non-marketable minority investment in NYCE Corporation for a
gain of approximately $45 million. HUSI had held its investment since 1985
and was obligated to sell its investment by the majority shareholder in
accordance with the terms of the shareholder agreement;
o HUSI recorded higher earnings from a foreign equity investment, resulting
in an increase in other income of approximately $13 million in 2004, as
compared with 2003; and
o various bank branches and other properties were sold during 2004, with
combined gains on sale of approximately $9 million being recorded as other
income.
37
Residential Mortgage Banking Revenue
The following table presents the components of residential mortgage banking
revenue. Net interest income includes interest earned on assets and paid on
liabilities of the residential mortgage banking business as well as an
allocation of the funding benefit or cost associated with these balances. The
net interest income component of the table is included in net interest income in
the consolidated statement of income and reflects actual interest earned, net of
interest expense and corporate transfer pricing cost of funds.
Effective January 2005, HUSI enhanced its funds transfer pricing methodology to
better approximate current external market pricing and valuation, resulting in
additional internal charges to the residential mortgage banking business,
included in the PFS segment, from CIBM. For comparability purposes, prior year
amounts in the following table have also been restated for this change in
methodology, which decreased net interest income for 2004 and 2003 by
approximately $206 million and $112 million respectively.
------------------------------------------------------------------------------------------------------------------------
2005 Compared to 2004 Compared to
2004 2003
Increase/(Decrease) Increase/(Decrease)
-------------------- --------------------
Year Ended December 31 2005 2004 2003 Amount % Amount %
------------------------------------------------------------------------------------------------------------------------
(in millions)
Net interest income ................. $ 447 $ 461 $ 318 $ (14) (3) $ 143 45
------ ------ ------ ------ ------ ------ ------
Servicing related income (expense):
Servicing fee income .......... 75 78 72 (3) (4) 6 8
MSRs amortization ............. (73) (101) (158) 28 28 57 36
MSRs temporary impairment
(provision) recovery ........ 47 (102) (27) 149 146 (75) (278)
Trading - Derivative instruments
used to offset changes in value
of MSRs ..................... 2 8 (135) (6) (75) 143 106
(Losses) gains on sales of available
for sale securities ......... (11) 8 22 (19) (238) (14) (64)
------ ------ ------ ------ ------ ------ ------
Total net servicing related income
(expense) ......................... 40 (109) (226) 149 137 117 52
------ ------ ------ ------ ------ ------ ------
Originations and sales related income (expense):
Gains (losses) on sales of mortgages 17 (4) 117 21 525 (121) (103)
Trading - Forward loan sale
commitments ....... (10) (2) 35 (8) (400) (37) (106)
- Interest rate lock
commitments ...... (4) (13) (40) 9 69 27 68
- Euro interest rate
contracts ........ 1 -- -- 1 -- -- --
Fair value hedge activity (1) . -- (2) -- 2 100 (2) --
------ ------ ------ ------ ------ ------ ------
Total net originations and sales related
income (expense) .................. 4 (21) 112 25 119 (133) (119)
------ ------ ------ ------ ------ ------ ------
Other mortgage income ............... 20 10 12 10 100 (2) (17)
------ ------ ------ ------ ------ ------ ------
Total residential mortgage banking
revenue (expense) included in other
revenues .......................... 64 (120) (102) 184 153 (18) (18)
------ ------ ------ ------ ------ ------ ------
Total residential mortgage banking
related revenue ................... $ 511 $ 341 $ 216 $ 170 50 $ 125 58
====== ====== ====== ====== ====== ====== ======
(1) Includes SFAS 133 qualifying fair value adjustments related to residential
mortgage banking warehouse fair value hedging activity This was
discontinued in 2005.
38
2005 Compared to 2004
The following strategic decisions and market factors affected residential
mortgage banking results for 2005:
o HUSI increased the proportion of loans originated through its retail
channels by leveraging the HSBC brand, branch network and customer base;
o HUSI opted to decrease the volumes generated through HSBC Finance
Corporation's network of residential mortgage loan correspondents,
resulting in a decline in the volume of mortgages originated during the
year;
o HUSI sold a higher proportion of adjustable rate residential mortgage
loans in 2005, which previously would have been held on the balance sheet.
Residential mortgage loans originated with the intention to sell increased
41% in 2005, as compared with 2004; and
o as interest rates rose in 2005, loan originations slowed in comparison to
the prior year, resulting in reversal of a significant portion of the
reserve for temporary MSRs impairment in 2005. Total loan originations
declined 50% overall in 2005. Adjustable rate loans originated, as a
percentage of all loans originated, fell from 67% in 2004 to 30% in 2005.
Net Interest Income
As a result of the strategies and market factors noted above, total residential
mortgage loans recorded on the consolidated balance sheet decreased 6% during
2005. Despite the decrease in actual balances however, average residential
mortgage loans increased 27% in 2005 due to full year impact of significant
portfolio growth in 2004, resulting in a significant increase in interest income
during the year.
Decreased net interest income in 2005 was attributable to a narrowing of
interest rate spreads on the core mortgage portfolio. Overall yields earned on
residential mortgage loans in 2005 were consistent with 2004.
Servicing Related Income (Expense)
Increased net servicing related income (expense) in 2005 was attributable to
decreased MSRs amortization expense and to recoveries of temporary impairment
valuation allowance during 2005, as compared with significant provisions for
impairment recorded in 2004.
During 2005, interest rates generally rose and prepayments of residential
mortgages, mostly in the form of loan refinancings, decreased in comparison with
2004 levels. Loan refinance activity represented 44% of total originations in
2005, as compared with 50% in 2004. This led to lower amortization charges and
the subsequent release of temporary impairment provision on MSRs.
HUSI maintains an available for sale securities portfolio that is used to offset
changes in the economic value of MSRs. Net servicing related income amounts in
the table do not reflect unrealized losses, reported as a component of other
comprehensive income, or net interest income related to these securities.
Additional analysis of MSRs activity is provided in Note 10 of the consolidated
financial statements beginning on page 108 of this Form 10-K.
Additional commentary regarding risk management associated with the MSRs hedging
program is presented on page 72 of this Form 10-K.
Origination and Sales Related Income (Expense)
HUSI routinely sells residential mortgage loans to government sponsored entities
and other private investors. The increase in originations and sales related
income for 2005 was attributable to a higher basis point gain on each individual
loan sale as compared with 2004, as well as a higher volume of originated loans
being sold during the year.
39
2004 Compared to 2003
Net Interest Income
Increased net interest income in 2004 resulted from the significant increase in
residential mortgage loans during the year, primarily due to the following
factors:
o approximately $4 billion of residential mortgage loans were acquired from
HSBC Finance Corporation and from originating lenders pursuant to an HSBC
Finance Corporation correspondent loan program; and
o increased origination volumes in the held loan portfolio. In 2004 HUSI
generally retained variable rate mortgage loans in the held portfolio,
while selling fixed rate loans to government sponsored entities and other
private investors. Consumer demand for variable rate products increased
significantly in 2004.
Residential mortgage loan portfolio increases were partially offset by lower
interest rate spreads on originated loans and by lower income on loans held for
sale due to reduced levels of loans originated for sale.
Servicing Related Income (Expense)
Decreased net servicing related expense for full year 2004 resulted from
increased servicing fee income, decreased MSRs amortization expense and
increased income associated with derivative instruments used to offset changes
in the economic value of MSRs. These were partially offset by increases in
temporary impairment reserves. Normal amortization of MSRs decreased $57 million
for full year 2004.
The recorded net book value of MSRs, as well as related amortization expense,
are directly impacted by levels of residential mortgage prepayments. Higher
levels of prepayments generally increase amortization expense and decrease the
net book value of MSRs. Conversely, lower levels of prepayments generally
decrease amortization expense and increase the net book value of MSRs. During
2004, prepayments of residential mortgages, mostly in the form of loan
refinancings, decreased in comparison with 2003 levels. 30 year fixed rate
mortgage rates generally rose in the second quarter of 2004 from the low rates
experienced in 2003, declined again through the third quarter, and leveled off
in the fourth quarter. Loan refinance activity represented 50% of total
originations in 2004, as compared with 74% in 2003. The reduction in
amortization is also partially due to lower MSRs balances in 2004, as compared
with 2003.
The positive impacts of amortization and trading revenue for 2004 were partially
offset by increases in the temporary impairment valuation allowance for the
MSRs. The net servicing related expense amounts in the tables do not reflect
approximately $4 million of unrealized losses, recorded as other comprehensive
income, on available for sale securities used to offset changes in the economic
value of MSRs, or net interest income of $19 million on these securities.
Originations and Sales Related Income (Expense)
Originations and sales related income in 2004 reflects a small amount of net
losses realized on sales of residential mortgage loans, as compared with net
gains of $117 million for 2003. Significantly lower volume of loans originated
with the intention to sell in 2004 were coupled with lower gains recorded on
each sale transaction. During 2004, residential mortgages originated with the
intention to sell declined 64% from 2003 levels, despite an overall increase in
residential mortgage loan originations. This was attributable to lower mortgage
refinancings and a larger proportion of adjustable rate mortgage originations in
2004, which are generally held on HBUS's balance sheet. In the low interest rate
environment that existed prior to 2004, customers tended to refinance with fixed
rate loans, which are generally sold. As interest rates have risen during 2004,
and refinancing activity has decreased, origination of fixed rate loans
originated for sale also has decreased.
General market conditions and industry factors affected the ability of lenders
to recognize the same level of gains in 2004 compared to 2003. During 2003, the
market demand for residential mortgages far outweighed the supply of such
mortgages originated by lenders, which drove up pricing and associated gains
recorded on the sales.
40
During 2004, due to lower mortgage refinancings and a contracting national
mortgage originations market, the demand weakened relative to supply, which in
turn returned pricing and net gains on sales of mortgages to more normal levels.
Trading Revenues
Trading revenues are generated by HUSI's participation in the foreign exchange,
credit derivative and precious metal markets; from trading derivative contracts,
including interest rate swaps and options; from trading securities; and as a
result of certain residential mortgage banking activities.
The following table presents trading related revenues by business. The data in
the table includes net interest income earned on trading instruments, as well as
an allocation of the funding benefit or cost associated with the trading
positions. The trading related net interest income component is not included in
other revenues, but is included in net interest income. Trading revenues related
to the mortgage banking business are included in residential mortgage banking
revenue. See analysis of residential mortgage banking revenue for details.
------------------------------------------------------------------------------------------------------------------------
2005 Compared to 2004 Compared to
2004 2003
Increase/(Decrease) Increase/(Decrease)
-------------------- --------------------
Year Ended December 31 2005 2004 2003 Amount % Amount %
------------------------------------------------------------------------------------------------------------------------
(in millions)
Trading revenues ........ $ 395 $ 288 $ 291 $ 107 37 $ (3) (1)
Net interest income ..... 5 76 81 (71) (93) (5) (6)
----- ----- ----- ----- ----- ----- -----
Trading related revenues $ 400 $ 364 $ 372 $ 36 10 $ (8) (2)
===== ===== ===== ===== ===== ===== =====
Business:
Derivatives ....... $ 166 $ 112 $ 125 $ 54 48 $ (13) (10)
Treasury (primarily
securities) ....... 50 37 65 13 35 (28) (43)
Foreign exchange and
banknotes ......... 134 143 102 (9) (6) 41 40
Precious metals ... 41 49 59 (8) (16) (10) (17)
Other trading ..... 9 23 21 (14) (61) 2 10
----- ----- ----- ----- ----- ----- -----
Trading related revenues $ 400 $ 364 $ 372 $ 36 10 $ (8) (2)
===== ===== ===== ===== ===== ===== =====
2005 Compared to 2004
Improved trading markets during the second half of 2005 offset the difficult
markets encountered during the first half of the year. Overall, client and
proprietary trading revenues increased during 2005 as a result of the following
factors:
o improved trading results from an expanded credit derivatives trading desk;
o successful rollout of a new structured transactions business within the
CIBM segment, which has increased derivatives related revenues in 2005;
and
o increased Treasury revenues associated with a new whole loan structuring
business initiated during 2005.
The yield curve continued to flatten during the 2005, which resulted in
significant decreases in interest rate spreads associated with various trading
assets.
2004 Compared to 2003
Derivatives and treasury revenue decreased in 2004, due primarily to a lower
interest rate environment, which decreased customer activity and reduced
proprietary gains.
Increased foreign exchange revenues resulted from improved performance for
foreign currency and banknotes trading activities. 2003 banknotes trading
results were negatively impacted by the SARS scare and by the war in Iraq. 2004
activity reflected a recovery of customer activity levels and improved
proprietary results.
41
Decreased precious metals trading revenue was primarily due to a significant
default by a customer in Australia, which was partially offset by slightly
improved results in other domestic and foreign locations.
Securities Gains, Net
The following table presents realized security gains and losses included in the
consolidated statement of income.
-----------------------------------------------------------------------------------------------------------------
Gross Realized Gross Realized Net Realized
Gains (Losses) Gains (Losses)
-----------------------------------------------------------------------------------------------------------------
(in millions)
Year Ended December 31, 2005:
Net gains included in:
Residential mortgage banking revenue (expense) (1) .. $ -- $ (11) $ (11)
Securities gains, net ............................... 108 (2) 106
------- ------- -------
$ 108 $ (13) $ 95
======= ======= =======
Year Ended December 31, 2004:
Net gains included in:
Residential mortgage banking revenue (1) ............ $ 8 $ -- $ 8
Securities gains, net ............................... 93 (8) 85
------- ------- -------
$ 101 $ (8) $ 93
======= ======= =======
Year Ended December 31, 2003:
Net gains included in:
Residential mortgage banking revenue (1) ............ $ 22 $ -- $ 22
Securities gains, net ............................... 59 (11) 48
------- ------- -------
$ 81 $ (11) $ 70
======= ======= =======
(1) Securities gains (losses) related to available for sale securities used to
offset charges in the economic value of MSRs are included in residential
mortgage banking revenue (expense).
HUSI maintains various securities portfolios as part of its overall liquidity,
balance sheet diversification and risk management strategy. The following table
summarizes the net securities gains resulting from non-mortgage banking
activities.
-----------------------------------------------------------------------------------------------------------------
Year Ended December 31 2005 2004 2003
-----------------------------------------------------------------------------------------------------------------
(in millions)
Balance sheet diversity and reduction of risk ............. $ 33 $ 45 $ 34
Reduction of Latin American exposure ...................... 22 30 18
Sale of an equity investment to an HSBC affiliate (1) ..... 48 -- --
Other ..................................................... 3 10 (4)
------- ------- -------
Total securities gains, net ............................... $ 106 $ 85 $ 48
======= ======= =======
(1) In June 2005, HUSI sold shares in a foreign equity fund to an HSBC
affiliate for a gain of $48 million, which is recorded within the PB
segment.
42
Operating Expenses
------------------------------------------------------------------------------------------------------------------------
2005 Compared to 2004 Compared to
2004 2003
Increase/(Decrease) Increase/(Decrease)
-------------------- ---------------------
Year Ended December 31 2005 2004 2003 Amount % Amount %
------------------------------------------------------------------------------------------------------------------------
(in millions)
Salaries and employee benefits . $ 1,052 $ 947 $ 1,138 $ 105 11 $ (191) (17)
Occupancy expense, net ......... 182 176 165 6 3 11 7
Support services from HSBC
affiliates:
Fees paid to HTSU for
technology services .... 216 172 -- 44 26 172 --
Fees paid to HSBC Finance
Corporation for loan
servicing and other
administrative support 415 35 -- 380 1,086 35 --
Other fees, primarily treasury
and traded markets
services ............... 288 213 160 75 35 53 33
------- ------- ------- ------- ------- ------- -------
919 420 160 499 119 260 163
------- ------- ------- ------- ------- ------- -------
Other expenses:
Equipment and software ... 91 108 145 (17) (16) (37) (26)
Marketing ................ 79 44 39 35 80 5 13
Outside services ......... 116 103 116 13 13 (13) (11)
Professional fees ........ 67 55 69 12 22 (14) (20)
Telecommunications ....... 19 17 42 2 12 (25) (60)
Postage, printing and
office supplies ........ 26 25 29 1 4 (4) (14)
Insurance business ....... 19 22 30 (3) (14) (8) (27)
Other .................... 188 184 107 4 2 77 72
------- ------- ------- ------- ------- ------- -------
Total other expenses..... 605 558 577 47 8 (19) (3)
------- ------- ------- ------- ------- ------- -------
Total operating expenses ....... $ 2,758 $ 2,101 $ 2,040 $ 657 31 $ 61 3
======= ======= ======= ======= ======= ======= =======
Personnel - average number ..... 11,275 11,416 13,486 (141) (1) (2,070) (15)
2005 Compared to 2004
Salaries and Employee Benefits
Salaries expense increased $55 million (8%) in 2005. During the first half of
2004, HUSI transferred its brokerage subsidiary and most of its branch
operations in Panama to other HSBC affiliates, resulting in a significant
reduction in staffing levels and salaries. Excluding these subsidiary transfers,
the average number of personnel associated with HUSI's remaining operations
increased for 2005. Business expansion initiatives in various business segments
were the primary drivers of increased staff counts and salaries expense. In
addition, in March 2005, HSBC transferred a subsidiary to HUSI that provides
accounting and valuation services to hedge fund clients, which also increased
staff counts and salaries expense.
Employee benefits expenses increased $50 million (22%) in 2005, due to:
o increased employer share of payroll taxes and other benefit costs
associated with the overall staffing and salaries increases noted above;
and
o an increase in HUSI's employer matching of employee retirement savings
contributions due to changes in matching program provisions which took
effect during 2004.
43
Support Services from HSBC Affiliates
Fees are charged by various HSBC affiliates for technology services, for
underwriting and broker-dealer services, for loan origination and servicing, and
for other operational and administrative support functions. Transactions with
HSBC affiliates are described and summarized in Note 20 of the consolidated
financial statements beginning on page 122 of this Form 10-K.
The overall increases in HSBC affiliate charges are due primarily to the
following activity:
o fees charged by HSBC Finance Corporation for loan origination and
servicing expenses increased significantly due to increased services
related to the private label receivable portfolio and other loans acquired
from HSBC Finance Corporation and from their correspondents in 2004 and
2005. Fees charged by HSBC Finance Corporation for various administrative
services also increased as a result of specific initiatives to centralize
administrative functions;
o fees charged by HTSU for technology services expenses increased, as HUSI
continues to upgrade its automated technology environment. Equipment and
software costs included in other expenses have decreased in 2005, as these
costs are now included in the charges by HTSU; and
o fees charged by HMUS and other HSBC affiliates for treasury and traded
markets services have also increased in 2005 due primarily to business
expansion initiatives within the CIBM segment.
Other Expenses
Increased marketing and promotional expenses resulted from increased use of
customer mailings and various media channels to enhance perception of the HSBC
brand and to market expanded products and services, including rollout of the
online savings account product in late 2005.
2004 Compared to 2003
During 2003, certain equipment finance, commercial finance and U.S. factoring
businesses were sold. In addition, during 2004, certain domestic and foreign
operations were sold or transferred to HSBC affiliates at fair value. These
transactions decreased various operating expense lines by an approximate
combined amount of $97 million in 2004.
HSBC affiliate charges included amounts for information technology, loan
origination and servicing, administrative and other operational support. During
2003 and into 2004, HSBC instituted certain organizational changes that resulted
in employees and other aspects of operations being transferred to other HSBC
affiliates in North America. These other HSBC affiliates in turn charge for
services in accordance with service level agreements. These organizational
changes have impacted the amounts recorded in various functional expense
categories included in operating expenses on the consolidated statement of
income. Direct expenses recorded in "salaries and employee benefits" on the
consolidated statement of income for 2003 are now recorded in "other expenses"
for 2004. In the preceding table, the increase in HSBC affiliate charges, as
well as the decreases for salaries and employee benefits, equipment and
software, telecommunications and outside services expenses primarily resulted
from these organizational changes.
Salaries and Employee Benefits
The decrease in salaries and employee benefits in 2004 was primarily due to the
transfer of employees to HSBC affiliates, to sales of various commercial lending
business units in 2003, and to the sales or transfers of various subsidiaries to
affiliated HSBC entities during 2004, as previously described. Additional
decreases in salaries resulted from ongoing efforts to integrate and centralize
operations of various departments with those of HSBC Finance Corporation. As a
result of the organizational changes and other efforts, the average number of
personnel employed directly by HUSI decreased 15% during 2004, as compared with
2003. During 2003, severance costs of $48 million were recorded as a result of
various expense reduction, global resourcing, and HSBC Finance Corporation
integration efforts. These initiatives were generally completed in 2003,
resulting in expense decreases in 2004.
44
Partially offsetting these salary decreases were increased expenses associated
with expanded residential mortgage lending and CIBM operations.
Support Services From HSBC Affiliates
As previously noted, a significant number of employees were transferred to HSBC
affiliates during 2004. Fees charged by these entities in accordance with
various service level agreements either began on January 1, 2004, or have
increased during the year due to expansion of the services they provide. Total
technology related expenses, net of related salary line decreases, increased
during 2004 as HUSI has continued to upgrade its automated technology
environment. Origination and servicing expenses have increased due to increased
services provided by HSBC Finance Corporation related to residential mortgages
and other consumer loans.
Other Expense
The 2004 increase in other expense was primarily due to the following factors:
o HUSI refined its methodology for calculating its reserve for off-balance
sheet exposure, resulting in an increase in the provision for off-balance
sheet exposure of approximately $53 million; and
o in the fourth quarter of 2004, HUSI recorded a provision of approximately
$26 million for U.S. withholding tax costs related to deficiencies in
client tax documentation through a charge to other expense.
Provision for Credit Losses
--------------------------------------------------------------------------------
Provisions for credit losses are recorded to adjust the allowance for credit
losses to the level that management deems adequate to absorb losses inherent in
the loan and lease portfolio. Such provisions increased $691 million in 2005,
due primarily to the following factors:
o exceptionally strong credit quality in 2004, particularly within the
commercial loan portfolio, resulted in a total net release of provisions
of $17 million for the year;
o increased 2005 provisions of $564 million related to the private label
receivable portfolio acquired from HSBC Finance Corporation on December
31, 2004 and throughout 2005;
o generally increased 2005 provisions for credit losses associated with
increased average balances for commercial, residential mortgage and other
consumer loan portfolios; and
o incremental 2005 credit card provisions totaling $15 million for losses
associated with Hurricane Katrina and for new bankruptcy legislation.
Analysis of the loan portfolios is presented within the Balance Sheet Review
section beginning on page 26 of this Form 10-K. Analysis of credit quality
associated with loan portfolios begins on page 53 of this Form 10-K.
Income Taxes
--------------------------------------------------------------------------------
Income tax expense decreased $152 million in 2005 due principally to a decrease
in pretax income combined with an adjustment of prior years' state and local tax
provisions to reflect the actual tax liabilities per the returns filed and a
higher level of low income housing tax credits. Analysis of income tax expense,
the effective tax rate, and the net deferred tax position is provided in Note 16
of the consolidated financial statements beginning on page 116 of this Form
10-K.
45
Business Segments
--------------------------------------------------------------------------------
HUSI's business segments are described beginning on page 4 of this Form 10-K.
Results for each segment are summarized in the following tables and commentary.
Prior period disclosures previously reported for 2004 and 2003 have been
conformed herein to the presentation of current segments, including methodology
changes related to the transfer pricing of assets and liabilities.
The net interest income component in the following tables reflect actual
interest earned/paid, net of value/cost of funds as determined by corporate
transfer pricing methodology. Effective January 2005, HUSI enhanced its funds
transfer pricing methodology to better approximate current external market
pricing and valuation, resulting in additional internal charges to the
residential mortgage banking business, included in the PFS segment, from the
CIBM segment. For comparability purposes, 2004 and 2003 segment results were
also restated, which increased CIBM net interest income by approximately $206
million and $112 million respectively, with the offsetting decreases to PFS net
interest income.
Personal Financial Services (PFS)
Additional resources and priority were focused on core retail banking businesses
during 2005. Investment in the retail branch network continues to be expanded
and reallocated to ensure coverage of high potential growth geographic areas.
Loan and deposit products offered to individuals were expanded in conjunction
with increased marketing efforts. HUSI has also continued to leverage its
relationship with HSBC Finance Corporation to increase consumer loan assets and
earnings, to obtain loan origination and servicing, and to reduce overall
operating costs of various administrative services.
The following table summarizes results for the PFS segment.
------------------------------------------------------------------------------------------------------------------------
2005 Compared 2004 Compared
To 2004 To 2003
Increase/(Decrease) Increase/(Decrease)
-------------------- --------------------
Year Ended December 31 2005 2004 2003 Amount % Amount %
------------------------------------------------------------------------------------------------------------------------
(in millions)
Net interest income ......... $ 1,203 $ 1,090 $ 1,081 $ 113 10 $ 9 1
Other revenues ..... ........ 442 381 250 61 16 131 52
------- ------- ------- ------- ------- ------- -------
Total revenues .............. 1,645 1,471 1,331 174 12 140 11
Operating expenses .......... 1,033 944 930 89 9 14 2
------- ------- ------- ------- ------- ------- -------
Working contribution ........ 612 527 401 85 16 126 31
Provision for credit losses . 103 81 68 22 27 13 19
------- ------- ------- ------- ------- ------- -------
Income before income tax
expense ................... $ 509 $ 446 $ 333 $ 63 14 $ 113 34
======= ======= ======= ======= ======= ======= =======
Average assets .............. $49,084 $41,202 $28,601
Average liabilities/equity .. 43,304 34,165 31,066
Goodwill at December 31 ..... 1,167 1,167 1,223
2005 Compared to 2004
Increased net interest income for 2005 was due to:
o significant growth in average consumer loan balances, particularly
adjustable rate residential mortgage loans, combined with slightly higher
average yields on these adjustable rate loans;
o more favorable interest rate spreads on a growing personal deposits base
during 2005; offset by
o $32 million of amortization of premium paid for MasterCard/Visa credit
card receivables acquired on a daily basis from HSBC Finance Corporation.
46
Other revenues includes the following significant activity for 2005 and 2004,
which affects the comparability of reported amounts:
2005
o non-interest residential mortgage banking revenue increased $184 million
in 2005, primarily resulting from significant recoveries of temporary MSRs
impairment allowances recorded in 2004. Commentary regarding residential
mortgage banking revenue begins on page 38 of this Form 10-K;
o HUSI sold certain properties to unaffiliated third parties during 2005.
Approximately $26 million of the gains realized on these transactions were
recorded in the PFS segment; and
o effective in October 2004, HBUS became the originating lender for HSBC
Finance Corporation's Taxpayer Financial Services program. Gains
recognized for tax refund anticipation loans sold to HSBC Finance
Corporation's Taxpayer Financial Services business were $19 million in
2005, most of which were recorded in the first quarter of the year.
2004
o HUSI recorded a $99 million gain on sale of certain Master Card/Visa
credit card relationships to HSBC Finance Corporation; and
o HUSI recorded a $45 million gain on sale of an equity investment.
Increased operating expenses for 2005 were due to:
o increased personnel, marketing and other direct expenses associated with
expanded consumer lending and retail banking operations; and
o increased fees paid to HTSU, as HUSI has continued to upgrade its
technology environment.
The provision for credit losses increased $22 million, as a direct result of
increased consumer loan balances.
2004 Compared to 2003
During 2004, HUSI sold or transferred certain foreign subsidiaries to HSBC
affiliates. As a result of these transactions, HUSI reported 2003 PFS amounts
associated with these sold subsidiaries, for net interest income, other
revenues, and operating expenses that exceeded 2004 amounts.
Excluding the effects of sales of the foreign subsidiaries noted above, net
interest income increased $16 million in 2004. Increased loan balances,
partially offset by a decline in the average interest rate earned on the held
mortgage loan portfolio, resulted in the minor net interest income increase.
Other revenues increased $170 million in 2004, primarily as a result of:
o certain MasterCard/Visa credit card relationships were sold to HSBC
Finance Corporation for a gain of $99 million;
o an investment in NYCE Corporation was sold for a gain of $45 million; and
o residential mortgage banking revenue decreased $18 million, as improved
servicing related income was more than offset by reduced gains on sales of
residential mortgage loans.
Operating expenses increased $53 million in 2004, due to:
o growth in residential mortgage operations to accommodate increased loan
production;
o increased technology costs due to conversions of consumer loan systems to
platforms that are shared with HSBC Finance Corporation; and
o a provision for U.S. withholding tax costs related to deficiencies in
client tax documentation.
47
The provision for credit losses increased $9 million in 2004 as a direct result
of increases in residential mortgage loan and other consumer loan portfolios.
Consumer Finance (CF)
Results of this segment, which was initiated in 2005, have been negatively
impacted by significant amortization of premiums paid for private label credit
card receivables acquired from HSBC Finance Corporation in 2004 and 2005.
Residential mortgage loans and other consumer loans acquired from HSBC Finance
Corporation and their correspondents have had a positive impact on income before
income tax expense.
The following table summarizes results for the CF segment.
-----------------------------------------------------------------------------------------------------------------------
2005 Compared 2004 Compared
To 2004 To 2003
Increase/(Decrease) Increase/(Decrease)
---------------------- ----------------------
Year Ended December 31 2005 2004 2003 Amount % Amount %
-----------------------------------------------------------------------------------------------------------------------
(in millions)
Net interest income ......$ 583 $ 182 $ -- $ 401 220 $ 182 --
Other revenues ........... 356 2 -- 354 17,700 2 --
-------- -------- --------- -------- -------- -------- ---------
Total revenues ........... 939 184 -- 755 410 184 --
Operating expenses ....... 424 17 -- 407 2,394 17 --
-------- -------- --------- -------- -------- -------- ---------
Working contribution ..... 515 167 -- 348 208 167 --
Provision for credit losses 599 22 -- 577 2,623 22 --
-------- -------- --------- -------- -------- -------- ---------
(Loss) income before
income tax expense .....$ (84) $ 145 $ -- $ (229) (158) $ 145 --
======== ======== ========= ======== ======== ======== =========
Average assets ...........$ 19,316 $ 4,256 $ --
Average liabilities/equity 684 (2) --
Goodwill at December 31 ... -- -- --
2005 Compared to 2004
This segment includes receivables associated with the private label receivable
portfolio (the PLRP) acquired in December 2004 from HSBC Finance Corporation and
other consumer loans acquired from HSBC Finance Corporation and their
correspondents. The following table summarizes the impact of the PLRP on
earnings during 2005 in comparison with the other portfolios included within
this segment.
------------------------------------------------------------------------------------------------------------------------
PLRP Other Total
------------------------------------------------------------------------------------------------------------------------
(in millions)
Year Ended December 31, 2005:
Net interest income ............................................... $ 383 $ 200 $ 583
Other revenues .................................................... 356 -- 356
--------- --------- ---------
Total revenues .................................................... 739 200 939
Operating expenses ................................................ 408 16 424
--------- --------- ---------
Working contribution .............................................. 331 184 515
Provision for credit losses ....................................... 564 35 599
--------- --------- ---------
(Loss) income before income tax expense ........................... $ (233) $ 149 $ (84)
========= ========= =========
During 2005, interest income for the PLRP was partially offset by approximately
$432 million of amortization of the initial premium paid for the portfolio. In
addition, amortization of premium paid for additional PLRP receivables acquired
during 2005 from HSBC Finance Corporation was $283 million.
48
Other revenues for the PLRP for 2005 is primarily comprised of the following:
o approximately $242 million of credit card and other fees from customers;
and
o securitization revenue totaling $114 million from residual interests in
securitized private label credit card receivables acquired as part of the
PLRP purchase.
Operating expenses for the PLRP are primarily fees paid to HSBC Finance
Corporation for loan servicing. Additional direct expenses for management of the
portfolio, including technology services and fraud losses, have also been
incurred.
The provision for credit losses includes incremental provisions totaling $15
million for losses associated with Hurricane Katrina and for new bankruptcy
legislation (see further commentary on page 6 of this Form 10-K). Future net
charge offs and provisions are not expected to be material. Commentary regarding
credit quality begins on page 53 of this Form 10-K.
As previously discussed, new domestic private label credit card receivables are
acquired from HSBC Finance Corporation on a daily basis. In accordance with
Federal Financial Institutions Examination Council (FFIEC) guidance, the
required minimum monthly payment amounts for domestic private label credit card
accounts has changed. The implementation of these new requirements began in the
fourth quarter of 2005 and will be completed in the first quarter of 2006.
Estimates of the potential impact to the business are based on numerous
assumptions and take into account a number of factors which are difficult to
predict such as changes in customer behavior, which will not be fully known or
understood until the changes are implemented. Based on current estimates, it is
anticipated that these changes will reduce the premium associated with the daily
acquisitions in 2006. Although this change is expected to impact the CF business
segment, the impact is not expected to be material for HUSI's consolidated
results.
Commercial Banking (CMB)
Improved results for 2005 resulted from successful rollout of planned expansion
initiatives. Office locations and staffing levels were expanded, as were loan
and deposit products offered to small businesses, and middle-market commercial
customers, in conjunction with increased marketing efforts. HUSI has also
leveraged its status as one of the top ranked small business lenders in New York
State.
The following table summarizes results for the CMB segment.
