HSBC Finance Corp 06 10-K P4

HSBC Holdings PLC 05 March 2007 PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1) ------------------------------------------------------------------------------------------------------- Private label(4,5) Subsequent to the adoption of Interest generally accrues until FFIEC policies in December 2004, charge-off, except for retail sales domestic receivables (excluding contracts at our Consumer Lending retail sales contracts at our business. Interest income accruals Consumer Lending business) are for retail sales contracts are charged-off by the end of the suspended when principal or interest month in which the account payments are more than three months becomes six months contractually contractually delinquent. After delinquent. Our domestic private suspension, interest income is label receivable portfolio generally recorded as collected. (excluding retail sales contracts at our Consumer Lending business) was sold to HSBC Bank USA ("HSBC Bank USA") on December 29, 2004. Prior to December 2004, receivables were generally charged-off the month following the month in which the account became nine months contractually delinquent, however, receivables originated through new domestic merchant relationships beginning in the fourth quarter of 2002 were charged-off by the end of the month in which the account became six months contractually delinquent. Retail sales contracts at our Consumer Lending business generally charge-off the month following the month in which the account becomes nine months contractually delinquent and no payment received in six months, but in no event to exceed 12 months contractually delinquent. Personal non-credit card(4) Generally charged-off the month Interest income accruals are following the month in which the suspended when principal or interest account becomes nine months payments are more than three months contractually delinquent and no contractually delinquent. For PHLs, payment received in six months, interest income accruals resume if but in no event to exceed 12 the receivable becomes less than months contractually delinquent. three months contractually past due. For all other personal non-credit card receivables for which income accruals are suspended, interest income is generally recorded as collected. 118 --------------- (1) For our United Kingdom business, interest income accruals are suspended when principal or interest payments are more than three months contractually delinquent. (2) For our United Kingdom business, real estate secured carrying values in excess of net realizable value are charged-off at time of sale. (3) Our Auto Finance charge-off policy was changed in December 2006. Prior to December 2006, carrying values in excess of net realizable value were charged-off at the earlier of a) sale; b) the collateral having been in our possession for more than 90 days; or c) the loan becoming 150 days contractually delinquent. Charge-offs of $24 million were recorded in December 2006 to reflect this policy change. (4) For our Canada business, the private label and personal non-credit card charge-off policy prior to December 2004 required a charge-off of an account the month following the month in which the account becomes nine months contractually delinquent and no payment was received in six months, but in no event was an account to exceed 18 months contractually delinquent. In December 2004, the policy was revised to charge-off accounts the month following the month in which the account becomes nine months contractually delinquent and no payment is received in six months but in no event is an account to exceed 12 months contractually delinquent. This policy change was not part of the adoption of FFIEC policies discussed in Note 4 and its impact was not material to our net income. (5) For our United Kingdom business, delinquent credit card accounts (prior to their sale in December 2005) were charged-off the month following the month in which the account becomes six months contractually delinquent. Delinquent private label receivables are charged-off the month following the month in which the account becomes nine months contractually delinquent. (6) For our Canada business, carrying values in excess of net realizable value are charged-off at the earlier of a) sale; b) the collateral having been in our possession for more than 90 days; or c) the loan becoming 150 days contractually delinquent and the interest income accruals on auto loans are suspended and the portion of previously accrued interest expected to be uncollectible is written off when principal payments are more than three months contractually past due and resumed when the receivables become less than three months contractually past due. Charge-off involving a bankruptcy for our domestic private label (excluding retail sales contracts at our Consumer Lending business) and credit card receivables subsequent to the adoption of FFIEC charge-off policies in December 2004 occurs by the end of the month 60 days after notification or 180 days delinquent, whichever is sooner. For domestic auto finance receivables, bankrupt accounts are charged off no later than the end of the month in which the loan becomes 210 days contractually delinquent. Charge-off involving a bankruptcy for our real estate secured and personal non-credit card receivables are consistent with the credit charge-off policy for these products. Prior to December 2004, charge-offs involving a bankruptcy for our domestic private label (excluding retail sales contracts at our Consumer Lending business) receivables occurred by the end of the month 90 days after notification. Our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business) was sold to HSBC Bank USA on December 29, 2004. RECEIVABLES SOLD AND SERVICED WITH LIMITED RECOURSE AND SECURITIZATION RELATED REVENUE Certain receivables have been securitized and sold to investors with limited recourse. We have retained the servicing rights to these receivables. Recourse is limited to our rights to future cash flow and any subordinated interest that we may retain. Upon sale, these 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 provisions. 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 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 sale 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, we record an interest-only strip receivable, representing our contractual right to receive interest and other cash flows from our securitization trusts. Our interest-only strip receivables are reported at fair value using discounted cash flow estimates as a separate component of receivables net of our 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. Our interest-only strip receivables are reviewed for impairment 119 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. We have 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. In order to align our accounting treatment with that of HSBC initially under U.K. GAAP and now under International Financial Reporting Standards ("IFRSs), starting in the third quarter of 2004 we began to structure all new collateralized funding transactions as secured financings. However, because existing public credit card transactions were structured as sales to revolving trusts that require replenishments to support previously issued securities, receivables continue to be sold to these trusts until the revolving periods end, the last of which is expected to occur in the fourth quarter of 2007. We continue to replenish, at reduced levels, personal non-credit card securities issued to conduits and record the resulting replenishment gains. PROPERTIES AND EQUIPMENT, NET Properties and equipment are recorded at cost, net of accumulated depreciation and amortization. As a result of our acquisition by HSBC, the amortized cost of our properties and equipment was adjusted to fair market value and accumulated depreciation and amortization on a "predecessor" basis was eliminated at the time of the acquisition. For financial reporting purposes, 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. 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. INSURANCE Insurance revenues on monthly premium insurance policies are recognized when billed. Insurance revenues on the remaining insurance contracts are recorded as unearned premiums and recognized into income based on the nature and terms of the underlying contracts. Liabilities for credit insurance policies are based upon estimated settlement amounts for both reported and incurred but not yet reported losses. Liabilities for future benefits on annuity contracts and specialty and corporate owned life insurance products are based on actuarial assumptions as to investment yields, mortality and withdrawals. INTANGIBLE ASSETS Intangible assets consist of purchased credit card relationships and related programs, retail services merchant relationships, other loan related relationships, trade names, technology, customer lists and other contracts. The trade names are not subject to amortization, as we believe they have indefinite lives. The remaining intangible assets are being amortized over their estimated useful lives either on a straight-line basis or in proportion to the underlying revenues generated. These useful lives range from 5 years for retail services merchant relationships to approximately 10 years for certain loan related relationships. Intangible assets are reviewed for impairment using discounted cash flows annually, or earlier if events indicate that the carrying amounts may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our primary indicator of potential impairment. Impairment charges, when required, are calculated using discounted cash flows. GOODWILL Goodwill represents the purchase price over the fair value of identifiable assets acquired less liabilities assumed from business combinations. Goodwill is not amortized, but is reviewed for impairment annually using discounted cash flows but impairment may be reviewed earlier if circumstances indicate that the carrying amount may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our primary indicator of potential impairment. DERIVATIVE FINANCIAL INSTRUMENTS All derivatives are recognized on the balance sheet at their fair value. At the inception of the hedging relationship, we designate the derivative as a fair value hedge, a cash flow hedge, or if the derivative does not quality in a hedging relationship, a non-hedging derivative. Fair value hedges include hedges of the fair value of a recognized asset or liability and certain foreign currency hedges. Cash flow hedges 120 include hedges of the variability of cash flows to be received or paid related to a recognized asset or liability and certain foreign currency hedges. Changes in the fair value of derivatives designated as fair value hedges, along with the change in fair value on the hedged risk, are recorded in current period earnings. Changes in the fair value of derivatives designated as cash flow hedges, 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. Changes in the fair value of derivative instruments not designated as hedging instruments and ineffective portions of changes in the fair value of hedging instruments are recognized in other revenue as derivative income in the current period. For derivative instruments designated as hedges, we formally document all relationships between hedging instruments and hedged items. This documentation includes our risk management objective and strategy for undertaking various hedge transactions, as well as how hedge effectiveness and ineffectiveness will be measured. This process includes linking derivatives to specific assets and liabilities on the balance sheet. We also formally assess, both at the hedge's inception and on a quarterly 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. This assessment is conducted using statistical regression analysis. When as a result of the quarterly assessment, it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, we discontinue hedge accounting as of the beginning of the quarter in which such determination was made. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective hedge, the derivative will continue to be carried on the balance sheet at its fair value, with changes in its fair value recognized in current period earnings. For fair value hedges, the formerly hedged asset or liability will no longer be adjusted for changes in fair value and any previously recorded adjustments to the carrying value of the hedged asset or liability will be amortized in the same manner that the hedged item affects income. For cash flow hedges, amounts previously recorded in accumulated other comprehensive income will be reclassified into income in the same manner that the hedged item affects income. If the hedging instrument is terminated early, the derivative is removed from the balance sheet. Accounting for the adjustments to the hedged asset or liability or adjustments to accumulated other comprehensive income are the same as described above when a derivative no longer qualifies as an effective hedge. If the hedged asset or liability is sold or extinguished, the derivative will continue to be carried on the balance sheet at its fair value, with changes in its fair value recognized in current period earnings. The hedged item, including previously recorded mark-to-market adjustments, is derecognized immediately as a component of the gain or loss upon disposition. FOREIGN CURRENCY TRANSLATION We have foreign subsidiaries located in the United Kingdom and Canada. The functional currency for each foreign subsidiary is its local currency. Assets and liabilities of these subsidiaries are translated at the rate of exchange in effect on the balance sheet date. Translation adjustments resulting from this process are accumulated in common shareholder's(s') equity as a component of accumulated other comprehensive income. Income and expenses are translated at the average rate of exchange prevailing during the year. Effects of foreign currency translation in the statements of cash flows are offset against the cumulative foreign currency adjustment, except for the impact on cash. Foreign currency transaction gains and losses are included in income as they occur. STOCK-BASED COMPENSATION We account for all of our stock based compensation awards including share options, restricted share awards and the employee stock purchase plan using the fair value method in accordance with Statement of Financial Accounting Standards No. 123(Revised 2004) "Share-Based Payment" (SFAS123(R)"). The fair value of the awards granted is recognized as expense over the vesting period generally either three or four years for options and three or five years for restricted share awards. The fair value of each option granted, measured at the grant date, is calculated using a binomial lattice methodology that is based on the underlying assumptions of the Black-Scholes option pricing model. 