------------------------------------------------------------------------------------------------------------------------
2005 Compared 2004 Compared
To 2004 To 2003
Increase/(Decrease) Increase/(Decrease)
--------------------- -----------------------
Year Ended December 31 2005 2004 2003 Amount % Amount %
------------------------------------------------------------------------------------------------------------------------
(in millions)
Net interest income ..... $ 661 $ 584 $ 592 $ 77 13 $ (8) (1)
Other revenues .......... 183 170 158 13 8 12 8
-------- -------- -------- -------- -------- -------- --------
Total revenues .......... 844 754 750 90 12 4 1
Operating expenses ...... 379 352 402 27 8 (50) (12)
-------- -------- -------- -------- -------- -------- --------
Working contribution .... 465 402 348 63 16 54 16
Provision for credit losses 22 (26) 55 48 185 (81) (147)
-------- -------- -------- -------- -------- -------- --------
Income before income tax
expense ............... $ 443 $ 428 $ 293 $ 15 4 $ 135 46
======== ======== ======== ======== ======== ======== ========
Average assets .......... $ 15,817 $ 13,750 $ 14,236
Average liabilities/equity 17,856 14,670 13,281
Goodwill at December 31 468 471 495
49
2005 Compared to 2004
Increased net interest income and other revenues for 2005 resulted from the
successful rollout of planned expansion of various small business, middle-market
and real estate commercial lending programs, which resulted in increased actual
and average commercial loan balances during 2005. The CMB segment also benefited
from more favorable interest rate spreads on a growing deposit base during 2005.
During the second quarter of 2004, HUSI transferred its Panamanian operations to
an HSBC affiliate. As a result, commercial loans, deposits and related net
interest income, included in the CMB segment, have decreased in 2005, partially
offsetting the increases from business expansion initiatives noted above.
During 2005, HUSI sold certain properties to unaffiliated third parties.
Approximately $14 million of the gains realized on these transactions were
recorded in other revenues within the CMB segment.
Increased operating expenses resulted from the business expansion initiatives
noted above and from increased fees paid to HTSU for technology services as HUSI
continued to upgrade its technology environment.
The provision for credit losses increased $48 million in 2005 as a direct result
of increased commercial loan portfolio balances. Credit quality was generally
strong and continued to be well-managed during 2005.
2004 Compared to 2003
During 2002 and 2003, certain equipment finance, commercial finance and U.S.
factoring businesses were exited or restructured resulting in office closings
and sales of customer relationships. Certain receivables associated with these
businesses were retained, but decreased throughout 2003 and 2004 as balances ran
off. During 2004, HUSI sold or transferred certain foreign subsidiaries to HSBC
affiliates. As a result of these transactions, reported CMB amounts for 2003
associated with these exited businesses, for net interest income, other revenues
and expenses all exceeded 2004 amounts.
Excluding the effect of the business sale and transfer transactions:
o net interest income increased $72 million, due to growth in net interest
income from loan and deposit activity with middle-market, commercial real
estate and small business customers in the second half of the year;
o revenue growth was achieved in 2004 while maintaining a stable operating
expense base, due to focused cost containment efforts; and
o the provision for credit losses decreased $58 million, due primarily to
continued improvement in commercial credit quality, as evidenced by
decreased nonaccruing loan balances, decreased criticized assets,
decreased charge offs, and increased recoveries of commercial loans
previously charged off. A reduction in the unallocated portion of the
allowance for credit losses also contributed to the overall decrease in
provision expense.
50
Corporate, Investment Banking and Markets (CIBM)
Decreased net interest income for 2005 is primarily the result of significant
increases in short-term interest rates. While increased short-term rates have a
positive impact on interest rate spreads for deposit generating businesses, such
as the PFS and CMB segments, they have an adverse impact on CIBM which does not
generate significant low cost deposit funding. Improved market conditions and
the rollout of new trading programs resulted in increased trading revenues in
the second half of 2005, which partially offset difficult markets encountered
during the first two quarters of the year.
Various treasury and traded markets activities were expanded in 2005 resulting
in increased products offered to customers, increased marketing efforts for
those products, increased proprietary activities, and increased infrastructure
expenses for the CIBM segment.
The following table summarizes results for the CIBM segment.
------------------------------------------------------------------------------------------------------------------------
2005 Compared 2004 Compared
To 2004 To 2003
Increase/(Decrease) Increase/(Decrease)
---------------------- -----------------------
Year Ended December 31 2005 2004 2003 Amount % Amount %
------------------------------------------------------------------------------------------------------------------------
(in millions)
Net interest income .. $ 456 $ 766 $ 731 $ (310) (40) $ 35 5
Other revenues ....... 641 534 526 107 20 8 2
-------- -------- -------- -------- -------- -------- --------
Total revenues ....... 1,097 1,300 1,257 (203) (16) 43 3
Operating expenses ... 650 525 442 125 24 83 19
-------- -------- -------- -------- -------- -------- --------
Working contribution 447 775 815 (328) (42) (40) (5)
Provision for credit losses (47) (95) (8) 48 51 (87) (1,088)
-------- -------- -------- -------- -------- -------- --------
Income before income tax
expense ............ $ 494 $ 870 $ 823 $ (376) (43) $ 47 6
======== ======== ======== ======== ======== ======== ========
Average assets ................... $ 57,597 $ 48,689 $ 45,738
Average liabilities/equity ....... 75,579 54,442 38,917
Goodwill at December 31 .......... 631 631 631
2005 Compared to 2004
Decreased net interest income for 2005 was primarily due to steadily rising
short-term interest rates during 2004 and 2005, which had an adverse impact on
CIBM interest rate spreads.
Increased other revenues for 2005 was mainly due to increased trading revenues
and increased gains on sales of securities. Increased fee-based income,
resulting from business expansion initiatives, also contributed to the overall
increase in other revenues. Commentary regarding trading revenues and securities
gains begins on page 41 of this Form 10-K.
HUSI recognizes gain or loss at the inception of derivative transactions only
when the fair value of the transaction can be verified to market transactions or
if all significant pricing model assumptions can be verified to observable
market data. Gain or loss not recognized at inception is recorded in trading
assets and recognized over the term of the derivative contract in correlation
with outstanding risk and valuation characteristics. The amount recorded in
trading assets was approximately $131 million and $34 million at December 31,
2005 and 2004 respectively.
Increased operating expenses resulted from:
o increased direct expenses associated with expanded operations in foreign
exchange, risk management products, and transaction banking business;
o increased expenses associated with development of an infrastructure to
support the growing complexity of the CIBM business; and
o increased fees paid to HTSU and other HSBC affiliates for technology
services, as CIBM required additional information technology resources to
support system conversions and business expansion.
51
Partially offsetting these increases were decreases in incentive compensation
expense resulting from a change in the amortization period utilized for
share-based compensation, and decreased incentive compensation expenses.
The provision for credit losses increased during 2005. The net provision credit
for 2004 reflected a period of unusually low loan charge offs and relatively
high recoveries of amounts previously charged off. The smaller net provision
credit for 2005 resulted from continuation of relatively low charge offs, but
lower recoveries of amounts previously charged off.
2004 Compared to 2003
The increase in income before income tax expense in 2004 primarily resulted from
increased net interest income and other revenues, and by decreased provision for
credit losses, offset by increased operating expenses.
The increase in net interest income of $35 million in 2004, was partly offset by
an increase in short-term borrowings and long-term debt balances during the
second half of the year, and partly to a flattening yield curve, which tightened
the interest spread earned on net earning assets.
The 2004 increase in other revenues was due to increased net gains on sales of
securities, which was partially offset by decreased trading revenues.
Operating expenses increased $83 million in 2004 due primarily to expansion
initiatives related to various treasury and traded markets products. These
initiatives resulted in higher salaries and benefits expenses, higher
information technology expenses and increased administrative and other fees
charged by HSBC and other affiliated entities.
The provision for credit losses decreased $87 million in 2004 due to general
improvement of commercial credit quality. Significant loan paydowns and
recoveries of amounts previously charged off were received during 2004. In
addition, there were upgrades of classification of certain large criticized
credits during the year. A reduction in the unallocated portion of the allowance
for credit losses also contributed to the overall decrease in provision expense.
Private Banking (PB)
During 2005, additional resources have been allocated to expand services
provided to high net worth customers served by this segment resulting in
increased revenues partially offset by increased expenses.
The following table summarizes results for the Private Banking (PB) segment.
------------------------------------------------------------------------------------------------------------------------
2005 Compared 2004 Compared
To 2004 To 2003
Increase/(Decrease) Increase/(Decrease)
-------------------- ---------------------
Year Ended December 31 2005 2004 2003 Amount % Amount %
------------------------------------------------------------------------------------------------------------------------
(in millions)
Net interest income ......... $ 172 $ 130 $ 123 $ 42 32 $ 7 6
Other revenues .............. 257 204 195 53 26 9 5
------- ------- ------- ------- ------- ------- -------
Total revenues .............. 429 334 318 95 28 16 5
Operating expenses .......... 272 263 265 9 3 (2) (1)
------- ------- ------- ------- ------- ------- -------
Working contribution ........ 157 71 53 86 121 18 34
Provision for credit losses (3) 1 (2) (4) (400) 3 150
------- ------- ------- ------- ------- ------- -------
Income before income tax
expense ................... $ 160 $ 70 $ 55 $ 90 129 $ 15 27
======= ======= ======= ======= ======= ======= =======
Average assets .............. $ 5,041 $ 4,029 $ 2,936
Average liabilities/equity .. 9,751 8,951 8,561
Goodwill at December 31 ..... 428 428 428
52
2005 Compared to 2004
Increased net interest income for 2005 resulted from increased average interest
earning assets, primarily loans.
Other revenues include the following significant non-recurring transactions
which affect comparability of results for 2005 and 2004:
2005
o shares in a foreign equity fund were sold to an HSBC affiliate, resulting
in a gain of approximately $48 million; and
o HUSI recognized a nominal gain on the sale of a portion of its personal
trust business.
2004
o HUSI realized higher revenue from a foreign equity investment, as compared
with the first quarter of 2005.
Increased operating expenses generally resulted from additional resources being
allocated to this segment to expand the services provided. Partially offsetting
increased operating expenses was the reversal of a portion of a provision for
U.S. withholding tax costs related to deficiencies in client tax documentation,
which was recorded in the fourth quarter of 2004.
2004 Compared to 2003
Income before income tax expense increased 27% in 2004 due to increased equity
investment revenue, increased wealth and tax advisory service revenues, and
increased gains on sales of investment securities.
Operating expenses were flat in 2004, as compared with 2003, as a provision for
U.S. withholding tax costs related to deficiencies in client tax documentation
was offset by decreases in other expenses.
Credit Quality
--------------------------------------------------------------------------------
Overview
HUSI enters into a variety of transactions in the normal course of business that
involve both on and off-balance sheet credit risk. Principal among these
activities is lending to various commercial, institutional, governmental and
individual customers. HUSI participates in lending activity throughout the U.S.
and, on a limited basis, internationally.
In general, HUSI controls the varying degrees of credit risk involved in on and
off-balance sheet transactions through specific credit policies. These policies
and procedures provide for a strict approval, monitoring and reporting process.
It is HUSI's policy to require collateral when it is deemed appropriate. Varying
degrees and types of collateral are secured depending upon management's credit
evaluation.
Increased provisions for credit losses during 2005 are primarily due to
significant increases in consumer loan balances, most notably balances
associated with the private label portfolio acquired from HSBC Finance
Corporation in December 2004. Commercial loan provisions and net charge offs
remained low in 2005 as a result of strong credit underwriting standards and
continued favorable economic conditions.
53
Regional Concentrations of Credit Risk
Regional exposure at December 31, 2005 for certain loan portfolios is summarized
in the following table.
--------------------------------------------------------------------------------------------------------------------
Commercial Residential Credit
Construction and Other Mortgage Card
December 31, 2005 Real Estate Loans Loans Receivables
--------------------------------------------------------------------------------------------------------------------
New York State ................................................... 56% 21% 24%
North Central United States ...................................... 3 13 31
North Eastern United States ...................................... 8 13 26
Southern United States ........................................... 16 25 13
Western United States ............................................ 17 28 5
Other ............................................................ -- -- 1
----- ----- ----
Total ........................................................... 100% 100% 100%
===== ===== ====
Cross-Border Net Outstandings
Cross-border net outstandings, as calculated in accordance with Federal
Financial Institutions Examination Council (FFIEC) guidelines, are amounts
payable to HUSI by residents of foreign countries regardless of the currency of
claim and local country claims in excess of local country obligations.
Cross-border net outstandings include deposits in other banks, loans,
acceptances, securities available for sale, trading securities, revaluation
gains on foreign exchange and derivative contracts and accrued interest
receivable. Excluded from cross-border net outstandings are, among other things,
the following: local country claims funded by non-local country obligations
(U.S. dollar or other non-local currencies), principally certificates of deposit
issued by a foreign branch, where the providers of funds agree that, in the
event of the occurrence of a sovereign default or the imposition of currency
exchange restrictions in a given country, they will not be paid until such
default is cured or currency restrictions lifted or, in certain circumstances,
they may accept payment in local currency or assets denominated in local
currency (hereinafter referred to as constraint certificates of deposit); and
cross-border claims that are guaranteed by cash or other external liquid
collateral. Net outstandings are summarized in the following table.
Cross-Border Net Outstandings Which Exceed .75% of Total Assets at Year End
-------------------------------------------------------------------------------------------------------------------
Banks and Commercial
Other Financial and
Institutions Industrial Total
-------------------------------------------------------------------------------------------------------------------
(in millions)
December 31, 2005:
United Kingdom .......................................... $ 1,497 $ 970 $ 2,467
======== ========= =========
December 31, 2004:
United Kingdom .......................................... $ 2,724 $ 1,086 $ 3,810
======== ========= =========
Problem Loan Management
Nonaccruing, impaired and criticized loan balances are summarized in Note 6 of
the consolidated financial statements beginning on page 103 of this Form 10-K.
Nonaccruing Loans
Borrowers who experience difficulties in meeting the contractual payment terms
of their loans receive special attention. Depending on circumstances, decisions
may be made to cease accruing interest on such loans.
54
Commercial loans are designated as nonaccruing when, in the opinion of
management, reasonable doubt exists with respect to collectibility of all
interest and principal based on certain factors, including adequacy of
collateral. However, HUSI complies with regulatory requirements, which mandate
that interest not be accrued on commercial loans with principal or interest past
due for a period of ninety days, unless the loan is both adequately secured and
in process of collection.
Residential mortgage loans are designated as nonaccruing when principal or
interest payments are more than three months contractually past due. Loans to
credit card customers that are past due more than ninety days are designated as
nonaccruing only if the customer has agreed to credit counseling; otherwise they
are charged off in accordance with a predetermined schedule. Other consumer
loans are generally not designated as nonaccruing and are charged off against
the allowance for credit losses according to an established delinquency
schedule.
Interest that has been accrued but unpaid on loans placed on nonaccruing status
generally is reversed and reduces current income at the time loans are so
categorized. Interest income on these loans may be recognized to the extent of
cash payments received. In those instances where there is doubt as to
collectibility of principal, any cash interest payments received are applied as
principal reductions. Loans are not reclassified as accruing until interest and
principal payments are brought current and future payments are reasonably
assured.
In certain situations where the borrower is experiencing temporary cash flow
problems, and after careful examination by management, the interest rate and
payment terms may be adjusted from the original contractual agreement. When this
occurs and the revised terms at the time of renegotiations are less than HUSI
would be willing to accept for a new loan with comparable risk, the loan is
separately identified as restructured.
HUSI has commitments to lend additional funds to borrowers whose loans are
classified as nonaccruing. A significant portion of these commitments includes
clauses that provide for cancellation in the event of a material adverse change
in the financial position of the borrower.
Impaired Loans
In accordance with HUSI's credit policy, a loan is considered to be impaired
when it is deemed probable that all principal and interest amounts due,
according to the contractual terms of the loan agreement, will not be collected.
Probable losses from impaired loans are quantified and recorded as a component
of the overall allowance for credit losses. Generally, impaired loans include
loans in nonaccruing status, loans which have been assigned a specific allowance
for credit losses, loans which have been partially or wholly charged off, and
loans designated as troubled debt restructures.
Criticized Loans
Problem loans are assigned various criticized facility grades under the
allowance for credit losses methodology.
Special Mention Loans are generally protected by collateral and/or the credit
worthiness of the customer, but are potentially weak based upon economic or
market circumstances which, if not checked or corrected, could weaken HUSI's
credit position at some future date.
Substandard Loans are inadequately protected by the underlying collateral and/or
general credit worthiness of the customer. These loans present a distinct
possibility that HUSI will sustain some loss if the deficiencies are not
corrected.
Doubtful Loans have all the weaknesses exhibited by substandard loans, with the
added characteristic that the weaknesses make collection or liquidation in full
of the recorded loan highly improbable. However, although the possibility of
loss is extremely high, certain pending factors exist which may strengthen the
credit at some future date, and therefore the decision to charge off the loan is
deferred. Loans graded as doubtful are required to be placed in nonaccruing
status.
55
Allowance for Credit Losses
HUSI's methodology and accounting policies related to its allowance for credit
losses are presented in Critical Accounting Policies beginning on page 22 and in
Note 2 of the consolidated financial statements beginning on page 88 of this
Form 10-K.
An analysis of overall changes in the allowance for credit losses and related
allowance ratios is presented in the following table.
------------------------------------------------------------------------------------------------------------------------
Year Ended December 31 2005 2004 2003 2002 2001
------------------------------------------------------------------------------------------------------------------------
(in millions)
Total loans at year end ............. $ 90,342 $ 84,947 $ 48,474 $ 43,636 $ 40,923
Average total loans ................. 87,898 60,328 44,187 42,054 41,441
Allowance for credit losses:
Balance at beginning of year .. $ 788 $ 399 $ 493 $ 506 $ 525
Allowance related to acquisitions
and (dispositions), net ..... -- 485 (15) (2) (19)
Charge offs:
Commercial .................... 75 54 160 151 188
Consumer:
Residential mortgages ...... 24 15 3 3 3
Credit card receivables .... 659 65 59 63 67
Other consumer loans ....... 113 23 21 24 23
-------- -------- -------- -------- --------
Total consumer loans ....... 796 103 83 90 93
-------- -------- -------- -------- --------
Total charge offs ................... 871 157 243 241 281
-------- -------- -------- -------- --------
Recoveries on loans charged off:
Commercial .................... 71 60 35 21 29
Consumer:
Residential mortgages ...... 1 2 1 1 1
Credit card receivables .... 146 8 8 8 9
Other consumer loans ....... 37 8 7 5 4
-------- -------- -------- -------- --------
Total consumer loans ....... 184 18 16 14 14
-------- -------- -------- -------- --------
Total recoveries .................... 255 78 51 35 43
-------- -------- -------- -------- --------
Total net charge offs ............... 616 79 192 206 238
-------- -------- -------- -------- --------
Provision charged (credited) to
income ............................ 674 (17) 113 195 238
-------- -------- -------- -------- --------
Balance at end of year .............. $ 846 $ 788 $ 399 $ 493 $ 506
======== ======== ======== ======== ========
Allowance ratios:
Total net charge offs to
average loans ................. .70% .13% .43% .49% .57%
Year-end allowance to:
Year-end total loans ....... .94% .93% .82% 1.13% 1.24%
Year-end total nonaccruing
loans .................... 351.04% 298.48% 109.02% 127.39% 121.34%
Total nonaccruing loans decreased in 2005 and 2004 while the allowance for
credit losses increased during both years resulting in a significant increase in
the ratio of year-end allowance to total nonaccruing loans in the preceding
table. The increased allowance for credit losses in 2005 and 2004 resulted from
the acquisition of the private label receivables from HSBC Finance Corporation.
As these receivable balances are typically maintained as accruing until charged
off, there were no loan balances included in this portfolio which were
classified as nonaccruing at December 31, 2005.
56
An analysis of changes in the allowance for credit losses during 2005, by
general loan categories, is provided in the following table.
------------------------------------------------------------------------------------------------------------------------
Year Ended Residential Credit Other
December 31, 2005 Commercial Mortgage Card Consumer Unallocated Total
------------------------------------------------------------------------------------------------------------------------
(in millions)
Balance at beginning of year ........ $ 182 $ 20 $ 553 $ 20 $ 13 $ 788
-------- -------- -------- -------- -------- --------
Charge offs ......................... 75 24 659 113 -- 871
Recoveries .......................... 71 1 146 37 -- 255
-------- -------- -------- -------- -------- --------
Net charge offs ..................... 4 23 513 76 -- 616
-------- -------- -------- -------- -------- --------
Provision charged (credited)
to income ......................... (16) 37 560 92 1 674
-------- -------- -------- -------- -------- --------
Balance at end of year .............. $ 162 $ 34 $ 600 $ 36 $ 14 $ 846
======== ======== ======== ======== ======== ========
An allocation of the allowance for credit losses by major loan categories is
presented in the following table. The 2004 decrease in the unallocated portion
noted in the table is due to refinement in the allowance methodology during that
year.
------------------------------------------------------------------------------------------------------------------------
2005 2004 2003 2002 2001
----------------- ----------------- ---------------- ----------------- --------------
% of % of % of % of % of
Loans Loans Loans Loans Loans
to to to to to
Total Total Total Total Total
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
------------------------------------------------------------------------------------------------------------------------
(in millions)
Commercial $ 162 31 $ 182 27 $ 252 39 $ 346 46 $ 354 49
Consumer:
Residential
mortgages 34 49 20 55 13 55 11 47 11 43
Credit card
receivables 600 17 553 14 54 2 51 3 53 3
Other consumer 36 3 20 4 16 4 27 4 29 5
Unallocated
reserve 14 -- 13 -- 64 -- 58 -- 59 --
------ ------ ------ ------ ------ ------ ------ ------ ------ -----
Total $ 846 100 $ 788 100 $ 399 100 $ 493 100 $ 506 100
====== ====== ====== ====== ====== ====== ====== ====== ====== =====
Commercial Loan Credit Quality
Components of the commercial allowance for credit losses are summarized in the
following table:
--------------------------------------------------------------------------------
Balance at December 31 2005 2004 2003
--------------------------------------------------------------------------------
(in millions)
On-balance sheet allowance:
Specific ....................... $ 9 $ 17 $ 87
Collective ..................... 149 151 132
Transfer risk .................. 4 14 33
-------- -------- --------
162 182 252
Unallocated .................... 14 13 64
-------- -------- --------
Total on-balance sheet allowance 176 195 316
Off-balance sheet allowance .......... 88 90 43
-------- -------- --------
Total commercial allowance ........... $ 264 $ 285 $ 359
======== ======== ========
57
The on-balance sheet allowance for credit losses associated with commercial loan
portfolios, including the unallocated portion, decreased $19 million during
2005. Net charge offs of $4 million and a $15 million credit to income in the
provision for credit losses resulted in the overall allowance decrease. Calendar
year 2004 was a period of unusually low charge offs and high recoveries of
commercial loans. During 2005, charge offs increased 39%, but the level of
charge offs was still well below 2003 and prior year levels. Recoveries
increased again in 2005 due to sales of certain problem credits at amounts
higher than recorded book values.
Commercial loan credit quality was generally stable throughout 2005. Nonaccruing
commercial loans decreased for the fifth consecutive year, reflecting HUSI's
generally strong credit underwriting standards and improving economic conditions
in recent years. Criticized assets classified as "substandard" have increased
$131 million during 2005, primarily due to the addition of non-investment grade
securities to the calculation of these assets. Excluding these securities,
criticized commercial loans have declined among all categories during 2005. At
December 31, 2005 HUSI had acceptable on-balance sheet exposure from industries
considered to be of higher risk. Overall exposures to these industries were
reduced in 2005.
HUSI expects that a more normalized commercial credit environment for 2006 will
result in lower recoveries and higher provision expense. Although overall
commercial credit quality is expected to remain stable and well controlled, any
sudden and/or unexpected adverse economic events or trends could significantly
affect credit quality and increase provisions for credit losses.
Credit Card Receivable Credit Quality
Credit card receivables are primarily private label receivables acquired from
HSBC Finance Corporation in 2004 and 2005. The allowance for credit losses
associated with credit card receivables increased $47 million during 2005. Net
charge offs of $513 million in 2005 were more than offset by provision for
credit losses of $560 million. The provision for 2005 includes total incremental
provisions of $15 million for Hurricane Katrina and new bankruptcy legislation.
Excluding these incremental provisions, allowance activity reflects normal
portfolio experience for the increased balances associated with the private
label receivables.
The following table provides select credit quality data for credit card
receivables. Net charge offs for 2004 pertain to the MasterCard/Visa credit card
portfolio held by HUSI prior to acquisition of the private label receivable
portfolio in late December 2004.
-----------------------------------------------------------------------------------------------------------------
December 31 2005 2004
-----------------------------------------------------------------------------------------------------------------
(in millions)
Accruing credit card receivables contractually past due 90 days or more:
Balance at end of period .................................................. $ 248 $ 223
As a percent of total credit card receivables ............................. 1.60% 1.85%
Allowance for credit losses associated with credit card receivables:
Balance at end of period .................................................. $ 600 $ 553
As a percent of total credit card receivables ............................. 3.87% 4.58%
Net charge offs of credit card receivables:
Total for the period ...................................................... $ 513 $ 57
Annualized net charge offs as a percent of average credit card
receivables ............................................................. 3.81% 4.69%
Receivables included in the private label receivable portfolio are generally
maintained in accruing status until being charged off six months after
delinquency.
58
Other Consumer Loan Credit Quality
The allowance for credit losses associated with residential mortgage and other
consumer loans increased approximately $30 million during 2005. Provision for
credit losses of $129 million, primarily associated with various unsecured
installment loan portfolios, was partially offset by net charge offs of $99
million, also primarily from installment lending portfolios. Increased net
charge offs and provisions were primarily attributable to significantly
increased consumer loan balances.
Reserve For Off-Balance Sheet Exposures
HUSI maintains a separate reserve for credit risk associated with certain
off-balance sheet exposures including letters of credit, unused commitments to
extend credit and financial guarantees. This reserve, included in other
liabilities, was approximately $88 million and $90 million at December 31, 2005
and 2004 respectively.
Descriptions and financial information for various off-balance sheet
arrangements are presented below.
Off-Balance Sheet Arrangements and Contractual Obligations
--------------------------------------------------------------------------------
Off-Balance Sheet Arrangements
The following table presents maturity information related to various off-balance
sheet arrangements. Descriptions of the various arrangements follow the table.
------------------------------------------------------------------------------------------------------------------------
One Over One Over
Year Through Five
December 31, 2005 or Less Five Years Years Total
------------------------------------------------------------------------------------------------------------------------
(in millions)
Standby letters of credit, net of participations ...... $ 4,365 $ 1,728 $ 21 $ 6,114(1)
Commercial letters of credit, net of participations ... 778 28 -- 806
Recourse on sold loans ................................ -- 1 8 9(2)
Securities lending indemnifications ................... 4,135 -- -- 4,135
Credit derivative contracts ........................... 3,363 158,795 60,261 222,419(3)
Commitments to extend credit:
Commercial ...................................... 20,934 27,977 2,373 51,284
Consumer ........................................ 8,305 -- -- 8,305
Commitments to deliver mortgage loans ................. 3,162 -- -- 3,162
-------- -------- -------- --------
Total ................................................. $ 45,042 $188,529 $ 62,663 $296,234
======== ======== ======== ========
(1) Includes $523 million issued for the benefit of related parties.
(2) $7 million of this amount is indemnified by third parties.
(3) Includes $51,202 million issued for the benefit of related parties.
Letters of Credit
HUSI may issue a letter of credit for the benefit of a customer, authorizing a
third party to draw on the letter for specified amounts under certain terms and
conditions. The issuance of a letter of credit is subject to HUSI's credit
approval process and collateral requirements. HUSI issues two types of letters
of credit, commercial and standby.
o A commercial letter of credit is drawn down on the occurrence of an
expected underlying transaction, such as the delivery of goods. Upon the
occurrence of the transaction, a commercial letter of credit is recorded
as a customer acceptance in other assets and other liabilities until
settled.
59
o A standby letter of credit is issued to third parties for the benefit of a
customer and is essentially a guarantee that the customer will perform, or
satisfy some obligation, under a contract. It irrevocably obligates HUSI
to pay a third party beneficiary when a customer either: (1) in the case
of a performance standby letter of credit, fails to perform some
contractual non-financial obligation, or (2) in the case of a financial
standby letter of credit, fails to repay an outstanding loan or debt
instrument.
Fees are charged for issuing letters of credit commensurate with the customer's
credit evaluation and the nature of any collateral. Included in other
liabilities are deferred fees on standby letters of credit, representing the
fair value of HUSI's "stand ready obligation to perform" under these guarantees,
amounting to $19 million and $15 million at December 31, 2005 and 2004
respectively. Also included in other liabilities is an allowance for credit
losses on unfunded standby letters of credit, of $20 million and $28 million at
December 31, 2005 and 2004 respectively.
Loan Sales with Recourse
HUSI securitizes and sells assets, generally without recourse. In prior years,
HUSI's mortgage banking subsidiary sold residential mortgage loans with recourse
upon borrower default, with partial indemnification from third parties.
Securities Lending Indemnifications
HUSI may lend securities of customers, on a fully collateralized basis, as an
agent to third party borrowers. HUSI indemnifies the customers against the risk
of loss and obtains collateral from the borrower with a market value exceeding
the value of the loaned securities. At December 31, 2005, the fair value of that
collateral was approximately $4,219 million.
Credit Derivatives
HUSI enters into credit derivative contracts both for its own benefit and to
satisfy the needs of its customers. Credit derivatives are arrangements that
provide for one party (the "beneficiary") to transfer the credit risk of a
"reference asset" to another party (the "guarantor"). Under this arrangement the
guarantor assumes the credit risk associated with the reference asset without
directly purchasing it. The beneficiary agrees to pay to the guarantor a
specified fee. In return, the guarantor agrees to pay the beneficiary an agreed
upon amount if there is a default during the term of the contract.
In accordance with its policy, HUSI offsets virtually all of the market risk it
assumes in selling credit guarantees through a credit derivative contract with
another counterparty. Credit derivatives, although having characteristics of a
guarantee, are accounted for as derivative instruments and are carried at fair
value. The commitment amount included in the table on the preceding page is the
maximum amount that HUSI could be required to pay, without consideration of the
approximately equal amount receivable from third parties and any associated
collateral.
Commitments to Extend Credit
Commitments include arrangements whereby HUSI is contractually obligated to
extend credit in the form of loans, participations in loans, lease financing
receivables, or similar transactions. Consumer commitments are comprised of
unused credit card lines and commitments to extend credit secured by residential
properties. HUSI has the right to change or terminate any terms or conditions of
a customer's credit card or home equity line of credit account, upon
notification to the customer.
Commitments to Deliver Mortgage Loans
In the normal course of business, HUSI sells residential mortgage loans in the
secondary market. During the period in which the buyer's bid is accepted and
before the sale has settled, the loans remain on HUSI's balance sheet. During
this time, HUSI has a commitment to deliver the mortgage loans to the buyer upon
settlement.
60
Contractual Obligations
Obligations to make future cash payments under contracts are presented in the
following table.
------------------------------------------------------------------------------------------------------------------------
One Over One Over
Year Through Five
December 31, 2005 or Less Five Years Years Total
------------------------------------------------------------------------------------------------------------------------
(in millions)
Subordinated long-term debt and perpetual capital notes (1) ....... $ 300 $ 800 $ 4,661 $ 5,761
Other long-term debt, including capital lease obligations (1) ..... 6,419 14,720 1,121 22,260
Pension and other postretirement benefit obligations (2) .......... 51 244 415 710
Minimum future rental commitments on operating leases (3) ......... 79 233 179 491
Purchase obligations (4) .......................................... 77 72 4 153
-------- -------- -------- --------
Total ............................................................. $ 6,926 $ 16,069 $ 6,380 $ 29,375
======== ======== ======== ========
(1) Represents future payments related to debt instruments included in Note 14
of the consolidated financial statements beginning on page 111 of this
Form 10-K.
(2) Represents estimated future employee service expected to be paid based on
assumptions used to measure HUSI's benefit obligation at December 31,
2005. See Note 22 of the consolidated financial statements beginning on
page 127 of this Form 10-K.
(3) Represents expected minimum lease payments under noncancellable operating
leases for premises and equipment included in Note 24 of the consolidated
financial statements beginning on page 133 of this Form 10-K.
(4) Represents binding agreements for facilities management and maintenance
contracts, custodial account processing services, internet banking
services, consulting services, real estate services and other services.
61
Risk Management
--------------------------------------------------------------------------------
Overview
Some degree of risk is inherent in virtually all of HUSI's activities. For the
principal activities undertaken by HUSI, the most important types of risks are
considered to be credit, interest rate, market, liquidity, operational,
fiduciary and reputational. Market risk broadly refers to price risk inherent in
mark to market positions taken on trading and non-trading instruments.
Operational risk technically includes legal and compliance risk. However, since
compliance risk, including anti-money laundering (AML) risk, has such broad
scope within HUSI's businesses, it is addressed below as a separate functional
discipline.
The objective of HUSI's risk management system is to identify, measure and
monitor risks so that:
o the potential costs can be weighed against the expected rewards from
taking the risks;
o unexpected losses can be minimized;
o appropriate disclosures can be made to all concerned parties;
o adequate protections, capital and other resources can be put in place to
weather all significant risks; and
o compliance with all relevant laws, regulations and regulatory requirements
is ensured through staff education, adequate processes and controls, and
ongoing monitoring efforts.
Historically, HUSI's approach toward risk management has emphasized a culture of
business line responsibility combined with central requirements for
diversification of customers and businesses. Extensive centrally determined
requirements for controls, limits, reporting and the escalation of issues have
been detailed in HUSI's and HSBC's policies and procedures. In addition, HUSI
has a formal independent compliance function, the staff of which has been
aligned with, and has advised, each business and support function.
As a result of an increasingly complex business environment, increased
regulatory scrutiny, and the evolution of improved risk management tools and
standards, HUSI has significantly upgraded, and continues to upgrade, its
methodologies and systems. New practices and techniques have been developed that
involve data development, modeling, simulation and analysis, management
information systems development, self-assessment, and staff education programs.
A senior leadership structure has been introduced at HUSI, under the direction
of the Chief Risk Officer, which includes dedicated independent risk specialists
for operational, AML and fiduciary risk, in addition to the existing specialists
for managing other risks. Staffing has been expanded, especially in the areas of
compliance/AML and market risk.
Risk management oversight begins with HUSI's Board of Directors and its various
committees, principally the Audit Committee. Specific oversight of various risk
management processes is provided by the Risk Management Committee, which is
chaired by the Chief Risk Officer, and its five principal subcommittees:
o the Credit Risk Committee;
o the Asset and Liability Policy Committee;
o the Operational Risk Management Committee;
o the Fiduciary Risk Management Committee; and
o the Compliance Risk Management Committee.
The Risk Management Committee and each sub-committee have charters established
by the Board of Directors. While the charters are tailored to reflect the roles
and responsibilities of each committee, they all have the following common
themes:
o defining risk appetites, policies and limits;
o monitoring and assessing exposures, trends and the effectiveness of risk
management;
o reporting to the Board of Directors; and
o promulgating a suitable risk taking, risk management, and compliance
culture.
62
Day-to-day management of credit risk is centralized under the Chief Credit
Officer. For retail consumer loan portfolios, such as credit cards, installment
loans, and residential mortgages, the Chief Credit Officer leverages off the
consumer credit management skills and tools of HSBC Finance Corporation.
Day-to-day management of interest rate and market risk is centralized
principally under the Treasurer. Operational, fiduciary, and compliance risk is
decentralized and is the responsibility of each business and support unit.
However, for all risk types, there are independent risk specialists that set
standards, develop new risk methodologies, maintain central risk databases, and
conduct reviews and analysis. The Chief Risk Officer and the Executive Vice
Presidents for Compliance and Anti-Money Laundering provide day-to-day oversight
of these activities and work closely with Internal Audit, and senior risk
officers and specialists at HNAH and HSBC.
Economic and Regulatory Capital
Economic Capital
Economic capital is defined as the amount of capital required to sustain a
business through a complete business cycle, enabling the business to absorb
unexpected losses and thus minimize the probability of insolvency. Economic
capital is measured at the business unit level based on four categories of risk:
o Credit risk
o Operational risk
o Market risk
o Interest rate risk
Whereas regulatory capital is traditionally only calculated at the total bank
level as a measure of the minimum capital needed for regulatory compliance and
is based on the amount of capital maintained in relation to risk-weighted assets
at a specific point in time, economic capital is actually a measure of risk. As
a result, economic capital can be compared to total corporate capital resources
and, since it can be assigned to each business unit according to its risk
characteristics, it can be used to establish business performance measures, make
pricing decisions or set portfolio guidelines.
Economic capital is an internal measure developed by HUSI based on its unique
set of diverse businesses, risk appetites, and management practices. In 2004,
HUSI began to calculate economic capital from statistical analyses of possible
losses related to credit, market, interest rate and operational risk. HUSI
calculates economic capital sufficient to cover losses over a one year time
horizon at a 99.95% confidence level. This is consistent with HBUS's "AA"
rating, as "AA" rated credits have historically defaulted at a rate of about
..05% per year. The one year time horizon is also consistent with traditional
planning and budgeting time horizons. Quantification of possible losses related
to other risks, such as fiduciary and reputational risk, are broadly covered
under the credit, market and operational risk measurements.
Basel Capital Standards
The status of HNAH's and HUSI's preparations relative to Basel II is summarized
on page 9 of this Form 10-K. Only the most advanced approaches toward
implementation of the Basel II framework are expected to be adopted by U.S.
regulators. For credit risk and operational risk, bank holding companies must
adopt the Advanced Internal Ratings Based approach and the Advanced Measurement
Approach, respectively, as described in the Basel framework. Market risk
assessment will continue to be based on the same value at risk calculations used
under current regulations.
HUSI will continue to leverage the internal economic capital development program
begun in 2002 in its preparations for the new capital adequacy standards. Many
of the practices related to the calculation of economic capital will be used to
satisfy regulatory requirements. While HUSI expects to qualify to use the new
approaches in time to meet the January 1, 2009 implementation date in the U.S.,
the Basel II framework must essentially be in place on January 1, 2008 to meet
HSBC requirements.
63
Credit Risk Management
Credit risk is the potential that a borrower or counterparty will default on a
credit obligation, as well as the impact on the value of credit instruments due
to changes in the probability of borrower default.
For HUSI, credit risk is inherent in various on and off-balance sheet
instruments and arrangements:
o in loan portfolios;
o in investment portfolios;
o in unfunded commitments such as letters of credit and lines of credit that
customers can draw upon; and
o in treasury instruments, such as interest rate swaps which, if more
valuable today than when originally contracted, may represent an exposure
to the counterparty to the contract.
While credit risk exists widely within HUSI, diversification among various
commercial and consumer portfolios helps HUSI to lessen risk exposure.
HUSI assesses, monitors and controls credit risk with formal standards, policies
and procedures. An independent Credit Risk function is maintained under the
direction of the Chief Credit Officer, who reports directly to the Chief
Executive Officer of HUSI, and indirectly to the Chief Risk Officer of HNAH and
to the Group General Manager, Head of Credit and Risk for HSBC.
The responsibilities of the credit risk function include:
o Formulating credit policies - HUSI's policies are designed to ensure that
various retail and commercial business units operate within clear
standards of acceptable credit risk. HUSI's policies ensure that the HSBC
standards are consistently implemented across all businesses and that all
regulatory requirements are also considered. Credit policies are reviewed
and approved annually by the Audit Committee.
o Approving new commercial and financial institution credit exposures and
reviewing large exposures annually - The Chief Credit Officer delegates
credit authority to various lending units throughout HUSI. However, most
large credits are reviewed and approved centrally through a dedicated
Credit Approval Unit that reports directly to the Chief Credit Officer. In
addition, the Chief Credit Officer coordinates the approval of material
credits with HSBC Group Credit and Risk which, subject to certain
agreed-upon limits, will review and concur on material new and renewal
transactions.
o Monitoring portfolio performance - HUSI has implemented a credit data
warehouse to centralize the reporting of its credit risk, support the
analysis of risk using tools such as economic capital, and to calculate
its credit loss reserves. This data warehouse will also support HSBC's
wider effort to meet the requirements of Basel II and to generate credit
reports for management and the Board of Directors.
o Establishing counterparty and portfolio limits - HUSI monitors and limits
its exposure to individual counterparties and to the combined exposure of
related counterparties. In addition, selected industry portfolios, such as
real estate, telecommunications, aviation, and shipping, are subject to
caps that are established by the Chief Credit Officer and reviewed where
appropriate by management committees and the Board of Directors.
Counterparty credit exposure related to derivative activities is also
managed under approved limits. Since the exposure related to derivatives
is variable and uncertain, HUSI uses internal risk management
methodologies to calculate the 95% worst-case potential future exposure
for each customer. These methodologies take into consideration, among
other factors, cross-product close-out netting, collateral received from
customers under Collateral Support Annexes (CSAs), termination clauses,
and off-setting positions within the portfolio.
o Managing problem commercial loans - Special attention is paid to problem
loans. When appropriate, HUSI's Special Credits Unit provides customers
with intensive management and control support in order to help them avoid
default wherever possible and maximize recoveries.
64
o Overseeing retail credit risk - Each retail business unit is supported by
dedicated advanced risk analytics units. The Chief Credit Officer provides
independent oversight of credit risk associated with these retail
portfolios and is supported by expertise from HNAH's Retail Credit
Management unit, under the direction of the HNAH's Chief Risk Officer.
o Chairing the Credit Risk Management Committee - The Chief Credit Officer
chairs the Credit Risk Management Committee and is responsible for
strategic and collective oversight of the scope of risk taken, the
adequacy of the tools used to measure it, and the adequacy of reporting.
During 2004, HUSI introduced a new two dimensional credit risk rating system to
replace its previous single dimensional, seven level system. Under the new
system, the first "dimension" is measurement of customer or counterparty credit
risk through a probability of default based "Customer Rating". The second
"dimension" is measurement of loss severity through a facility level "Loss Given
Default" assessment.
Customer Rating entails a 22 level grading system. Each grade has its own
specified probability of default calibrated to the performance of Standard and
Poor's and Moody's Long-Term Debt Ratings across an economic cycle. A suite of
models, tools and templates developed using quantitative and statistical
techniques, as well as expert judgment, supports the estimation of the
probability of default. This suite of tools has been developed using a
combination of internal and external resources and data and aims at following
what has been determined to be best practice in the industry. To estimate the
probable loss in the event of default, HUSI is working with other members of
HSBC to collect data regarding historical internal credit losses which will be
supplemented by data from external sources, and has implemented other tools and
models to support this effort.
The Customer Rating and Loss Given Default measures are also leveraged to
support the calculation of HUSI's commercial credit loss reserves beginning with
year-end 2004. These measures are modified from their Basel II definitions to
ensure that the calculation will comply with U.S. accounting and regulatory
standards for credit reserves.
In 2004, HUSI implemented the first stage of its credit economic capital risk
measurement system, using the measure in certain internal and Board of Directors
reporting. Simulation models are used to determine the amount of unexpected
losses, beyond expected losses, that HUSI must be prepared to support with
capital given its targeted debt rating. Monthly credit economic capital reports
are generated and reviewed with management and the business units. Efforts
continue to refine both the inputs and assumptions used in the credit economic
capital model to increase its usefulness in pricing and the evaluation of large
and small commercial and retail customer portfolio products and business unit
return on risk. During 2005, HUSI continued to refine its calculation of
economic capital related to credit risk and begin to integrate the new credit
risk modeling tools into the credit risk and portfolio management processes as
appropriate.
Asset/Liability Management
Asset and liability management includes management of liquidity, interest rate
and market risk. Liquidity risk is the potential that an institution will be
unable to meet its obligations as they become due or fund its customers because
of inadequate cash flow or the inability to liquidate assets or obtain funding
itself. Market risk includes both interest rate and trading risk. Interest rate
risk is the potential impairment of net interest income due to mismatched
pricing between assets and liabilities and off-balance sheet instruments. Market
risk is the potential for losses in daily mark to market positions (mostly
trading) due to adverse movements in money, foreign exchange, equity or other
markets. In managing these risks, HUSI seeks to protect both its income stream
and the value of its assets.
65
HUSI has substantial, but historically well controlled, interest rate risk in
large part as a result of its large portfolio of residential mortgages and
mortgage backed securities, which consumers can prepay without penalty, and to a
lesser extent the result of its large base of demand and savings deposits. These
deposits can be withdrawn by consumers at will, but historically they have been
a stable source of funds. Market risk exists principally in treasury businesses
and to a lesser extent in the residential mortgage business where mortgage
servicing rights and the pipeline of forward mortgage sales are hedged. HUSI has
little foreign exchange exposure from investments in overseas operations, which
are limited in scope. Total equity investments, excluding stock owned in the
Federal Reserve and New York Federal Home Loan Bank, represent less than 2% of
total available for sale securities.
The management of liquidity, interest rate and most market risk is centralized
in treasury and mortgage banking operations. In all cases, the valuation of
positions and tracking of positions against limits is handled independently by
HUSI's finance units. Oversight of all liquidity, interest rate and market risks
is provided by the Asset and Liability Policy Committee (ALCO) which is chaired
by the Chief Financial Officer. Subject to the approval of the HUSI Board of
Directors and HSBC, ALCO sets the limits of acceptable risk, monitors the
adequacy of the tools used to measure risk, and assesses the adequacy of
reporting. ALCO also conducts contingency planning with regard to liquidity.
Liquidity Risk Management
Liquidity risk is the risk that an institution will be unable to meet its
obligations as they become due because of an inability to liquidate assets or
obtain adequate funding. Liquidity is managed to provide the ability to generate
cash to meet lending, deposit withdrawal and other commitments at a reasonable
cost in a reasonable amount of time, while maintaining routine operations and
market confidence. HUSI is planning its funding and liquidity management in
conjunction with HSBC Finance Corporation and HSBC, as the markets increasingly
view debt issuances from the separate companies within the context of their
common parent company. Liquidity management is performed at HUSI and at HBUS.
Each entity is required to have sufficient liquidity for a crisis situation.
ALCO is responsible for the development and implementation of related policies
and procedures to ensure that the minimum liquidity ratios and a strong overall
liquidity position are maintained.
In carrying out this responsibility, ALCO projects cash flow requirements and
determines the level of liquid assets and available funding sources to have at
HUSI's disposal, with consideration given to anticipated deposit and balance
sheet growth, contingent liabilities, and the ability to access wholesale
funding markets. Our liquidity management approach has been supplemented by
increased long-term debt issuances to third parties, and potential asset
sales/securitizations (e.g. residential mortgage loans) in liquidity contingency
plans. In addition, ALCO monitors the overall mix of deposit and funding
concentrations to avoid undue reliance on individual funding sources and large
deposit relationships. It must also maintain a liquidity management contingency
plan, which identifies certain potential early indicators of liquidity problems,
and actions that can be taken both initially and in the event of a liquidity
crisis, to minimize the long-term impact on HUSI's business and customer
relationships. In the event of a cash flow crisis, HUSI's objective is to fund
cash requirements without access to the wholesale unsecured funding market for
at least one year. Contingency funding needs will be satisfied primarily through
the sale of the investment portfolio and liquidation of the residential mortgage
portfolio. Securities may be sold or used as collateral in a repurchase
agreement depending on the scenario. Portions of the mortgage portfolio may be
sold, securitized, or used for collateral at the FHLB to increase borrowings.
66
Deposits from a diverse mix of "core" retail, commercial and public sources
represent a significant, cost-effective and stable source of liquidity under
normal operating conditions. HUSI's ability to regularly attract wholesale funds
at a competitive cost is enhanced by strong ratings from the major credit
ratings agencies. At December 31, 2005, HUSI and HBUS maintained the following
long and short-term debt ratings:
--------------------------------------------------------------------------------
Moody's S&P Fitch
--------------------------------------------------------------------------------
HUSI:
Short-term borrowings ................ P-1 A-1 F1+
Long-term debt ....................... Aa3 A+ AA
Preferred stock ...................... A2 A- AA-
HBUS:
Short-term borrowings ................ P-1 A-1+ F1+
Long-term debt ....................... Aa2 AA- AA
In December 2005, both Standard and Poor's and Moody's Investor Service upgraded
their outlook on the ratings of HBUS and HUSI from stable to positive.
HUSI's continued success and prospects for growth are dependent upon access to
the global capital markets. Numerous factors, internal and external, may impact
HUSI's access to and costs associated with issuing debt in these markets. These
factors include our debt ratings, overall economic conditions, overall capital
markets volatility and the effectiveness of our management of credit risks
inherent in our customer base.
Cash resources, short-term investments and a trading asset portfolio are
available to provide highly liquid funding for HUSI. Additional liquidity is
provided by debt securities included in the available for sale securities
portfolio. Approximately $3 billion of debt securities in this portfolio at
December 31, 2005 is expected to mature in 2006. The remaining available for
sale securities not maturing in 2006, and the held to maturity portfolio of $3
billion are available to provide liquidity by serving as collateral for secured
borrowings, or if needed, by being sold. Further liquidity is available through
HUSI's ability to sell or securitize loans in secondary markets through
whole-loan sales and securitizations. In 2005, HUSI sold residential mortgage
loans of approximately $10 billion. The amount of residential mortgage loans and
credit card receivables available to be sold or securitized totaled
approximately $56 billion at December 31, 2005.
The economics and long-term business impact of obtaining liquidity from assets
must be weighed against the economics of obtaining liquidity from liabilities,
along with consideration given to the associated capital ramifications of these
two alternatives. Currently, assets would be used to supplement liquidity
derived from liabilities only in a crisis scenario.
It is the policy of HBUS to maintain both primary and secondary collateral in
order to ensure precautionary borrowing availability from the Federal Reserve.
Primary collateral is that which is physically maintained at the Federal
Reserve, and serves as a safety net against any unexpected funding shortfalls
that may occur. Secondary collateral is collateral that is acceptable to the
Federal Reserve, but is not maintained there. If unutilized borrowing capacity
were to be low, secondary collateral would be identified and maintained as
necessary. Further liquidity is available from the Federal Home Loan Bank of New
York. As of December 31, 2005 HUSI had outstandings of $5 billion. HUSI has
access to further borrowings based on the amount of mortgages pledged as
collateral to the FHLB.
HUSI maintains sufficient liquidity to meet all unsecured debt obligations
scheduled to mature in 2006 at its parent company level without the need for
incremental access to the unsecured markets. As of December 31, 2005, HBUS can
declare dividends to the parent company, without regulatory approval, of
approximately $2 billion. However, in determining the extent of dividends to
pay, HBUS must also consider the effect of dividend payments on applicable
risk-based capital and leverage ratio requirements, as well as policy statements
of federal regulatory agencies that indicate that banking organizations should
generally pay dividends out of current operating earnings.
HUSI filed a $2.3 billion shelf registration statement with the Securities and
Exchange Commission in 2005, under which it may issue debt and equity
securities. During 2005, HUSI issued perpetual non-cumulative preferred stock
totaling approximately $.4 billion and $1.5 billion of extendible term senior
debt from this shelf.
67
HBUS has a $20 billion Global Bank Note Program, which provides for issuance of
subordinated and senior global notes. Borrowings from the Global Bank Note
Program totaled $1 billion and $14 billion for 2005 and 2004 respectively.
At December 31, 2005, HUSI also had a $2 billion back-up credit facility for
issuances of commercial paper.
Interest Rate Risk Management
HUSI is subject to interest rate risk associated with the repricing
characteristics of its balance sheet assets and liabilities. Specifically, as
interest rates change, amounts of interest earning assets and liabilities
fluctuate, and interest earning assets reprice at intervals that do not
correspond to the maturities or repricing patterns of interest bearing
liabilities. This mismatch between assets and liabilities in repricing
sensitivity results in shifts in net interest income as interest rates move. To
help manage the risks associated with changes in interest rates, and to manage
net interest income within ranges of interest rate risk that management
considers acceptable, HUSI uses derivative instruments such as interest rate
swaps, options, futures and forwards as hedges to modify the repricing
characteristics of specific assets, liabilities, forecasted transactions or firm
commitments.
The following table shows the repricing structure of assets and liabilities as
of December 31, 2005. For assets and liabilities whose cash flows are subject to
change due to movements in interest rates, such as the sensitivity of mortgage
loans to prepayments, data is reported based on the earlier of expected
repricing or maturity and reflects anticipated prepayments based on the current
rate environment. The resulting "gaps" are reviewed to assess the potential
sensitivity to earnings with respect to the direction, magnitude and timing of
changes in market interest rates. Data shown is as of year end, and one-day
figures can be distorted by temporary swings in assets or liabilities.
------------------------------------------------------------------------------------------------------------------------
Within After One After Five After
One But Within But Within Ten
December 31, 2005 Year Five Years Ten Years Years Total
------------------------------------------------------------------------------------------------------------------------
(in millions)
Commercial loans ................... $ 24,173 $ 2,247 $ 948 $ 353 $ 27,721
Residential mortgages .............. 19,478 20,114 3,249 1,129 43,970
Credit card receivables ............ 13,958 1,556 -- -- 15,514
Other consumer loans ............... 716 2,138 242 41 3,137
--------- --------- --------- --------- ---------
Total loans .................. 58,325 26,055 4,439 1,523 90,342
--------- --------- --------- --------- ---------
Securities available for sale and
securities held to maturity ..... 4,569 8,175 5,081 3,110 20,935
Other assets ....................... 37,523 2,839 2,220 -- 42,582
--------- --------- --------- --------- ---------
Total assets ................. 100,417 37,069 11,740 4,633 153,859
--------- --------- --------- --------- ---------
Domestic deposits (1)
Savings and demand ........... 20,301 8,677 9,487 -- 38,465
Certificates of deposit ...... 11,831 1,317 108 190 13,446
Long-term debt ..................... 22,509 2,858 1,569 1,023 27,959
Other liabilities/equity ........... 66,348 4,414 3,227 -- 73,989
--------- --------- --------- --------- ---------
Total liabilities and equity 120,989 17,266 14,391 1,213 153,859
--------- --------- --------- --------- ---------
Total balance sheet gap ...... (20,572) 19,803 (2,651) 3,420 --
--------- --------- --------- --------- ---------
Effect of derivative contracts ..... 17,411 (17,370) 148 (189) --
--------- --------- --------- --------- ---------
Total gap position ........... $ (3,161) $ 2,433 $ (2,503) $ 3,231 $ --
========= ========= ========= ========= =========
(1) Does not include purchased or wholesale treasury deposits. The placement
of administered deposits such as savings and demand for interest rate risk
purposes reflects behavioral expectations associated with these balances.
Long-term core balances are differentiated from more fluid balances in an
effort to reflect anticipated shifts of non-core balances to other deposit
products or equities over time.
68
Various techniques are utilized to quantify and monitor risks associated with
the repricing characteristics of HUSI's assets, liabilities and derivative
contracts. During 2005, capital at risk analysis was replaced by an economic
value of equity analysis that more fully incorporates market risk.
In the course of managing interest rate risk, Present Value of a Basis Point
(PVBP) analysis is utilized in conjunction with a combination of other risk
assessment techniques, including economic value of equity, dynamic simulation
modeling, capital risk and Value at Risk (VAR) analyses. The combination of
these tools enables management to identify and assess the potential impact of
interest rate movements and take appropriate action. This combination of
techniques, with some focusing on the impact of interest rate movements on the
value of the balance sheet (PVBP, economic value of equity, VAR) and others
focusing on the impact of interest rate movements on earnings (dynamic
simulation modeling) allows for comprehensive analyses from different
perspectives.
A key element of managing interest rate risk is the management of the convexity
of the balance sheet, largely resulting from the mortgage related products on
the balance sheet. Convexity risk arises as mortgage loan consumers change their
behavior significantly in response to large rate movements in market rates, but
do not change behavior appreciably for smaller changes in market rates. Some of
the above noted interest rate management tools, such as dynamic simulation
modeling and economic value of equity better capture the embedded convexity in
the balance sheet, while measures such as PVBP are designed to capture the risk
of smaller changes in rates.
The assessment techniques discussed below act as a guide for managing interest
rate risk associated with balance sheet composition and off-balance sheet
hedging strategy (the risk position). Calculated values within limit ranges
reflect an acceptable risk position, although possible future unfavorable trends
may prompt adjustments to on or off-balance sheet exposure. Calculated values
outside of limit ranges will result in consideration of adjustment of the risk
position, or consideration of temporary dispensation from making adjustments.
Dynamic Simulation Modeling
ALCO uses modeling techniques to monitor a number of interest rate scenarios for
their impact on net interest income. The following table reflects the impact on
net interest income over the next twelve months of the scenarios utilized by
these modeling techniques.
-----------------------------------------------------------------------------------------------------------------------
December 31, 2005 Amount %
-----------------------------------------------------------------------------------------------------------------------
(in millions)
Projected change in net interest income (reflects projected rate movements on January 1, 2006):
Institutional base earnings movement limit ............................................. (10)
Change resulting from a gradual 200 basis point increase in the yield curve ............ $(162) (5)
Change resulting from a gradual 200 basis point decrease in the yield curve ............ 240 8
Change resulting from a gradual 100 basis point increase in the yield curve ............ (78)
Change resulting from a gradual 100 basis point decrease in the yield curve ............ 131
Other significant scenarios monitored (reflects projected rate movements on January 1, 2006):
Change resulting from an immediate 100 basis point increase in the yield curve ......... (128)
Change resulting from an immediate 100 basis point decrease in the yield curve ......... 74
Change resulting from an immediate 200 basis point increase in the yield curve ......... (258)
Change resulting from an immediate 200 basis point decrease in the yield curve ......... 162
Change resulting from an immediate 100 basis point increase in short-term rates ........ (213)
The projections do not take into consideration possible complicating factors
such as the effect of changes in interest rates on the credit quality, size and
composition of the balance sheet, except for some changes in residential
mortgage loans and various types of personal deposits. Therefore, although this
provides a reasonable estimate of interest rate sensitivity for the next twelve
months, actual results will vary from these estimates, possibly by significant
amounts. The impact of the rate changes noted above also reaches into year two
and beyond. The cumulative impact is more fully reflected in the economic value
of equity analysis.
69
Present Value of a Basis Point (PVBP)
PVBP is the change in value of the balance sheet for a one basis point upward
movement in all interest rates. The following table reflects the PVBP position
at December 31, 2005.
------------------------------------------------------------------------------------------------------------------
December 31, 2005 Values
------------------------------------------------------------------------------------------------------------------
(in millions)
Institutional PVBP movement limit .............................................................. $ 7.5
PVBP position at period end .................................................................... 3.5
Economic Value of Equity
Economic value of equity is the change in value of the assets and liabilities
(excluding capital and goodwill) for either a 200 basis point immediate rate
increase or decrease. The following table reflects the economic value of equity
position at December 31, 2005.
------------------------------------------------------------------------------------------------------------------
December 31, 2005 Values
------------------------------------------------------------------------------------------------------------------
Institutional economic value of equity limit ................................................... +/- 20%
Projected change in value (reflects projected rate movements on January 1, 2006):
Change resulting from a gradual 200 basis point increase in interest rates ............... (11)
Change resulting from a gradual 200 basis point decrease in interest rates ............... --
The projected decrease in value for a 200 basis point increase in rates is
primarily related to the anticipated slowing of prepayments for the held
mortgage and mortgage backed securities portfolios in this higher rate
environment. This assumes that no management actions are taken to manage
exposures to the changing interest rate environment.
Capital Risk/Sensitivity of Other Comprehensive Income
Large movements of interest rates could directly affect some reported capital
and capital ratios. The mark to market valuation of available for sale
securities is credited on a tax effective basis to accumulated other
comprehensive income. This valuation mark is excluded from Tier 1 and Tier 2
capital ratios but it would be included in two important accounting based
capital ratios: the tangible common equity to tangible assets and the tangible
common equity to risk weighted assets. As of December 31, 2005, HUSI had an
available for sale securities portfolio of approximately $18 billion with a net
negative mark to market of $275 million included in tangible common equity of $8
billion. An increase of 25 basis points in interest rates of all maturities
would lower the mark to market by approximately $165 million to a net loss of
$440 million with the following results on the tangible capital ratios.
-------------------------------------------------------------------------------------------------------------
Proforma - Reflecting
25 Basis Points
December 31, 2005 Actual Increase in Rates
-------------------------------------------------------------------------------------------------------------
Tangible common equity to tangible assets ............................ 5.00% 4.95%
Tangible common equity to risk weighted assets ....................... 6.40 6.32
Value at Risk (VAR)
VAR analysis is also used to measure interest rate risk and to calculate the
economic capital required to cover potential losses due to interest risk. As it
relates to net interest income, VAR looks at a historical observation period and
shows the potential loss from unfavorable market conditions during a "given
period" with a certain confidence level (99% for HUSI). HUSI uses a one-day
"given period" or "holding period" for setting limits and measuring results. At
a 99% confidence level for a two year observation period, HUSI is setting as its
limit the fifth worse loss performance in the last 500 business days.
The predominant VAR methodology used by HUSI, "historical simulation", has a
number of limitations, including the use of historical data as a proxy for the
future, the assumption that position adjustments can be made within the holding
period specified, and the use of a 99% confidence level, which does not take
into account potential losses that might occur beyond that level of confidence.
70
Trading Activities
Trading portfolios reside primarily within the Markets unit of the CIBM business
segment, which include warehoused residential mortgage loans purchased for
securitizations and within the mortgage banking subsidiary included within the
PFS business segment. Portfolios include foreign exchange, derivatives, precious
metals (gold, silver, platinum), equities and money market instruments including
"repos" and securities. Trading occurs as a result of customer facilitation,
proprietary position taking, and economic hedging. In this context, economic
hedging may include, for example, forward contracts to sell residential
mortgages and derivative contracts which, while economically viable, may not
satisfy the hedge requirements of Statement of Financial Accounting Standards
No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS
133).
The trading portfolios have defined limits pertaining to items such as
permissible investments, risk exposures, loss review, balance sheet size and
product concentrations. "Loss review" refers to the maximum amount of loss that
may be incurred before senior management intervention is required.
Trading Activities - Treasury
Value at Risk
Value at Risk (VAR) analysis is relied upon as a basis for quantifying and
managing risks associated with the Treasury trading portfolios and for required
regulatory and economic capital calculations. Such analysis is based upon the
following two general principles:
(i) VAR applies to all trading positions across all risk classes including
interest rate, equity, commodity, optionality and global/foreign exchange
risks; and
(ii) VAR is based on the concept of independent valuations, with all
transactions being repriced by an independent risk management function
using separate models prior to being stressed against VAR parameters.
VAR attempts to capture the potential loss resulting from unfavorable market
developments within a given time horizon (typically ten days), given a certain
confidence level (99%) and based on a two year observation period. VAR
calculations are performed for all material trading and investment portfolios
and for market risk-related treasury activities. The VAR is calculated using the
historical simulation method.
In 2004, a mortgage banking business was developed to buy and sell residential
mortgage loans for securitization. As a result, it is envisioned that HBUS will
have warehoused loans recorded on an accrual basis and associated hedges
recorded on a mark to market basis, resulting in volatility in reported
accounting earnings from quarter to quarter.
The following table summarizes trading VAR for 2005, assuming a 99% confidence
level for a two year observation period and a 10 day "holding period".
-------------------------------------------------------------------------------------------------------------------
Full Year 2005
December 31, ---------------------------------- December 31,
2005 Minimum Maximum Average 2004
-------------------------------------------------------------------------------------------------------------------
(in millions)
Total trading ........................ $ 53 $ 26 $ 66 $ 42 $ 41
Precious metals ...................... 5 1 13 4 11
Credit derivatives ................... 18 13 32 19 9
Equities ............................. 1 -- 2 1 1
Foreign exchange ..................... 4 2 19 7 1
Interest rate ........................ 69 27 74 52 27
71
Trading Volatility
The following table summarizes the frequency distribution of daily market
risk-related revenues for Treasury trading activities during calendar year 2005.
Market risk-related Treasury trading revenues include realized and unrealized
gains (losses) related to Treasury trading activities, but exclude the related
net interest income. Analysis of the 2005 gain (loss) data shows that the
largest daily gain was $13 million and the largest daily loss was $9 million.
--------------------------------------------------------------------------------------------------------------------
Ranges of daily Treasury trading revenue
earned from market risk-related activities Below $(2) to $0 to $2 to $4 to Over
(in millions) $(2) $0 $2 $4 $6 $6
--------------------------------------------------------------------------------------------------------------------
Number of trading days market risk-related
revenue was within the stated range ....... 19 46 75 58 29 21
Trading Activities - HSBC Mortgage Corporation (USA)
HSBC Mortgage Corporation (USA) is HUSI's mortgage banking subsidiary. Trading
occurs in mortgage banking operations as a result of an economic hedging program
intended to offset changes in value of mortgage servicing rights and the salable
loan pipeline. Economic hedging may include, for example, forward contracts to
sell residential mortgages and derivative contracts used to protect the value of
MSRs which, while economically viable, may not satisfy the hedge requirements of
SFAS 133.
MSRs are assets that represent the present value of net servicing income
(servicing fees, ancillary income, escrow and deposit float servicing costs).
MSRs are recognized upon the sale of the underlying loans or at the time that
servicing rights are purchased. MSRs are subject to interest rate risk, in that
their value will decline as a result of actual and expected acceleration of
prepayment of the underlying loans in a falling interest rate environment.
Interest rate risk is mitigated through an active hedging program that uses
available for sale securities and derivative instruments to offset changes in
value of MSRs. Since the hedging program involves trading activity, risk is
quantified and managed using a number of risk assessment techniques.
Rate Shock Analysis
Modeling techniques are used to monitor certain interest rate scenarios for
their impact on the economic value of net hedged MSRs, as reflected in the
following table.
--------------------------------------------------------------------------------------------------------------------
December 31, 2005 Value
--------------------------------------------------------------------------------------------------------------------
(in millions)
Projected change in net market value of hedged MSRs portfolio (reflects projected rate
movements on January 1, 2006):
Value of hedged MSRs portfolio .................................................................. $ 418
Change resulting from an immediate 50 basis point decrease in the yield curve:
Change limit (no worse than) ................................................................. (16)
Calculated change in net market value ........................................................ (5)
Change resulting from an immediate 50 basis point increase in the yield curve:
Change limit (no worse than) ................................................................. (8)
Calculated change in net market value ........................................................ 8
Change resulting from an immediate 100 basis point increase in the yield curve:
Change limit (no worse than) ................................................................. (12)
Calculated change in net market value ........................................................ 14
Economic Value of MSRs
The economic value of the net, hedged MSRs portfolio is monitored on a daily
basis for interest rate sensitivity. If the economic value declines by more than
established limits for one day or one month, various levels of management
review, intervention and/or corrective actions are required.
72
Hedge Volatility
The following table summarized the frequency distribution of the weekly economic
value of the MSR asset during calendar year 2005. This includes the change in
the market value of the MSR asset net of changes in the market value of the
underlying hedging positions used to hedge the asset. The changes in economic
value are adjusted for changes in MSR valuation assumptions that were made
during the course of the year.