121 Compensation expense relating to restricted share awards is based upon the market value of the share on the date of grant. In 2004, we began to consider forfeitures for all stock awards granted subsequent to March 28, 2003 as part of our estimate of compensation expense rather than adjust compensation expense as forfeitures occur. The cumulative impact of the change was not material. INCOME TAXES HSBC Finance Corporation is included in HSBC North America's consolidated federal income tax return and in various state income tax returns. In addition, HSBC Finance Corporation files some unconsolidated state tax returns. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect. Investment tax credits generated by leveraged leases are accounted for using the deferral method. Changes in estimates of the basis in our assets and liabilities or other estimates recorded at the date of our acquisition by HSBC or our acquisition of Metris are adjusted against goodwill. TRANSACTIONS WITH RELATED PARTIES In the normal course of business, we enter into transactions with HSBC and its subsidiaries. These transactions occur at prevailing market rates and include funding arrangements, derivative execution, purchases and sales of receivables, servicing arrangements, information technology services, item processing and statement processing services, banking and other miscellaneous services. NEW ACCOUNTING PRONOUNCEMENTS Effective January 1, 2006, we adopted FASB Statement No. 123 (Revised), "Share-Based Payment," ("SFAS No. 123R"). Because we had previously adopted the fair value method of accounting for all equity based awards, the adoption of SFAS No. 123R did not have a significant impact on our operations or cash flow. Effective January 1, 2006, we adopted FASB Statement No. 154, "Accounting Changes and Error Corrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3" ("SFAS No. 154"). The adoption of SFAS No 154 did not have any impact on our financial position or results of operations. Effective January 1, 2006, we adopted FASB Staff Position Nos. FAS 115-1 and FAS 124-1 ("FSP 115-1 and FSP 124-1"), "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," in response to Emerging Issues Task Force 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The adoption of the impairment guidance contained in FSP 115-1 and FSP 124-1 did not have a material impact on our financial position or results of operations. In February 2006, the FASB issued FASB Statement No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS No. 155"). SFAS No. 155 permits companies to elect to measure at fair value entire financial instruments containing embedded derivatives that would otherwise have to be bifurcated and accounted for separately. SFAS No. 155 also requires companies to identify interests in securitized financial assets that are free standing derivatives or contain embedded derivatives that would have to be accounted for separately, clarifies which interest-and principal-only strips are subject to SFAS No. 133, and amends SFAS No 140 to revise the conditions of a qualifying special purpose entity. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of a company's first fiscal year that begins after September 15, 2006. Early adoption is permitted as of the beginning of a company's fiscal year, provided the company has not yet issued financial statements for that fiscal year. We elected to early adopt SFAS No. 155 effective January 1, 2006. The adoption of SFAS No. 155 did not have a significant impact on our financial position or results of operations. In March 2006, the FASB issued FASB Statement No. 156, "Accounting for Servicing of Financial Assets," ("SFAS No. 156"). SFAS No. 156, which is an amendment to SFAS No. 140, addresses the recognition and measurement of separately recognized servicing assets and liabilities and provides an approach to simplify the efforts to obtain hedge-like (offset) accounting. SFAS No. 156 is effective for financial years beginning after September 15, 2006, with early adoption permitted. We elected to early adopt SFAS No. 156 effective January 1, 2006. As we do not have servicing assets recorded on our balance sheet the early adoption of SFAS No. 156 did not have any impact on our financial position or results of operations. 122 In September 2006, the FASB issued FASB Statement No. 158, "Employer's Accounting for Defined Benefit Pension and Other Postretirement Plans," ("SFAS No. 158"). SFAS No. 158 requires balance sheet recognition of the funded status of pension and other postretirement benefits with the offset to accumulated other comprehensive income. Employers will recognize actuarial gains and losses, prior service cost, and any remaining transition amounts when recognizing a plan's funded status. SFAS No. 158 is effective for fiscal years ending after December 15, 2006. We adopted SFAS No. 158 effective December 31, 2006. The adoption of SFAS No. 158 resulted in a reduction of accumulated other comprehensive income within common shareholder's equity of $1 million at December 31, 2006. In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109" ("FIN No. 48"). FIN No. 48 establishes threshold and measurement attributes for financial statement measurement and recognition of tax positions taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. We adopted FIN No. 48 on January 1, 2007. The adoption of FIN 48 will not have a significant impact on the financial results of the Company and will not result in a significant cumulative effect adjustment to the January 1, 2007 balance of retained earnings. However, it will result in the reclassification of $65 million of deferred tax liability to current tax liability to account for uncertainty in the timing of tax benefits as well as the reclassification of $141 million of deferred tax asset to current tax asset to account for highly certain pending adjustments in the timing of tax benefits. In September 2006, the FASB issued FASB Statement No. 157, "Fair Value Measurements," ("SFAS No. 157"). SFAS No. 157 establishes a single authoritative definition of value, sets out a framework for measuring fair value, and requires additional disclosures about fair-value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those years. Early application is permissible only if no annual or interim financial statements have been issued for the earlier periods. We are considering whether to elect early adoption of this pronouncement and are currently evaluating the impact that adoption of SFAS No. 157 will have on our financial position and results of operations. In September 2006, the U.S. Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements" ("SAB 108"). SAB 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB 108 requires companies to quantify misstatements using both the balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. SAB 108 is effective for fiscal years ending after November 15, 2006. The adoption of SAB 108 did not have an impact on our financial position or results of operations. In February, 2007, the FASB issued FASB Statement No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," ("SFAS No. 159") which creates an alternative measurement treatment for certain financial assets and financial liabilities. SFAS No. 159 permits fair value to be used for both the initial and subsequent measurements on an instrument by instrument basis, with changes in the fair value to be recognized in earnings as those changes occur. This election is referred to as the fair value option. SFAS No. 159 also requires additional disclosures to compensate for the lack of comparability that will arise from the use of the fair value option. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. Early adoption is permitted as of the beginning of a company's fiscal year, provided the company has not yet issued financial statements for that fiscal year. We are considering whether to elect early adoption of this pronouncement and are currently evaluating the impact that the adoption of SFAS No. 159 will have on our financial position and results of operations. We anticipate that we would apply SFAS No. 159 largely to certain fixed rate debt which are already accounted for at fair value under IFRSs. Based on our latest analysis, we currently estimate that such election would result in a cumulative-effect after-tax reduction to the January 1, 2007 opening balance of retained earnings of approximately $550 million. 123 3. BUSINESS ACQUISITIONS AND DIVESTITURES -------------------------------------------------------------------------------- SALE OF EUROPEAN OPERATIONS On November 9, 2006, as part of our continuing evaluation of strategic alternatives with respect to our U.K. and European operations, we sold all of the capital stock of our operations in the Czech Republic, Hungary, and Slovakia (the "European Operations") to a wholly owned subsidiary of HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, for an aggregate purchase price of approximately $46 million. The assets consisted primarily of $199 million of receivables and goodwill which totaled approximately $13 million at November 9, 2006. The liabilities consisted primarily of debt which totaled $179 million at November 9, 2006. HBEU assumed all the liabilities of the European Operations as a result of this transaction. Because the sale of this business is between affiliates under common control, the premium received in excess of the book value of the stock transferred of $13 million, including the goodwill assigned to this business, was recorded as an increase to additional paid-in capital and will not be reflected in earnings. Our European Operations are reported in the International Segment. The following summarizes the operating results of our European Operations for the periods presented: PERIOD ENDED YEAR ENDED YEAR ENDED NOVEMBER 9, DECEMBER 31, DECEMBER 31, 2006 2005 2004 ----------------------------------------------------------------------------------------------------- (IN MILLIONS) Net interest income...................................... $24 $ 22 $ 10 Income before income tax expense......................... (5) (8) (11) Income tax expense....................................... - (3) 2 Net loss................................................. (5) (11) (9) ACQUISITION OF SOLSTICE CAPITAL GROUP INC ("SOLSTICE") On October 4, 2006 our Consumer Lending business purchased Solstice with assets of approximately $49 million, in an all cash transaction for approximately $50 million. Additional consideration may be paid based on Solstice's 2007 pre-tax income. Solstice markets a range of mortgage and home equity products to customers through direct mail. This acquisition will add momentum to our origination growth plan by providing an additional channel to customers. The results of Solstice are included in our consolidated financial statements beginning October 4, 2006. The purchase price was allocated to the assets and liabilities acquired based on their estimated fair values at the acquisition date. These fair value adjustments represent current estimates and are subject to further adjustment as our valuation data is finalized. Goodwill associated with the Solstice acquisition is not tax deductible. The initial purchase price allocations may be adjusted within one year of the purchase date for changes in estimates of the fair value of assets acquired and liabilities assumed. The following table summarizes the estimated fair values of the acquired and liabilities assumed as a result of the acquisition of Solstice: (IN MILLIONS) --------------------------------------------------------------------------- ASSETS ACQUIRED: Cash........................................................ $11 Receivables, net............................................ 37 Goodwill.................................................... 46 Properties and equipment.................................... 1 --- Total assets acquired..................................... $95 === LIABILITIES ASSUMED: Other liabilities........................................... $45 --- Total liabilities assumed................................. $45 === TOTAL PURCHASE PRICE........................................ $50 === 124 ACQUISITION OF METRIS COMPANIES INC. On December 1, 2005, we acquired the outstanding capital stock of Metris Companies Inc. ("Metris"), a provider of financial products and services to middle market consumers throughout the United States, in an all-cash transaction for $1.6 billion. HSBC Investments (North America) Inc. ("HINO") made a capital contribution of $1.2 billion to fund a portion of the purchase price. This acquisition expanded our presence in the near-prime credit card market and strengthened our capabilities to serve the full spectrum of credit card customers. The results of Metris are included in our consolidated financial statements beginning December 1, 2005. The purchase price was allocated to the assets and liabilities acquired based on their estimated fair values at the acquisition date. These preliminary fair values were estimated, in part, based on third party valuation data. Goodwill associated with the Metris acquisition is not tax deductible. In the third quarter of 2006, we made an adjustment to our estimated fair value related to Metris following an adverse judgment in litigation involving Metris that preceded the merger. This adjustment resulted in a net increase to goodwill of approximately $25 million. Since the one-year anniversary of the Metris acquisition was completed during the fourth quarter of 2006, no further acquisition-related adjustments to the purchase price will occur, except for changes in estimates for the tax basis in our assets and liabilities or other tax estimates recorded at the date of the Metris acquisition pursuant to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." SALE OF U.K. CREDIT CARD BUSINESS In December 2005, we sold our U.K. credit card business, including $2.5 billion of receivables, the associated cardholder relationships and the related retained interests in securitized credit card receivables to HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, for an aggregate purchase price of $3.0 billion. The purchase price, which was determined based on a comparative analysis of sales of other credit card portfolios, was paid in a combination of cash and $261 million of preferred stock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assets referred to above, the sale also included the account origination platform, including the marketing and credit employees associated with this function, as well as the lease associated with the credit card call center and the related leaseholds and call center employees to provide customer continuity after the transfer as well as to allow HBEU direct ownership and control of origination and customer service. We have retained the collection operations related to the credit card operations and have entered into a service level agreement for a period of not less than two years to provide collection services and other support services, including components of the compliance, financial reporting and human resource functions, for the sold credit card operations to HBEU for a fee. Additionally, the management teams of HBEU and our remaining U.K. operations will be jointly involved in decision making involving card marketing to ensure that growth objectives are met for both businesses. Because the sale of this business is between affiliates under common control, the premium received in excess of the book value of the assets transferred of $182 million, including the goodwill assigned to this business, was recorded as an increase to additional paid in capital and has not been included in earnings. As a result of this sale, our net interest income, fee income and provision for credit losses related to the U.K. credit card business has been reduced, while other income has increased by the receipt of servicing and support services revenue from HBEU. The net effect of this sale did not result in a material reduction of net income of our consolidated results. 