--------------------------------------------------------------------------------------------------------------------
Ranges of mortgage economic value from Below $(2) to $0 to $2 to Over
market risk-related activities (in millions) $(2) $0 $2 $4 $4
--------------------------------------------------------------------------------------------------------------------
Number of trading weeks market risk-related
revenue was within the stated range .................. 7 16 14 10 5
Operational Risk
Operational risk is the risk of loss arising through fraud, unauthorized
activities, error, omission, inefficiency, system failure or from external
events. It is inherent in every business organization and covers a wide spectrum
of issues.
HUSI has established an independent Operational Risk Management discipline. The
Operational Risk Management Committee, chaired by the Executive Vice
President-Operations and including the Chief Risk Officer, is responsible for
oversight of the operational risks being taken, the analytic tools used to
monitor those risks, and reporting. Results from this Committee are communicated
to the Risk Management Committee and subsequently to the Audit Committee of the
Board of Directors. Business unit line management is responsible for managing
and controlling all risks and for communicating and implementing all control
standards. A Corporate Operational Risk Coordinator provides functional
oversight by coordinating the following activities:
o maintaining a network of business line Operational Risk Coordinators;
o developing scoring and risk assessment tools and databases;
o providing training and developing awareness; and
o independently reviewing and reporting the assessments of operational
risks.
Management of operational risk includes identification, assessment, monitoring,
control and mitigation, rectification and reporting of the results of risk
events and compliance with local regulatory requirements. These key components
of the Operational Risk Management process have been communicated by issuance of
a high level standard. Key features within the standard that have been addressed
in HUSI's Operational Risk Management program include:
o each business and support department is responsible for the identification
and management of their operational risks;
o each risk is evaluated and scored by its likelihood to occur; its
potential impact on shareholder value; and by exposure-based on the
effectiveness of current controls to prevent or mitigate losses. An
operational risk automated database is used to record risk assessments and
track risk mitigation action plans. The risk assessments are reviewed at
least annually, or as business conditions change;
o key risk indicators are established where appropriate, and
monitored/tracked; and
o the database is also used to track operational losses for analysis of root
causes, comparison with risk assessments and lessons learned.
Management practices include standard monthly reporting to business line
managers, senior management and the Operational Risk Management Committee of
high risks, risk mitigation action plan exceptions, losses and key risk
indicators. Monthly certification of internal controls includes an operational
risk attestation. Operational Risk Management is an integral part of the new
product development process and the management performance measurement process.
An online certification process, attesting to the completeness and accuracy of
operational risk, is completed by senior business management on an annual basis.
73
Analysis of primary types of operational risks reflects a 70% concentration in
process risk. The remaining 30% is divided fairly equally between the other
three primary operational risk types - systems, people and external events. The
same percent distribution of primary operational risk types applies for the
higher or more critical operational risks. Within the process risk type, greater
than 80% of risk is concentrated within internal and external reporting and
payment/settlement/delivery risk.
Internal audits, including audits by specialist teams in information technology
and treasury, provide an important check on controls and test institutional
compliance with the Operational Risk Management policy.
An annual review of internal controls is conducted by internal audit as part of
HUSI's compliance with the Federal Deposit Insurance Corporation Improvement Act
(FDICIA) and its comprehensive examination and documentation of controls across
HUSI involving all business and support units.
Compliance Risk
Compliance Risk is the risk arising from failure to comply with relevant laws,
regulations, and regulatory requirements governing the conduct of specific
businesses. It is a composite risk that can result in regulatory sanctions,
financial penalties, litigation exposure and loss of reputation. Compliance risk
is inherent throughout the HUSI organization.
Consistent with HSBC's commitment to ensure adherence with applicable regulatory
requirements for all of its world-wide affiliates, HUSI has implemented a
multi-faceted Compliance Risk Management Program. This program addresses the
following priorities, among other issues:
o anti-money laundering (AML) regulations;
o fair lending laws;
o dealings with affiliates;
o the Community Reinvestment Act;
o permissible activities; and
o conflicts of interest.
Oversight of the Compliance Risk Management Program is provided by the Audit
Committee of the Board of Directors through the Risk Management Committee and
its Compliance Risk Management Subcommittee. This subcommittee is chaired by the
Chief Executive Officer and comprised of representatives from key business and
support areas having significant compliance risk, the Chief Risk Officer, the
General Counsel and executive compliance management. It was established in 2004
and is responsible for overseeing the effectiveness of the overall compliance
program and providing counsel to line and compliance management on major
potential issues, strategic policy-making decisions and reputational risk
matters. Group Audit USA, through continuous monitoring and periodic internal
audits, tests the effectiveness of the overall Compliance Risk Management
Program.
The independent Corporate Compliance function is comprised of separate Corporate
Compliance units focusing on General Compliance and Anti-Money Laundering (AML)
compliance, as well as various compliance teams supporting specific business
units. The Corporate Compliance function is responsible for the following
activities:
o advising management on compliance matters;
o providing independent assessment and monitoring; and
o reporting compliance issues to HUSI senior management and Board of
Directors, as well as to HSBC Group Compliance.
74
The overall Corporate Compliance program elements include identification,
assessment, monitoring, control and mitigation of the risk and timely resolution
of the results of risk events. These functions are generally performed by line
management, with oversight provided by Corporate Compliance. Controls for
mitigating compliance risk are incorporated into business operating policies and
procedures. Processes are in place to ensure controls are appropriately updated
to reflect changes in regulatory requirements as well as changes in business
practices, including new or revised products, services and marketing programs. A
wide range of compliance training is provided to relevant staff, including
mandated programs for such areas as anti-money laundering, fair lending and
privacy.
HUSI took the following steps during 2004 and 2005 to enhance its Corporate
Compliance program:
o compliance staffing was significantly increased to accommodate expansion
of compliance monitoring and testing and to respond to the changing
regulatory requirements and business strategies;
o independent AML and General Compliance teams were enhanced to support
existing and new business initiatives;
o the Corporate Compliance function created a new centralized compliance
testing unit to supplement testing performed by the business compliance
teams. This testing unit conducts AML testing throughout HUSI as well as
certain general compliance testing programs;
o new AML procedures were written and implemented for each business unit;
o an automated transaction monitoring program was implemented within retail
banking and existing transaction monitoring systems enhanced for private
and correspondent banking and assessments performed for the purpose of
implementing further automated monitoring tools;
o the existing Operational Risk methodology was leveraged to develop a new
compliance self-assessment tool for business units. A common database is
used for compliance, operational and fiduciary risk management; and
o initial business Compliance Self Assessments were completed by all
businesses in 2004 and the self assessment program was further expanded
and modified in 2005 to include additional regulatory requirements and
further development of key risk indicators.
Fiduciary Risk
Fiduciary risk is the risk associated with offering services honestly and
properly to clients in a fiduciary capacity in accordance with Regulation 12 CFR
9, Fiduciary Activity of National Banks. Fiduciary capacity is defined in the
regulation as:
o serving traditional fiduciary duties such as trustee, executor,
administrator, registrar of stocks and bonds, guardian, receiver or
assignee, or
o providing investment advice for a fee, or
o processing investment discretion on behalf of another.
Fiduciary risks reside in Private Banking businesses (including Investment
Management, Personal Trust, Custody, Trust Operations) and in several other
business lines outside of Private Banking (including Retirement Financial
Services, Corporate Trust and Asset Management). These risks almost always occur
where HUSI is entrusted to handle and execute client business affairs and
transactions in a fiduciary capacity. HUSI's policies and procedures for
addressing fiduciary risks generally address various risk categories including
suitability, conflicts, fairness, disclosure, fees, AML, operational,
safekeeping, efficiencies, etc.
75
Oversight for the Fiduciary Risk Management function falls to the Fiduciary Risk
Management Committee of the Risk Management Committee. This committee is chaired
by the Senior Executive Vice President - Private Banking and Wealth Management
and includes the Chief Risk Officer and the Senior Vice President - Fiduciary
Risk. The Senior Vice President - Fiduciary Risk is responsible for an
independent Fiduciary Risk Management Unit that is responsible for day to day
oversight of the Fiduciary Risk Management function. The main goals and
objectives of this unit include:
o development and implementation of control self assessments, which have
been completed for all fiduciary businesses;
o developing, tracking and collecting rudimentary key risk indicators (KRI),
and collecting data regarding errors associated with these risks. KRIs for
each fiduciary business are in the process of being expanded;
o designing, developing and implementing risk monitoring tools, approaches
and programs for the relevant business lines and senior management that
will facilitate the identification, evaluation, monitoring, measurement,
management and reporting of fiduciary risks. In this regard, a common
database is used for compliance, operational and fiduciary risks; and
o ongoing development and implementation of more robust and enhanced key
risk indicator/key performance indicator process with improved risk
focused reporting.
Business Continuity Planning
HUSI is committed to the protection of employees, customers and shareholders by
a quick response to all threats to the organization, whether they are of a
physical or financial nature. For this purpose, HUSI has established a Business
Continuity Event Management (EM) process. EM provides an enterprise-wide
response and communication framework for managing major business continuity
events or incidents. It is designed to be flexible and is scaled to the scope
and magnitude of the event or incident.
The EM process works in tandem with HUSI's business continuity policy, plans and
key business continuity committees to manage events. HUSI's Crisis Management
Committee, a 24/7 standing committee, is activated to manage the EM process in
concert with senior HUSI management. This committee provides critical strategic
and tactical management of business continuity crisis issues, risk management,
communication, coordination and recovery management. HUSI also has designated an
Institutional Manager for Business Continuity who plays a key role on the Crisis
Management Committee. All major business and support functions have a senior
representative assigned to HUSI's Business Continuity Planning Committee chaired
by the Institutional Manager.
HUSI has dedicated certain work areas as hot and warm backup sites, which serve
as primary business recovery locations. HUSI also has concentrations of major
operations in both upstate and downstate New York. This geographic split of
major operations is leveraged to provide secondary business recovery sites for
many critical business and support areas of HUSI.
HUSI has built its own data center with the intention of developing the highest
level of resiliency for disaster recovery as defined by industry standards. Data
is mirrored synchronously to the disaster recovery site across duplicate dark
fiber loops. A high level of network backup resiliency has been established. In
a disaster situation, HUSI is positioned to bring main systems and server
applications online within predetermined timeframes.
HUSI tests business continuity and disaster recovery resiliency and capability
through routine contingency tests and actual events. Business continuity and
disaster recovery programs have been strengthened in numerous areas as a result
of these tests or actual events. There is a continuing effort to enhance the
program well beyond the traditional business resumption and disaster recovery
model.
In 2003, HUSI determined the applicability of the Interagency Paper on "Sound
Practices to Strengthen the Resiliency of the U.S. Financial System". HUSI is
committed to meeting or exceeding the requirements of the paper for the
businesses impacted by the compliance due date.
76
Glossary of Terms
--------------------------------------------------------------------------------
Cost/Income Ratio - Ratio of total operating expenses, reduced by minority
interests and certain non-recurring expense items, to the sum of net interest
income and other revenues.
Federal Reserve - the Federal Reserve Board; the principal regulator for HUSI.
Global Bank Note Program - $20 billion note program, under which HBUS issues
senior and subordinated debt.
Goodwill - Represents the purchase price over the fair value of identifiable
assets acquired, reduced by liabilities assumed, for business combinations.
HBUS - HSBC Bank USA, National Association; a wholly-owned U.S. banking
subsidiary of HUSI.
HMUS - HSBC Markets (USA) Inc.; an indirect wholly-owned subsidiary of HNAH
which provides investment banking and brokerage services.
HNAH - HSBC North America Holdings Inc.; a wholly-owned subsidiary of HSBC and
HSBC's top-tier bank holding company in North America.
HNAI - HSBC North America Inc.; an indirect wholly-owned subsidiary of HNAH.
HSBC - HSBC Holdings plc.; HNAH's U.K. parent company.
HSBC Affiliate - any direct or indirect subsidiary of HSBC outside of the HUSI
consolidated group of entities.
HSBC Finance Corporation - an indirect wholly-owned finance company subsidiary
of HNAH.
HTSU - HSBC Technology & Services (USA) Inc.; an indirect wholly-owned
subsidiary of HNAH which provides information technology services to all
subsidiaries of HNAH and to other subsidiaries of HSBC.
HUSI - HSBC USA Inc.; the registrant, and a wholly-owned subsidiary of HNAI.
Intangible Assets - Assets (not including financial assets) that lack physical
substance. HUSI's acquired intangible assets include mortgage servicing rights
and favorable lease arrangements.
Mortgage Servicing Rights - Intangible assets representing the right to service
mortgage loans, which are recognized at the time the related loans are sold or
the rights are acquired.
Net Interest Margin to Earning Assets - Net interest income divided by average
interest earning assets for a given period.
Net Interest Margin to Total Assets - Net interest income divided by average
total assets for a given period.
Nonaccruing Loans - Loans for which interest is no longer accrued because
ultimate collection is unlikely.
OCC - the Office of the Comptroller of the Currency; the principal regulator for
HBUS.
Private Label Loan Portfolio - Loan and credit card receivable portfolio
acquired from HSBC Finance Corporation on December 29, 2004.
Rate of Return on Common Shareholder's Equity - Net income, reduced by preferred
dividends, divided by average common shareholder's equity for a given period.
77
Rate of Return on Total Assets - Net income after taxes divided by average total
assets for a given period.
SEC - The Securities and Exchange Commission.
Total Average Shareholders' Equity to Total Assets - Average total shareholders'
equity divided by average total assets for a given period.
Total Period End Shareholders' Equity to Total Assets - Total shareholders'
equity divided by total assets as of a given date.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
--------------------------------------------------------------------------------
Refer to the disclosure in Item 7 of the Management's Discussion and Analysis of
Financial Condition and Results of Operations under the captions "Interest Rate
Risk Management" and "Trading Activities".
78
CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES - THREE YEARS
The following table shows the average balances of the principal components of
assets, liabilities and shareholders' equity, together with their respective
interest amounts and rates earned or paid on a taxable equivalent basis.
2005
----------------------------------------
Balance Interest Rate*
------------------------------------------------------------------------------------------------------------------------
Assets
Interest bearing deposits with banks ................................. $ 3,577 $ 120 3.35%
Federal funds sold and securities purchased under resale agreements .. 5,481 191 3.48
Trading assets ....................................................... 7,029 275 3.91
Securities ........................................................... 19,024 899 4.73
Loans
Commercial ....................................................... 23,814 1,233 5.18
Consumer
Residential mortgages ....................................... 47,092 2,321 4.93
Credit cards ................................................ 13,455 812 6.04
Other consumer .............................................. 3,537 264 7.46
--------- --------- ---------
Total consumer ................................................. 64,084 3,397 5.30
--------- --------- ---------
Total loans .................................................... 87,898 4,630 5.27
--------- --------- ---------
Other ................................................................ 624 32 5.13
--------- --------- ---------
Total earning assets ................................................. 123,633 $ 6,147 4.97%
--------- --------- ---------
Allowance for credit losses .......................................... (910)
Cash and due from banks .............................................. 3,717
Other assets ......................................................... 20,736
---------
Total assets ......................................................... $ 147,176
=========
Liabilities and Shareholders' Equity
Deposits in domestic offices
Savings deposits ................................................... $ 28,571 $ 318 1.11%
Other time deposits ................................................ 25,146 822 3.27
Deposits in foreign offices
Foreign banks deposits ............................................. 8,440 277 3.28
Other time and savings ............................................. 14,173 354 2.50
--------- --------- ---------
Total interest bearing deposits ...................................... 76,330 1,771 2.32
--------- --------- ---------
Short-term borrowings ................................................ 11,494 276 2.40
Long-term debt ....................................................... 24,648 1,019 4.13
--------- --------- ---------
Total interest bearing liabilities ................................... 112,472 3,066 2.73
--------- --------- ---------
Net interest income / Interest rate spread $ 3,081 2.24%
--------- ----------
Noninterest bearing deposits ......................................... 9,193
Other liabilities .................................................... 13,957
Total shareholders' equity ........................................... 11,554
---------
Total liabilities and shareholders' equity ........................... $ 147,176
=========
Net yield on average earning assets .................................. 2.49%
---------
Net yield on average total assets .................................... 2.09%
=========
* Rates are calculated on unrounded numbers.
Total weighted average rate earned on earning assets is interest and fee
earnings divided by daily average amounts of total interest earning assets,
including the daily average amount on nonperforming loans. Loan interest
included fees of $47 million for 2005, $78 million for 2004 and $68 million for
2003.
79
2004 2003
------------------------------ ----------------------------
Balance Interest Rate* Balance Interest Rate*
--------------------------------------------------------------
Assets (in millions)
Interest bearing deposits with banks ................. $ 2,499 $ 41 1.66% $ 1,682 $ 25 1.46%
Federal funds sold and securities purchased under
resale agreements..................................... 4,682 74 1.58 4,521 55 1.22
Trading assets ....................................... 5,685 165 2.90 4,659 137 2.93
Securities ........................................... 18,224 885 4.86 19,051 908 4.76
Loans
Commercial ....................................... 19,747 831 4.21 19,893 931 4.68
Consumer
Residential mortgages ....................... 37,134 1,831 4.93 21,324 1,178 5.53
Credit cards ................................ 1,216 107 8.80 1,116 112 10.05
Other consumer .............................. 2,231 143 6.40 1,854 129 6.96
--------- -------- ------ --------- -------- ------
Total consumer ................................. 40,581 2,081 5.13 24,294 1,419 5.84
--------- -------- ------ --------- -------- ------
Total loans .................................... 60,328 2,912 4.83 44,187 2,350 5.32
--------- -------- ------ --------- -------- ------
Other ................................................ 533 18 3.46 482 20 4.28
--------- -------- ------ --------- -------- ------
Total earning assets ................................. 91,951 $ 4,095 4.45% 74,582 $ 3,495 4.69%
--------- -------- ------ --------- -------- ------
Allowance for credit losses .......................... (359) (476)
Cash and due from banks .............................. 3,276 2,513
Other assets ......................................... 17,358 15,206
--------- ---------
Total assets ......................................... $ 112,226 $ 91,825
========= =========
Liabilities and Shareholders' Equity
Deposits in domestic offices
Savings deposits ................................... $ 27,224 $ 179 0.66% $ 24,822 $ 189 0.76%
Other time deposits ................................ 16,081 365 2.27 10,691 223 2.09
Deposits in foreign offices
Foreign banks deposits ............................. 7,162 107 1.49 3,264 47 1.45
Other time and savings ............................. 14,737 174 1.18 16,226 207 1.27
--------- -------- ------ --------- -------- ------
Total interest bearing deposits ...................... 65,204 825 1.27 55,003 666 1.21
--------- -------- ------ --------- -------- ------
Short-term borrowings ................................ 9,320 132 1.42 8,885 91 1.03
Long-term debt ....................................... 9,655 380 3.93 3,738 206 5.50
--------- -------- ------ --------- -------- ------
Total interest bearing liabilities ................... 84,179 1,337 1.59 67,626 963 1.42
--------- -------- ------ --------- -------- ------
Net interest income / Interest rate spread $ 2,758 2.86% $ 2,532 3.27%
-------- ------ -------- ------
Noninterest bearing deposits ......................... 7,649 6,464
Other liabilities .................................... 12,341 10,203
Total shareholders' equity ........................... 8,057 7,532
--------- ---------
Total liabilities and shareholders' equity ........... $ 112,226 $ 91,825
========= =========
Net yield on average earning assets .................. 3.00% 3.39%
------ ------
Net yield on average total assets .................... 2.46% 2.76%
====== ======
80
Item 8. Financial Statements and Supplementary Data
--------------------------------------------------------------------------------
Page
Report of Independent Registered Public Accounting Firm ................. 82
HSBC USA Inc.:
Consolidated Statement of Income ................................. 83
Consolidated Balance Sheet ....................................... 84
Consolidated Statement of Changes in Shareholders' Equity ........ 85
Consolidated Statement of Cash Flows ............................. 86
HSBC Bank USA, National Association:
Consolidated Balance Sheet ....................................... 87
Notes to Consolidated Financial Statements .............................. 88
81
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of
HSBC USA Inc.:
We have audited the accompanying consolidated balance sheets of HSBC USA Inc.
and subsidiaries (the Company) as of December 31, 2005 and 2004, and the related
consolidated statements of income, changes in shareholders' equity, and cash
flows for each of the years in the three-year period ended December 31, 2005,
and the accompanying consolidated balance sheets of HSBC Bank USA, National
Association and subsidiaries (the Bank) as of December 31, 2005 and 2004. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of the Company as of
December 31, 2005 and 2004, and the results of their operations and their cash
flows for each of the years in the three-year period ended December 31, 2005,
and the financial position of the Bank as of December 31, 2005 and 2004, in
conformity with United States generally accepted accounting principles.
/s/ KPMG LLP
New York, New York
March 3, 2006
82
HSBC USA Inc.
--------------------------------------------------------------------------------
CONSOLIDATED STATEMENT OF INCOME
Year Ended December 31, 2005 2004 2003
------------------------------------------------------------------------------------------------------------------------
(in millions)
Interest income:
Loans ........................................................ $ 4,630 $ 2,912 $ 2,350
Securities ................................................... 882 868 887
Trading assets ............................................... 275 165 136
Short-term investments ....................................... 310 115 80
Other ........................................................ 32 18 20
------------ ------------ ------------
Total interest income ............................................ 6,129 4,078 3,473
------------ ------------ ------------
Interest expense:
Deposits ..................................................... 1,771 825 666
Short-term borrowings ........................................ 276 132 91
Long-term debt ............................................... 1,019 380 206
------------ ------------ ------------
Total interest expense ........................................... 3,066 1,337 963
------------ ------------ ------------
Net interest income .............................................. 3,063 2,741 2,510
Provision (credit) for credit losses ............................. 674 (17) 113
------------ ------------ ------------
Net interest income after provision for credit losses ............ 2,389 2,758 2,397
------------ ------------ ------------
Other revenues:
Trust income ................................................. 87 95 94
Service charges .............................................. 210 213 212
Other fees and commissions ................................... 698 425 446
Securitization revenue ....................................... 114 -- --
Other income ................................................. 237 333 165
Residential mortgage banking revenue (expense) ............... 64 (120) (102)
Trading revenues ............................................. 395 288 291
Security gains, net .......................................... 106 85 48
------------ ------------ ------------
Total other revenues ............................................. 1,911 1,319 1,154
------------ ------------ ------------
Operating expenses:
Salaries and employee benefits ............................... 1,052 947 1,138
Occupancy expense, net ....................................... 182 176 165
Support services from HSBC affiliates ........................ 919 420 160
Other expenses ............................................... 605 558 577
------------ ------------ ------------
Total operating expenses ......................................... 2,758 2,101 2,040
------------ ------------ ------------
Income before income tax expense ................................. 1,542 1,976 1,511
Income tax expense ............................................... 566 718 570
------------ ------------ ------------
Net income ....................................................... $ 976 $ 1,258 $ 941
============ ============ ============
The accompanying notes are an integral part of the consolidated financial
statements.
83
HSBC USA Inc.
--------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEET
December 31, 2005 2004
------------------------------------------------------------------------------------------------------------------------
(in millions)
Assets
Cash and due from banks .................................................. $ 4,441 $ 2,682
Interest bearing deposits with banks ..................................... 3,001 2,776
Federal funds sold and securities purchased under resale agreements ...... 4,568 3,126
Trading assets ........................................................... 21,220 19,815
Securities available for sale ............................................ 17,764 14,655
Securities held to maturity (fair value $3,262 and $4,042) ............... 3,171 3,881
Loans .................................................................... 90,342 84,947
Less - allowance for credit losses ....................................... 846 788
------------ ------------
Loans, net ......................................................... 89,496 84,159
------------ ------------
Properties and equipment, net ............................................ 538 594
Intangible assets, net ................................................... 463 352
Goodwill ................................................................. 2,694 2,697
Other assets ............................................................. 6,503 6,313
------------ ------------
Total assets ............................................................. $ 153,859 $ 141,050
============ ============
Liabilities
Deposits in domestic offices:
Noninterest bearing .................................................... $ 9,695 $ 7,639
Interest bearing ....................................................... 57,911 50,069
Deposits in foreign offices:
Noninterest bearing .................................................... 320 248
Interest bearing ....................................................... 23,889 22,025
------------ ------------
Total deposits ..................................................... 91,815 79,981
------------ ------------
Trading account liabilities .............................................. 10,710 12,120
Short-term borrowings .................................................... 7,049 9,874
Interest, taxes and other liabilities .................................... 4,732 4,370
Long-term debt ........................................................... 27,959 23,839
------------ ------------
Total liabilities ........................................................ 142,265 130,184
------------ ------------
Shareholders' equity
Preferred stock .......................................................... 1,316 500
Common shareholder's equity:
Common stock ($5 par; 150,000,000 shares authorized;
706 shares issued) ............................... --(1) --(1)
Capital surplus ........................................................ 8,118 8,418
Retained earnings ...................................................... 2,172 1,917
Accumulated other comprehensive (loss) income .......................... (12) 31
------------ ------------
Total common shareholder's equity .................................. 10,278 10,366
------------ ------------
Total shareholders' equity ............................................... 11,594 10,866
------------ ------------
Total liabilities and shareholders' equity ............................... $ 153,859 $ 141,050
============ ============
The accompanying notes are an integral part of the consolidated financial
statements.
(1) Less than $500 thousand
84
HSBC USA Inc.
--------------------------------------------------------------------------------
CONSOLIDATED STATEMENT OF CHANGES
IN SHAREHOLDERS' EQUITY
2005 2004 2003
-----------------------------------------------------------------------------------------------------------------------
(in millions)
Preferred stock
Balance, January 1, ........................................................ $ 500 $ 500 $ 500
Preferred stock issuances, net of redemptions .............................. 816 -- --
---------- --------- ---------
Balance, December 31, ...................................................... 1,316 500 500
Common stock
Balance, January 1 and December 31, ........................................ --(1) --(1) --(1)
---------- --------- ---------
Capital surplus
Balance, January 1, ........................................................ 8,418 6,027 6,056
Capital contribution from parent ........................................... 3 2,411 15
Preferred stock issuance costs ............................................. (22) -- --
Employee benefit plans, including transfers and other ...................... (281) (20) (44)
---------- --------- ---------
Balance, December 31, ...................................................... 8,118 8,418 6,027
---------- --------- ---------
Retained earnings
Balance, January 1, ........................................................ 1,917 807 578
Net income ................................................................. 976 1,258 941
Cash dividends declared:
Preferred stock ............................................................ (46) (23) (22)
Common stock ............................................................... (675) (125) (690)
---------- --------- ---------
Balance, December 31, ...................................................... 2,172 1,917 807
---------- --------- ---------
Accumulated other comprehensive (loss) income
Balance, January 1, ........................................................ 31 128 262
Net change in unrealized (losses) gains on securities ...................... (149) (40) (175)
Net change in unrealized (losses) gains on derivatives classified as cash
flow hedges ................................................................ 104 (58) 11
Net change in unrealized gains on interest-only strip receivables .......... 7 -- --
Foreign currency translation adjustments ................................... (5) 1 30
---------- --------- ---------
Other comprehensive loss, net of tax ....................................... (43) (97) (134)
---------- --------- ---------
Balance, December 31, ...................................................... (12) 31 128
---------- --------- ---------
Total shareholders' equity, December 31, ................................... $ 11,594 $ 10,866 $ 7,462
========== ========= =========
Comprehensive income
Net income ................................................................. $ 976 $ 1,258 $ 941
Other comprehensive loss ................................................... (43) (97) (134)
---------- --------- ---------
Comprehensive income ....................................................... $ 933 $ 1,161 $ 807
========== ========= =========
The accompanying notes are an integral part of the consolidated financial
statements.
(1) Less than $500 thousand
85
HSBC USA Inc.
--------------------------------------------------------------------------------
CONSOLIDATED STATEMENT OF CASH FLOWS
Year Ended December 31, 2005 2004 2003
------------------------------------------------------------------------------------------------------------------------
(in millions)
Cash flows from operating activities
Net income ................................................................ $ 976 $ 1,258 $ 941
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation, amortization and deferred taxes ........................ 762 459 399
Provision (credit) for credit losses ................................. 674 (17) 113
Net change in other accrual accounts ................................. 1,021 (66) (960)
Net change in loans held for sale .................................... (2,775) (423) 1,033
Net change in trading assets and liabilities ......................... (2,390) (2,974) 448
Other, net ........................................................... (602) (623) (485)
-------- -------- --------
Net cash (used in) provided by operating activities ............. (2,334) (2,386) 1,489
-------- -------- --------
Cash flows from investing activities
Net change in interest bearing deposits with banks ........................ (355) (2,126) (396)
Net change in short-term investments ...................................... (1,441) (909) 494
Net change in securities available for sale:
Purchases of securities available for sale ........................... (12,301) (11,306) (13,827)
Proceeds from sales of securities available for sale ................. 4,053 6,129 3,637
Proceeds from maturities of securities available for sale ............ 4,273 5,578 10,752
Net change in securities held to maturity:
Purchases of securities held to maturity ............................. (694) (1,190) (2,678)
Proceeds from maturities of securities held to maturity .............. 1,412 1,826 3,004
Net change in loans:
Originations, net of collections ..................................... 19,161 (21,044) (2,972)
Loans purchased from HSBC Finance Corporation ........................ (23,106) (16,227) (2,847)
Sales of loans and other ............................................. 146 466 669
Net change in tax refund anticipation loans program:
Originations of loans ................................................ (24,300) -- --
Sales of loans to HSBC Finance Corporation, including premium ........ 24,319 -- --
Net cash provided by (used for) sales (acquistions) of properties and
equipment ................................................................. 13 (29) (65)
Net cash provided by (used for) acquisitions (disposals) of
branches/subsidiaries ..................................................... (90) 196 403
Other, net ................................................................ (512) (849) (366)
-------- -------- --------
Net cash used in investing activities ........................... (9,422) (39,485) (4,192)
-------- -------- --------
Cash flows from financing activities
Net change in deposits .................................................... 11,900 17,030 4,405
Net change in short-term borrowings ....................................... (2,825) 3,333 (661)
Net change in long-term debt:
Issuance of long-term debt ........................................... 5,062 20,481 271
Repayment of long-term debt .......................................... (706) (1,068) (118)
Preferred stock issuance, net of redemptions .............................. 816 -- --
Capital contribution from parent .......................................... 3 2,411 15
Other reductions of capital surplus ....................................... (24) (20) (44)
Dividends paid ............................................................ (711) (148) (712)
-------- -------- --------
Net cash provided by financing activities ....................... 13,515 42,019 3,156
-------- -------- --------
Net change in cash and due from banks ......................................... 1,759 148 453
Cash and due from banks at beginning of year .................................. 2,682 2,534 2,081
-------- -------- --------
Cash and due from banks at end of year ........................................ $ 4,441 $ 2,682 $ 2,534
======== ======== ========
Cash paid for: Interest ....................................................... $ 2,892 $ 1,195 $ 990
Income taxes ................................................... 566 569 331
The accompanying notes are an integral part of the consolidated financial
statements.
Pending settlement receivables/payables related to securities and trading assets
and liabilities are treated as non-cash items for cash flow reporting.
86
HSBC Bank USA, National Association
--------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEET
December 31, 2005 2004
------------------------------------------------------------------------------------------------------------------------
(in millions)
Assets
Cash and due from banks .......................................................... $ 4,440 $ 2,624
Interest bearing deposits with banks ............................................. 2,917 2,701
Federal funds sold and securities purchased under resale agreements .............. 4,562 3,123
Trading assets ................................................................... 19,807 19,240
Securities available for sale .................................................... 17,548 14,547
Securities held to maturity (fair value $3,126 and $3,880) ....................... 3,044 3,730
Loans ............................................................................ 90,214 84,418
Less - allowance for credit losses ............................................... 845 787
---------- ----------
Loans, net ................................................................. 89,369 83,631
---------- ----------
Properties and equipment, net .................................................... 536 591
Intangible assets, net ........................................................... 462 350
Goodwill ......................................................................... 2,090 2,092
Other assets ..................................................................... 5,904 5,679
---------- ----------
Total assets ..................................................................... $ 150,679 $ 138,308
========== ==========
Liabilities
Deposits in domestic offices:
Noninterest bearing ............................................................ $ 9,657 $ 7,589
Interest bearing ............................................................... 57,911 50,069
Deposits in foreign offices:
Noninterest bearing ............................................................ 320 249
Interest bearing ............................................................... 27,160 23,372
---------- ----------
Total deposits ............................................................. 95,048 81,279
---------- ----------
Trading account liabilities ...................................................... 10,644 12,075
Short-term borrowings ............................................................ 4,066 7,305
Interest, taxes and other liabilities ............................................ 4,121 3,985
Long-term debt ................................................................... 24,912 22,279
---------- ----------
Total liabilities ................................................................ 138,791 126,923
---------- ----------
Shareholder's equity
Common shareholder's equity:
Common stock ($100 par; 50,000 shares authorized;
20,004 and 20,002 shares issued) .................................. 2 2
Capital surplus ................................................................ 9,709 9,527
Retained earnings .............................................................. 2,192 1,851
Accumulated other comprehensive (loss) income .................................. (15) 5
---------- ----------
Total shareholder's equity ....................................................... 11,888 11,385
---------- ----------
Total liabilities and shareholder's equity ....................................... $ 150,679 $ 138,308
========== ==========
87
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Organization
--------------------------------------------------------------------------------
HSBC USA Inc. is a New York State based bank holding company, and an indirect
wholly owned subsidiary of HSBC North America Holdings Inc. (HNAH). HSBC USA
Inc. and its subsidiaries are collectively referred to as "HUSI".
HNAH is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC).
Effective January 1, 2004, HSBC created a new North American organizational
structure, HNAH, as the top-tier bank holding company parent. HUSI routinely
conducts transactions in the normal course of business with HNAH's other
principal direct and indirect subsidiaries, which include:
o HSBC Finance Corporation, a consumer finance company;
o HSBC Bank USA, National Association (HBUS), HUSI's principal banking
subsidiary;
o HSBC Bank Canada (HBCA), a Canadian banking subsidiary;
o HSBC Markets (USA) Inc. (HMUS), a holding company for investment banking
and markets subsidiaries in the U.S.; and
o HSBC Technology & Services (USA) Inc. (HTSU), a provider of information
technology services for other HNAH subsidiaries.
On July 1, 2004, HUSI consolidated its then existing banking operations under a
single national charter, following approval from the Office of the Comptroller
of the Currency (the OCC).
Note 2. Summary of Significant Accounting Policies and New Accounting
Pronouncements
--------------------------------------------------------------------------------
Significant Accounting Policies
Basis of Presentation
The accounting and reporting policies of HUSI conform to accounting principles
generally accepted in the United States of America (U.S. GAAP) and to
predominant practice within the banking industry. The preparation of financial
statements in conformity with U.S. GAAP requires the use of estimates and
assumptions that affect reported amounts in the financial statements and
accompanying notes. Actual results could differ from those estimates. Certain
reclassifications have been made to prior year amounts to conform to current
year presentation.
Principles of Consolidation
The consolidated financial statements include the accounts of HUSI and its
subsidiaries. HUSI consolidates subsidiaries in which it holds, directly or
indirectly, more than 50% of the voting rights, or where it exercises control.
HUSI also consolidates all variable interest entities in which it is the primary
beneficiary as defined by Financial Accounting Standards Board Interpretation
No. 46 (Revised). Unaffiliated trusts to which HUSI has transferred securitized
receivables which are qualifying special purpose entities (QSPEs), as defined by
Statement of Financial Accounting Standards No. 140, Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities, are not
consolidated. All material intercompany accounts and transactions have been
eliminated. Investments in companies in which the percentage of ownership is at
least 20%, but not more than 50%, are generally accounted for as equity method
investments and reported in other assets.
88
Foreign Currency Translation
The accounts of HUSI's foreign operations are measured using local currency as
the functional currency. Assets and liabilities are translated into United
States dollars at the rate of exchange in effect on the balance sheet date.
Income and expenses are translated at average monthly exchange rates. Net
exchange gains or losses resulting from such translation are included in common
shareholder's equity as a component of accumulated other comprehensive income.
Foreign currency denominated transactions in other than the local functional
currency are translated using the period end exchange rate with any foreign
currency transaction gain or loss recognized currently in income.
Resale and Repurchase Agreements
HUSI purchases securities under agreements to resell (resale agreements) and
sells securities under agreements to repurchase (repurchase agreements). Resale
agreements and repurchase agreements are generally accounted for as secured
lending and secured borrowing transactions respectively.
The amounts advanced under resale agreements and the amounts borrowed under
repurchase agreements are carried on the consolidated balance sheet at the
amount advanced or borrowed, plus accrued interest to date. Interest earned on
resale agreements is reported as interest income. Interest paid on repurchase
agreements is reported as interest expense. HUSI offsets resale and repurchase
agreements executed with the same counterparty under legally enforceable netting
agreements that meet the applicable netting criteria as permitted by U.S. GAAP.
Repurchase agreements may require HUSI to deposit cash or other collateral with
the lender. In connection with resale agreements, it is the policy of HUSI to
obtain possession of collateral, which may include the securities purchased,
with market value in excess of the principal amount loaned. The market value of
the collateral subject to the resale and repurchase agreements is regularly
monitored, and additional collateral is obtained or provided when appropriate,
to ensure appropriate collateral coverage of these secured financing
transactions.
Securities
Debt securities that HUSI has the ability and intent to hold to maturity are
reported at cost, adjusted for amortization of premiums and accretion of
discounts which are recognized as adjustments to yield over the expected lives
of the related securities. Securities acquired principally for the purpose of
selling them in the near term are classified as trading assets and reported at
fair value, with unrealized gains and losses included in earnings. Investments
in Federal Home Loan Bank and Federal Reserve Bank stock are reported at cost in
other assets. All other securities are classified as available for sale and
carried at fair value, with unrealized gains and losses, net of related income
taxes, recorded as adjustments to common shareholder's equity as a component of
accumulated other comprehensive income.
The fair value of securities is based on current market quotations where
available, or internal valuation models that approximate market pricing. The
validity of internal pricing models is regularly substantiated by reference to
actual market prices realized upon sale or liquidation of these instruments.
Realized gains and losses on sales of securities not classified as trading
assets are computed on a specific identified cost basis and are reported in
other revenues as security gains, net. Adjustments to fair value of trading
assets, as well as gains and losses on the sale of such securities, are reported
in other revenues as trading revenues. HUSI regularly evaluates its securities
to identify losses in fair value that are considered other than temporary. Any
decline in the fair value of investments which is deemed to be other than
temporary is charged against current earnings in other revenues and a new cost
basis is established for the security.
Loans
Loans are stated at their amortized cost, which represents the principal amount
outstanding, net of unearned income, charge offs, unamortized purchase premium
or discount, unamortized nonrefundable fees and related direct loan origination
costs and purchase accounting fair value adjustments. Loans are further reduced
by the allowance for credit losses.
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Loans held for sale are carried at the lower of aggregate cost or market value
and continue to be reported as loans in the consolidated balance sheet. Premiums
and discounts, purchase accounting fair value adjustments and deferred fees and
origination costs are recognized as adjustments to yield over the life of the
related receivables. Interest income is recorded based on methods that result in
level rates of return over the terms of the loans.
Restructured loans are loans for which the original contractual terms have been
permanently modified to provide for terms that are less than HUSI would be
willing to accept for new loans with comparable risk because of deterioration in
the borrower's financial condition. Interest on these loans is accrued at the
renegotiated rates.
Loan Charge Off Policies and Practices
Commercial loan balances are charged off at the time all or a portion of the
balance 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 before
the time foreclosure is completed or when settlement is reached with the
borrower. If foreclosure is not pursued, and there is no reasonable expectation
for recovery, the account is generally charged off no later than the end of the
month in which the account becomes six months contractually delinquent.
Auto Finance
Carrying values in excess of net realizable value are generally charged off no
later than the month in which the account becomes four months contractually
delinquent.
MasterCard/Visa and Private Label Credit Card Loans
Loan balances are generally charged off by the end of the month in which the
account becomes six months contractually delinquent.
Other Consumer Loans
Loan balances are generally charged off during the month following the month in
which 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 of
management, reasonable doubt exists with respect to the ultimate collectibility
of interest or principal based on certain factors including period of time past
due and adequacy of collateral. At the time a loan is classified as nonaccruing,
any accrued interest recorded on the loan is generally reversed and charged
against income. Interest income on these loans is subsequently recognized only
to the extent of cash received or until the loan is placed on accrual status. In
those instances where there is doubt as to collectibility of principal, any
interest payments received are applied to principal. Loans are not reclassified
as accruing until interest and principal payments are brought current and future
payments are reasonably assured.
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Consumer
Residential mortgage loans are generally designated as nonaccruing when
contractually delinquent for more than three months. Credit card receivables and
other consumer loans generally accrue interest until charge off.
Loan Fees and Costs
Nonrefundable fees and related direct costs associated with the origination of
loans are deferred and netted against outstanding loan balances. The
amortization of net deferred fees, which include points on real estate secured
loans and costs, is recognized in interest income, generally by the interest
method, based on the estimated lives of the related loans. MasterCard/Visa
annual fees, net of direct lending costs, are deferred and amortized on a
straight-line basis over one year. Nonrefundable fees related to lending
activities other than direct loan origination are recognized as other revenues
over the period in which the related service is provided. This includes fees
associated with the issuance of loan commitments where the likelihood of the
commitment being exercised is considered remote. In the event of the exercise of
the commitment, the remaining unamortized fee is recognized in interest income
over the loan term using the interest method. Other credit-related fees, such as
standby letter of credit fees, loan syndication and agency fees are recognized
as 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 of
management, adequate to absorb estimated probable losses of principal, interest
and fees inherent in its commercial and consumer loan portfolios. The adequacy
of the allowance for credit losses is assessed within the context of appropriate
U.S. GAAP guidance, and is based, in part, upon an evaluation of various factors
including:
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 and
reserves as a percentage of net charge offs in developing its loss reserve
estimate. Loss estimates are reviewed periodically and adjustments are reported
in earnings when they become known. These estimates are influenced by factors
outside of the control of HUSI management, such as consumer payment patterns and
economic 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 periodic
assessment on a loan-by-loan basis of losses it believes to be inherent in the
loan portfolio. When it is deemed probable, based upon known facts and
circumstances, that full contractual interest and principal on an individual
loan will not be collected in accordance with its contractual terms, the loan is
considered impaired. An impairment reserve is established based upon the present
value of expected future cash flows, discounted at the loan's original effective
interest rate, or as a practical expedient, at the loan's observable market
price or the fair value of the collateral if the loan is collateral dependent.
Generally, impaired loans include loans in nonaccruing status, loans which have
been assigned a specific allowance for credit losses, loans which have been
partially charged off, and loans designated as troubled debt restructures.
Problem commercial loans are assigned various criticized facility grades under
the allowance for credit losses methodology.
Formula-based reserves are also established against commercial loans when, based
upon an analysis of relevant data, it is probable that a loss has been incurred
and the amount of that loss can be reasonably estimated, even though an actual
loss has yet to be identified. A separate reserve for credit losses associated
with off-balance sheet exposures including letters of credit, guarantees to
extend credit and financial guarantees is also maintained and included in other
liabilities, which incorporates estimates of the probability that customers
will actually draw upon off-balance sheet obligations. This estimation
methodology uses the probability of default from the customer rating assigned to
each counterparty, the "Loss Given Default" rating assigned to each transaction
or facility based on the collateral securing the transaction, and the measure of
exposure based on the transaction. These reserves are determined by reference to
continuously monitored and updated historical loss rates or factors, which are
derived from a migration analysis considering net charge off experience by loan
and industry type in relation to internal credit grading.
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Probable losses for pools of homogeneous consumer loans are generally estimated
using a roll rate migration analysis that estimates the probability that a loan
will progress through the various stages of delinquency, and ultimately charge
off. This analysis considers delinquency status, loss experience and severity
and takes into consideration whether loans are in bankruptcy, have been
restructured, or are subject to forbearance, an external debt management plan,
hardship, modification, extension or deferment. The allowance for credit losses
on consumer receivables also takes into consideration the loss severity expected
based on the underlying collateral, if any, for the loan in the event of
default. In addition, loss estimates on consumer receivables are maintained to
reflect HUSI's judgment of portfolio risk factors, which may not be fully
reflected in the statistical roll rate calculation. Risk factors considered in
establishing loss reserves on consumer loans include recent growth, product mix,
bankruptcy trends, geographic concentrations, economic conditions, portfolio
seasoning, account management policies and practices and current levels of
charge offs and delinquencies.
Properties and Equipment, Net
Properties and equipment are recorded at cost, net of accumulated depreciation
and amortization. Depreciation is provided on a straight-line basis over the
estimated useful lives of the assets which generally range from 3 to 40 years.
Leasehold improvements are amortized over the lesser of the economic useful life
of the improvement or the term of the lease. Costs of maintenance and repairs
are expensed as incurred.
Repossessed Collateral
Real estate owned is valued at the lower of cost or fair value less estimated
costs to sell. These values are periodically reviewed and reduced, if necessary.
Costs of holding real estate and related gains and losses on disposition are
credited or charged to operations as incurred as a component of operating
expense. Repossessed vehicles, net of loss reserves when applicable, are
recorded at the lower of the estimated fair market value or the outstanding
receivable balance.
Mortgage Servicing Rights
HUSI recognizes the right to service mortgages as a separate and distinct asset
at 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 and
carried on the balance sheet in other assets at the lower of their initial
carrying value, adjusted for amortization, or fair value.
As interest rates decline, prepayments generally accelerate, thereby reducing
future net servicing cash flows from the mortgage portfolio. The carrying value
of the mortgage servicing rights (MSRs) is periodically evaluated for impairment
based on the difference between the carrying value of such rights and their
current fair value. If the carrying value of the servicing rights exceeds fair
value, the asset is deemed impaired and, if deemed temporary, impairment is
recognized by recording a balance sheet valuation reserve with a corresponding
charge to income. If deemed permanent, impairment is recorded as a reduction to
the MSRs and valuation reserve balances. For purposes of measuring impairment,
MSRs are stratified based upon interest rates and whether such rates are fixed
or variable and other loan characteristics. Fair value is determined based upon
the application of pricing valuation models incorporating portfolio specific
prepayment assumptions. The reasonableness of these pricing models is
periodically substantiated by reference to independent broker price quotations
and industry surveys.
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HUSI uses certain derivative financial instruments including options and
interest rate swaps to protect against the decline in economic value of MSRs.
These instruments have not been designated as qualifying hedges in accordance
with U.S. GAAP guidelines and are therefore recorded as trading instruments that
are marked to market through earnings.
Goodwill
Goodwill, representing the excess of purchase price over the fair value of net
identifiable assets acquired, results from purchase business combinations.
Goodwill is not amortized, but is reviewed for impairment annually using
discounted cash flows. Impairment may be reviewed earlier if circumstances
indicate that the carrying amount may not be recoverable. HUSI considers
significant and long-term changes in industry and economic conditions to be
primary indicators of potential impairment.
Receivables Sold and Serviced with Limited Recourse and Securitization
Revenue
Certain private label credit card receivables have been securitized and sold to
investors with limited recourse. Recourse is limited to HUSI's rights to future
cash flow and any subordinated interest that HUSI may retain. Upon sale, the
receivables are removed from the balance sheet and a gain on sale is recognized
for the difference between the carrying value of the receivables and the
adjusted sales proceeds. The adjusted sales proceeds include cash received and
the present value estimate of future cash flows to be received over the lives of
the sold receivables. Future cash flows are based on estimates of prepayments,
the impact of interest rate movements on yields of receivables and securities
issued, delinquency of receivables sold, servicing fees and other factors. The
resulting gain is also adjusted by a provision for estimated probable losses
under the recourse provision. This provision, and the related reserve for
receivables serviced with limited recourse, are established at the time of sale
to cover all probable credit losses over the life of the receivables sold based
on historical experience and estimates of expected future performance. The
methodologies vary depending upon the type of receivables sold, using either
historical net charge off rates applied to the expected balances to be received
over the remaining life of the receivable or a historical static pool analysis.
The reserves are reviewed periodically by evaluating the estimated future cash
flows of each securitized pool to ensure that there is sufficient remaining cash
flow to cover estimated future credit losses. Any changes to the estimates for
the reserve for receivables serviced with limited recourse are made in the
period they become known. Gains on sales net of recourse provisions, servicing
income and excess spread relating to securitized receivables are reported in the
accompanying consolidated statements of income as securitization revenue.
In connection with these transactions, HUSI records an interest-only strip
receivable, representing HUSI's contractual right to receive interest and other
cash flows from the securitization trusts. HUSI's interest-only strip
receivables are reported at fair value using discounted cash flow estimates as a
separate component of receivables net of HUSI's estimate of probable losses
under the recourse provisions. Cash flow estimates include estimates of
prepayments, the impact of interest rate movements on yields of receivables and
securities issued, delinquency of receivables sold, servicing fees and estimated
probable losses under the recourse provisions. Unrealized gains and losses are
recorded as adjustments to common shareholder's equity in accumulated other
comprehensive income, net of income taxes. The interest-only strip receivables
are reviewed for impairment quarterly or earlier if events indicate that the
carrying value may not be recovered. Any decline in the fair value of the
interest-only strip receivable which is deemed to be other than temporary is
charged against current earnings.
HUSI has also, in certain cases, retained other subordinated interests in these
securitizations. Neither the interest-only strip receivables nor the other
subordinated interests are in the form of securities.
Prior to the third quarter of 2004, public private label credit card
transactions were structured as sales to revolving trusts that require
replenishments to support previously issued securities. Receivables of these
asset types will continue to be sold to these trusts until their revolving
period ends, the last of which is expected to occur in 2008. Beginning in the
third quarter of 2004, it is intended that all new collateralized funding
transactions be structured as secured financings.
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HUSI has also continued to replenish, at reduced levels, certain non-public
private 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 tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases, as well as the estimated future tax consequences attributable to net
operating loss and tax credit carryforwards. These deferred tax assets and
liabilities are measured using the tax rates and laws that are expected to be in
effect. A valuation allowance is established if, based on available evidence, it
is more likely than not that some portion or all of the deferred tax asset will
not be realized. Foreign taxes paid are applied as credits to reduce federal
income taxes payable, unless utilization of the credit is limited.
Derivative Financial Instruments
Derivative financial instruments are recognized on the balance sheet at their
fair value. On the date a derivative contract is entered into, HUSI designates
it 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 qualifies
as a fair value hedge, along with the changes in the fair value of the hedged
asset or liability that is attributable to the hedged risk (including losses or
gains on firm commitments), are recorded in current period earnings. Changes in
the fair value of a derivative that has been designated and qualifies as a cash
flow hedge, to the extent effective as a hedge, are recorded in accumulated
other comprehensive income and reclassified into earnings in the period during
which the hedged item affects earnings. Ineffectiveness is reflected in current
earnings. Changes in the fair value of derivatives held for trading purposes are
reported in current period earnings.
At the inception of each hedge, HUSI formally documents all relationships
between hedging instruments and hedged items, as well as its risk management
objective and strategy for undertaking various hedge transactions, the nature of
the hedged risk, and how hedge effectiveness and ineffectiveness will be
measured. This process includes linking all derivatives that are designated as
fair value or cash flow hedges to specific assets and liabilities on the balance
sheet or to specific firm commitments or forecasted transactions. HUSI also
formally assesses, both at inception and on a recurring basis, whether the
derivatives that are used in hedging transactions are highly effective in
offsetting changes in fair values or cash flows of hedged items and whether they
are expected to continue to be highly effective in future periods. This
assessment is conducted using statistical regression analysis. For interest rate
swaps that meet the criteria whereby no ineffectiveness can be assumed in
accordance with U.S. GAAP guidance, no ongoing assessment is required.
Earnings volatility may result from the on-going mark to market of certain
economically viable derivative contracts that do not satisfy the hedging
requirements of U.S. GAAP guidance, as well as from the hedge ineffectiveness
associated with the qualifying contracts.
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Embedded Derivatives
HUSI may acquire or originate a financial instrument that contains a derivative
instrument "embedded" within it. Upon origination or acquisition of any such
instrument, HUSI assesses whether the economic characteristics of the embedded
derivative are clearly and closely related to the economic characteristics of
the principal component of the financial instrument (i.e., the host contract)
and whether a separate instrument with the same terms as the embedded instrument
would meet the definition of a derivative instrument.
When it is determined that: (1) the embedded derivative possesses economic
characteristics that are not clearly and closely related to the economic
characteristics of the host contract; and (2) a separate instrument with the
same terms would qualify as a derivative instrument, the embedded derivative is
separated from the host contract, carried at fair value, and designated a
trading instrument. If these conditions are not met, the derivative is not
separated from the host contract. Any gain recognized at inception related to
the derivative is effectively embedded in the debt host contract and is
recognized over the life of the debt instrument.
Hedge Discontinuation
If it is determined that a derivative is not highly effective as a hedge, or
that in the future it ceases to be a highly effective hedge, HUSI discontinues
hedge accounting as of the beginning of the quarter in which such determination
was 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 the
derivative 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 fair
value.
In the case of a fair value hedge of a recognized asset or liability, as long as
the hedged item continues to exist on the balance sheet, the hedged item will no
longer be adjusted for changes in fair value. The basis adjustment that had
previously been recorded to the hedged item during the period from the
designation date to the hedge discontinuation date is amortized over the
remaining 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 as
the hedged item continues to exist on the balance sheet, the effective portion
of the changes in fair value of the hedging derivative will no longer be
reclassified into other comprehensive income. The balance applicable to the
discontinued hedging relationship will be amortized into earnings over the
remaining life of the hedged item. If the hedged item was a firm commitment or
forecasted transaction that is not expected to occur, any amounts recorded on
the balance sheet related to the hedged item, including any amounts recorded in
other comprehensive income, are reclassified to current period earnings.
In the case of either a fair value hedge or a cash flow hedge, if the previously
hedged item is sold or extinguished, the basis adjustment to the underlying
asset or liability or any remaining unamortized other comprehensive income
balance will be reclassified to current period earnings.
In all other situations in which hedge accounting is discontinued, the
derivative will be carried at its fair value on the balance sheet, with changes
in its fair value recognized in current period earnings unless redesignated as a
qualifying hedge.
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Day One Revenue Recognition
HUSI recognizes gain or loss at the inception of derivative transactions only
when the fair value of the transaction can be verified to market transactions or
if all significant pricing model assumptions can be verified to observable
market data. The net realized gains recorded in trading assets associated with
these transactions is offset by a reserve until the transaction can be verified
to observable market data.
Stock-Based Compensation
HUSI uses the fair value method of accounting for stock awards granted to
employees under various stock option and employee stock purchase plans. Stock
compensation costs are recognized prospectively for all new awards granted under
these plans. Compensation expense relating to share options is calculated using
a binomial lattice methodology that is based on the underlying assumptions of
the Black-Scholes option pricing model and is charged to expense over the
vesting period, generally three to five years. Compensation expense relating to
restricted stock rights (RSRs) is based upon the market value of the RSRs on the
date 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 and
its subsidiaries. These transactions include funding arrangements,
administrative and operational support, and other miscellaneous services. All
material related party balances and transactions among various direct and
indirect subsidiaries of HUSI are eliminated in consolidation. All material
related party transactions between HUSI and other HSBC subsidiaries are reported
in Note 20 beginning on page 122 of these consolidated financial statements.
New Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued the
Statement of Financial Accounting Standards No. 123 (Revised), Share-Based
Payment (SFAS 123R). SFAS 123R requires public entities to measure the cost of
stock-based compensation based on the grant date fair value of the award, as
well as other disclosure requirements. On March 28, 2005, the Securities and
Exchange Commission (SEC) issued Staff Accounting Bulletin 107 which amended the
compliance date to allow public companies to comply with the provisions of SFAS
123R 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 on
operating 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 apply
voluntary changes in accounting principles retrospectively whenever it is
practicable. The retrospective application requirement replaces APB 20's
requirement to recognize most voluntary changes in accounting principle by
including the cumulative effect of the change in net income during the period
the change occurs. Retrospective application will be the required transition
method for new accounting pronouncements in the event that a newly-issued
pronouncement does not specify transition guidance. SFAS 154 is effective for
accounting 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 Certain
Investments (FSP 115-1 and FSP 124-1), in response to Emerging Issues Task Force
03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments (EITF 03-1). FSP 115-1 and FSP 124-1 provide guidance
regarding the determination as to when an investment is considered impaired,
whether that impairment is other-than-temporary, and the measurement of an
impairment loss. FSP 115-1 and FSP 124-1 also include accounting considerations
subsequent to the recognition of an other-than-temporary impairment and requires
certain disclosures about unrealized losses that
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have not been recognized as other than temporary impairments. These requirements
are 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 not
expected to have a material impact on HUSI's financial position or results of
operations.
In February 2006, the FASB issued Statement of Financial Accounting Standards
No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155). SFAS
155 permits fair value measurement for any hybrid financial instrument that
contains an embedded derivative that would otherwise require bifurcation and
separate accounting. An irrevocable election may be made at inception to measure
such a hybrid financial instrument at fair value, with changes in fair value
recognized through income. Such an election needs to be supported by concurrent
documentation. SFAS 155 is effective for fiscal years beginning after September
15, 2006, with early adoption permitted. HUSI is currently considering the
impact that adoption will have on its consolidated results and financial
position.
In August 2005, the FASB issued an exposure draft for a proposed Statement of
Financial Accounting Standards entitled, Accounting for Servicing of Financial
Assets (the proposed SFAS). The proposed SFAS would amend previously issued
guidance with respect to accounting for separately recognized loan servicing
rights. Under the proposed SFAS, all servicing rights would initially be
measured at fair value, if practicable. For each class of servicing rights, an
entity 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 of
available for sale securities used to offset changes in the economic value of
MSRs to trading securities, without calling into question the treatment of those
securities under Statement of Financial Accounting Standards No. 115, Accounting
for Certain Investments in Debt and Equity Securities (SFAS 115). This
reclassification would be permitted upon initial adoption of the proposed SFAS
as of the beginning of the fiscal year of adoption. If issued in the form of the
proposed SFAS, HUSI plans to early adopt its provisions as of January 1, 2006
and recognize residential mortgage servicing rights (MSRs) at fair value. The
effect of measuring existing MSRs at fair value and reclassifying available for
sale securities to trading securities will be accounted for as a cumulative
effect adjustment to retained earnings. Adoption of this proposed SFAS is not
expected to have a material effect on HUSI's consolidated results or financial
position.
In January 2006, the FASB issued an exposure draft for a proposed SFAS, The Fair
Value Option for Financial Assets and Financial Liabilities, Including an
Amendment of FASB Statement No. 115 (the proposed SFAS). Under this proposed
SFAS, an entity may irrevocably elect fair value as the initial and subsequent
measurement attribute for certain financial assets and financial liabilities,
with changes in fair value recognized in earnings as those changes occur. If the
final SFAS is issued in this form, HUSI plans to make the election for certain
categories of financial instruments.
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Note 3. Acquisitions and Divestitures
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2005
There were no material business acquisitions or divestitures during 2005.
2004
On December 29, 2004, HUSI purchased approximately $12 billion of private label
loans, primarily credit card receivables, from HSBC Finance Corporation at fair
value. HSBC Finance Corporation retained the customer relationships associated
with these balances. This portfolio acquisition resulted in creation of the
Consumer Finance business segment in 2005. See Note 23 beginning page 132 of
this Form 10-K for a summary of HUSI's results by business segment.
On June 1, 2004, HUSI transferred a wholly owned domestic brokerage subsidiary
to HMUS at fair value. The transaction did not have a material impact on HUSI's
operations for 2005 or 2004.
On July 31, 2004, HUSI transferred most of its Panamanian branch operations to
an HSBC affiliate at fair value. The transaction did not have a material impact
on HUSI's operations for 2005 or 2004.
On February 29, 2004, HUSI sold its banking subsidiary in Uruguay to an HSBC
affiliate at fair value. The transaction did not have a material impact on
HUSI's operations for 2005 or 2004.
Note 4. Trading Assets and Liabilities
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Trading assets and liabilities are summarized in the following table.
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December 31, 2005 2004
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(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 value
that exceeded 10% of shareholders' equity.
The amortized cost and fair value of the available for sale and held to maturity
securities portfolios are summarized in the following table.
------------------------------------------------------------------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
December 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 Fair
December 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 to
the 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 Value
December 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 Value
December 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 sale
securities and held to maturity securities portfolios during 2005, due to rising
short-term and medium-term interest rates. Since substantially all of these
securities are high credit grade (i.e., AAA or AA), and HUSI has the intent to
hold these securities until maturity or a market price recovery, they are not
considered to be other than temporarily impaired.
100
The following table summarizes realized gains and losses on investment
securities transactions attributable to available for sale and held to maturity
securities. Amounts in the table include net realized gains (losses) of $(11)
million, $8 million and $22 million reported in residential mortgage banking
revenue in the consolidated statement of income for 2005, 2004 and 2003
respectively.
-------------------------------------------------------------------------------------------------------------------
Net
Gross Gross Realized
Realized Realized Gains
Year Ended December 31 Gains (Losses) (Losses)
--------------------------------------------------------------------------------------------------------------------
(in millions)
2005
Securities available for sale .................................. $ 107 $ (13) $ 94
Securities held to maturity:
Maturities, calls and mandatory redemptions ................ 1 -- 1
---------- ---------- -----------
$ 108 $ (13) $ 95
========== ========== ===========
2004
Securities available for sale .................................. $ 100 $ (8) $ 92
Securities held to maturity:
Maturities, calls and mandatory redemptions ................ 1 -- 1
---------- ---------- -----------
$ 101 $ (8) $ 93
========== ========== ===========
2003
Securities available for sale .................................. $ 81 $ (11) $ 70
========== ========== ===========
101
The amortized cost and fair values of securities available for sale and
securities held to maturity at December 31, 2005, by contractual maturity are
summarized in the following table. Expected maturities differ from contractual
maturities because borrowers have the right to prepay obligations without
prepayment penalties in certain cases. Available for sale amounts exclude $49
million cost ($55 million fair value) of equity securities that do not have
maturities.
The following table also reflects the distribution of maturities of debt
securities held at December 31, 2005, together with the approximate taxable
equivalent yield of the portfolio. The yields shown are calculated by dividing
annual interest income, including the accretion of discounts and the
amortization of premiums, by the amortized cost of securities outstanding at
December 31, 2005. Yields on tax-exempt obligations have been computed on a
taxable equivalent basis using applicable statutory tax rates.
------------------------------------------------------------------------------------------------------------------------
Within After One After Five After
Taxable One But Within But Within Ten
Equivalent Year Five Years Ten Years Years
Basis 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, is
summarized 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 portfolio
from HSBC Finance Corporation. The portfolio consisted of approximately $11
billion of private label credit card receivables and $1 billion of other
consumer and commercial loans. By agreement, HUSI is purchasing additional
receivables generated under current and future private label credit card
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 credit card
portfolio balance to approximately $15 billion at December 31, 2005.
During 2005, HUSI purchased $1.5 billion of residential mortgage loans from
originating lenders pursuant to HSBC Finance Corporation correspondent loan
programs. Purchases of residential mortgage loans from HSBC Finance Corporation
were discontinued effective September 1, 2005.
Residential mortgage loan originations generally declined during 2005 due to a
rising interest rate environment. In addition, originations of various
adjustable rate residential mortgage loan products that would have been retained
on the balance sheet prior to 2005 were being sold in the secondary market
beginning in 2005. These factors contributed to the overall decrease in
residential mortgage loans during 2005.
In June 2005, HUSI began acquiring residential mortgage loans from unaffiliated
third parties, with the intent of selling the loans to HMUS. The increase in
held for sale loans during 2005 directly resulted from this new activity. The
sale of these loans to HMUS are further described in Note 20 beginning on page
122 of this Form 10-K.
Commercial loans include certain bonds issued by the government of Venezuela as
part of debt renegotiations (Brady Bonds). HUSI's intent is to hold these
instruments until maturity. The Brady Bonds are fully secured as to principal by
zero-coupon U.S. Treasury securities with a face value equal to that of the
underlying bonds. The following table presents information regarding Brady
Bonds.
--------------------------------------------------------------------------------
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. The
loans were made on substantially the same terms, including interest rates and
collateral, as those prevailing at the same time for comparable transactions
with 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 at
December 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 following
table.
------------------------------------------------------------------------------------------------------------------------
2005 2004 2003
------------------------------------------------------------------------------------------------------------------------
(in millions)
Balance at beginning of year ............................................... $ 788 $ 399 $ 493
Allowance related to acquisitions and (dispositions), net .................. -- 485 (15)
Charge offs ................................................................ 871 157 243
Recoveries ................................................................. 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 label
loans from HSBC Finance Corporation, including an allowance for credit losses of
approximately $505 million associated with the purchased loans. The 2005
provision for credit losses and levels of allowance for credit losses reflect
the impact of the acquisition of private label receivables, as well as the
impact of other loans and receivables growth during 2005. Additionally, the
provision for 2005 and overall allowance levels at December 31, 2005 include
total incremental provisions of $10 million relating to Hurricane Katrina and $5
million relating to new bankruptcy legislation.
Included in the December 31, 2005 and December 31, 2004 allowances for credit
losses are approximately $4 million and $14 million respectively, of non-United
States transfer risk reserves.
Note 8. Asset Securitizations
--------------------------------------------------------------------------------
On December 29, 2004, HUSI acquired a domestic private label loan portfolio from
HSBC Finance Corporation, without recourse, which included a consumer private
label credit card portfolio, securitized receivables related to this portfolio,
and retained interest assets related to these securitizations. HUSI purchased
all retained interests associated with these securitizations.
Structure of Credit Card Securitizations
These credit card securitization transactions are structured to receive sale
treatment under Statement of Financial Accounting Standards No. 140, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities, a replacement of FASB Statement No. 125, (SFAS 140). In a
securitization, a designated pool of private label credit card receivables is
removed from the balance sheet and transferred to an unaffiliated trust. This
unaffiliated trust is a qualifying special purpose entity (QSPE) as defined by
SFAS 140 and, therefore, is not consolidated. The QSPE funds its receivable
purchase through the issuance of securities to investors, entitling them to
receive specified cash flows during the life of the securities. The securities
are collateralized by the underlying receivables transferred to the QSPE.
To help ensure that adequate funds are available to meet the cash needs of the
QSPE, various forms of interests in securitized assets may be retained including
interest-only strip receivables, over collateralization, subordinated tranches,
interest in accrued interest and fees, or other retained interests which provide
credit enhancement to investors. Interest-only strip receivables are rights to
future cash flows arising from the securitized receivables after the investors
receive their contractual return, and are recorded at fair value, net of related
loss reserves. Investors and the securitization trusts have only limited
recourse to HUSI's assets for failure of debtors to pay. That recourse is
limited to the rights to future cash flows and other subordinated interest that
HUSI may retain. Cash flows related to the interest-only strip receivables are
collected over the life of the underlying securitized receivables.