4. SALE OF DOMESTIC PRIVATE LABEL RECEIVABLE PORTFOLIO AND ADOPTION OF FFIEC POLICIES -------------------------------------------------------------------------------- On December 29, 2004, we sold our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business), including the retained interests associated with securitized private label receivables, to HSBC Bank USA for an aggregate purchase price of $12.4 billion and recorded a gain of $663 million ($423 million after-tax). Included in this gain was the release of $505 million in credit loss reserves associated with the portfolio. The domestic private label receivable portfolio sold consisted of receivables with a balance of $12.2 billion. The purchase price was determined based upon an independent valuation opinion. We retained the customer relationships and by agreement will continue to sell additional domestic private label receivable originations (excluding retail sales contracts) generated under current and future private label 125 accounts to HSBC Bank USA on a daily basis at fair market value. We will also service the receivables for HSBC Bank USA for a fee under a service agreement that was reviewed by the staff of the Board of Governors of the Federal Reserve Board (the "Federal Reserve Board".) Upon receipt of regulatory approval for the sale of this domestic private label receivable portfolio, we adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC Policies") for our domestic private label (excluding retail sales contracts at our Consumer Lending business) and credit card portfolios. The adoption of FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our Consumer Lending business) and credit card receivables resulted in a reduction to our 2004 net income of $121 million. 5. SECURITIES -------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR DECEMBER 31, 2006 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities............................ $2,373 $10 $(39) $2,344 Money market funds................................... 1,051 - - 1,051 U.S. government sponsored enterprises(1)............. 179 - (2) 177 U.S. government and Federal agency debt securities... 144 - (1) 143 Non-government mortgage backed securities............ 367 - (1) 366 Other................................................ 578 2 (4) 576 ------ --- ---- ------ Subtotal............................................. 4,692 12 (47) 4,657 Accrued investment income............................ 38 - - 38 ------ --- ---- ------ Total securities available for sale.................. $4,730 $12 $(47) $4,695 ====== === ==== ====== GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR DECEMBER 31, 2005 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities............................ $2,337 $23 $(38) $2,322 Money market funds................................... 315 - - 315 U.S. government sponsored enterprises(1)............. 96 - (2) 94 U.S. government and Federal agency debt securities... 744 - (4) 740 Non-government mortgage backed securities............ 88 - (1) 87 Other................................................ 463 1 (5) 459 ------ --- ---- ------ Subtotal............................................. 4,043 24 (50) 4,017 Accrued investment income............................ 34 - - 34 ------ --- ---- ------ Total securities available for sale.................. $4,077 $24 $(50) $4,051 ====== === ==== ====== --------------- (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Proceeds from the sale of available-for-sale investments totaled approximately $.5 billion in 2006, $.4 billion in 2005 and $.9 billion in 2004. We realized gross gains of $125 million in 2006, $12 million in 2005 and $15 million in 2004. We realized gross losses of $2 million in 2006, $12 million in 2005 and $3 million in 2004. 126 Money market funds at December 31, 2006 include $854 million which is restricted for the sole purpose of paying down certain secured financings at the established payment date. There were no such restricted balances at December 31, 2005. A summary of gross unrealized losses and related fair values as of December 31, 2006, classified as to the length of time the losses have existed is presented in the following table: LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- GROSS AGGREGATE GROSS AGGREGATE NUMBER OF UNREALIZED FAIR VALUE OF NUMBER OF UNREALIZED FAIR VALUE OF DECEMBER 31, 2006 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS ------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities.............. 130 $(5) $433 503 $(34) $1,151 U.S. government sponsored enterprises............. 19 -(1) 77 22 (2) 84 U.S. government and Federal agency debt securities.............. 10 -(1) 27 30 (1) 54 Non-government mortgage... 20 -(1) 78 25 (1) 40 Other..................... 18 -(1) 89 55 (4) 195 LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- GROSS AGGREGATE GROSS AGGREGATE NUMBER OF UNREALIZED FAIR VALUE OF NUMBER OF UNREALIZED FAIR VALUE OF DECEMBER 31, 2005 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS ------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities.............. 272 $(14) $695 381 $(24) $898 U.S. government sponsored enterprises............. 11 -(1) 28 25 (2) 64 U.S. government and Federal agency debt securities.............. 18 (1) 71 40 (3) 117 Non-government mortgage... 3 -(1) 4 16 (1) 22 Other..................... 12 (1) 49 49 (4) 148 --------------- (1) Less than $500 thousand. The gross unrealized losses on our securities available for sale were flat during 2006. The contractual terms of these securities do not permit the issuer to settle the securities at a price less than the par value of the investment. Since substantially all of these securities are rated A- or better, and because we have the ability and intent to hold these investments until maturity or a market price recovery, these securities are not considered other-than temporarily impaired. The amortized cost of our securities available for sale was adjusted to fair market value at the time of the merger with HSBC. See Note 23, "Fair Value of Financial Instruments," for further discussion of the relationship between the fair value of our assets and liabilities. 127 Contractual maturities of and yields on investments in debt securities were as follows: AT DECEMBER 31, 2006 ---------------------------------------------------- DUE AFTER 1 AFTER 5 WITHIN BUT WITHIN BUT WITHIN AFTER 1 YEAR 5 YEARS 10 YEARS 10 YEARS TOTAL ---------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities: Amortized cost.............................. $474 $1,054 $247 $598 $2,373 Fair value.................................. 472 1,036 242 594 2,344 Yield(1).................................... 3.68% 4.47% 5.29% 5.60% 4.68% U.S. government sponsored enterprises: Amortized cost.............................. $ 50 $ 69 $ 5 $ 55 $ 179 Fair value.................................. 49 69 5 54 177 Yield(1).................................... 4.59% 4.98% 5.05% 4.33% 4.68% U.S. government and Federal agency debt securities: Amortized cost.............................. $ 32 $ 28 $ 21 $ 63 $ 144 Fair value.................................. 31 28 21 63 143 Yield(1).................................... 4.58% 3.66% 4.53% 4.85% 4.51% --------------- (1) Computed by dividing annualized interest by the amortized cost of respective investment securities. 6. RECEIVABLES -------------------------------------------------------------------------------- Receivables consisted of the following: AT DECEMBER 31, ------------------- 2006 2005 --------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 97,761 $ 82,826 Auto finance................................................ 12,504 10,704 Credit card................................................. 27,714 24,110 Private label............................................... 2,509 2,520 Personal non-credit card.................................... 21,367 19,545 Commercial and other........................................ 181 208 -------- -------- Total receivables........................................... 162,036 139,913 HSBC acquisition purchase accounting fair value adjustments............................................... (60) 63 Accrued finance charges..................................... 2,228 1,831 Credit loss reserve for owned receivables................... (6,587) (4,521) Unearned credit insurance premiums and claims reserves...... (412) (505) Interest-only strip receivables............................. 6 23 Amounts due and deferred from receivable sales.............. 51 185 -------- -------- Total receivables, net...................................... $157,262 $136,989 ======== ======== HSBC acquisition purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our receivables at fair value at the date of acquisition by HSBC. We have a subsidiary, Decision One Mortgage Company, LLC, which directly originates mortgage loans sourced by mortgage brokers and sells all loans to secondary market purchasers, including our Mortgage Services businesses. Loans held for sale to external parties by this subsidiary totaled $1.6 billion at 128 December 31, 2006 and $1.7 billion at December 31, 2005 and are included in real estate secured receivables. At December 31, 2006 our Consumer Lending business also had loans held for sale totaling $32 million as a result of the Solstice purchase. In November 2006, we sold our European Operations, including $199 million of receivables to a wholly owned subsidiary of HBEU. In December 2005, we sold our U.K. based credit card operations, including $2.5 billion of receivables and the related retained interests in securitized credit card receivables to HBEU. See Note 3, "Business Acquisitions and Divestitures," for additional information regarding these sales. In November 2006, we acquired $2.5 billion of real estate secured receivables from Champion Mortgage ("Champion") a division of KeyBank, N.A. and as part of our acquisition of Metris on December 1, 2005, we acquired $5.3 billion of receivables. These receivables acquired were subject to the requirements of Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3") to the extent there was evidence of deterioration of credit quality since origination and for which it was probable, at acquisition, that all contractually required payments would not be collected and that the associated line of credit had been closed. The following table summarizes, for Champion, the outstanding receivable balances, the cash flows expected to be collected and the fair value of the receivables to which SOP 03-3 has been applied: (IN MILLIONS) --------------------------------------------------------------------------- Outstanding contractual receivable balance at acquisition... $ 152 Cash flows expected to be collected at acquisition.......... 136 Basis in acquired receivables at acquisition................ 117 The carrying amount of Champion real estate secured receivables subject to the requirements of SOP 03-3 was $116 million at December 31, 2006 and is included in the real estate secured receivables in the table above. The outstanding contractual balance of these receivables was $143 million at December 31, 2006. At December 31, 2006, no credit loss reserve for the acquired receivables subject to SOP 03-3 has been established as there has been no decrease to the expected future cash flows since the acquisition. As discussed more fully in Note 3, "Business Acquisitions and Divestitures," as part of our acquisition of Metris on December 1, 2005, we acquired $5.3 billion of receivables. The carrying amount of the credit card receivables which were subject to SOP 03-3 was $223 million at December 31, 2006 and $414 million at December 31, 2005 and is included in the credit card receivables in the table above. The outstanding contractual balance of these receivables was $334 million at December 31, 2006 and $804 million at December 31, 2005. At December 31, 2006, no credit loss reserve for the acquired receivables subject to SOP 03-3 has been established as there has been no decrease to the expected future cash flows since the acquisition. There was a reclassification to accretable yield from non-accretable difference during 2006. This reclassification from non-accretable difference represents an increase to the estimated cash flows to be collected on the underlying Metris portfolio. The following summarizes the accretable yield on Metris and Champion receivables at December 31, 2006: (IN MILLIONS) --------------------------------------------------------------------------- Accretable yield at December 31, 2005....................... $(122) Accretable yield additions during the period................ (19) Accretable yield amortized to interest income during the period.................................................... 100 Reclassification from non-accretable difference............. (35) ----- Accretable yield at December 31, 2006....................... $ (76) ===== 129 Real estate secured receivables are comprised of the following: AT DECEMBER 31, ----------------- 2006 2005 ------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured: Closed-end: First lien............................................. $77,901 $66,819 Second lien............................................ 15,090 11,815 Revolving: First lien............................................. 556 626 Second lien............................................ 4,214 3,566 ------- ------- Total real estate secured receivables..................... $97,761 $82,826 ======= ======= Foreign receivables included in receivables were as follows: AT DECEMBER 31, --------------------------------------------------- UNITED KINGDOM AND THE REST OF EUROPE CANADA ------------------------ ------------------------ 2006 2005 2004 2006 2005 2004 ----------------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured....................... $1,786 $1,654 $1,832 $1,766 $1,380 $1,042 Auto finance.............................. - - - 311 270 54 Credit card............................... - - 2,264 215 147 - Private label............................. 