105
HUSI's retained securitization interests are not in the form of securities and
are included in other assets on the consolidated balance sheet. The composition
of 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 to
align accounting treatment with that of HSBC, all new collateralized funding
transactions are structured as secured financings. However, because existing
public private label credit card transactions were structured as sales to
revolving trusts that require replenishments of receivables to support
previously issued securities, receivables will continue to be sold to these
trusts until the revolving periods end, the last of which is expected to occur
in 2007.
In a secured financing, a designated pool of receivables are conveyed to a
wholly owned limited purpose subsidiary, which in turn transfers receivables to
a trust that sells interests to investors. Repayment of the debt issued by the
trust is secured by the receivables transferred. The transactions are structured
as secured financings under SFAS 140. Therefore, the receivables and the
underlying debt of the trust remain on HUSI's balance sheet. HUSI does not
recognize a gain in a secured financing transaction. Because the receivables and
debt remain on the balance sheet, revenues and expenses are reported consistent
with the owned balance sheet portfolio. As of December 31, 2005, secured
financings of $1.5 billion were secured by $2.2 billion of private label credit
card receivables.
Securitization revenue primarily includes servicing revenue and excess spread
associated with the current and prior period securitization of loans with
limited recourse structured as sales.
Interest-only strip receivables, net of the related losses and excluding the
mark to market adjustment recorded in accumulated other comprehensive income
decreased by $46 million in 2005.
Credit card revolving securitization trusts are established at fixed levels and
require frequent sales of new loan balances into the trust to replace loans as
they run off. These replenishments totaled $8.7 billion in 2005.
Cash flows received from credit card revolving securitization trusts were as
follows.
------------------------------------------------------------------------------------------------------------------------
Year Ended December 31 2005
------------------------------------------------------------------------------------------------------------------------
(in millions)
Servicing fees received .................................................................................. $ 50
Other 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 the
interest-only strip receivables to immediate unfavorable 10% and 20% changes in
assumptions was tested, resulting in insignificant impacts on the carrying
value.
Static pool credit losses are calculated by summing actual and projected future
credit losses and dividing them by the original balance of each pool of asset.
Due to the short term revolving nature of credit card balances, the
weighted-average percentage of static pool credit losses is not considered to be
materially different from the weighted-average charge off assumptions used in
determining the fair value of interest-only strip receivables.
Total receivables and two-month-and over contractual delinquencies for the
private 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 card
portfolio are presented in the following table. Since the portfolio was
purchased on December 29, 2004, average balances are not available as of
December 31, 2004. Net charge offs were minimal for the period in which HUSI
owned the portfolio in 2004.
------------------------------------------------------------------------------------------------------------------
Average Net
December 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 and
amortization, is summarized in the following table.
--------------------------------------------------------------------------------------------------------------------
Depreciable
December 31 Life (Years) 2005 2004
--------------------------------------------------------------------------------------------------------------------
(in millions)
Land -- $ 92 $ 99
Buildings ......................................................... 5-40 688 711
Furniture 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 $98
million 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 $ 309
Other ......................................................................................... 45 43
------- -------
Intangible assets, net ........................................................................ $ 463 $ 352
======= =======
Mortgage Servicing Rights (MSRs)
HUSI recognizes the right to service mortgages as a separate and distinct asset
at 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 the
balance sheet at the lower of their initial carrying value, adjusted for
amortization, or fair value.
Fair value is based on the present value of future cash flows which, at December
31, 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 of
5.5 years.
The following table summarizes activity for MSRs and the related valuation
allowance.
-----------------------------------------------------------------------------------------------------------------------
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 the
accompanying consolidated balance sheets. The outstanding principal balances of
these loans were $32 billion and $28 billion at December 31, 2005 and 2004
respectively. Custodial balances maintained in connection with the foregoing
loan servicing, and included in noninterest bearing deposits in domestic
offices, were approximately $628 million and $546 million at December 31, 2005
and 2004 respectively.
Normal amortization for the current MSRs portfolios is expected to be
approximately $73 million for the year ending December 31, 2006, declining
gradually to approximately $36 million for the year ending December 31, 2010.
Actual levels of amortization could increase or decrease depending upon changes
in interest rates and loan prepayment activity. Actual levels of amortization
are also dependent upon future levels of MSRs recorded.
108
Other Intangible Assets
Other intangible assets primarily includes favorable lease arrangements, which
resulted from various business acquisitions. Scheduled amortization will
approximate $5 million per year for 2006 through 2010.
Note 11. Goodwill
--------------------------------------------------------------------------------
During the second quarter of 2005, HUSI completed its annual impairment test of
goodwill and determined that the fair value of each of the reporting units
exceeded its carrying value. As a result, no impairment loss was required to be
recognized.
During 2005, HUSI sold certain branches, which resulted in insignificant
decreases in goodwill.
During 2004, HUSI sold or transferred certain domestic and foreign operations to
affiliated HSBC entities, resulting in reductions of goodwill of approximately
$80 million.
Note 12. Deposits
--------------------------------------------------------------------------------
The aggregate amount of time deposit accounts (primarily certificates of
deposits) each with a minimum of $100,000 included in domestic office deposits
were approximately $23 billion and $19 billion at December 31, 2005 and 2004
respectively. The scheduled maturities of all time deposits at December 31, 2005
follows.
--------------------------------------------------------------------------------
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 34,664
2007 ........................... 3,187 3 3,190
2008 ........................... 1,355 5 1,360
2009 ........................... 176 -- 176
2010 ........................... 103 -- 103
Later 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 following
table. Average interest rates during each year are computed by dividing total
interest 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 2,563
Securities 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 1,475
Commercial 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 1,730
Precious 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 3,735
All 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 HSBC
Finance Corporation. The interest rate is comparable to third party rates for a
line 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 and
commitment fees are not significant. Interest rates are comparable to third
party rates for lines of credit with similar terms.
At December 31, 2005, HUSI had an unused line of credit from HNAI of $150
million. The interest rate is comparable to third party rates for a line of
credit with similar terms.
As a member of the New York Federal Home Loan Bank (FHLB), HUSI has a secured
borrowing facility which is collateralized by residential mortgage loan assets.
At December 31, 2005, the facility included $5 billion of borrowings included in
long-term debt (see Note 14 on page 111). The facility also allows access to
further short-term borrowings based upon the amount of residential mortgage
loans 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. Interest
rates on floating rate notes are determined periodically by formulas based on
certain money market rates or, in certain instances, by minimum interest rates
as specified in the agreements governing the issues. Interest rates in effect at
December 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 --
--------- ---------
1,598 101
Subordinated 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 13,113
Federal 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 subsidiaries
payable to HUSI. Of this amount, the earliest note is due to mature in November
2006 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 $300
million, was closed out and combined into the 2005 shelf to create one shelf in
the aggregate amount of $2.3 billion. The 2005 shelf enables HUSI to issue
senior debt securities, subordinated debt securities, preferred stock and
depositary shares.
The $1.5 billion Floating Rate Extendible Notes were issued by HUSI in November
2005 under the 2005 shelf. These senior debt securities require the noteholders
to decide each month whether or not to extend the maturity date of their notes
by one month beyond the initial maturity date of December 15, 2006. In no event
will the maturity of the notes be extended beyond December 15, 2011, the final
maturity date. If on any election date a noteholder decides not to extend the
maturity of all or any portion of the principal amount of his notes, the notes
will mature on the previously elected maturity date, which will be the maturity
date that is twelve months from the current election date. On the December 2005
election date, all noteholders elected to extend the maturity date of their
notes to January 15, 2007. The notes are not subject to redemption by HUSI prior
to the final maturity date. Interest is payable on the notes in arrears on the
15th day of each month, commencing December 15, 2005 and ending on the final
maturity date. The interest rate will be determined by reference to the
one-month LIBOR, plus or minus the applicable spread for that particular
interest period. The spread for each interest period ranges from minus 2 basis
points for the interest period ending December 15, 2006 to plus 3 basis points
for the interest period ending December 15, 2011.
Certain statutory business trusts (issuer trusts) that issued guaranteed
mandatorily redeemable securities (Capital Securities) were considered
consolidated subsidiaries of HUSI. Capital Securities issued by these trusts to
third party investors, along with common securities of the trusts (Common
Securities) issued to HUSI, were invested in Junior Subordinated Debentures of
HUSI. Prior to HUSI's adoption of FIN 46 at December 31, 2003, the Capital
Securities were included in long-term debt on HUSI's consolidated balance sheet
and the Common Securities and Junior Subordinated Debentures were eliminated in
consolidation. Upon adoption of FIN 46, HUSI deconsolidated the issuer trusts.
As a result, the Junior Subordinated Debentures issued by HUSI to the trusts are
reflected in total long-term debt on HUSI's consolidated balance sheet at
December 31, 2005 and 2004.
Debt Issued by HBUS or its Subsidiaries
In June 2004, HBUS finalized a $10 billion Global Bank Note Program, which
provided for issuance of subordinated and senior global notes. In September
2004, this program was replaced by a $20 billion Global Bank Note Program. The
following 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 financing
transaction in the amount of $1.5 billion. A designated pool of consumer private
label credit card receivables were conveyed to a wholly owned limited purpose
subsidiary, which in turn transferred the receivables to a trust that sold
interests to investors. Since the transaction was structured as a secured
financing under Statement of Financial Accounting Standards No. 140, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities, (SFAS 140), the receivables and the underlying debt of the trust
remain on HUSI's balance sheet. Repayment of the debt issued by the trust is
secured 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 card
receivables. As payments on the receivables are collected, funds are transferred
to the trustee and new receivables are added to the trust to maintain the agreed
upon level of collateral.
Contractual scheduled maturities for total long-term debt over the next five
years are as follows.
--------------------------------------------------------------------------------
(in millions)
2006 ......................................................... $ 6,716
2007 ......................................................... 7,639
2008 ......................................................... 3,125
2009 ......................................................... 4,435
2010 ......................................................... 302
Note 15. Derivative Instruments and Hedging Activities
--------------------------------------------------------------------------------
HUSI is party to various derivative financial instruments as an end user (1) for
asset and liability management purposes; (2) in order to offset the risk
associated with changes in the value of various assets and liabilities accounted
for in the trading account; (3) to protect against changes in value of its
mortgage servicing rights portfolio; and (4) for trading in its own account.
HUSI is also an international dealer in derivative instruments denominated in
U.S. dollars and other currencies which include futures, forwards, swaps and
options related to interest rates, foreign exchange rates, equity indices,
commodity prices and credit, focusing on structuring of transactions to meet
clients' needs.
Fair Value Hedges
Specifically, interest rate swaps that call for the receipt of a variable market
rate and the payment of a fixed rate are utilized under fair value strategies to
hedge the risk associated with changes in the risk free rate component of the
value of certain fixed rate investment securities. Interest rate swaps that call
for the receipt of a fixed rate and payment of a variable market rate are
utilized to hedge the risk associated with changes in the risk free rate
component of certain fixed rate debt obligations.
Where the critical terms of the hedge instrument are identical at hedge
inception, the short-cut method of accounting is utilized. As a result, no
retrospective or prospective assessment of effectiveness is required and no
hedge ineffectiveness is recognized. However, in instances where the short-cut
method of accounting cannot be applied, the regression and cumulative dollar
offset methods are utilized in order to satisfy the retrospective and
prospective 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), which
represented the ineffective portion of all fair value hedges. Only the time
value component of these derivative contracts has been excluded from the
assessment of hedge effectiveness.
113
Cash Flow Hedges
Similarly, interest rate swaps and futures contracts that call for the payment
of a fixed rate are utilized under the cash flow strategy to hedge the
forecasted repricing of certain deposit liabilities. In order to initially
qualify for hedge accounting, assessment of hedge effectiveness is demonstrated
on a prospective basis utilizing the regression method. In order to satisfy the
retrospective assessment of hedge effectiveness, the cumulative dollar offset
method is utilized and ineffectiveness is recorded to the income statement on a
monthly 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 of
income), which represented the total ineffectiveness of all cash flow hedges.
Only the time value component of these derivative contracts has been excluded
from the assessment of hedge effectiveness.
Gains or losses on derivative contracts that are reclassified from accumulated
other comprehensive income to current period earnings pursuant to this strategy,
are included in interest expense on deposit liabilities during the periods that
net income is impacted by the underlying liabilities. As of December 31, 2005,
approximately $14 million of deferred net gains on derivative instruments
accumulated in other comprehensive income are expected to be included in
earnings during 2006.
Trading and Other Activities
HUSI enters into certain derivative contracts for purely trading purposes in
order to realize profits from short-term movements in interest rates, commodity
prices, foreign exchange rates and credit spreads. In addition, certain
derivative contracts are accounted for on a full mark to market basis through
current earnings even though they were acquired for the purpose of protecting
the 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 entering
into transactions with high quality counterparties including other HSBC
entities. 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 subject
to regular credit review by the credit risk management department. Most
derivative contracts are governed by an International Swaps and Derivatives
Association Master Agreement. Depending on the type of counterparty and the
level of expected activity, bilateral collateral arrangements may be required as
well.
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 associated
with derivative contracts. In the table, current credit risk exposure is the
recorded fair value of derivative receivables, which represents revaluation
gains from the marking to market of derivative contracts held for trading
purposes, for all counterparties with an International Swaps and Derivatives
Association Master Agreement in place.
Future credit risk exposure in the following table is measured using rules
contained in the risk-based capital guidelines published by U.S. banking
regulatory agencies. The risk exposure calculated in accordance with the
risk-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 the
impact of bilateral netting (i.e., netting with a single counterparty when a
bilateral netting agreement is in place). However, the risk-based capital
guidelines recognize that bilateral netting agreements reduce credit risk and
therefore allow for reductions of risk-weighted assets when netting requirements
have been met. In addition, risk-based capital rules require that netted
exposures of various counterparties be assigned risk-weightings, which result in
risk-weighted amounts for regulatory capital purposes that are a fraction of the
original netted exposures.
-------------------------------------------------------------------------------
December 31 2005 2004
-------------------------------------------------------------------------------
(in millions)
Risk associated with derivative contracts:
Current credit risk exposure ..................... $ 8,155 $ 9,607
Future credit risk exposure ...................... 61,548 29,538
-------- --------
Total risk exposure .............................. 69,703 39,145
Less: 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 on
balance sheet exposure to derivative contracts, net of cash and other highly
liquid 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 47
BBB+ to BBB- .................................. 22 11
BB+ to B- ..................................... 4 6
CCC+ and below ................................ 7 4
------ ------
Total ......................................... 100% 100%
====== ======
Market risk is the adverse effect that a change in interest rates, currency, or
implied volatility rates has on the value of a financial instrument. HUSI
manages the market risk associated with interest rate and foreign exchange
contracts by establishing and monitoring limits as to the types and degree of
risk that may be undertaken. HUSI also manages the market risk associated with
the 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 and
defining the scope and nature of various strategies utilized to manage interest
rate risk that are developed through its analysis of data from financial
simulation models and other internal and industry sources. The resulting hedge
strategies are then incorporated into HUSI's overall interest rate risk
management 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 $ 570
To 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 ................................................................... 581 622 437
Deferred, primarily federal ..................................................... (15) 96 133
------- ------- -------
Total income tax expense ........................................................ $ 566 $ 718 $ 570
======= ======= =======
116
The following table is an analysis of the difference between effective rates
based on the total income tax provision attributable to pretax income and the
statutory 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 following
table.
----------------------------------------------------------------------------------------------------------------
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 to
accrued pension cost resulted from the transfer of sponsorship of HUSI's defined
benefit pension plan to HNAH, effective January 1, 2005. See Note 22 beginning
on page 127 of this Form 10-K for further information.
Realization of deferred tax assets is contingent upon the generation of future
taxable income or the existence of sufficient taxable income within the
carryback period. Based upon the level of historical taxable income and the
scheduled reversal of the deferred tax liabilities over the periods in which the
deferred tax assets are deductible, management believes that it is more likely
than 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 preferred
stock 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 5.715 150 150
Dutch 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 62
CTUS 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-Cumulative
Preferred Stock, Series F. Dividends on the Series F Preferred Stock are
non-cumulative and will be payable when and if declared by the board of
directors of HUSI quarterly on the first calendar day of January, April, July
and October of each year. Dividends on the stated value per share are payable
for 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% per
annum. The Series F Preferred Stock may be redeemed at the option of HUSI, in
whole or in part, on or after April 7, 2010 at a redemption price equal to $25
per share, plus accrued and unpaid dividends for the then-current dividend
period.
In October 2005 HUSI issued $373.8 million of Floating Rate Non-Cumulative
Preferred Stock, Series G. Dividends on the Series G Preferred Stock are
non-cumulative and will be payable when and if declared by the board of
directors of HUSI quarterly on the first calendar day of January, April, July
and October of each year. Dividends on the stated value per share are payable
for 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% per
annum. The Series G Preferred Stock may be redeemed at the option of HUSI, in
whole 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-current
dividend period.
The Adjustable Rate Cumulative Preferred Stock, Series D is redeemable, as a
whole or in part, at the option of HUSI at $100 per share (or $25 per depositary
share), plus accrued and unpaid dividends. The dividend rate is determined
quarterly, by reference to a formula based on certain benchmark market interest
rates, but will not be less than 4 1/2% or more than 10 1/2% per annum for any
applicable dividend period.
The $2.8575 Cumulative Preferred Stock may be redeemed at the option of HUSI, in
whole or in part, on or after October 1, 2007 at $50 per share, plus accrued and
unpaid 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 unpaid
dividends. Dividend rates for each dividend period are set pursuant to an
auction procedure. The maximum applicable dividend rates on the shares of DARTS
range 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 CT
Financial Services Inc. (the Seller). CTUS owned First Federal Savings and Loan
Association of Rochester (First Federal). The acquisition agreement provided
that HUSI issue preferred shares to the Seller. The preferred shares provide
for, and only for, a contingent dividend or redemption equal to the amount of
recovery, net of taxes and costs, if any, by First Federal resulting from the
pending action against the United States government alleging breaches by the
government of contractual obligations to First Federal following passage of the
Financial Institutions Reform, Recovery and Enforcement Act of 1989. HUSI issued
100 preferred shares at a par value of $1.00 per share in connection with the
acquisition.
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 shareholder
dividends and along with interest earned on investments, cover HUSI's operating
expenses which consist primarily of interest on outstanding debt. The approval
of the Federal Reserve Board is required if the total of all dividends declared
by HBUS in any year exceeds the net profits for that year, combined with the
retained profits for the two preceding years. Under a separate restriction,
payment of dividends is prohibited in amounts greater than undivided profits
then on hand, after deducting actual losses and bad debts. Bad debts are debts
due and unpaid for a period of six months unless well secured, as defined, and
in the process of collection.
Under the more restrictive of the above rules HBUS can pay dividends to HUSI as
of December 31, 2005 of approximately $2 billion, adjusted by the effect of its
net income (loss) for 2006 up to the date of such dividend declaration.
Capital amounts and ratios of HUSI and HBUS, calculated in accordance with
banking regulations, are summarized in the following table.
-----------------------------------------------------------------------------------------------------------------------
2005 2004
---------------------------------------- -----------------------------------------
Capital Well-Capitalized Actual Capital Well-Capitalized Actual
December 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 12.46
Tier 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 8.66
Tier 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 7.51
Tangible common equity
(to risk weighted assets):
HUSI .............. 7,562 6.40 7,611 7.07
HBUS .............. 9,778 8.33 9,249 8.70
Risk 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 following
table.
------------------------------------------------------------------------------------------------------------------------
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 reported
directly within a separate component of shareholders' equity. The following
table 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 its
affiliates (HSBC affiliates). These transactions occur at prevailing market
rates and terms. All extensions of credit by HUSI to other HSBC affiliates are
legally required to be secured by eligible collateral. The following table
presents related party balances and the income and expense generated by related
party 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 $ 17
Interest expense .................................................. 293 119 96
Trading (losses) income ........................................... (2,543) (2,821) 428
Other revenues .................................................... 130 147 58
Support 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 as
technology services employees from other HSBC affiliates in the United States,
were transferred to HTSU. In addition, all technology related assets and
software purchased subsequent to January 1, 2004 are generally purchased and
owned by HTSU. Technology related assets owned by HUSI prior to January 1, 2004
remain in place and were not transferred to HTSU. Pursuant to a master service
level agreement, HTSU charges HUSI for technology services and software
development.
122
The following business transactions were conducted with HSBC Finance Corporation
during 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 with
similar terms.
HUSI has extended loans and lines of credit to various other HSBC affiliates
totaling $1.4 billion, of which $167 million was outstanding at December 31,
2005. Interest rates are comparable to third party rates for lines of credit
with similar terms.
At December 31, 2005 and December 31, 2004, the aggregate notional amounts of
all derivative contracts with HSBC affiliates were approximately $570 billion
and $302 billion respectively. The net credit risk exposure related to these
contracts was approximately $5 billion and $2 billion at December 31, 2005 and
2004 respectively.
Employees of HUSI participate in one or more stock compensation plans sponsored
by HSBC. HUSI's share of the expense of the plans for the year ended 2005 and
2004 was $51 million and $61 million respectively. HUSI's share of expense has
been reduced during 2005, resulting from a change in the amortization period
utilized for share-based compensation in the CIBM business segment. A
description of these plans is included in Note 21 beginning on page 124 of this
Form 10-K.
During 2004, HUSI received capital contributions of $2.4 billion from its direct
parent company, HNAI, in exchange for two shares of common stock. HUSI also
contributed $2.4 billion to HBUS in exchange for two shares of common stock.
HUSI periodically pays dividends to its parent company, HNAI. Dividends declared
in 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 Group
Share Option Plan (the Group Share Option Plan), the HSBC Holdings Executive
Share Option Scheme (the Executive Share Option Plan) and under the HSBC
Holdings Savings-Related Share Option Plan (Sharesave). Since the shares and
contribution commitment have been granted directly by HSBC, the offset to
compensation expense was a credit to capital surplus, representing a
contribution of capital from HSBC.
124
The following table presents information for each plan. Descriptions of each
plan 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 compensation
plan available prior to 2005, to certain HUSI employees based on performance
criteria. Options were granted at market value and are normally exercisable
between the third and tenth anniversaries of the date of grant, subject to
vesting conditions.
Fair values of Group Share Option Plan awards made in 2004, measured at the date
of grant, were calculated using a binomial lattice methodology that is based on
the underlying assumptions of the Black-Scholes option pricing model. When
modeling options with vesting dependent on attainment of certain performance
conditions over a period of time, these performance targets are incorporated
into the model using Monte-Carlo simulation. The expected life of options
depends on the behavior of option holders, which is incorporated into the option
model consistent with historic observable data. The fair values are inherently
subjective and uncertain due to the assumptions made and the limitations of the
model 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 the
plan was terminated by HSBC in May 2005. In lieu of options, employees now
receive grants of HSBC Holdings ordinary shares subject to certain vesting
conditions. All existing stock option grants under the Group Share Option Plan
remain in effect subject to the same conditions as before plan termination and
compensation expense continues to be recognized over the various grant vesting
periods.
125
Sharesave
Sharesave is an employee share option plan that enables eligible employees to
enter into savings contracts of either three or five year terms, with the
ability to decide at the end of the contract term, to either use their
accumulated savings to purchase HSBC Holdings ordinary shares at a discounted
option price or have the savings plus interest repaid in cash. Employees can
save up to approximately $400 per month over all their Sharesave savings
contracts. The option price is determined at the beginning of the offering
period each plan year and represents a 20% discount from the average price in
London of the HSBC Holdings ordinary shares over the five trading days preceding
the offering. The options are exercisable within six months following the third
or fifth anniversary of the beginning of the relevant savings contract.
The fair value of options granted under Sharesave was estimated as of the date
of grant using a third party option pricing model in 2005 and 2004, and the
Black-Scholes option pricing model in 2003.
Restricted Share Plans
Awards are granted to key individuals in the form of performance and
non-performance restricted shares. The awards are based on an individual's
demonstrated performance and future potential. Performance related restricted
shares generally vest after three years from date of grant, based on HSBC's
Total Shareholder Return (TSR) relative to a benchmark TSR during the
performance period. TSR is defined as the growth in share value and declared
dividend income during the period and the benchmark is composed of HSBC's peer
group of financial institutions. If the performance conditions are met, the
shares vest and are released to the recipients two years later. Non-performance
restricted 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 incentive
compensation plan available to certain HUSI employees, based on performance
criteria and potential, with grants usually made each year. Options were granted
at market value and were normally exercisable between the third and tenth
anniversaries of the date of grant, subject to vesting conditions. No grants
have been made under this plan since the adoption of the Group Share Option Plan
in 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 and
the defined benefit pension plan of HSBC Finance Corporation was transferred to
HNAH. Effective January 1, 2005, the two separate plans were combined into a
single HNAH defined benefit pension plan which facilitates the development of a
unified employee benefit policy and unified employee benefit plan administration
for HSBC companies operating in the U.S. As a result, the pension asset relating
to HUSI's defined benefit plan of $279 million, net of tax, was transferred to
HNAH as a capital transaction in the first quarter of 2005.
The components of pension expense for the defined benefit plan reflected in
HUSI's consolidated statement of income, are shown in the table below. The
pension expense for the year ended December 31, 2005 reflects the portion of the
pension expense of the combined HNAH pension plan which has been allocated to
HUSI.
------------------------------------------------------------------------------------------------------------------
Year Ended December 31 2005 2004 2003
------------------------------------------------------------------------------------------------------------------
(in millions)
Service cost-benefits earned during the period ................. $ 27 $ 31 $ 29
Interest cost on projected benefit obligation .................. 62 69 64
Expected return on assets ...................................... (89) (96) (87)
Amortization of prior service cost ............................. 1 1 1
Recognized losses .............................................. 5 26 32
-------- -------- --------
Pension expense ................................................ $ 6 $ 31 $ 39
======== ======== ========
The information and activity presented below as of and for the year ended
December 31, 2005 relates to the post-merger HNAH defined benefit pension plan,
unless noted otherwise. The information and activity presented as of December
31, 2004 and December 31, 2003 and for the years then ended, reflect the
pre-merger HUSI defined benefit pension plan balances and activity.
The assumptions used in determining pension expense of the defined benefit plan
are 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 3.75
Expected 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 provide
investment consulting services. Given the plan's current allocation of equity
and fixed income securities and using investment return assumptions which are
based on long term historical data, the long term expected return for plan
assets is reasonable.
The funded status of the defined benefit pension plan is shown below. The
components shown below as of December 31, 2005 reflect the funded status of the
post-merger HNAH pension plan and not the interests of HUSI.
------------------------------------------------------------------------------------------------------------------
December 31 2005 2004
------------------------------------------------------------------------------------------------------------------
(Post-merger) (Pre-merger)
(in millions)
Funded status $ (146) $ 130
Unrecognized net actuarial gain 502 348
Unamortized prior service cost 3 4
---------- ----------
Prepaid pension cost $ 359 $ 482
========== ==========
127
A reconciliation of beginning and ending balances of the fair value of plan
assets associated with the defined benefit pension plan is shown below. The
activity shown for the year ended December 31, 2005 reflects the activity of the
merged 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 $ 1,222
Transfer in of assets from the former HSBC Finance Corporation Plan ............... 1,001 --
Actual return on plan assets ...................................................... 169 120
Benefits 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 defined
benefit plan in 2006.
The allocation of the pension plan assets at December 31, 2005 and 2004 is as
follows:
--------------------------------------------------------------------------------------------------------------------
Percentage of Plan Assets
at December 31,
-----------------------------
2005 2004
--------------------------------------------------------------------------------------------------------------------
(Post-merger) (Pre-merger)
Equity securities ................................................................. 69% 61%
Debt securities ................................................................... 31 36
Other ............................................................................. -- 3
--------- ---------
Total ............................................................................. 100% 100%
========= =========
There were no investments in HSBC ordinary shares or American depositary shares
at December 31, 2005 and 2004.
The primary objective of the defined benefit pension plan is to provide eligible
employees with regular pension benefits. Since the plans are governed by the
Employee Retirement Income Security Act of 1974 (ERISA), ERISA regulations serve
as guidance for the management of plan assets. Consistent with prudent standards
of preservation of capital and maintenance of liquidity, the goals of the plans
are to earn the highest possible rate of return consistent with the tolerance
for 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 plan
assets are considered secondary to long-term investment results. A third party
is used to provide investment consulting services such as recommendations on the
type 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 are
diversified to ensure that adverse results from one security or security class
will not have an unduly detrimental effect on the entire investment portfolio.
Assets are diversified by type, characteristic and number of investments as well
as by investment style of management organization. Equity securities are
invested in large, mid and small capitalization domestic stocks as well as
international stocks.
128
A reconciliation of beginning and ending balances of the projected benefit
obligation of the defined benefit pension plans is shown below. The projected
benefit obligation shown for the year ended December 31, 2005 reflects the
projected benefit obligation of the merged HNAH plan.
--------------------------------------------------------------------------------------------------------------------
Year Ended December 31 2005 2004
--------------------------------------------------------------------------------------------------------------------
(Post-merger) (Pre-merger)
(in millions)
Projected benefit obligation at beginning of year ............. $ 1,173 $ 1,102
Transfer in from the HSBC Finance Corporation Plan ............ 1,020 --
Service cost .................................................. 94 31
Interest cost ................................................. 130 69
Actuarial gains ............................................... 203 9
Benefits paid ................................................. (90) (38)
--------- ---------
Projected benefit obligation at end of year ................... $ 2,530 $ 1,173
========= =========
HUSI's share of the projected benefit obligation at December 31, 2005 is
approximately $1 billion. The accumulated benefit obligation for the post-merger
HNAH defined benefit pension plans was approximately $2 billion at December 31,
2005. HUSI's share of the accumulated benefit obligation at December 31, 2005
was approximately $1 billion. The accumulated benefit obligation for the
pre-merger defined benefit pension plans was approximately $1 billion at
December 31, 2004.
Estimated future benefit payments for the HNAH defined benefit plan and HUSI's
share of those payments are as follows:
--------------------------------------------------------------------------------------------------------------------
HUSI's
HNAH Share
--------------------------------------------------------------------------------------------------------------------
(in millions)
2006 ...................................................................... $ 102 $ 42
2007 ...................................................................... 112 46
2008 ...................................................................... 121 50
2009 ...................................................................... 129 54
2010 ...................................................................... 136 58
2011-2015 ................................................................. 848 366
The assumptions used in determining the projected benefit obligation of the
defined benefit plans at December 31 are as follows:
--------------------------------------------------------------------------------------------------------------------
2005 2004 2003
--------------------------------------------------------------------------------------------------------------------
(Post-merger) (Pre-merger) (Pre-merger)
Discount rate ......................................... 5.70% 6.00% 6.25%
Salary increase assumption ............................ 3.75 3.75 3.75
Postretirement Plans Other Than Pensions
HUSI's employees also participate in several plans which provide medical, dental
and life insurance benefits to retirees and eligible dependents. These plans
cover substantially all employees who meet certain age and vested service
requirements. HUSI has instituted dollar limits on payments under the plans to
control the cost of future medical benefits.
129
The net postretirement benefit cost included the following:
-----------------------------------------------------------------------------------------------------------------
Year Ended December 31 2005 2004 2003
-----------------------------------------------------------------------------------------------------------------
(in millions)
Service cost - benefits earned during the period ............... $ 2 $ 2 $ 3
Interest cost .................................................. 7 7 7
Amortization of transition obligation .......................... 3 3 3
------- -------- --------
Net periodic postretirement benefit cost ....................... $ 12 $ 12 $ 13
======= ======== ========
The assumptions used in determining the net periodic postretirement benefit cost
for HUSI's postretirement benefit plans at December 31 are as follows:
-----------------------------------------------------------------------------------------------------------------
2005 2004 2003
-----------------------------------------------------------------------------------------------------------------
Discount rate .................................................... 6.00% 5.75% 6.25%
Salary increase assumption ....................................... 3.75 3.75 3.75
A reconciliation of the beginning and ending balances of the accumulated
postretirement benefit obligation is as follows:
-----------------------------------------------------------------------------------------------------------------
Year Ended December 31 2005 2004
-----------------------------------------------------------------------------------------------------------------
(in millions)
Accumulated benefit obligation at beginning of year ........................ $ 122 $ 124
Service cost ............................................................... 2 2
Interest cost .............................................................. 7 6
Foreign currency exchange rate changes ..................................... 1 1
Actuarial losses ........................................................... (4) --
Benefits paid .............................................................. (9) (11)
-------- --------
Accumulated benefit obligation at end of year .............................. $ 119 $ 122
======== ========
HUSI's postretirement benefit plans are funded on a pay-as-you-go basis. HUSI
currently estimates that it will pay benefits of approximately $9 million
relating to the postretirement benefit plans in 2006. The components of the
accrued postretirement benefit obligation are as follows:
-----------------------------------------------------------------------------------------------------------------
December 31 2005 2004
-----------------------------------------------------------------------------------------------------------------
(in millions)
Funded status .............................................................. $ (119) $ (122)
Unrecognized net actuarial (loss) gain ..................................... 8 12
Unamortized transition obligation .......................................... 21 24
---------- ----------
Accrued postretirement benefit obligation .................................. $ (90) $ (86)
========== ==========
Estimated future benefit payments for HUSI's plans are as follows:
----------------------------------------------------------------------------------------------------------------
(in millions)
2006 ........................................................................................... $ 9
2007 ........................................................................................... 9
2008 ........................................................................................... 9
2009 ........................................................................................... 9
2010 ........................................................................................... 9
2011-2015 ...................................................................................... 49
130
The assumptions used in determining the benefit obligation of HUSI's
postretirement benefit plans at December 31 are as follows:
----------------------------------------------------------------------------------------------------------------
2005 2004 2003
----------------------------------------------------------------------------------------------------------------
Discount rate ............................................... 5.70% 6.00% 5.75%
Salary increase assumption .................................. 3.75 3.75 3.75
A 10.5 percent annual rate of increase in the gross cost of covered health care
benefits was assumed for 2006. This rate of increase is assumed to decline
gradually to 5 percent in 2014.