1,333 1,330 2,249 887 834 821 Personal non-credit card.................. 2,425 3,038 3,562 697 607 517 Commercial and other...................... - - - - - 2 ------ ------ ------ ------ ------ ------ Total..................................... $5,544 $6,022 $9,907 $3,876 $3,238 $2,436 ====== ====== ====== ====== ====== ====== Foreign receivables represented 6 percent of receivables at December 31, 2006 and 7 percent of receivables at December 31, 2005. Receivables serviced with limited recourse consisted of the following: AT DECEMBER 31, --------------- 2006 2005 ----------------------------------------------------------------------------- (IN MILLIONS) Auto finance................................................ $271 $1,192 Credit card................................................. 500 1,875 Personal non-credit card.................................... 178 1,007 ---- ------ Total....................................................... $949 $4,074 ==== ====== We maintain facilities with third parties which provide for the securitization or secured financing of receivables on both a revolving and non-revolving basis totaling $19.0 billion, of which $9.1 billion were utilized at December 31, 2006. The amount available under these facilities will vary based on the timing and volume of public securitization or secured financing transactions and our general liquidity plans. 130 Contractual maturities of our receivables were as follows: AT DECEMBER 31, 2006 -------------------------------------------------------------------- 2007 2008 2009 2010 2011 THEREAFTER TOTAL ----------------------------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured.................. $ 528 $ 479 $ 388 $ 423 $ 591 $ 95,352 $ 97,761 Auto finance......................... 2,983 2,744 2,496 2,100 1,487 694 12,504 Credit card.......................... 3,768 2,961 2,503 2,132 1,828 14,522 27,714 Private label........................ 1,167 532 349 216 118 127 2,509 Personal non-credit card............. 2,448 1,640 2,394 3,922 6,035 4,928 21,367 Commercial and other................. 1 - 45 58 - 77 181 ------- ------ ------ ------ ------- -------- -------- Total................................ $10,895 $8,356 $8,175 $8,851 $10,059 $115,700 $162,036 ======= ====== ====== ====== ======= ======== ======== A substantial portion of consumer receivables, based on our experience, will be renewed or repaid prior to contractual maturity. The above maturity schedule should not be regarded as a forecast of future cash collections. The following table summarizes contractual maturities of receivables due after one year by repricing characteristic: AT DECEMBER 31, 2006 --------------------- OVER 1 BUT WITHIN OVER 5 YEARS 5 YEARS ----------------------------------------------------------------------------------- (IN MILLIONS) Receivables at predetermined interest rates................. $26,977 $ 95,521 Receivables at floating or adjustable rates................. 8,464 20,179 ------- -------- Total....................................................... $35,441 $115,700 ======= ======== Nonaccrual consumer receivables totaled $4.8 billion (including $482 million relating to foreign operations) at December 31, 2006 and $3.5 billion (including $463 million relating to foreign operations) at December 31, 2005. Interest income that would have been recorded if such nonaccrual receivables had been current and in accordance with contractual terms was approximately $639 million (including $72 million relating to foreign operations) in 2006 and $475 million (including $66 million relating to foreign operations) in 2005. Interest income that was included in finance and other interest income prior to these loans being placed on nonaccrual status was approximately $338 million (including $36 million relating to foreign operations) in 2006 and $229 million (including $31 million relating to foreign operations) in 2005. For an analysis of reserves for credit losses, see our "Analysis of Credit Loss Reserves Activity" in Management's Discussion and Analysis and Note 7, "Credit Loss Reserves." Interest-only strip receivables are reported net of our estimate of probable losses under the recourse provisions for receivables serviced with limited recourse. Reductions to our interest-only strip receivables in 2006 reflect the impact of reduced securitization levels, including our decision in 2004 to structure new collateralized funding transactions as secured financings. Amounts due and deferred from receivable sales include assets established for certain receivable sales, including funds deposited in spread accounts, and net customer payments due from (to) the securitization trustee. We issued securities backed by dedicated home equity loan receivables of $4.8 billion in 2006 and $4.5 billion in 2005. We issued securities backed by dedicated auto finance loan receivables of $2.8 billion in 2006 and $3.4 billion in 2005. We issued securities backed by dedicated credit card receivables of $4.8 billion in 2006 and $1.8 billion in 2005. We issued securities backed by dedicated personal non-credit card receivables of $2.5 billion in 2006. For accounting purposes, these transactions were structured as secured financings, 131 therefore, the receivables and the related debt remain on our balance sheet. Additionally, as part of the Metris acquisition in 2005, we assumed $4.6 billion of securities backed by credit card receivables which were accounted for as secured financings. Real estate secured receivables included closed-end real estate secured receivables totaling $9.7 billion at December 31, 2006 and $7.5 billion at December 31, 2005 that secured the outstanding debt related to these transactions. Auto finance receivables totaling $6.0 billion at December 31, 2006 and $5.1 billion at December 31, 2005 secured the outstanding debt related to these transactions. Credit card receivables totaling $8.9 billion at December 31, 2006 and $7.1 billion at December 31, 2005 secured the outstanding debt related to these transactions. Personal non-credit card receivables of $3.5 billion at December 31, 2006 secured the outstanding debt related to these transactions. There were no transactions structured as secured financings in 2005 for personal non-credit card receivables. 7. CREDIT LOSS RESERVES -------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: AT DECEMBER 31, ------------------------ 2006 2005 2004 -------------------------------------------------------------------------------------- (IN MILLIONS) Credit loss reserves at beginning of period................. $4,521 $3,625 $3,793 Provision for credit losses................................. 6,564 4,543 4,334 Charge-offs................................................. (5,164) (4,100) (4,409) Recoveries.................................................. 645 447 376 Other, net.................................................. 21 6 (469) ------ ------ ------ Credit loss reserves at end of period....................... $6,587 $4,521 $3,625 ------ ------ ------ Further analysis of credit quality and credit loss reserves is presented in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of Form 10-K under the caption "Credit Quality." 8. ASSET SECURITIZATIONS -------------------------------------------------------------------------------- We have sold receivables in various securitization transactions. We continue to service and receive servicing fees on the outstanding balance of these securitized receivables. We also retain rights to future cash flows arising from these receivables after the investors receive their contractual return. We have also, in certain cases, retained other subordinated interests in these securitizations. These transactions result in the recording of an interest-only strip receivable which represents the value of the future residual cash flows from securitized receivables. The investors and the securitization trusts have only limited recourse to our assets for failure of debtors to pay. That recourse is limited to our rights to future cash flow and any subordinated interest we retain. Servicing assets and liabilities are not recognized in conjunction with our securitizations since we receive adequate compensation relative to current market rates to service the receivables sold. See Note 2, "Summary of Significant Accounting Policies," for further discussion on our accounting for interest-only strip receivables. In the third quarter of 2004, we began to structure all new collateralized funding transactions as secured financings. However, because existing public 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 the fourth quarter of 2007. In addition, we continue to replenish at reduced levels, certain non-public personal non-credit card securities issued to conduits and record the resulting replenishment gains. Securitization related revenue includes income associated with the current and prior period securitization of receivables with limited recourse structured as sales. Such income includes gains on sales, net of our estimate of probable credit losses under the recourse provisions, servicing income and excess spread relating to those receivables. 132 YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004 -------------------------------------------------------------------------------------------------------- Net initial gains(1)........................................ $ - $ - $ 25 Net replenishment gains(2).................................. 30 154 414 Servicing revenue and excess spread......................... 137 57 569 ---- ---- ------ Total securitization related revenue........................ $167 $211 $1,008 ==== ==== ====== --------------- (1) Net initial gains reflect inherent recourse provisions of $47 million in 2004. (2) Net replenishment gains reflect inherent recourse provisions of $41 million in 2006, $252 million in 2005 and $850 million in 2004. Net initial gains represent gross initial gains net of our estimate of probable credit losses under the recourse provisions. There were no net initial gains in 2006 or 2005. Net initial gains and the key economic assumptions used in measuring the net initial gains from securitizations for 2004 were as follows: AUTO CREDIT PRIVATE YEAR ENDED DECEMBER 31, FINANCE CARD LABEL TOTAL ------------------------------------------------------------------------------------------------ 2004 Net initial gains (in millions)............................. $ 6(2) $ 14 $ 5 $25 Key economic assumptions:(1) Weighted-average life (in years).......................... 2.1 .3 .4 Payment speed............................................. 35.0% 93.5% 93.5% Expected credit losses (annual rate)...................... 5.7 4.9 4.8 Discount rate on cash flows............................... 10.0 9.0 10.0 Cost of funds............................................. 3.0 1.5 1.4 --------------- (1) Weighted-average annual rates for securitizations entered into during the period for securitizations of loans with similar characteristics. (2) In 2004, auto finance was involved in a securitization which later was restructured as a secured financing. The initial gain reflected above was the gain on the initial transaction that remained after the securitization was restructured, as required under Emerging Issues Task Force Issue No. 02-9. Certain securitization trusts, such as credit cards, are established at fixed levels and require frequent sales of new receivables into the trust to replace receivable run-off. These replenishments totaled $2.5 billion in 2006, $8.8 billion in 2005 and $30.3 billion in 2004. 133 Cash flows received from securitization trusts were as follows: PERSONAL REAL ESTATE AUTO CREDIT PRIVATE NON-CREDIT YEAR ENDED DECEMBER 31, SECURED FINANCE CARD LABEL CARD TOTAL ------------------------------------------------------------------------------------------------------- (IN MILLIONS) 2006 Proceeds from initial securitizations...................... $- $ - $ - $ - $ - $ - Servicing fees received................ - 16 22 - 10 48 Other cash flow received on retained interests(1)......................... - 97 108 - 18 223 2005 Proceeds from initial securitizations...................... $- $ - $ - $ - $ - $ - Servicing fees received................ - 45 97 - 46 188 Other cash flow received on retained interests(1)......................... - 40 243 - 52 335 2004 Proceeds from initial securitizations...................... $- $ -(2) $550 $190 $ - $ 740 Servicing fees received................ 1 86 185 93 161 526 Other cash flow received on retained interests(1)......................... 4 (1) 696 252 80 1,031 --------------- (1) Other cash flows include all cash flows from interest-only strip receivables, excluding servicing fees. (2) In 2004, auto finance was involved in a securitization which was later restructured as a secured financing. These transactions are reported net in the table above. At December 31, 2006, the sensitivity of the current fair value of the interest-only strip receivables to an immediate 10 percent and 20 percent unfavorable change in assumptions are presented in the table below. These sensitivities are based on assumptions used to value our interest-only strip receivables at December 31, 2006. PERSONAL AUTO CREDIT NON-CREDIT FINANCE CARD CARD ------------------------------------------------------------------------------------------- Carrying value (fair value) of interest-only strip receivables............................................... $ (4) $ 9 $ 1 Weighted-average life (in years)............................ .7 .3 .3 Payment speed assumption (annual rate)...................... 74.3% 98.9% 99.2% Impact on fair value of 10% adverse change................ $ - $ (1) $ - Impact on fair value of 20% adverse change................ (1) (2) - Expected credit losses (annual rate)........................ 10.0% 3.7% 9.8% Impact on fair value of 10% adverse change................ $ (2) $ - $ - Impact on fair value of 20% adverse change................ (3) (1) (1) Discount rate on residual cash flows (annual rate).......... 10.0% 9.0% 11.0% Impact on fair value of 10% adverse change................ $ - $ - $ - Impact on fair value of 20% adverse change................ (1) - - Variable returns to investors (annual rate)................. - 4.7% 6.0% Impact on fair value of 10% adverse change................ $ - $ (1) $ - Impact on fair value of 20% adverse change................ - (1) (1) These sensitivities are hypothetical and should not be considered to be predictive of future performance. As the figures indicate, the change in fair value based on a 10 percent variation in assumptions cannot necessarily be extrapolated because the relationship of the change in assumption to the change in fair value may not be 134 linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the residual cash flow is calculated independently from any change in another assumption. In reality, changes in one factor may contribute to changes in another (for example, increases in market interest rates may result in lower prepayments) which might magnify or counteract the sensitivities. Furthermore, the estimated fair values as disclosed should not be considered indicative of future earnings on these assets. 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 receivables, 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 our interest-only strip receivables in the table above. At December 31, 2006, static pool credit losses for auto finance loans securitized in 2003 were estimated to be 10.0 percent. Receivables and two-month-and-over contractual delinquency for our owned and serviced with limited recourse receivables were as follows: AT DECEMBER 31, ----------------------------------------------------- 2006 2005 ------------------------- ------------------------- RECEIVABLES DELINQUENT RECEIVABLES DELINQUENT OUTSTANDING RECEIVABLES OUTSTANDING RECEIVABLES -------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) OWNED RECEIVABLES: First mortgage(1).............................. $ 15 3.01% $ 21 8.41% Real estate secured............................ 97,761 3.54 82,826 2.72 Auto finance................................... 12,504 3.18 10,704 3.04 Credit card.................................... 27,714 4.57 24,110 3.66 Private label.................................. 2,509 5.31 2,520 5.43 Personal non-credit card....................... 21,367 10.17 19,545 9.40 -------- ----- -------- ----- Total consumer................................. 161,870 4.59 139,726 3.89 Commercial..................................... 166 - 187 - -------- ----- -------- ----- Total owned receivables.......................... $162,036 4.59% $139,913 3.89% ======== ===== ======== ===== RECEIVABLES SERVICED WITH LIMITED RECOURSE: Auto finance................................... $ 271 6.64% $ 1,192 7.55% Credit card.................................... 500 2.00 1,875 1.60 Personal non-credit card....................... 178 14.61 1,007 12.41 -------- ----- -------- ----- Total receivables serviced with limited recourse....................................... $ 949 5.69% $ 4,074 6.01% ======== ===== ======== ===== --------------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. 135 Average receivables and net charge-offs for our owned and serviced with limited recourse receivables were as follows: YEAR ENDED DECEMBER 31, ----------------------------------------------------- 2006 2005 ------------------------- ------------------------- AVERAGE NET AVERAGE NET RECEIVABLES CHARGE-OFFS RECEIVABLES CHARGE-OFFS -------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) OWNED RECEIVABLES: First mortgage(1).............................. $ 18 1.28% $ 24 .90% Real estate secured............................ 92,318 1.00 73,097 .76 Auto finance................................... 11,660 3.67 9,074 3.27 Credit card.................................... 25,065 5.56 17,823 7.12 Private label.................................. 2,492 5.80 2,948 4.83 Personal non-credit card....................... 20,611 7.89 17,558 7.88 -------- ----- -------- ----- Total consumer.............................. 152,164 2.97 120,524 3.03 Commercial..................................... 177 .43 231 2.60 -------- ----- -------- ----- Total owned receivables.......................... $152,341 2.97% $120,755 3.03% ======== ===== ======== ===== RECEIVABLES SERVICED WITH LIMITED RECOURSE: Real estate secured............................ $ - -% $ 23 -% Auto finance................................... 720 10.28 1,863 10.90 Credit card.................................... 974 3.49 4,871 5.52 Personal non-credit card....................... 498 9.24 2,398 9.84 -------- ----- -------- ----- Total receivables serviced with limited recourse....................................... $ 2,192 7.03% $ 9,155 7.73% ======== ===== ======== ===== --------------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. 9. PROPERTIES AND EQUIPMENT, NET -------------------------------------------------------------------------------- AT DECEMBER 31, ------------------- DEPRECIABLE 2006 2005 LIFE ----------------------------------------------------------------------------------------------- (IN MILLIONS) Land........................................................ $ 29 $ 28 - Buildings and improvements.................................. 315 288 10-40 years Furniture and equipment..................................... 146 376 3-10 ---- ---- Total....................................................... 490 692 Accumulated depreciation and amortization................... 64 234 ---- ---- Properties and equipment, net............................... $426 $458 ==== ==== Depreciation and amortization expense totaled $115 million in 2006, $131 million in 2005 and $127 million in 2004. 136 10. INTANGIBLE ASSETS -------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYING DECEMBER 31, 2006 GROSS AMORTIZATION VALUE ---------------------------------------------------------------------------------------------- (IN MILLIONS) Purchased credit card relationships and related programs.... $1,736 $ 580 $1,156 Retail services merchant relationships...................... 270 203 67 Other loan related relationships............................ 333 135 198 Trade names................................................. 717 13 704 Technology, customer lists and other contracts.............. 282 189 93 ------ ------ ------ Total....................................................... $3,338 $1,120 $2,218 ====== ====== ====== ACCUMULATED CARRYING DECEMBER 31, 2005 GROSS AMORTIZATION VALUE ---------------------------------------------------------------------------------------------- (IN MILLIONS) Purchased credit card relationships and related programs.... $1,736 $442 $1,294 Retail services merchant relationships...................... 270 149 121 Other loan related relationships............................ 326 104 222 Trade names................................................. 717 13 704 Technology, customer lists and other contracts.............. 282 143 139 ------ ---- ------ Total....................................................... $3,331 $851 $2,480 ====== ==== ====== During the third quarter of 2006, we completed our annual impairment test of intangible assets. As a result of our testing, we determined that the fair value of each intangible asset exceeded its carrying value. Therefore we have concluded that none of our intangible assets are impaired. Weighted-average amortization periods for our intangible assets as of December 31, 2006 were as follows: (IN MONTHS) -------------------------------------------------------------------------- Purchased credit card relationships and related programs.... 106 Retail services merchant relationships...................... 60 Other loan related relationships............................ 109 Technology, customer lists and other contracts.............. 85 Intangible assets........................................... 95 Intangible amortization expense totaled $269 million in 2006, $345 million in 2005 and $363 million in 2004. The trade names are not subject to amortization as we believe they have indefinite lives. The remaining acquired intangibles are being amortized as applicable over their estimated useful lives either on a straight-line basis or in proportion to the underlying revenues generated. These useful lives range from 5 years for retail services merchant relationships to approximately 10 years for certain loan related relationships. Our purchased credit card relationships have estimated residual values of $162 million as of December 31, 2006. 137 Estimated amortization expense associated with our intangible assets for each of the following years is as follows: YEAR ENDING DECEMBER 31, (IN MILLIONS) --------------------------------------------------------------------------- 2007........................................................ $253 2008........................................................ 211 2009........................................................ 198 2010........................................................ 169 2011........................................................ 169 Thereafter.................................................. 354 11. GOODWILL -------------------------------------------------------------------------------- Goodwill balances associated with our foreign businesses will change from period to period due to movements in foreign exchange. Changes in estimates of the tax basis in our assets and liabilities or other tax estimates recorded at the date of our acquisition by HSBC or our acquisition of Metris are adjusted against goodwill pursuant to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Changes in the carrying amount of goodwill are as follows: 2006 2005 ----------------------------------------------------------------------------- (IN MILLIONS) Balance at beginning of year................................ $7,003 $6,856 Adjustment to Metris purchase price......................... 21 - Acquisitions - 2006 Solstice; 2005 primarily Metris......... 46 533 Goodwill allocated to our European Operations sold to HBEU...................................................... (13) - Goodwill allocated to the U.K. credit card business sold to HBEU...................................................... - (218) Change in estimate of the tax basis of assets and liabilities recorded in the HSBC acquisition.............. (89) (76) Change in estimate of the tax basis of assets and liabilities recorded in the Metris acquisition............ (13) - Impact of foreign currency translation...................... 55 (92) ------ ------ Balance at end of year...................................... $7,010 $7,003 ====== ====== Goodwill established as a result of our acquisition by HSBC has not been allocated to or included in the reported results of our reportable segments as the acquisition by HSBC was outside of the ongoing operational activities of our reportable segments. This is consistent with management's view of our reportable segment results. Goodwill relating to acquisitions, such as Metris and Solstice are included in the reported respective segment results as these acquisitions specifically related to the operations and is consistent with management's view of the segment results. See Note 21, "Business Segments," for further information on goodwill by reportable segment. During the third quarter of 2006, we completed our annual impairment test of goodwill. For purposes of this test, we assigned the goodwill established as a result of our acquisition by HSBC to our reporting units (as defined in SFAS No. 142, "Goodwill and Other Intangible Assets"). The fair value of each of the reporting units to which goodwill was assigned exceeded its carrying value including goodwill, resulting in a conclusion that none of our goodwill is impaired. As required by SFAS No. 142, "Goodwill and Other Intangible Assets," subsequent to the sale of our European Operations we performed an interim goodwill impairment test for our remaining U.K. operations. As the estimated fair value of our remaining U.K. operations exceeded its carrying value subsequent to the sale, we concluded that the remaining goodwill assigned to this reporting unit was not impaired. As previously 138 reported, we continue to evaluate the scope of our U.K. operations and, as a result, it is reasonably possible we could make changes in the future. As a result of the adverse change in the business climate experienced by our Mortgage Services business in the second half of 2006, we performed an interim goodwill impairment test for this reporting unit as of December 31, 2006. As the estimated fair value of our Mortgage Services business exceeded our carrying value, we concluded that the remaining goodwill assigned to this reporting unit was not impaired. We are currently evaluating the most effective structure for our Mortgage Services operations which, depending upon the outcome, may change the scope and size of this business going forward. 12. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS -------------------------------------------------------------------------------- COMMERCIAL BANK AND OTHER PAPER BORROWINGS TOTAL ------------------------------------------------------------------------------------------------- (IN MILLIONS) 2006 Balance................................................... $11,012 $ 43 $11,055 Highest aggregate month-end balance....................... 17,530 Average borrowings........................................ 12,344 494 12,838 Weighted-average interest rate: At year-end............................................. 5.3% 2.8% 5.3% Paid during year........................................ 5.0 3.3 4.9 2005 Balance................................................... $11,360 $ 94 $11,454 Highest aggregate month-end balance....................... 14,801 Average borrowings........................................ 11,877 111 11,988 Weighted-average interest rate: At year-end............................................. 4.2% 3.9% 4.2% Paid during year........................................ 3.4 2.5 3.4 2004 Balance................................................... $ 8,969 $ 91 $ 9,060 Highest aggregate month-end balance....................... 16,173 Average borrowings........................................ 