Assumed health care cost trend rates have an effect on the amounts reported for
health care plans. A one-percentage point change in assumed health care cost
trend rates would increase (decrease) service and interest costs and the
postretirement benefit obligation as follows:
---------------------------------------------------------------------------------------------------------------
One Percent One Percent
Increase Decrease
---------------------------------------------------------------------------------------------------------------
(in millions)
Effect on total of service and interest cost components ........... $ -- $ --
Effect on postretirement benefit obligation ....................... 1 (2)
Other Plans
HUSI maintains a 401(k) plan covering substantially all employees. Employer
contributions to the plan are based on employee contributions. Total expense
recognized for this plan was approximately $33 million, $18 million and $18
million in 2005, 2004 and 2003 respectively.
Certain employees are participants in various defined contribution and other
non-qualified supplemental retirement plans. Total expense recognized for these
plans was immaterial in 2005, 2004 and 2003.
131
Note 23. Business Segments
--------------------------------------------------------------------------------
HUSI reports and manages its business segments consistently with the line of
business groupings used by HSBC. HUSI has five distinct segments that it
utilizes for management reporting and analysis purposes. Descriptions of HUSI's
business segments are presented in Item 1 on pages 4-5 of this Form 10-K.
Results for each segment are summarized in the following tables. Prior period
disclosures previously reported for 2004 and 2003 have been conformed herein to
the presentation of current segments, including methodology changes related to
the transfer pricing of assets and liabilities.
------------------------------------------------------------------------------------------------------------------------
PFS CF CMB CIBM PB Other Total
------------------------------------------------------------------------------------------------------------------------
(in millions)
2005
Net interest income (1) $ 1,203 $ 583 $ 661 $ 456 $ 172 $ (12) $ 3,063
Other revenues 442 356 183 641 257 32 1,911
--------- --------- --------- --------- --------- --------- ---------
Total revenues 1,645 939 844 1,097 429 20 4,974
Operating expenses (2) 1,033 424 379 650 272 -- 2,758
--------- --------- --------- --------- --------- --------- ---------
Working contribution 612 515 465 447 157 20 2,216
Provision for credit
losses (3) 103 599 22 (47) (3) -- 674
--------- --------- --------- --------- --------- --------- ---------
Income (loss) before
income tax expense $ 509 $ (84) $ 443 $ 494 $ 160 $ 20 $ 1,542
========= ========= ========= ========= ========= ========= =========
Average assets $ 49,084 $ 19,316 $ 15,817 $ 57,597 $ 5,041 $ 321 $ 147,176
Average liabilities/
equity (4) 43,304 684 17,856 75,579 9,751 2 147,176
Goodwill at December 31,
2005 (5) 1,167 -- 468 631 428 -- 2,694
2004
Net interest income (1) $ 1,090 $ 182 $ 584 $ 766 $ 130 $ (11) $ 2,741
Other revenues 381 2 170 534 204 28 1,319
--------- --------- --------- --------- --------- --------- ---------
Total revenues 1,471 184 754 1,300 334 17 4,060
Operating expenses (2) 944 17 352 525 263 -- 2,101
--------- --------- --------- --------- --------- --------- ---------
Working contribution 527 167 402 775 71 17 1,959
Provision for credit
losses (3) 81 22 (26) (95) 1 -- (17)
--------- --------- --------- --------- --------- --------- ---------
Income before income
tax expense $ 446 $ 145 $ 428 $ 870 $ 70 $ 17 $ 1,976
========= ========= ========= ========= ========= ========= =========
Average assets $ 41,202 $ 4,256 $ 13,750 $ 48,689 $ 4,029 $ 300 $ 112,226
Average liabilities/
equity (4) 34,165 (2) 14,670 54,442 8,951 -- 112,226
Goodwill at December 31,
2004 (5) 1,167 -- 471 631 428 -- 2,697
132
------------------------------------------------------------------------------------------------------------------------
PFS CF CMB CIBM PB Other Total
------------------------------------------------------------------------------------------------------------------------
(in millions)
2003
Net interest income (1) .. $ 1,081 $ -- $ 592 $ 731 $ 123 $ (17) $ 2,510
Other revenues ........... 250 -- 158 526 195 25 1,154
-------- -------- -------- -------- -------- -------- --------
Total revenues ........... 1,331 -- 750 1,257 318 8 3,664
Operating expenses (2) ... 930 -- 402 442 265 1 2,040
-------- -------- -------- -------- -------- -------- --------
Working contribution ..... 401 -- 348 815 53 7 1,624
Provision for credit
losses (3) ............. 68 -- 55 (8) (2) -- 113
-------- -------- -------- -------- -------- -------- --------
Income before income
tax expense ............ $ 333 $ -- $ 293 $ 823 $ 55 $ 7 $ 1,511
======== ======== ======== ======== ======== ======== ========
Average assets ........... $ 28,601 $ -- $ 14,236 $ 45,738 $ 2,936 $ 314 $ 91,825
Average liabilities/
equity (4) ............. 31,066 -- 13,281 38,917 8,561 -- 91,825
Goodwill at
December 31, 2003 (5) .... 1,223 -- 495 631 428 -- 2,777
(1) Net interest income of each segment represents the difference between
actual interest earned on assets and interest paid on liabilities of the
segment adjusted for a funding charge or credit. Segments are charged a
cost to fund assets (e.g. customer loans) and receive a funding credit for
funds provided (e.g. customer deposits) based on equivalent market rates.
(2) Expenses for the segments include fully apportioned corporate overhead
expenses.
(3) The provision apportioned to the segments is based on the segments' net
charge offs and the change in allowance for credit losses. Credit loss
reserves are established at a level sufficient to absorb the losses
considered to be inherent in the portfolio.
(4) Common shareholder's equity and earnings on common shareholder's equity
are allocated back to the segments based on the percentage of capital
assigned to the business.
(5) The reduction in goodwill from December 31, 2004 to December 31, 2005
resulted from the sale of certain branches during 2005. The reduction in
goodwill from December 31, 2003 to December 31, 2004 resulted from the
sale or transfer of certain domestic and foreign operations during 2004.
Note 24. Collateral, Commitments and Contingent Liabilities
--------------------------------------------------------------------------------
Pledged Assets
The following table presents pledged assets included in the consolidated balance
sheet.
--------------------------------------------------------------------------------------------------------------------
December 31 2005 2004
--------------------------------------------------------------------------------------------------------------------
(in millions)
Interest bearing deposits with banks .................................... $ 1,170 $ 767
Trading assets .......................................................... 1,452 305
Securities available for sale ........................................... 6,369 6,096
Securities held to maturity ............................................. 447 655
Loans ................................................................... 8,204 5,971
---------- ----------
Total ................................................................... $ 17,642 $ 13,794
========== ==========
Securities available for sale are primarily pledged against various short-term
borrowings. Loans are primarily residential mortgage loans pledged against
long-term borrowings from the Federal Home Loan Bank and private label credit
card receivables pledged against secured long-term borrowings.
In accordance with the Statement of Financial Accounting Standards No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities (SFAS 140), debt securities pledged as collateral that can be
sold or repledged by the secured party continue to be reported on the
consolidated balance sheet. The fair value of securities available for sale that
can be sold or repledged at December 31, 2005 and 2004 was approximately $2,152
million and $1,320 million respectively.
133
The fair value of collateral accepted by HUSI not reported on the consolidated
balance sheet that can be sold or repledged at December 31, 2005 and 2004 was
approximately $5,800 million and $2,834 million respectively. This collateral
was obtained under security resale agreements. Of this collateral, approximately
$1,158 million at December 31, 2005 has been sold or repledged as collateral
under repurchase agreements or to cover short sales compared with $2,081 million
at December 31, 2004.
The 2004 increase in pledged assets resulted from collateral requirements
associated with increased short-term borrowings and with increased derivatives
activity.
Lease Obligations
HUSI and its subsidiaries are obligated under a number of noncancellable leases
for premises and equipment. Certain leases contain renewal options and
escalation clauses. The following table presents actual and expected minimum
lease payments under noncancellable operating leases, net of sublease rentals.
--------------------------------------------------------------------------------------------------------------------
December 31 2005 2004 2003
--------------------------------------------------------------------------------------------------------------------
(in millions)
Actual annual rental expense .................................. $ 89 $ 82 $ 63
======= ===== ======
Minimum expected future payments:
2006 .......................................................... $ 79
2007 .......................................................... 72
2008 .......................................................... 61
2009 .......................................................... 54
2010 .......................................................... 46
Thereafter .................................................... 179
-------
$ 491
=======
Litigation
HUSI is named in and is defending legal actions in various jurisdictions arising
from its normal business. None of these proceedings is regarded as material
litigation. In addition, there are certain proceedings related to the "Princeton
Note Matter" that are described below.
In relation to the Princeton Note Matter, as disclosed in HUSI's 2002 Annual
Report on Form 10-K, two of the noteholders were not included in the settlement
and their civil suits are continuing. The U.S. Government excluded one of them
from the restitution order (Yakult Honsha Co., Ltd.) because a senior officer of
the noteholder was being criminally prosecuted in Japan for his conduct relating
to its Princeton Notes. The senior officer in question was convicted during
September 2002 of various criminal charges related to the sale of the Princeton
Notes. The U.S. Government excluded the other noteholder (Maruzen Company,
Limited) because the sum it is likely to recover from the Princeton Receiver
exceeds its losses attributable to its funds transfers with Republic New York
Securities Corporation as calculated by the U.S. Government. Both of these civil
suits seek compensatory, punitive, and treble damages pursuant to RICO and
assorted fraud and breach of duty claims arising from unpaid Princeton Notes
with face amounts totaling approximately $125 million. No amount of compensatory
damages is specified in either complaint. These two complaints name HUSI, HBUS,
and Republic New York Securities Corporation as defendants. HUSI and HBUS have
moved to dismiss both complaints. The motion is fully briefed and sub judice.
Mutual production of documents took place in 2001, but additional discovery
proceedings have been suspended pending the Court's resolution of the motions to
dismiss.
134
Note 25. Variable Interest Entities (VIEs)
--------------------------------------------------------------------------------
HUSI, in the ordinary course of business, makes use of VIE structures in a
variety of business activities, primarily to facilitate client needs. VIE
structures are utilized after careful consideration of the most appropriate
structure needed to achieve HUSI's control and risk management objectives and to
help ensure an efficient structure from a taxation and regulatory perspective.
Consolidated VIEs
HUSI entered into a series of transactions with VIEs organized by HSBC
affiliates and unrelated third parties. These VIEs were structured as trusts or
corporations that issue fixed or floating rate instruments backed by the assets
of the issuing entities. HUSI sold trading assets to the VIEs and subsequently
entered into total return swaps with the VIEs whereby HUSI receives the total
return on the transferred assets and, in return, pays a market rate of return to
its counterparties. HUSI has determined that it is the primary beneficiary of
these VIEs under the applicable accounting literature and, accordingly,
consolidated $1,060 million in trading assets at December 31, 2005. These assets
are pledged as collateral for obligations of the VIEs. The holders of the
instruments issued by the VIEs have no recourse to the general credit of HUSI
beyond the assets sold to the VIEs and pledged as collateral.
Unconsolidated VIEs
HUSI also holds variable interests in various other VIEs which are not
consolidated at December 31, 2005. HUSI is not the primary beneficiary of these
VIE structures. Information for unconsolidated VIEs is presented in the
following table and commentary.
--------------------------------------------------------------------------------------------------------------------
December 31, 2005 December 31, 2004
------------------------------ ----------------------------
Maximum Maximum
Total Exposure Total Exposure
Assets to Loss Assets to Loss
--------------------------------------------------------------------------------------------------------------------
(in millions)
Asset backed commercial paper conduit ......... $ 10,183 $ 7,423 $ 5,657 $ 5,867
Securitization vehicles ....................... 1,774 565 1,062 552
Investment funds . ............................ 2,513 -- 2,832 36
Capital funding vehicles ...................... 1,093 32 1,093 32
Low income housing tax credits ................ 1,080 165 994 88
---------- --------- --------- --------
Total $ 16,643 $ 8,185 $ 11,638 $ 6,575
========== ========= ========= ========
Asset Backed Commercial Paper Conduits
HSBC affiliates support the financing needs of customers by facilitating their
access to the commercial paper markets. Specifically, pools of customers'
assets, typically trade receivables, are sold to an independently rated,
commercial paper financing entity, which in turn issues short-term, asset backed
commercial paper that is collateralized by such assets. Neither the HSBC
affiliates nor HUSI service the assets or transfer their own receivables into
the financing entities.
HUSI and other banks provide one year liquidity facilities, in the form of
either loan or asset purchase commitments, in support of each transaction in the
financing entity. HUSI does not provide any program wide enhancements to the
financing entities. In the preceding table, HUSI's maximum exposure to loss is
the total notional amount of the liquidity facilities.
In the normal course of business, HUSI provides liquidity facilities to asset
backed commercial paper conduits sponsored by unrelated third parties. HUSI does
not transfer their own receivables into the financing entity, has no ownership
interest in, no administrative duties, and does not service any assets of these
conduits. The only interest HUSI has in these entities are liquidity facilities
in the amount of approximately $1.4 billion at December 31, 2005. These
facilities are excluded from the table summarizing HUSI's involvement in VIEs.
135
Credit risk is managed on these commitments by subjecting them to HUSI's normal
underwriting and risk management processes.
Securitization Vehicles
An HSBC affiliate and third parties organize trusts that are special purpose
entities (SPEs) that issue fixed or floating rate debt backed by the assets of
the trusts. Neither the HSBC affiliate nor HUSI transfer their own assets into
the trusts. HUSI's relationship with the SPEs is primarily as counterparty to
the SPE's derivative transactions (interest rate, credit default and currency
swaps). HUSI's maximum exposure to loss from the unconsolidated trust entities
is comprised of investments in the trust and the market risk on the derivative
transactions.
Investment Funds
HUSI is a derivative counterparty (total return swap) with a hedge fund
established by an unrelated third party. The total return swap creates a
variable interest in the fund for HUSI. HUSI does not hold shares in or have any
other involvement with the fund. As such, HUSI is not the primary beneficiary.
HUSI is also an investor in a hedge fund established by an unrelated third
party. The shares owned by HUSI do not have voting rights but do participate in
profits and losses based on percentage of share ownership. HUSI does not hold
sufficient beneficial interests in the fund to be considered the primary
beneficiary.
HUSI is a sub-investment advisor to mutual funds structured as trusts and
managed by an HSBC affiliate. As sub-investment advisor, HUSI receives a
variable fee based on the value of funds. HUSI has no ownership interest in or
credit exposure resulting from its duties as investment advisor.
Capital Funding Vehicles
Prior to 2005, HUSI established five Capital Trust entities. These trusts issue
preferred securities and common stock. HUSI purchased all of the common equity
issued by the trusts, which equates to approximately 3% of the total assets of
the trusts. HUSI does not own any of the preferred securities issued by the
trusts. It has been determined that the majority of the benefit of profit and/or
risk of loss lies with the preferred security holders. Thus, HUSI is not the
primary beneficiary of the trusts and is not required to consolidate these
entities.
Low Income Housing Tax Credits
HUSI participates as a limited partner in Low Income Housing Tax Credit
Partnerships. These investments are recorded as other assets on the consolidated
balance sheet using the equity method of accounting. HUSI also receives tax
benefits over a period of time specified in the investment contracts. HUSI's
investment is reduced over time for its share of any operating losses incurred
by the partnership as well as for any amortization over the time period in which
tax credits are received. Tax credits may be subject to recapture if the
underlying properties do not remain in compliance with certain conditions. Some
of these partnerships have been determined to be VIEs. HUSI's maximum exposure
to loss shown in the table represents the net assets recorded on the balance
sheet, estimated expected reduction of future tax liabilities, and potential
recapture of tax credits allowed in prior years.
Note 26. Fair Value of Financial Instruments
--------------------------------------------------------------------------------
HUSI is required to disclose the estimated fair value of its financial
instruments in accordance with Statement of Financial Accounting Standards No.
107, Disclosures about Fair Value of Financial Instruments (SFAS 107). The
disclosures do not attempt to estimate or represent the fair value of HUSI as a
whole. The disclosures exclude assets and liabilities that are not financial
instruments, including intangible assets, such as goodwill. The estimation
methods and assumptions used by HUSI to value individual classifications of
financial instruments are described below. Different assumptions could
significantly affect the estimates. Accordingly, the net realizable values upon
liquidation of the financial instruments could be materially different from the
estimates presented.
136
Financial instruments with carrying value equal to fair value - The carrying
value of certain financial assets and liabilities is considered to be equal to
fair value as a result of their short term nature. These include cash and due
from banks, interest bearing deposits with banks, federal funds sold and
securities purchased under resale agreements, accrued interest receivable,
customers' acceptance liability and certain financial liabilities including
acceptances outstanding, short-term borrowings and interest, taxes, and other
liabilities.
Securities and trading assets and liabilities - The fair value of securities and
derivative contracts is based on current market quotations, where available. If
quoted market prices are not available, fair value is estimated based on the
quoted price of similar instruments or internal valuation models that
approximate market pricing.
Loans - The fair value of the performing loan portfolio is determined primarily
by calculating the present value of expected cash flows using a discount rate as
noted below. The loans are grouped, to the extent possible, into homogeneous
pools, segregated by maturity, weighted average maturity, and average coupon
rate. Depending upon the type of loan involved, maturity assumptions are based
on either the contractual or expected maturity date.
For commercial loans, the allowance for credit losses is allocated to the
expected cash flows to provide for credit risk. A published interest rate that
equates closely to a "risk-free" or "low-risk" loan rate is used as the discount
rate. The interest rate is adjusted for a liquidity factor, as appropriate.
The discount rate used to calculate the fair value of consumer loans is computed
using the estimated rate of return an investor would demand for the product
without regard to credit risk. The discount rate is formulated by reference to
current market rates.
The discount rate used to calculate the fair value of residential mortgages is
determined by reference to quoted market prices for loans with similar
characteristics and maturities.
Deposits - The fair value of demand, savings, and money market deposits is equal
to the carrying value. For deposits with fixed maturities, fair value is
estimated using market interest rates currently offered on deposits with similar
characteristics and maturities.
Long-term debt - Fair value is estimated using interest rates currently
available to HUSI for borrowings with similar characteristics and maturities.
The summarized carrying values and estimated fair values of financial
instruments as of December 31, 2005 and 2004 follows.
------------------------------------------------------------------------------------------------------------------------
2005 2004
---------------------- ----------------------
Carrying Fair Carrying Fair
December 31 Value Value Value Value
------------------------------------------------------------------------------------------------------------------------
(in millions)
Financial assets:
Instruments with carrying value equal to fair value ....... $ 13,385 $ 13,385 $ 9,845 $ 9,845
Trading assets ............................................ 21,220 21,220 19,815 19,815
Securities available for sale ............................. 17,764 17,764 14,655 14,655
Securities held to maturity ............................... 3,171 3,262 3,881 4,042
Loans, net of allowance ................................... 89,496 88,467 84,159 84,216
Derivative instruments included in other assets (1) ....... 305 305 217 217
Financial liabilities:
Instruments with carrying value equal to fair value ....... 7,562 7,562 10,200 10,200
Deposits:
Without fixed maturities ............................... 77,924 77,924 68,234 68,234
Fixed maturities ....................................... 13,891 13,889 11,747 11,749
Trading account liabilities ............................... 10,710 10,710 12,120 12,120
Long-term debt ............................................ 27,959 28,448 23,839 24,589
Derivative instruments included in other liabilities (1) .. 80 80 176 176
(1) At December 31, 2005 and 2004, the amounts reported relate to derivative
contracts that qualify for hedge accounting treatment as defined by SFAS
133.
137
The fair value of commitments to extend credit, standby letters of credit and
financial guarantees, is not included in the previous table. These instruments
generate fees, which approximate those currently charged to originate similar
commitments.
Note 27. Financial Statements of HSBC USA Inc. (parent)
--------------------------------------------------------------------------------
Condensed parent company financial statements follow.
------------------------------------------------------------------------------------------------------------------------
Balance Sheet
December 31 2005 2004
------------------------------------------------------------------------------------------------------------------------
(in millions)
Assets:
Cash and due from banks .................................................................... $ -- $ --
Interest bearing deposits with banks (including $3,216 and $1,286 in banking subsidiary) ... 3,281 1,351
Trading assets ............................................................................. 584 279
Securities purchased under resale agreements ............................................... 6 3
Securities available for sale .............................................................. 157 20
Securities held to maturity (fair value $136 and $162) ..................................... 128 151
Loans (net of allowance for credit losses of $1 and $1) .................................... 131 533
Receivables from subsidiaries .............................................................. 1,616 1,766
Investment in subsidiaries at amount of their net assets:
Banking .............................................................................. 11,888 11,385
Other ................................................................................ 403 350
Goodwill ................................................................................... 604 604
Other assets ............................................................................... 158 179
--------- ---------
Total assets ............................................................................... $ 18,956 $ 16,621
========= =========
Liabilities:
Interest, taxes and other liabilities ...................................................... $ 147 $ 180
Short-term borrowings ...................................................................... 2,620 2,480
Long-term debt (1) ......................................................................... 4,595 3,092
Long-term debt due to subsidiary (1) ....................................................... -- 3
--------- ---------
Total liabilities .......................................................................... 7,362 5,755
Shareholders' equity * ..................................................................... 11,594 10,866
--------- ---------
Total liabilities and shareholders' equity ................................................. $ 18,956 $ 16,621
========= =========
* See Consolidated Statement of Changes in Shareholders' Equity, page 85.
(1) Contractual scheduled maturities for the debt over the next five years are
as follows: $300 million for 2006; 2007, $1,598 million; 2008, $240
million; 2009, $561 million and none in 2010.
138
------------------------------------------------------------------------------------------------------------------------
Statement of Income
Year Ended December 31 2005 2004 2003
------------------------------------------------------------------------------------------------------------------------
(in millions)
Income:
Dividends from banking subsidiaries ........................... $ 675 $ 125 $ 690
Dividends from other subsidiaries ............................. 2 2 34
Interest from banking subsidiaries ............................ 167 104 99
Interest from other subsidiaries .............................. 1 1 1
Other interest income ......................................... 30 19 16
Securities transactions ....................................... 13 4 (2)
Other income .................................................. 35 91 49
---------- ---------- ----------
Total income ........................................................ 923 346 887
---------- ---------- ----------
Expenses:
Interest (including $-, $86 and $64 paid to subsidiaries) ..... 350 240 229
Provision for credit losses ................................... -- 3 36
Other expenses ................................................ 17 20 24
---------- ---------- ----------
Total expenses ...................................................... 367 263 289
---------- ---------- ----------
Income before taxes and equity in undistributed income of subsidiaries 556 83 598
Income tax benefit .................................................. (40) (21) (64)
---------- ---------- ----------
Income before equity in undistributed income of subsidiaries ........ 596 104 662
Equity in undistributed income of subsidiaries ...................... 380 1,154 279
---------- ---------- ----------
Net income .......................................................... $ 976 $ 1,258 $ 941
========== ========== ==========
139
------------------------------------------------------------------------------------------------------------------------
Statement of Cash Flows
Year Ended December 31 2005 2004 2003
------------------------------------------------------------------------------------------------------------------------
(in millions)
Cash flows from operating activities:
Net income ....................................................... $ 976 $ 1,258 $ 941
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation, amortization and deferred taxes ................. (3) 13 13
Provision for credit losses ................................... -- 3 36
Net change in other accrued accounts .......................... (77) 137 25
Undistributed income of subsidiaries .......................... (380) (1,154) (279)
Other, net .................................................... (286) (80) (63)
---------- ---------- ----------
Net cash provided by operating activities .................. 230 177 673
---------- ---------- ----------
Cash flows from investing activities:
Net change in interest bearing deposits with banks ............... (1,930) (738) 306
Purchases of securities .......................................... (174) (11) (1)
Sales and maturities of securities ............................... 58 41 31
Net originations and maturities of loans ......................... 414 (435) (32)
Net change in investments in and advances to subsidiaries ........ (490) (1,510) (539)
Other, net ....................................................... 172 (65) 56
---------- ---------- ----------
Net cash used in investing activities ...................... (1,950) (2,718) (179)
---------- ---------- ----------
Cash flows from financing activities:
Net change in short-term borrowings .............................. 140 733 261
Issuance of long-term debt, net of issuance costs ................ 1,497 -- --
Repayment of long-term debt ...................................... (3) (424) --
Dividends paid ................................................... (711) (148) (712)
Reductions of capital surplus .................................... (22) (20) (44)
Preferred stock issuance, net of redemptions ..................... 816 -- --
Capital contribution from HNAI ................................... 3 2,400 --
---------- ---------- ----------
Net cash provided by (used in) financing activities .................... 1,720 2,541 (495)
---------- ---------- ----------
Net change in cash and due from banks .................................. -- -- (1)
Cash and due from banks at beginning of year ........................... -- -- 1
---------- ---------- ----------
Cash and due from banks at end of year ................................. $ -- $ -- $ --
========== ========== ==========
Cash paid for:
Interest ......................................................... $ 349 $ 237 $ 228
========== ========== ==========
HBUS is subject to legal restrictions on certain transactions with its nonbank
affiliates in addition to the restrictions on the payment of dividends to HUSI.
See Note 18 on page 119 for further discussion.
140
Quarterly Results of Operations (Unaudited)
--------------------------------------------------------------------------------
The following table presents a quarterly summary of selected financial
information.
------------------------------------------------------------------------------------------------------------------------
Quarter Ended December 31 September 30 June 30 March 31
------------------------------------------------------------------------------------------------------------------------
(in millions)
2005
Net interest income .................................... $ 742 $ 761 $ 785 $ 775
------- ------- ------- -------
Trading revenues ....................................... 127 137 35 96
Residential mortgage banking revenue (expense) ......... 23 31 (13) 23
Securities gains, net .................................. 2 17 64 23
Other income ........................................... 362 320 327 337
------- ------- ------- -------
Total other revenues ................................... 514 505 413 479
------- ------- ------- -------
Operating expenses ..................................... 746 673 684 655
Provision for credit losses ............................ 198 199 170 107
------- ------- ------- -------
Income before income tax expense ....................... 312 394 344 492
Income tax expense ..................................... 116 142 131 177
------- ------- ------- -------
Net income ............................................. $ 196 $ 252 $ 213 $ 315
======= ======= ======= =======
2004
Net interest income .................................... $ 700 $ 698 $ 689 $ 654
------- ------- ------- -------
Trading revenues ....................................... 99 21 78 90
Residential mortgage banking revenue (expense) ......... (14) (65) (17) (24)
Securities gains, net .................................. 26 18 3 38
Other income ........................................... 214 388 234 230
------- ------- ------- -------
Total other revenues ................................... 325 362 298 334
------- ------- ------- -------
Operating expenses ..................................... 613 480 520 488
Provision (credit) for credit losses ................... (24) 27 6 (26)
------- ------- ------- -------
Income before income tax expense ....................... 436 553 461 526
Income tax expense ..................................... 167 214 130 207
------- ------- ------- -------
Net income ............................................. $ 269 $ 339 $ 331 $ 319
======= ======= ======= =======
141
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
--------------------------------------------------------------------------------
There were no disagreements on accounting and financial disclosure matters
between HUSI and its independent accountants during 2005.
Item 9A. Controls and Procedures
--------------------------------------------------------------------------------
HUSI maintains a system of internal and disclosure controls and procedures
designed to ensure that information required to be disclosed in reports filed or
submitted under the Securities Exchange Act of 1934, as amended, (the Exchange
Act), is recorded, processed, summarized and reported on a timely basis. HUSI's
Board of Directors, operating through its Audit Committee, which is composed
entirely of independent outside directors, provides oversight to the financial
reporting process.
An evaluation was conducted, with the participation of the Chief Executive
Officer and Chief Financial Officer, of the effectiveness of HUSI's disclosure
controls and procedures as of the end of the period covered by this report.
Based upon that evaluation, the Chief Executive Officer and Chief Financial
Officer concluded that HUSI's disclosure controls and procedures were effective
as of the end of the period covered by this report, so as to alert them in a
timely fashion to material information required to be disclosed in reports filed
under the Exchange Act.
There have been no significant changes in HUSI's internal controls or in other
factors that could significantly affect internal and disclosure controls
subsequent to the date that the evaluation was carried out.
HUSI continues the process to complete a thorough review of its internal
controls as part of its preparation for compliance with the requirements of
Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404). Section 404
requires management to report on, and external auditors to attest to, the
effectiveness of HUSI's internal controls structure and procedures for financial
reporting. As a non-accelerated filer under Rule 12b-2 of the Exchange Act,
HUSI's first report under Section 404 will be contained in its Form 10-K for the
period ended December 31, 2007.
142
PART III
Item 10. Directors and Executive Officers of the Registrant
--------------------------------------------------------------------------------
Directors
Set forth below is certain biographical information relating to the members of
HUSI's Board of Directors. The members of the HUSI Board of Directors also
comprise the HBUS Board of Directors. Each director is elected annually. There
are no family relationships among the directors.
Salvatore H. Alfiero, age 68, Chairman and Chief Executive Officer, Protective
Industries, LLC. since May 2001. He is also a director of Phoenix Companies,
Inc., Southwire Company, Fresh Del Monte Produce Company and National Health
Care Affiliates. He has been a director of HBUS since 1996, a director of HUSI
since 2000 and a director of HNAH since 2005.
Donald K. Boswell, age 54, President and Chief Executive Officer, Western New
York Public Broadcasting Association since 1998. Mr. Boswell has been in public
broadcasting since 1977. He has been a director of HBUS and HUSI since 2002.
James H. Cleave, age 63, formerly President and Chief Executive Officer of HUSI
and HBUS from 1993 through 1997. Prior to that Mr. Cleave was President and
Chief Executive Officer of HSBC Bank Canada and he is currently a director and
Vice Chairman of HSBC Bank Canada. He has been a director of HBUS and HUSI since
1991.
Frances D. Fergusson, age 61, President, Vassar College since 1986. Dr.
Fergusson was formerly Provost and Vice President for Academic Affairs, Bucknell
University. Dr. Fergusson is also director of Wyeth Pharmaceuticals and a member
of the Board of Overseers of Harvard University. She has been a director of HBUS
since 1990 and a director of HUSI since 2000.
Martin J. G. Glynn, age 54, President and Chief Executive Officer of HUSI and
HBUS since 2003. Mr. Glynn also has been a Group General Manager for HSBC since
2001 and Chairman of HSBC Bank Canada since 2004. He has been a director of HSBC
Bank Canada since 1999 and was formerly President and Chief Executive Officer of
HSBC Bank Canada from 1999 to 2003. He is also a director of AEA Investors LLC
and Husky Energy Inc. He has been a director of HUSI and HBUS since 2000.
Stephen K. Green, age 57, Chairman of HUSI and HBUS since April 2005. Mr. Green
is HSBC Group Chairman (designate) and has been Group Chief Executive, HSBC
since 2003 and an Executive Director of HSBC since 1998. Mr. Green joined HSBC
in 1982 and more recently served as Executive Director, Corporate, Investment
Banking and Markets from 1998 to 2003 and as Group Treasurer from 1992 to 1998.
Mr. Green is also Chairman of HSBC Bank plc, HSBC Bank Middle East Limited, HSBC
Group Investment Businesses Limited and HSBC Private Banking Holdings (Suisse)
S.A. He is a director of The Bank of Bermuda Limited, HSBC France S.A. (formerly
CCF S.A.), The Hongkong and Shanghai Banking Corporation Limited, Grupo
Financiero HSBC, S.A. de C.V., HSBC North America Holdings Inc. and HSBC
Trinkaus & Burkhardt KGaA. He was previously a director of HBUS and HUSI from
2000 to 2004 and re-elected in 2005.
Richard A. Jalkut, age 61, Lead Director of HUSI and HBUS since January 2005.
Mr. Jalkut is President and Chief Executive Officer, Telepacific Communications
and Chairman of Birch Telecom, Inc. Formerly President and Chief Executive of
Pathnet and previously President and Group Executive, NYNEX Telecommunications.
Mr. Jalkut is also a director of IKON Office Solutions and Covad Communications.
He has been a director of HBUS since 1992 and a director of HUSI since 2000.
Peter Kimmelman, age 61, private investor and managing member of Peter Kimmelman
Asset Management LLC, an investment advisory firm registered with the Securities
and Exchange Commission. Mr. Kimmelman was formerly a director of Republic New
York Corporation and Republic National Bank of New York from 1976 until 1999. He
has been a director of HBUS and HUSI since 2000.
143
Charles G. Meyer, Jr., age 68, Director and former President of Cord Meyer
Development Company. Mr. Meyer was formerly a director of Republic National Bank
of New York from 1987 until 1999. He has been a director of HBUS and HUSI since
2000.