11,403 126 11,529 Weighted-average interest rate: At year-end............................................. 2.2% 2.5% 2.2% Paid during year........................................ 1.8 1.9 1.8 Commercial paper included obligations of foreign subsidiaries of $223 million at December 31, 2006, $442 million at December 31, 2005 and $248 million at December 31, 2004. Bank and other borrowings included obligations of foreign subsidiaries of $35 million at December 31, 2006, $55 million at December 31, 2005 and $52 million at December 31, 2004. At December 31, 2006 deposits of $36 million, primarily held by our U.K. business, have been classified as bank and other borrowings due to their short-term nature. Prior period amounts have been reclassified to conform to the current presentation. Interest expense for commercial paper, bank and other borrowings totaled $628 million in 2006, $402 million in 2005 and $213 million in 2004. We maintain various bank credit agreements primarily to support commercial paper borrowings and also to provide funding in the U.K. We had committed back-up lines and other bank lines of $17.0 billion at December 31, 2006, including $7.7 billion with HSBC and subsidiaries and $16.3 billion at December 31, 2005, including $8.0 billion with HSBC and subsidiaries. Our U.K. subsidiary had drawn $4.3 billion at December 31, 2006 and $4.2 billion on its bank lines of credit at December 31, 2005 which are included in 139 Due to Affiliates for both periods. Formal credit lines are reviewed annually and expire at various dates through 2009. Borrowings under these lines generally are available at a surcharge over LIBOR. The most restrictive financial covenants contained in the back-up line agreements that could restrict availability is an obligation to maintain minimum common and preferred shareholder's equity of $11.0 billion which is substantially below our December 31, 2006 common and preferred shareholders' equity balance of $20.1 billion. Because our U.K. subsidiary receives its funding directly from HSBC, we eliminated all third-party back-up lines at our U.K. subsidiary in 2004. Annual commitment fee requirements to support availability of these lines at December 31, 2006 totaled $8 million and included $1 million for the HSBC lines. Annual commitment fee requirements to support availability of these lines at December 31, 2005 totaled $9 million and included $2 million for the HSBC lines. 13. LONG TERM DEBT (WITH ORIGINAL MATURITIES OVER ONE YEAR) -------------------------------------------------------------------------------- AT DECEMBER 31, -------------------- 2006 2005 ---------------------------------------------------------------------------------- (IN MILLIONS) SENIOR DEBT FIXED RATE: 8.875% Adjustable Conversion-Rate Equity Security Units................................................. $ 542 $ 541 Secured financings: 3.00% to 3.99%; due 2007 to 2008..................... 195 3,947 4.00% to 4.49%; due 2007 to 2010..................... 1,312 2,254 4.50% to 4.99%; due 2007 to 2011..................... 3,956 1,024 Other fixed rate senior debt: 2.40% to 3.99%; due 2007 to 2010..................... 6,880 2,864 4.00% to 4.99%; due 2007 to 2023..................... 16,806 21,902 5.00% to 5.49%; due 2007 to 2023..................... 16,657 6,188 5.50% to 5.99%; due 2007 to 2024..................... 16,031 7,188 6.00% to 6.49%; due 2007 to 2033..................... 9,591 8,453 6.50% to 6.99%; due 2007 to 2033..................... 4,981 8,076 7.00% to 7.49%; due 2007 to 2032..................... 3,364 4,587 7.50% to 7.99%; due 2007 to 2032..................... 3,249 4,906 8.00% to 9.00%; due 2007 to 2012..................... 1,263 1,244 VARIABLE INTEREST RATE: Secured financings - 2.63% to 5.28%; due 2007 to 2010.................................................. 16,364 7,893 Other variable interest rate senior debt - 2.16% to 6.73%; due 2007 to 2018............................... 24,666 21,488 JUNIOR SUBORDINATED NOTES ISSUED TO CAPITAL TRUSTS.......... 1,031 1,443 UNAMORTIZED DISCOUNT........................................ (377) (341) HSBC ACQUISITION PURCHASE ACCOUNTING FAIR VALUE ADJUSTMENTS............................................... 1,079 1,506 -------- -------- TOTAL LONG TERM DEBT........................................ $127,590 $105,163 ======== ======== HSBC acquisition purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our long term debt at fair value at the date of our acquisition by HSBC. Secured financings of $21.8 billion at December 31, 2006 are secured by $28.1 billion of real estate secured, auto finance, credit card and personal non-credit card receivables. Secured financings of $15.1 billion at December 31, 2005 are secured by $19.7 billion of real estate secured, auto finance and credit card receivables. 140 At December 31, 2006, long term debt included carrying value adjustments relating to derivative financial instruments which decreased the debt balance by $1.3 billion and a foreign currency translation adjustment relating to our foreign denominated debt which increased the debt balance by $2.4 billion. At December 31, 2005, long term debt included carrying value adjustments relating to derivative financial instruments which decreased the debt balance by $862 million and a foreign currency translation adjustment relating to our foreign denominated debt which increased the debt balance by $272 million. Weighted-average interest rates were 5.5 percent at December 31, 2006 and 5.3 percent at December 31, 2005 (excluding HSBC acquisition purchase accounting adjustments). Interest expense for long term debt was $5.8 billion in 2006, $3.7 billion in 2005, $2.6 billion in 2004. The most restrictive financial covenants contained in the terms of our debt agreements are the maintenance of a minimum common and preferred shareholder's equity of $11.0 billion which is substantially lower than our common and preferred shareholders' equity balance of $20.1 billion at December 31, 2006. Debt denominated in a foreign currency is included in the applicable rate category based on the effective U.S. dollar equivalent rate as summarized in Note 14, "Derivative Financial Instruments." In 2002, we issued $541 million of 8.875 percent Adjustable Conversion-Rate Equity Security Units. Each Adjustable Conversion-Rate Equity Security Unit consisted initially of a contract to purchase, for $25, a number of shares of HSBC Finance Corporation (formerly known as Household International, Inc.) common stock on February 15, 2006 and a senior note issued by our then wholly owned subsidiary, Household Finance Corporation, with a principal amount of $25. In November 2005 we remarketed the notes and reset the rate. All remaining stock purchase contracts matured on February 15, 2006 and HSBC issued ordinary shares for the remaining stock purchase contracts on that date. The following table summarizes our junior subordinated notes issued to capital trusts ("Junior Subordinated Notes") and the related company obligated mandatorily redeemable preferred securities ("Preferred Securities"): HOUSEHOLD CAPITAL TRUST IX ("HCT IX") ------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) JUNIOR SUBORDINATED NOTES: Principal balance......................................... $ 1,031 Interest rate............................................. 5.91% Redeemable by issuer...................................... November 2015 Stated maturity........................................... November 2035 PREFERRED SECURITIES: Rate...................................................... 5.91% Face value................................................ $ 1,000 Issue date................................................ November 2005 In the first quarter of 2006, we redeemed the junior subordinated notes issued to Household Capital Trust VI with an outstanding principal balance of $206 million. In the fourth quarter of 2006, we redeemed the junior subordinated notes issued to Household Capital Trust VII with an outstanding principal balance of $206 million. The Preferred Securities must be redeemed when the Junior Subordinated Notes are paid. The Junior Subordinated Notes have a stated maturity date, but are redeemable by us, in whole or in part, beginning on the dates indicated above at which time the Preferred Securities are callable at par ($25 per Preferred Security) plus accrued and unpaid dividends. Dividends on the Preferred Securities are cumulative, payable quarterly in arrears, and are deferrable at our option for up to five years. We cannot pay dividends on our preferred and common stocks during such deferments. The Preferred Securities have a liquidation value of $25 per preferred security. Our obligations with respect to the Junior Subordinated Notes, when considered 141 together with certain undertakings of HSBC Finance Corporation with respect to the Trusts, constitute full and unconditional guarantees by us of the Trusts' obligations under the respective Preferred Securities. Maturities of long term debt at December 31, 2006 were as follows: (IN MILLIONS) --------------------------------------------------------------------------- 2007........................................................ $ 26,555 2008........................................................ 22,136 2009........................................................ 17,128 2010........................................................ 12,824 2011........................................................ 13,960 Thereafter.................................................. 34,987 -------- Total....................................................... $127,590 ======== Certain components of our long term debt may be redeemed prior to its stated maturity. 14. DERIVATIVE FINANCIAL INSTRUMENTS -------------------------------------------------------------------------------- Our business activities involve analysis, evaluation, acceptance and management of some degree of risk or combination of risks. Accordingly, we have comprehensive risk management policies to address potential financial risks, which include credit risk (which includes counterparty credit risk), liquidity risk, market risk, and operational risks. Our risk management policy is designed to identify and analyze these risks, to set appropriate limits and controls, and to monitor the risks and limits continually by means of reliable and up-to-date administrative and information systems. Our risk management policies are primarily carried out in accordance with practice and limits set by the HSBC Group Management Board. The HSBC Finance Corporation Asset Liability Committee ("ALCO") meets regularly to review risks and approve appropriate risk management strategies within the limits established by the HSBC Group Management Board. Additionally, our Audit Committee receives regular reports on our liquidity positions in relation to the established limits. In accordance with the policies and strategies established by ALCO, in the normal course of business, we enter into various transactions involving derivative financial instruments. These derivative financial instruments primarily are used to manage our market risk. For further information on our strategies for managing interest rate and foreign exchange rate risk, see the "Risk Management" section within our Management's Discussion and Analysis of Financial Condition and Results of Operations. OBJECTIVES FOR HOLDING DERIVATIVE FINANCIAL INSTRUMENTS Market risk (which includes interest rate and foreign currency exchange risks) is the possibility that a change in interest rates or foreign exchange rates will cause a financial instrument to decrease in value or become more costly to settle. Customer demand for our receivable products shifts between fixed rate and floating rate products, based on market conditions and preferences. These shifts in loan products result in different funding strategies and produce different interest rate risk exposures. We maintain an overall risk management strategy that uses a variety of interest rate and currency derivative financial instruments to mitigate our exposure to fluctuations caused by changes in interest rates and currency exchange rates. We manage our exposure to interest rate risk primarily through the use of interest rate swaps, but also use forwards, futures, options, and other risk management instruments. We manage our exposure to foreign currency exchange risk primarily through the use of currency swaps, options and forwards. We do not use leveraged derivative financial instruments for interest rate risk management. Interest rate swaps are contractual agreements between two counterparties for the exchange of periodic interest payments generally based on a notional principal amount and agreed-upon fixed or floating rates. The majority of our interest rate swaps are used to manage our exposure to changes in interest rates by converting floating rate debt to fixed rate or by converting fixed rate debt to floating rate. We have also entered into currency swaps to convert both principal and interest payments on debt issued from one currency to the appropriate functional currency. 142 Forwards and futures are agreements between two parties, committing one to sell and the other to buy a specific quantity of an instrument on some future date. The parties agree to buy or sell at a specified price in the future, and their profit or loss is determined by the difference between the arranged price and the level of the spot price when the contract is settled. We have used both interest rate and foreign exchange rate forward contracts as well as interest rate futures contracts. We use foreign exchange rate forward contracts to reduce our exposure to foreign currency exchange risk. Interest rate forward and futures contracts are used to hedge resets of interest rates on our floating rate assets and liabilities. Cash requirements for forward contracts include the receipt or payment of cash upon the sale or purchase of the instrument. Purchased options grant the purchaser the right, but not the obligation, to either purchase or sell a financial instrument at a specified price within a specified period. The seller of the option has written a contract which creates an obligation to either sell or purchase the financial instrument at the agreed-upon price if, and when, the purchaser exercises the option. We use caps to limit the risk associated with an increase in rates and floors to limit the risk associated with a decrease in rates. CREDIT RISK By utilizing derivative financial instruments, we are exposed to counterparty credit risk. Counterparty credit risk is our primary exposure on our interest rate swap portfolio. Counterparty credit risk is the risk that the counterparty to a transaction fails to perform according to the terms of the contract. We control the counterparty credit (or repayment) risk in derivative instruments through established credit approvals, risk control limits, collateral, and ongoing monitoring procedures. Our exposure to credit risk for futures is limited as these contracts are traded on organized exchanges. Each day, changes in futures contract values are settled in cash. In contrast, swap agreements and forward contracts have credit risk relating to the performance of the counterparty. We utilize an affiliate, HSBC Bank USA, as the primary provider of new domestic derivative products. We have never suffered a loss due to counterparty failure. At December 31, 2006, most of our existing derivative contracts are with HSBC subsidiaries, making them our primary counterparty in derivative transactions. Most swap agreements require that payments be made to, or received from, the counterparty when the fair value of the agreement reaches a certain level. Generally, third-party swap counterparties provide collateral in the form of cash which is recorded in our balance sheet as other assets or derivative related