James L. Morice, age 68, President and Chief Executive Officer since January 1,
2006 of Morice Consulting, LLC, successor to the JLM Group LLC, a management
consulting firm. Mr. Morice was previously Executive Vice President and Director
of NationsBuilders Insurance Services, Inc. He was formerly a director of
Republic New York Corporation and Republic National Bank of New York from 1987
until 1999 and a member of the Human Resources Committee of the University of
New Haven from 2003 through 2005. He has been a director of HBUS and HUSI since
2000.
Executive Officers
--------------------------------------------------------------------------------
Information regarding the executive officers of HUSI as of March 6, 2006 is
presented in the following table.
-------------------------------------------------------------------------------------------------------------------
Year
Name Age Appointed Present Position with HUSI
-------------------------------------------------------------------------------------------------------------------
Martin J. G. Glynn 54 2003 President and Chief Executive Officer
Brendan McDonagh 47 2002 Chief Operating Officer
Gerard Aquilina 54 2002 Senior Executive Vice President, Private Banking and Wealth
Management
Janet L. Burak 50 2004 Senior Executive Vice President, General Counsel and Secretary
Robert M. Butcher 62 1988 Senior Executive Vice President and Chief Risk Officer
David Dew 50 2006 Senior Executive Vice President and Group Audit Executive, USA
John J. McKenna 46 2005 Senior Executive Vice President and Chief Financial Officer
Joseph M. Petri 53 2001 Senior Executive Vice President, Treasurer and Co-Head, CIBM
Americas
George T. Wendler 61 2000 Senior Executive Vice President and Chief Credit Officer
Anthony J. Murphy 46 2005 Co-Head, CIBM Americas
Paulette M. Crooke 52 2004 Executive Vice President, Operations
Jeanne G. Ebersole 44 2004 Executive Vice President, Human Resources
Seamus McMahon 46 2004 Executive Vice President and Regional President, Atlantic Region
Teresa A. Pesce 46 2005 Executive Vice President, AML Compliance
Carolyn M. Wind 52 2005 Executive Vice President, Compliance
Michael P. Ebbs 46 2005 Managing Director, Chief Information Officer
Joseph R. Simpson 44 2003 Chief Accounting Officer
Clive R. Bucknall 42 2006 Chief Accounting Officer (Designate)
-------------------------------------------------------------------------------------------------------------------
Martin J. G. Glynn was appointed President and Chief Executive Officer of HUSI
and HBUS in October 2003. Prior to joining HUSI, he was President and Chief
Executive Officer of HSBC Bank Canada from 1999 to 2003. Mr. Glynn was appointed
a Group General Manager in 2001 and has been with the HSBC Group since 1982.
Brendan McDonagh was appointed Chief Operating Officer, HBUS in October 2004.
Mr. McDonagh is an HSBC International Manager who has been with the HSBC Group
for over twenty five years and was appointed a Group General Manager effective
August 1, 2005. He is Chairman of HSBC Investments (USA) Inc., a wholly owned
subsidiary of HBUS. Mr. McDonagh has extensive commercial and retail management
experience and prior to joining HUSI in 2002 as Senior Executive Vice President,
Retail and Commercial Banking, he served as Senior Executive, Strategy
Implementation, at HSBC Group headquarters.
Gerard Aquilina assumed responsibilities for Private Banking and Wealth
Management Services for HSBC in North America in 2003. Mr. Aquilina joined HSBC
in June 2002 as Chief Executive Officer, International Private Banking,
Americas. He previously held various management positions with Merrill Lynch
from 1984 to 2002, including Global Head of Marketing and Wealth Management for
their International Private Client Group.
Janet L. Burak was appointed General Counsel and Secretary for HUSI and HBUS in
April 2004. Ms. Burak had served as an attorney with HSBC Finance Corporation
for twelve years and most recently as their Group General Counsel. Prior to
joining HSBC Finance Corporation, she was an associate with Shearman & Sterling
and an attorney with Citigroup.
144
Robert M. Butcher was appointed Chief Risk Officer for HUSI and HBUS in May
2003. Mr. Butcher was Chief Financial Officer of HUSI and HBUS from 1990 to
2003. Prior to joining HBUS's predecessor, Marine Midland Bank in 1988, Mr.
Butcher was with Citicorp for 15 years where he held various senior officer
positions in the corporate finance department.
David Dew was appointed Senior Executive Vice President, Audit, HSBC North
America Inc. (HNAI) effective January 1, 2006. Prior to this appointment Mr. Dew
served as Chief Auditor, Group Audit, HSBC Finance Corporation from November
2004 to December 2005. He was Executive Director & Chief Operating Officer, The
Saudi British Bank, Riyadh, Saudi Arabia from March 2001 to November 2004;
Deputy Chief Executive Officer, The Hongkong and Shanghai Banking Corporation
Limited, Singapore from September 1997 to March 2001; and Chief Executive
Officer, HSBC Bank plc, Milan, Italy from November 1994 to September 1997. Mr.
Dew has been an HSBC employee since 1977.
John J. McKenna was appointed Senior Executive Vice President and Chief
Financial Officer of HUSI effective October 3, 2005. Prior to this appointment,
Mr. McKenna served as Chief Financial Officer, HSBC Mexico, S.A. from November
2002 through September 2005. From July 2000 to October 2002, he held the
position of Senior Vice President and Director of Financial Management for HUSI.
Since joining HSBC in 1986, Mr. McKenna has held a variety of financial
management positions focusing on strategic planning, business controllership and
management information.
Joseph M. Petri was appointed Co-Head of Corporate, Investment Banking and
Markets (CIBM) Americas in November 2004. Mr. Petri had been Head of Global
Markets, Americas. He joined HUSI in April 2000 as Executive Managing Director
and head of sales for HSBC's Investment Banking and Markets, Americas division.
From 1995 to 1998, he was President and Senior Partner of Summit Capital
Advisors LLC, a New Jersey based hedge fund. Prior to that, Mr. Petri held a
variety of management positions with Merrill Lynch.
George T. Wendler was appointed Chief Credit Officer of HUSI in 2000. Mr.
Wendler was Chief Credit Officer and a member of the Senior Management Committee
of Republic New York Corporation when it was acquired by HSBC in December 1999.
He was also a director and Vice Chairman of Republic New York Corporation from
1997 to 1999.
Anthony J. Murphy, Chief Executive Officer, HSBC Securities (USA) Inc., was
appointed Co-Head, CIBM Americas in November 2004. Mr. Murphy has been with the
HSBC Group since 1990. Prior to his appointment as Chief Executive Officer, HSBC
Securities (USA) Inc. in April 2003, Mr. Murphy served as Chief Strategic
Officer, CIBM Americas from 2000. Prior to that assignment, he was Head of
Market Risk Management for HSBC Bank plc and HSBC Investment Bank in London from
1996.
Paulette M. Crooke was appointed Executive Vice President, Operations for HUSI
and HBUS in July 2004. Ms. Crooke has previously held various management
positions within the HBUS Human Resources Division, as well as various retail
banking positions, most recently directing PFS activities in Manhattan. She has
been with HBUS for over thirty years.
Jeanne G. Ebersole joined HUSI from HSBC Finance Corporation in May 2004 as
Executive Vice President, Human Resources. Prior to this appointment, Ms.
Ebersole had overall human resources responsibility for HSBC Finance
Corporation's retail services, insurance services and refund lending businesses
since August 2002. She held a variety of human resources positions since joining
HSBC Finance Corporation in 1980.
Seamus McMahon was appointed Executive Vice President in charge of strategic
planning, corporate development and acquisitions, and ongoing integration
initiatives in May 2004. In October 2004, Mr. McMahon was appointed HBUS
Regional President, Atlantic Region. Mr. McMahon has more than twenty years of
experience in the financial services industry. Prior to joining HUSI, Mr.
McMahon served as President and Chief Executive Officer of TD Bank, USA, a
wholly owned subsidiary of Toronto Dominion Bank. He also led the retail
financial services practices at First Manhattan Consulting Group and Booz Allen
& Hamilton, and worked for Chase Manhattan in New York and Accenture (then
Andersen Consulting) in Europe.
145
Teresa A. Pesce joined HUSI in September 2003 as Executive Vice President and
Anti-Money Laundering (AML) Director. In 2004 she was appointed the AML Director
for all HSBC businesses in North America. Ms. Pesce joined HUSI from the United
States Attorney's Office, Southern District of New York where she was Senior
Trial Counsel, White Plains Division and previously Chief of the Major Crimes
Unit and Deputy Chief of the Criminal Division. From 1992 to 1999 she served as
a Line Assistant in the Major Crimes, Narcotics, and General Crimes Units.
Carolyn M. Wind, Executive Vice President, Compliance, was the Chief Compliance
Officer for Republic New York Corporation when it was acquired by HSBC in
December 1999. Prior to joining Republic New York Corporation, she was a senior
national bank examiner with the Office of the Comptroller of the Currency (OCC).
Michael P. Ebbs was appointed Managing Director and Chief Information Officer -
HBUS Banking Systems in January 2005. Mr. Ebbs was Head of Information
Technology at The Bank of Bermuda Limited when it was acquired by HSBC in
February 2004. Prior to his thirteen years at The Bank of Bermuda Limited, Mr.
Ebbs held senior technology positions at The Putnam Companies and the Bank of
New England.
Joseph R. Simpson was appointed Controller and Chief Accounting Officer for HUSI
and HBUS in 2003. Prior to that appointment, he held the position of Manager of
External Financial Reporting and previous to that, Manager of Accounting Policy.
Mr. Simpson has been with HUSI for over fifteen years.
Clive R. Bucknall was appointed Controller and Chief Accounting Officer, HUSI
effective March 7, 2006. Prior to this appointment Mr. Bucknall served as Senior
Financial Officer, HSBC Singapore from March 2002 through December 2005. He was
Senior Financial Officer, HSBC Thailand from September 1998 to March 2002 and
Senior Area Accounting Manager, HSBC Hong Kong from September 1994 to September
1998. In 1991, Mr. Bucknall joined Midland Bank in London, which was acquired by
HSBC in 1992, as Financial Accounting Manager.
Audit Committee
--------------------------------------------------------------------------------
The Audit Committee of HUSI's Board of Directors is comprised of Messrs.:
Alfiero (Chairman), Cleave, Jalkut and Kimmelman. Messrs. Alfiero and Cleave
have been determined by HUSI's Board of Directors to be audit committee
financial experts, each having the attributes prescribed by the SEC, and are
independent as that term is used in Item 7(d)(3)(iv) of Schedule 14A under the
Exchange Act.
Code of Ethics
--------------------------------------------------------------------------------
HUSI has adopted a code of ethics applicable to its chief executive officer, its
chief financial officer, and its chief accounting officer and is included herein
as Exhibit 14.
146
Item 11. Executive Compensation
--------------------------------------------------------------------------------
The following table presents the compensation earned for the three years ending
December 31, 2005 by the President and Chief Executive Officer of HUSI and HBUS
and by the four most highly compensated Executive Officers of HUSI and HBUS, who
were serving as such on December 31, 2005 (the named executive officers).
Principal position indicates capacity served in 2005.
Summary Compensation Table
------------------------------------------------------------------------------------------------------------------------
Long Term
Annual Compensation Compensation
---------------------------------------- -------------
Restricted All Other
Name and Principal Position Year Salary Bonus Other Stock Awards(6) Compensation
------------------------------------------------------------------------------------------------------------------------
Martin J. G. Glynn (1) 2005 $ 707,692 $1,650,000 $ 295,235(2) $1,200,000 $ 10,500(5)
President and 2004 600,000 1,500,000 299,312(2) 526,693 7,738
Chief Executive Officer 2003 103,846 1,000,000 70,449(2) 278,758 1,846
Joseph M. Petri 2005 325,000 3,960,000 -- 2,790,000 10,500(5)
Senior Executive Vice
President, 2004 325,000 3,210,000 69,355(3) 3,879,045 7,175
Treasurer and Co-Head,
Corporate, 2003 325,000 3,750,000 246,553(3) 2,794,674 7,000
Investment Banking and Markets,
Americas
Gerard Aquilina 2005 500,000 1,050,000 -- 775,000 10,500(5)
Senior Executive Vice
President, 2004 490,173 875,000 -- 700,000 6,384
Private Banking and Wealth 2003 465,000 750,000 -- 412,000 781
Management
Brendan McDonagh 2005 636,960 789,000 477,756(4) 376,000 156,265(5)
Senior Executive Vice
President 2004 529,796 475,500 401,871(4) 228,000 164,041
and Chief Operating Officer 2003 470,333 219,598 464,264(4) 150,000 93,174
George T. Wendler 2005 566,500 747,780 -- 150,000 12,600(5)
Senior Executive Vice
President 2004 566,500 700,194 -- -- --
and Chief Credit Officer 2003 566,500 475,000 -- 56,000 --
(1) Mr. Glynn was appointed President and Chief Executive Officer of HUSI and
HBUS effective October 22, 2003. His 2003 salary figure represents the
salary earned and paid by HUSI from October 22, 2003 to December 31, 2003.
Prior to joining HUSI, Mr. Glynn was President and Chief Executive Officer
of HSBC Bank Canada.
(2) Mr. Glynn's Other Annual Compensation represents perquisites and other
personal benefits. The amount reported for 2005, 2004 and 2003 includes
reimbursements and tax gross-ups related to rental expenses of $259,285,
$272,115 and $69,222 respectively.
(3) Mr. Petri's Other Annual Compensation for 2004 and 2003 principally
represents imputed interest income from the investment of deferred bonus
amounts from previous years.
(4) Mr. McDonagh's Other Annual Compensation includes perquisites and other
personal benefits of $452,232, $366,984 and $424,964 for 2005, 2004 and
2003 respectively. Total perquisites and personal benefits for 2005
include reimbursements and tax gross-ups related to rental expenses of
$172,645 and children's educational expenses of $130,858. Perquisites and
personal benefits for 2004 include reimbursements and tax gross-ups
related to rental expenses of $135,501 and children's educational expenses
of $103,205. Perquisites and personal benefits for 2003 include
reimbursements and tax gross-ups related to rental expenses of $169,283
and children's educational expenses of $124,149.
(5) All Other Compensation in 2005 for each of the named executive officers,
except Mr. McDonagh, represents HUSI's matching 401(k) plan contribution.
Mr. McDonagh's 2005 All Other Compensation represents pension
contributions made by HSBC on his behalf.
(6) Restricted stock awards granted in the past three fiscal years include
performance and non-performance based awards.
147
The restricted stock awards included in the Summary Compensation Table represent
the monetary value on the date of grant of awards received during the years
indicated. Dividends are paid on all restricted shares and are reinvested in
additional restricted shares.
The following table presents the number and value of the aggregate restricted
stock holdings at December 31, 2005 for each named executive officer.
-----------------------------------------------------------------------------------------------------------------------
Number of
December 31, 2005 Shares Value
-----------------------------------------------------------------------------------------------------------------------
Martin J. G. Glynn .................................................................... 177,208 $ 2,845,664
Joseph M. Petri (1) ................................................................... 475,924 7,642,537
Gerard Aquilina ....................................................................... 139,696 2,243,280
Brendan McDonagh ...................................................................... 81,987 1,316,567
George T. Wendler ..................................................................... 34,372 551,953
(1) Mr. Petri's restricted share holdings at December 31, 2005 include 96,332
shares representing the balance of shares originally granted in March
2003, two thirds of which vested equally in 2004 and 2005 and the balance
of which will vest in 2006 on the date HSBC publishes its 2005 annual
results. Restricted share holdings at December 31, 2005 also include
170,109 shares representing the balance of shares originally granted in
March 2004, one third of which vested in 2005 and two thirds of which will
vest equally in 2006 and 2007 on the date HSBC publishes its annual
results. Also included in Mr. Petri's total restricted share holdings are
174,548 shares representing the accumulated balance of shares originally
granted in February 2005. These shares will vest in equal increments on
the date HSBC publishes its annual results in 2006, 2007 and 2008.
No stock options on HSBC Holdings plc common stock were granted during 2005 to
any of the named executive officers and none of the named executive officers
exercised any previously awarded stock options during 2005.
The only named executive officer with any unexercised stock options on HSBC
Holdings plc common stock is Mr. McDonagh. His options were granted under the
HSBC Holdings Executive Share Option Scheme for performance years 1996 through
1998 while employed by other HSBC entities. The number of Mr. McDonagh's options
and their value at December 31, 2005 are presented in the following table.
--------------------------------------------------------------------------------------------------------------------
Aggregated Stock Options Exercised in 2005 and Option Values as of Year End 2005
Number of Securities Value of Unexercised
Underlying Unexercised Options In-the-Money Options
Shares as of December 31, 2005 as of December 31, 2005 (2)
Acquired on Value ------------------------------- ----------------------------
Name Exercise (#) Realized ($) Exercisable(1) Unexercisable Exercisable Unexercisable
--------------------------------------------------------------------------------------------------------------------
Martin J. G. Glynn -- $ -- -- -- $ -- $ --
Joseph M. Petri -- -- -- -- -- --
Gerard Aquilina -- -- -- -- -- --
Brendan McDonagh -- -- 33,900 -- 187,959 --
George T. Wendler -- -- -- -- -- --
(1) Although the performance conditions have been met on the above unexercised
options, HSBC Staff Dealing Rules prohibit the exercise of these options
until the 2005 financial results of HSBC have been publicly announced.
(2) The value of unexercised in-the-money options is based on the December 31,
2005 closing price per share of 9.330 GBP for HSBC Holdings plc common
stock and a U.S. dollar exchange rate of 1.72115 per GBP.
148
Pension Benefits for the Named Executive Officers
--------------------------------------------------------------------------------
Mr. Glynn's pension benefits will be provided pursuant to the terms of the
qualified and non-qualified supplemental pension plan of HSBC Bank Canada.
HSBC Bank Canada's qualified pension plan is a defined benefit plan under which
benefits are determined primarily by final average earnings, years of service
and a plan formula. Benefits payable under this plan are limited to the maximum
allowed by Canada Revenue Agency (CRA). For example, in year 2005 the limit was
$2,000 and in year 2006, the limit is $2,111.11 per year of pensionable service.
The following table, which is presented in Canadian currency, indicates the
maximum pension benefits allowed by law for plan participants in the specified
compensation and years of service classifications for year 2006. The table
assumes payments in the form of a life annuity, guaranteed for ten years.
--------------------------------------------------------------------------------------------------------------------
Compensation 15 20 25 30
--------------------------------------------------------------------------------------------------------------------
$ 500,000 $ 31,666 $ 42,222 $ 52,777 $ 63,333
600,000 31,666 42,222 52,777 63,333
700,000 31,666 42,222 52,777 63,333
800,000 31,666 42,222 52,777 63,333
900,000 31,666 42,222 52,777 63,333
1,000,000 31,666 42,222 52,777 63,333
--------------------------------------------------------------------------------------------------------------------
The pension benefit for plan participants in the compensation levels presented
above is capped for all participants having the number of years of credited
service indicated. The compensation covered by the plan is limited to straight
salary. At the plan's normal retirement date of age 60, Mr. Glynn will have
28.75 years of credited service.
In addition to the pension benefit available from the HSBC Bank Canada qualified
plan, Mr. Glynn is entitled to receive an annual pension benefit during his
lifetime pursuant to a non-qualified supplemental retirement agreement with HSBC
Bank Canada. Under the terms of this agreement, the supplemental allowance is
forfeited if Mr. Glynn ceases employment with HSBC before age 55 and goes to
work for a competitor within two years. The supplemental allowance is calculated
based on Mr. Glynn's highest three years average base salary, excluding all
bonuses. The supplemental pension agreement formula is 2.5% of final average
earnings, times years of pensionable service. Mr. Glynn's earnings under this
formula are converted into Canadian currency by multiplying his current earnings
in U.S. currency by 1.3333.
Based on an annual salary of $933,310 in Canadian currency, the estimated annual
total pension benefit at the normal retirement age of 60 for Mr. Glynn is
$670,815. Of this amount, $60,694 is payable from the HSBC Bank Canada qualified
plan and $610,121 from the non-qualified supplemental retirement agreement. In
U.S. currency, these pension benefits amount to $45,522 from the qualified plan
and $457,602 from the non-qualified plan.
The pension benefits for Joseph M. Petri, Gerard Aquilina and George T. Wendler
will be provided pursuant to the terms of the HSBC - North America (USA)
Retirement Income Plan, a non-contributory defined benefit pension plan under
which HBUS and other participating subsidiaries of HNAH make contributions in
actuarially determined amounts.
The pension benefits under the Retirement Income Plan for employees hired before
January 1, 2000 are determined primarily by compensation and years of service.
The following table shows the estimated annual retirement benefit payable upon
normal retirement on a straight life annuity basis to participating employees,
including officers, in the compensation and years of service classifications
indicated under the Retirement Income Plan and non-qualified supplemental
benefit plans. The amounts shown are before application of social security
reductions. Years of service for benefit purposes is limited to 30 years in the
aggregate.
149
--------------------------------------------------------------------------------------------------------------------
Five Year
Average
Compensation 15 20 25 30 35
--------------------------------------------------------------------------------------------------------------------
$ 300,000 $ 87,750 $ 117,450 $ 147,450 $ 177,450 $ 178,200
400,000 117,000 156,600 196,600 236,600 237,600
500,000 146,250 195,750 245,750 295,750 297,000
600,000 175,500 234,900 294,900 354,900 356,400
700,000 204,750 274,050 344,050 414,050 415,800
800,000 234,000 313,200 393,200 473,200 475,200
900,000 263,250 352,350 442,350 532,350 534,600
1,000,000 292,500 391,500 491,500 591,500 594,000
--------------------------------------------------------------------------------------------------------------------
Compensation covered by the Retirement Income Plan in the above table includes
regular basic earnings (including salary reduction contributions to the 401(k)
plan), but not incentive awards, bonuses, special payments or deferred salary.
HNAH maintains supplemental benefit plans which provide for the difference
between the benefits actually payable under the Retirement Income Plan and those
that would have been payable if certain other awards, special payments and
deferred salaries were taken into account and if compensation in excess of the
limitations set by the Internal Revenue Code could be counted. Payments under
these plans are unfunded and will be made out of the general funds of HBUS or
other participating subsidiaries. The calculation of retirement benefits is
based on the highest five-consecutive year compensation.
Mr. Wendler is the only named executive officer participating in the Retirement
Income Plan who was hired before January 1, 2000. He is also a member of the
Senior Management Committee of HBUS. Individuals who were members of the Senior
Management Committee prior to July 1, 2004, and who participate in the
Retirement Income Plan receive two times their normal credited service for each
year and fraction thereof served as a committee member in determining pension
and severance benefits to a maximum of 30 years of credited service in total.
This additional service accrual is unfunded and payments will be made from the
general funds of HBUS or other subsidiaries. As of December 31, 2005, Mr.
Wendler had 23.76 total years of credited service in determining benefits
payable under the Retirement Income Plan and other non-qualified supplemental
benefit plans.
The pension benefits for Joseph M. Petri and Gerard Aquilina under the HSBC -
North America (USA) Retirement Income Plan are based on the formula applicable
to employees hired on or after January 1, 2000.
Under this formula, benefits are calculated at 2% of pensionable pay for each
year of service, credited with interest at the end of the year at a rate equal
to the lesser of the average of the 10-year treasury rates or the average of the
30-year treasury rates for the September of the preceding year. Under certain
circumstances, this benefit may be reduced due to federal regulations.
Pensionable pay is defined as base pay plus overtime, bonuses and commissions
paid in that calendar year. Employee pre-tax contributions to any benefit plan
maintained by HNAH are also included in pensionable pay. Deferred compensation
is not included.
The estimated pension benefit available for Mr. Petri at age 65, the normal
retirement age, is a one time only, lump sum benefit of $67,652.83. The
estimated age 65 benefit available for Mr. Aquilina is a one time only, lump sum
benefit of $59,585.58.
Since Brendan McDonagh is an HSBC International Manager, he participates in the
HSBC International Staff Retirement Benefits Scheme (ISRBS), a defined benefit
plan. Based on a benefit formula that approximates 85% of his Sterling Basic
Salary of 161,310.60 GBP and a normal retirement date of July 31, 2011, at age
53 and over 30 years of service, Mr. McDonagh's pension benefit is 136,357.87
GBP per annum. At a U.S. dollar exchange rate of 1.72115 per GBP at December 31,
2005, this benefit equates to $234,692.35 in U.S. currency. Mr. McDonagh makes
ISRBS contributions at the current rate of 6.67% of Sterling Basic Salary and
HSBC makes contributions on his behalf at the current rate of 57.5% of Sterling
Basic Salary.
150
Directors' Compensation
--------------------------------------------------------------------------------
Directors who are employees of HSBC or other Group Affiliates, including HUSI
and HBUS, do not receive annual retainers or fees. For their services as
directors of both HUSI and HBUS, all nonemployee directors, including the
Chairman of the Board but excluding the Lead Director, receive an annual
retainer of $50,000. The Lead Director receives an annual retainer of $75,000.
Committee chairmen receive an additional annual fee of $2,500 for acting in that
capacity. Members of the Audit Committee receive an annual fee which is $10,000
for the chairman and $6,000 for the other members. Directors are reimbursed for
their expenses incurred in attending meetings. HUSI and HBUS have standard
arrangements pursuant to which directors elected prior to June 1999 may defer
all or part of their fees.
Employment Contracts
--------------------------------------------------------------------------------
Mr. Joseph M. Petri has an agreement with HUSI whereby he will give six months
notice before leaving and sign a non-compete agreement in order to receive all
restricted stock granted to him at that time. There are no other employment
contracts between HUSI and any of its other named executive officers.
Compensation Committee Interlocks and Insider Participation
--------------------------------------------------------------------------------
The current members of the Human Resources and Compensation Committee of HUSI's
Board of Directors are: nonemployee director Dr. Frances D. Fergusson, Chair;
Mr. Martin J. G. Glynn, President and Chief Executive Officer of HUSI and HBUS;
nonemployee director Mr. James L. Morice and nonemployee director Mr. Donald K.
Boswell. There are no interlocking relationships.
151
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Matters
--------------------------------------------------------------------------------
Security Ownership of Certain Beneficial Owners
HUSI's common stock is 100% owned by HSBC North America Inc. (HNAI). HNAI is an
indirect wholly owned subsidiary of HSBC.
Security Ownership by Management
The following table shows the beneficial ownership of HSBC $0.50 ordinary shares
as of December 31, 2005 by each of HUSI's directors, the named executive
officers in the Summary Compensation Table on page 147 and by all of HUSI's
directors and executive officers as a group. Each of the individuals listed
below and all directors and executive officers as a group own less than 1% of
the outstanding shares of stock.
--------------------------------------------------------------------------------------------------------------------
Shares That
Shares May be Acquired Total
Beneficially Within 60 Days by Beneficially
Directors Owned (1) Exercise of Options (2) Owned Shares
--------------------------------------------------------------------------------------------------------------------
Salvatore H. Alfiero 259,000 -- 259,000
Donald K. Boswell 220 -- 220
James H. Cleave 218,578 -- 218,578
Frances D. Fergusson 100 -- 100
Martin J. G. Glynn (3) 219,968 -- 219,968
Stephen K. Green 1,094,648 -- 1,094,648
Richard A. Jalkut 250 -- 250
Peter Kimmelman 17,035 -- 17,035
Charles G. Meyer, Jr. 500 -- 500
James L. Morice 613 -- 613
--------------------------------------------------------------------------------------------------------------------
Named executive officers
--------------------------------------------------------------------------------------------------------------------
Joseph M. Petri 477,281 -- 477,281
Gerard Aquilina 139,696 -- 139,696
Brendan McDonagh 109,937 33,900 143,837
George T. Wendler 34,372 -- 34,372
--------------------------------------------------------------------------------------------------------------------
All directors and executive officers
as a group 3,129,096 247,031 3,376,127
--------------------------------------------------------------------------------------------------------------------
(1) Beneficially owned shares include restricted stock awards which do not
carry voting rights.
(2) HSBC Staff Dealing Rules prohibit the exercise of these options until the
2005 financial results of HSBC have been publicly announced.
(3) As the President and Chief Executive Officer of HUSI and HBUS, Mr. Glynn
is also one of the named executive officers.
No director or executive officer of HUSI owned any of HUSI's outstanding
preferred stock at December 31, 2005.
152
Item 13. Certain Relationships and Related Transactions
--------------------------------------------------------------------------------
None.
Item 14. Principal Accounting Fees and Services
--------------------------------------------------------------------------------
Fees billed to HUSI by its auditing firm, KPMG LLP, were as follows.
------------------------------------------------------------------------------------------------------------------------
Year Ended December 31 2005 2004
------------------------------------------------------------------------------------------------------------------------
(in thousands)
Audit fees:
Auditing of financial statements, quarterly reviews, statutory audits, preparation of comfort
letters, consents and review of registration statements .............................. $ 5,137 $ 4,310
Audit related fees:
Employee benefit plan audits, due diligence assistance, internal control review assistance,
and audit or attestation services not required by statute or regulation .............. 870 1,478
Tax fees:
Tax related research, general tax services in connection with transactions and legislation,
and review of federal and state tax accounts for possible over-assessment of interest
and/or penalties ..................................................................... 51 1,762
All other fees ............................................................................... -- 46
-------- --------
Total KPMG LLP fees .......................................................................... $ 6,058 $ 7,596
======== ========
Audit Committee Pre-approval Policies and Procedures
It is the practice of the Audit Committee of HUSI's Board of Directors to
approve the annual audit fees, including those covering audit services beyond
HUSI's financial statements, before any audit procedures are undertaken. Prior
to 2003, management had the implicit pre-approval of the Audit Committee to
engage KPMG LLP, or any other professional service firm, to perform tax and
other services. Any such services provided by KPMG LLP were reported to the
Audit Committee after the fact. Beginning in 2003, the Audit Committee assumed
responsibility for pre-approving all auditing services and permitted
non-auditing services, including the related fees and terms thereof.
153
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
--------------------------------------------------------------------------------
(a) (1) Financial Statements
HSBC USA Inc.:
Consolidated Balance Sheet
Consolidated Statement of Income
Consolidated Statement of Changes in Shareholders' Equity
Consolidated Statement of Cash Flows
HSBC Bank USA, National Association:
Consolidated Balance Sheet
Notes to Financial Statements
(2) Not applicable
(3) Exhibits
3(i) Articles of Incorporation and amendments and supplements
thereto (incorporated by reference to Exhibit 3(a) to HUSI's
Annual Report on Form 10-K for the year ended December 31,
1999, filed with the Securities and Exchange Commission on
March 30, 2000, Exhibit 3 to HUSI's Quarterly Report on Form
10-Q for the quarter ended September 30, 2000, filed with
the Securities and Exchange Commission on November 9, 2000,
Exhibits 3.2 and 3.3 to HUSI's Current Report on Form 8-K
dated March 30, 2005, filed with the Securities and Exchange
Commission on April 4, 2005, and Exhibit 3.2 to HUSI's
Current Report on Form 8-K dated October 11, 2005 and filed
with the Securities and Exchange Commission on October 14,
2005).
3(ii) By-Laws dated April 21, 2005.
4(i) Senior Indenture, dated as of October 24, 1996, by and
between HUSI and Bankers Trust Company, as trustee, as
amended and supplemented (incorporated by reference to
Exhibits 4.1 and 4.2 to Post-Effective Amendment No. 1 to
HUSI's registration statement on Form S-3, Registration No.
333-42421, filed with the Securities and Exchange Commission
on April 3, 2002, and Exhibit 4.1 to HUSI's Current Report
on Form 8-K dated November 21, 2005 and filed with the
Securities and Exchange Commission on November 28, 2005).
4(ii) Subordinated Indenture, dated as of October 24, 1996, by and
HUSI and Bankers Trust Company, as trustee, as amended and
supplemented (incorporated by reference to Exhibits 4.3,
4.4, 4.5 and 4.6 to Post-Effective Amendment No. 1 to HUSI's
registration statement on Form S-3, Registration No.
333-42421, filed with the Securities and Exchange Commission
on April 3, 2002.
12.01 Computation of Ratio of Earnings to Fixed Charges
12.02 Computation of Ratio of Earnings to Combined Fixed Charges
and Preferred Dividends
14 Code of Ethics for Senior Financial Officers
21 Subsidiaries of HSBC USA Inc.
23 Consent of Independent Registered Public Accounting Firm
31.1 Certification of Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
32 Certification of Chief Executive Officer and Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
154
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
HSBC USA Inc.
Registrant
---------------------------------------
/s/ Janet L. Burak
---------------------------------------
Janet L. Burak
Senior Executive Vice President, General Counsel
and Secretary
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed on March 6, 2006 by the following persons on behalf of the
registrant and in the capacities indicated:
/s/ John J. McKenna Stephen K. Green*
-------------------------------------- Chairman of the Board
John J. McKenna Salvatore H. Alfiero* Director
Senior Executive Vice President and Donald K. Boswell* Director
Chief Financial Officer James H. Cleave* Director
(Principal Financial Officer) Frances D. Fergusson* Director
Martin J. G. Glynn*
Director, President and Chief Executive Officer
Richard A. Jalkut* Director
Peter Kimmelman* Director
/s/ Joseph R. Simpson Charles G. Meyer, Jr.* Director
-------------------------------------- James L. Morice* Director
Joseph R. Simpson
Chief Accounting Officer
(Principal Accounting Officer)
* /s/ Janet L. Burak
------------------------------------------------
Janet L. Burak
Attorney-in-fact
155
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
HSBC Holdings plc
By:
Name: P A Stafford
Title: Assistant Group Secretary
Date: 6 March, 2006