liabilities and totaled a net liability of $158 million at December 31, 2006 for third-party counterparties. Beginning in the second quarter of 2006, when the fair value of our agreements with affiliate counterparties requires the posting of collateral by the affiliate, it is provided in the form of cash and recorded on the balance sheet, consistent with third party arrangements. Previously, the posting of collateral by affiliates was provided in the form of securities, which were not recorded on our balance sheet. Also during 2006, we lowered the fair value of our agreements with affiliate counterparties above which collateral is required to be posted to $75 million. At December 31, 2006, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $1.0 billion which is recorded in our balance sheet as a component of derivative related liabilities. At December 31, 2006, we had derivative contracts with a notional value of approximately $94.4 billion, including $86.3 billion outstanding with HSBC Bank USA. Derivative financial instruments are generally expressed in terms of notional principal or contract amounts which are much larger than the amounts potentially at risk for nonpayment by counterparties. FAIR VALUE AND CASH FLOW HEDGES To manage our exposure to changes in interest rates, we enter into interest rate swap agreements and currency swaps which have been designated as fair value or cash flow hedges under SFAS No. 133. Prior to the acquisition by HSBC, the majority of our fair value and cash flow hedges were effective hedges which qualified for the shortcut method of accounting. Under the Financial Accounting Standards Board's interpretations of SFAS No. 133, the shortcut method of accounting was no longer allowed for interest rate swaps which were outstanding at the time of the acquisition by HSBC. As a result of the acquisition, we were required to reestablish and formally document the hedging relationship associated with all of our fair value and cash flow hedging instruments and assess the effectiveness of each hedging relationship, both at inception of the hedge relationship and on an ongoing basis. Due to deficiencies in our contemporaneous hedge documentation at the time of acquisition, we lost the ability to apply hedge accounting to our entire cash flow and fair value hedging portfolio that existed at the time of acquisition by HSBC. During 2005, we reestablished hedge treatment under the long haul method of accounting for a significant number of the 143 derivatives in this portfolio. We currently utilize the long-haul method to test effectiveness of all derivatives designated as hedges. Fair value hedges include interest rate swaps which convert our fixed rate debt to variable rate debt and currency swaps which convert debt issued from one currency into pay variable debt of the appropriate functional currency. Hedge ineffectiveness associated with fair value hedges is recorded in other revenues as derivative income and was a gain of $252 million ($159 million after tax) in 2006, a gain of $117 million ($75 million after tax) in 2005 and a gain of $.6 million ($.4 million after tax) in 2004. All of our fair value hedges were associated with debt during 2006, 2005 and 2004. We recorded fair value adjustments for unexpired fair value hedges which decreased the carrying value of our debt by $292 million at December 31, 2006 and $695 million at December 31, 2005. Cash flow hedges include interest rate swaps which convert our variable rate debt to fixed rate debt and currency swaps which convert debt issued from one currency into pay fixed debt of the appropriate functional currency. Gains and (losses) on unexpired derivative instruments designated as cash flow hedges (net of tax) are reported in accumulated other comprehensive income and totaled a gain of $256 million ($161 million after tax) at December 31, 2006 and $237 million ($151 million after tax) at December 31, 2005. We expect $121 million ($76 million after tax) of currently unrealized net gains will be reclassified to earnings within one year, however, these unrealized gains will be offset by increased interest expense associated with the variable cash flows of the hedged items and will result in no significant net economic impact to our earnings. Hedge ineffectiveness associated with cash flow hedges recorded in other revenues as derivative income was a loss of $83 million ($53 million after tax) in 2006, a loss of $76 million ($49 million after tax) in 2005 and was immaterial in 2004. At December 31, 2006, $1,461 million of derivative instruments, at fair value, were recorded as derivative financial assets and $58 million as derivative related liabilities. At December 31, 2005, $234 million of derivative instruments, at fair value, were recorded in derivative financial assets and $292 million in derivative related liabilities. Information related to deferred gains and losses before taxes on terminated derivatives was as follows: 2006 2005 ---------------------------------------------------------------------------------- (IN MILLIONS) Deferred gains.............................................. $ 156 $ 180 Deferred losses............................................. 176 196 Weighted-average amortization period: Deferred gains............................................ 7 years 6 years Deferred losses........................................... 6 years 6 years Increases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt............................................ $ (47) $ (25) Accumulated other comprehensive income.................... 27 9 144 Information related to deferred gains and losses before taxes on discontinued hedges was as follows: 2006 2005 ---------------------------------------------------------------------------------- (IN MILLIONS) Deferred gains.............................................. $ 269 $ 331 Deferred losses............................................. 1,052 232 Weighted-average amortization period: Deferred gains............................................ 5 years 4 years Deferred losses........................................... 5 years 5 years Increases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt............................................ $ (941) $ (76) Accumulated other comprehensive income.................... 158 175 Amortization of net deferred gains (losses) totaled ($80) million in 2006, ($12) million in 2005, ($23) million in 2004. NON-QUALIFYING HEDGING ACTIVITIES We may use forward rate agreements, interest rate caps, exchange traded options, and interest rate and currency swaps which are not designated as hedges under SFAS No. 133, either because they do not qualify as effective hedges or because we lost the ability to apply hedge accounting following our acquisition by HSBC as discussed above. These financial instruments are economic hedges but do not qualify for hedge accounting and are primarily used to minimize our exposure to changes in interest rates and currency exchange rates. Unrealized and realized gains (losses) on derivatives which were not designated as hedges are reported in other revenues as derivative income and totaled $21 million ($14 million after tax) in 2006, $208 million ($133 million after tax) in 2005 and $510 million ($324 million after tax) in 2004. DERIVATIVE INCOME Derivative income as discussed above includes realized and unrealized gains and losses on derivatives which do not qualify as effective hedges under SFAS No. 133 as well as the ineffectiveness on derivatives associated with our qualifying hedges and is summarized in the table below: 2006 2005 2004 -------------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)................................. $ (7) $ 52 $ 68 Mark-to-market on derivatives which do not qualify as effective hedges.......................................... 28 156 442 Ineffectiveness............................................. 169 41 1 ---- ---- ---- Total....................................................... $190 $249 $511 ==== ==== ==== Net income volatility, whether based on changes in interest rates for swaps which do not qualify for hedge accounting or ineffectiveness recorded on our qualifying hedges under the long-haul method of accounting, impacts the comparability of our reported results between periods. Accordingly, derivative income for the year ended December 31, 2006 should not be considered indicative of the results for any future periods. 145 DERIVATIVE FINANCIAL INSTRUMENTS The following table summarizes derivative financial instrument activity: EXCHANGE TRADED NON-EXCHANGE TRADED ------------------------------ ------------------------------------------ INTEREST RATE FOREIGN EXCHANGE FUTURES CONTRACTS INTEREST RATE CONTRACTS ------------------ OPTIONS RATE CURRENCY -------------------- PURCHASED SOLD PURCHASED SWAPS SWAPS PURCHASED SOLD ------------------------------------------------------------------------------------------------------------- (IN MILLIONS) 2006 Notional amount, 2005........... $ - $ - $ 4,870 $ 49,468 $21,719 $ 1,633 $ 465 New contracts................... - - - - - - - New contracts purchased from subsidiaries of HSBC........... - - 20,205 61,205 8,687 2,071 5,694 Matured or expired contracts.... - - (17,675) (5,319) (4,291) (2,851) (5,710) Terminated contracts............ - - (2,800) (49,571) - - - Change in Notional amount....... - - - 1,217 (1,274) - - Change in foreign exchange rate........................... - - - - - 221 134 In-substance maturities(1)...... - - - - - - - Assignment of contracts to subsidiaries of HSBC........... - - - - - - - - - - - - - - ---- ---- ------- -------- ------- -------- -------- Notional amount, 2006........... $ - $ - $ 4,600 $ 57,000 $24,841 $ 1,074 $ 583 ==== ==== ======= ======== ======= ======== ======== Fair value, 2006(3): Fair value hedges.............. $ - $ - $ - $ (740) $ (26) $ - $ - Cash flow hedges............... - - - 14 1,976 - - Net investment in foreign operations................... - - - - - - - Non-hedging derivatives........ - - - (64) 244 4 (6) ---- ---- ------- -------- ------- -------- -------- Total.......................... $ - $ - $ - $ (790) $ 2,194 $ 4 $ (6) ==== ==== ======= ======== ======= ======== ======== 2005 Notional amount, 2004........... $ - $ - $ 1,691 $ 45,253 $18,150 $ 1,146 $ 614 New contracts................... - - - 1 - - - New contracts purchased from subsidiaries of HSBC........... - - 5,570 25,373 6,824 1,113 4,860 Matured or expired contracts.... - - (2,391) (5,657) (3,255) (482) (4,762) Terminated contracts............ - - - (15,502) - (144) (247) In-substance maturities(1)...... - - - - - - - Assignment of contracts to subsidiaries of HSBC........... - - - - - - - - - - - - - - ---- ---- ------- -------- ------- -------- -------- Notional amount, 2005........... $ - $ - $ 4,870 $ 49,468 $21,719 $ 1,633 $ 465 ==== ==== ======= ======== ======= ======== ======== Fair value, 2005(3): Fair value hedges.............. $ - $ - $ - $ (612) $ (178) $ - $ - Cash flow hedges............... - - - 103 658 (22) - Net investment in foreign operations................... - - - - - - - Non-hedging derivatives........ - - - (31) 24 - - ---- ---- ------- -------- ------- -------- -------- Total.......................... $ - $ - $ - $ (540) $ 504 $ (22) $ - ==== ==== ======= ======== ======= ======== ======== 2004 Notional amount, 2003........... $ - $ - $ 1,900 $ 41,312 $16,538 $ 1,223 $ 594 New contracts................... - - - - - 1,628 1,432 New contracts purchased from subsidiaries of HSBC........... - - 3,491 29,607 11,457 17,988 8,778 Matured or expired contracts.... - - (3,700) (7,568) (1,407) (14,343) (4,840) Terminated contracts............ - - - (7,211) (5,333) - - In-substance maturities(1)...... - - - - - (5,350) (5,350) Assignment of contracts to subsidiaries of HSBC........... - - - (10,887) (3,105) - - ---- ---- ------- -------- ------- -------- -------- Notional amount, 2004........... $ - $ - $ 1,691 $ 45,253 $18,150 $ 1,146 $ 614 ==== ==== ======= ======== ======= ======== ======== Fair value, 2004(3): Fair value hedges.............. $ - $ - $ - $ (46) $ - $ - $ (2) Cash flow hedges............... - - - 12 403 24 - Non-hedging derivatives........ - - - (81) 3,670 - - ---- ---- ------- -------- ------- -------- -------- Total.......................... $ - $ - $ - $ (115) $ 4,073 $ 24 $ (2) ==== ==== ======= ======== ======= ======== ======== NON-EXCHANGE TRADED ---------------------------- INTEREST RATE FORWARD CONTRACTS CAPS ------------------ AND PURCHASED SOLD FLOORS TOTAL -------------------------------- --------------------------------------- (IN MILLIONS) 2006 Notional amount, 2005........... $ 172 $ - $10,700 $ 89,027 New contracts................... - - - - New contracts purchased from subsidiaries of HSBC........... 1,344 - 65 99,271 Matured or expired contracts.... - - (4,505) (40,351) Terminated contracts............ (1,516) - - (53,887) Change in Notional amount....... - - - (57) Change in foreign exchange rate........................... - - - 355 In-substance maturities(1)...... - - - - Assignment of contracts to subsidiaries of HSBC........... - - - - - - - - ------- ---- ------- -------- Notional amount, 2006........... $ 0 $ - $ 6,260 $ 94,358 ======= ==== ======= ======== Fair value, 2006(3): Fair value hedges.............. $ - $ - $ - $ (766) Cash flow hedges............... - - - 1,990 Net investment in foreign operations................... - - - - Non-hedging derivatives........ - - 1 179 ------- ---- ------- -------- Total.......................... $ - $ - $ 1 $ 1,403 ======= ==== ======= ======== 2005 Notional amount, 2004........... $ 374 $ - $ 4,380 $ 71,608 New contracts................... - - 30 31 New contracts purchased from subsidiaries of HSBC........... 1,707 - 8,433 53,880 Matured or expired contracts.... - - (1,894) (18,441) Terminated contracts............ (1,909) - (249) (18,051) In-substance maturities(1)...... - - - - Assignment of contracts to subsidiaries of HSBC........... - - - - - - - - ------- ---- ------- -------- Notional amount, 2005........... $ 172 $ - $10,700 $ 89,027 ======= ==== ======= ======== Fair value, 2005(3): Fair value hedges.............. $ - $ - $ - $ (790) Cash flow hedges............... - - - 739 Net investment in foreign operations................... - - - - Non-hedging derivatives........ - - - (7) ------- ---- ------- -------- Total.......................... $ - $ - $ - $ (58) ======= ==== ======= ======== 2004 Notional amount, 2003........... $ 174 $ - $ 6,627 $ 68,368 New contracts................... - - - 3,060 New contracts purchased from subsidiaries of HSBC........... 1,643 - 444 73,408 Matured or expired contracts.... (1,443) - (2,691) (35,992) Terminated contracts............ - - - (12,544) In-substance maturities(1)...... - - - (10,700) Assignment of contracts to subsidiaries of HSBC........... - - - (13,992) ------- ---- ------- -------- Notional amount, 2004........... $ 374 $ - $ 4,380 $ 71,608 ======= ==== ======= ======== Fair value, 2004(3): Fair value hedges.............. $ - $ - $ - $ (48) Cash flow hedges............... - - - 439 Non-hedging derivatives........ - - - 3,589 ------- ---- ------- -------- Total.......................... $ - $ - $ - $ 3,980 ======= ==== ======= ======== --------------- (1) Represent contracts terminated as the market execution technique of closing the transaction either (a) just prior to maturity to avoid delivery of the underlying instrument or (b) at the maturity of the underlying items being hedged. (2) Under the Financial Accounting Standards Board's interpretations of SFAS No. 133, the shortcut method of accounting was no longer allowed for interest rate swaps which were outstanding at the time of the acquisition by HSBC. (3) (Bracketed) unbracketed amounts represent amounts to be (paid) received by us had these positions been closed out at the respective balance sheet date. Bracketed amounts do not necessarily represent risk of loss as the fair value of the derivative financial instrument and the items being hedged must be evaluated together. See Note 23, "Fair Value of Financial Instruments," for further discussion of the relationship between the fair value of our assets and liabilities. 146 We operate in three functional currencies, the U.S. dollar, the British pound and the Canadian dollar. The U.S. dollar is the functional currency for exchange-traded interest rate futures contracts and options. Non-exchange traded instruments are restated in U.S. dollars by country as follows: FOREIGN EXCHANGE INTEREST RATE RATE CONTRACTS FORWARD OTHER RISK INTEREST RATE CURRENCY ---------------- CONTRACTS MANAGEMENT SWAPS SWAPS PURCHASED SOLD PURCHASED INSTRUMENTS --------------------------------------------------------------------------------------------------------- (IN MILLIONS) 2006 United States................. $54,703 $24,841 $1,068 $571 $ - $ 6,260 Canada........................ 1,207 - 6 12 - - United Kingdom................ 1,090 - - - - - ------- ------- ------ ---- ---- ------- $57,000 $24,841 $1,074 $583 $ - $ 6,260 ======= ======= ====== ==== ==== ======= 2005 United States................. $47,693 $21,175 $1,622 $465 $ - $10,700 Canada........................ 855 - 11 - 172 - United Kingdom................ 920 544 - - - - ------- ------- ------ ---- ---- ------- $49,468 $21,719 $1,633 $465 $172 $10,700 ======= ======= ====== ==== ==== ======= 2004 United States................. $42,365 $17,543 $1,146 $599 $ - $ 4,345 Canada........................ 582 - - 15 374 - United Kingdom................ 2,306 607 - - - 35 ------- ------- ------ ---- ---- ------- $45,253 $18,150 $1,146 $614 $374 $ 4,380 ======= ======= ====== ==== ==== ======= Long term debt hedged using derivative financial instruments which qualify for hedge accounting at December 31, 2006 included debt of $51.0 billion hedged by interest rate swaps and debt of $22.7 billion hedged by currency swaps. The significant terms of the derivative financial instruments have been designed to match those of the related asset or liability. The following table summarizes the maturities and related weighted-average receive/pay rates of interest rate swaps outstanding at December 31, 2006: 2007 2008 2009 2010 2011 2012 THEREAFTER TOTAL ------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) PAY A FIXED RATE/RECEIVE A FLOATING RATE: Notional value.............. $8,650 $10,220 $ 6,963 $ 232 $ 153 $ 15 $ 436 $26,669 Weighted-average receive rate...................... 5.34% 5.36% 5.05% 2.08% 2.08% 2.06% 2.14% 5.17% Weighted-average pay rate... 4.75 5.03 5.17 4.10 4.36 4.21 4.98 4.96 ------ ------- ------- ------ ------ ------ ------- ------- PAY A FLOATING RATE/RECEIVE A FIXED RATE: Notional value.............. $ 484 $ 2,584 $ 5,657 $3,119 $5,550 $3,159 $ 9,778 $30,331 Weighted-average receive rate...................... 3.13 3.71 4.19 4.28 4.55 4.45 5.18 4.56 Weighted-average pay rate... 5.38 5.30 5.12 5.38 5.45 5.37 5.31 5.31 ------ ------- ------- ------ ------ ------ ------- ------- Total notional value........ $9,134 $12,804 $12,620 $3,351 $5,703 $3,174 $10,214 $57,000 ====== ======= ======= ====== ====== ====== ======= ======= TOTAL WEIGHTED-AVERAGE RATES ON SWAPS: Receive rate................ 5.22% 5.03% 4.67% 4.13% 4.48% 4.44% 5.05% 4.84% Pay rate.................... 4.78 5.08 5.15 5.29 5.42 5.37 5.29 5.15 147 The floating rates that we pay or receive are based on spot rates from independent market sources for the index contained in each interest rate swap contract, which generally are based on either 1, 3 or 6-month LIBOR. These current floating rates are different than the floating rates in effect when the contracts were initiated. Changes in spot rates impact the variable rate information disclosed above. However, these changes in spot rates also impact the interest rate on the underlying assets or liabilities. In addition to the information included in the tables above, we had unused commitments to extend credit related to real estate secured loans totaling $1.4 billion at December 31, 2006 and $1.4 billion at December 31, 2005. Commitments to extend credit are agreements, with fixed expiration dates, to lend to a customer as long as there is no violation of any condition established in the agreement. These commitments are considered derivative instruments in accordance with SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS No. 149) and, as a result, are recorded on our balance sheet at fair market value which resulted in a liability of $2.7 million at December 31, 2006 and a liability of $.3 million at December 31 2005. We also had outstanding forward sales commitments related to real estate secured loans totaling $607 million at December 31, 2006 and $450 million as of December 31, 2005. Forward sales commitments are considered derivative instruments under SFAS No. 149 and, as a result, are recorded on our balance sheet at fair market value which resulted in an asset of $1.4 million at December 31, 2006 and an asset of $.4 million at December 31, 2005. 15. INCOME TAXES -------------------------------------------------------------------------------- Total income taxes were: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004 ---------------------------------------------------------------------------------------------------- (IN MILLIONS) Provision for income taxes related to operations........ $ 844 $891 $1,000 Income taxes related to adjustments included in common shareholder's equity: Unrealized gains (losses) on investments and interest-only strip receivables, net............... (11) (29) (71) Unrealized gains (losses) on cash flow hedging instruments........................................ (192) 74 61 Minimum pension liability............................. - 2 (2) Adjustment to initially apply FASB Statement No. 158................................................ 1 - - Foreign currency translation adjustments.............. (9) (6) 12 Exercise of stock based compensation.................. (21) (9) (18) Tax on sale of European Operations to affiliate....... 3 - - Tax on sale of U.K. credit card business to affiliate.......................................... - (21) - ----- ---- ------ Total................................................... $ 615 $902 $ 982 ===== ==== ====== 148 Provisions for income taxes related to operations were: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004 ---------------------------------------------------------------------------------------------------- (IN MILLIONS) CURRENT United States........................................... $1,396 $1,253 $ 593 Foreign................................................. 8 4 59 ------ ------ ------ Total current........................................... 1,404 1,257 652 ------ ------ ------ DEFERRED United States........................................... (541) (396) 348 Foreign................................................. (19) 30 - ------ ------ ------ Total deferred.......................................... (560) (366) 348 ------ ------ ------ Total income taxes...................................... $ 844 $ 891 $1,000 ====== ====== ====== The significant components of deferred provisions attributable to income from operations were: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004 ---------------------------------------------------------------------------------------------------- (IN MILLIONS) Deferred income tax (benefit) provision (excluding the effects of other components).......................... $(566) $(342) $348 Adjustment of valuation allowance....................... 2 (2) - Change in operating loss carryforwards.................. 8 (12) - Adjustment to statutory tax rate........................ (4) (10) - ----- ----- ---- Deferred income tax provision........................... $(560) $(366) $348 ===== ===== ==== Income before income taxes were: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004 ---------------------------------------------------------------------------------------------------- (IN MILLIONS) United States........................................... $2,361 $2,560 $2,786 Foreign................................................. (74) 103 154 ------ ------ ------ Total income before income taxes........................ $2,287 $2,663 $2,940 ====== ====== ====== Effective tax rates are analyzed as follows: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004 ---------------------------------------------------------------------------------------------------- (IN MILLIONS) Statutory Federal income tax rate....................... 35.0% 35.0% 35.0% Increase (decrease) in rate resulting from: State and local taxes, net of Federal benefit......... 4.1 .9 1.4 Low income housing and other tax credits.............. (3.5) (3.2) (2.9) Other................................................. 1.3 .8 .5 ---- ---- ---- Effective tax rate...................................... 36.9% 33.5% 34.0% ==== ==== ==== 149 Temporary differences which gave rise to a significant portion of deferred tax assets and liabilities were as follows: AT DECEMBER 31, --------------- 2006 2005 ----------------------------------------------------------------------------- (IN MILLIONS) DEFERRED TAX ASSETS Credit loss reserves........................................ $2,053 $1,438 Other reserves.............................................. 84 129 Market value adjustment..................................... 311 95 Other....................................................... 549 509 ------ ------ Total deferred tax assets................................... 2,997 2,171 Valuation allowance......................................... (25) (28) ------ ------ Total deferred tax assets net of valuation allowance........ 2,972 2,143 ------ ------ DEFERRED TAX LIABILITIES Intangibles................................................. 838 779 Fee income.................................................. 568 545 Deferred loan origination costs............................. 312 239 Receivables................................................. 97 163 Other....................................................... 181 262 ------ ------ Total deferred tax liabilities.............................. 1,996 1,988 ------ ------ Net deferred tax asset...................................... $ 976 $ 155 ====== ====== Based upon the level of historical taxable income and the reversal of the deferred tax liabilities over the periods over which the deferred tax assets are deductible, management believes that it is more likely than not we would realize the benefits of these deductible differences net of the valuation allowance noted above. Provision for U.S. income tax had not been made on net undistributed earnings of foreign subsidiaries of $178 million at December 31, 2006 and $293 million at December 31, 2005. We have determined that no U.S. tax liability will arise upon repatriation of these earnings. The American Jobs Creation Act of 2004 (the "AJCA") included provisions to allow a deduction of 85% of certain foreign earnings that are repatriated in 2004 or 2005. We elected to apply this provision to a $489 million distribution in December 2005 by our U.K. subsidiary. Tax of $26 million related to this distribution is included as part of the current 2005 U.S. tax expense shown above. At December 31, 2006, we had net operating loss carryforwards of $740 million for state tax purposes which expire as follows: $226 million in 2007-2011; $162 million in 2012-2016; $201 million in 2017-2021 and $151 million in 2022 and forward. 16. REDEEMABLE PREFERRED STOCK -------------------------------------------------------------------------------- On December 15, 2005, we issued four shares of common stock to HINO in exchange for the Series A Preferred Stock. See Note 18, "Related Party Transactions," for further discussion. In June 2005, we issued 575,000 shares of 6.36 percent Non-Cumulative Preferred Stock, Series B ("Series B Preferred Stock"). Dividends on the Series B Preferred Stock are non-cumulative and payable quarterly at a rate of 6.36 percent commencing September 15, 2005. The Series B Preferred Stock may be redeemed at our option after June 23, 2010 at $1,000 per share, plus accrued dividends. The redemption and liquidation value is $1,000 per share plus accrued and unpaid dividends. The holders of Series B Preferred Stock are entitled to payment before any capital distribution is made to the common shareholder and have no voting rights except for the right to elect two additional members to the board of directors in the event that dividends have not been declared and paid for six quarters, or as otherwise provided by law. Additionally, as long as any shares of the Series B Preferred Stock are outstanding, the authorization, creation or issuance of any class or series of 150 stock which would rank prior to the Series B Preferred Stock with respect to dividends or amounts payable upon liquidation or dissolution of HSBC Finance Corporation must be approved by the holders of at least two-thirds of the shares of Series B Preferred Stock outstanding at that time. Related issuance costs of $16 million have been recorded as a reduction of additional paid-in capital. In 2006, we declared dividends totaling $37 million on the Series B Preferred Stock which were paid prior to December 31, 2006. In 2005, we declared dividends totaling $17 million on the Series B Preferred Stock which were paid prior to December 31, 2005. 17. 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. YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004 -------------------------------------------------------------------------------------------------------- (IN MILLIONS) Unrealized gains (losses) on investments and interest-only strip receivables: Balance at beginning of period............................ $ (2) $ 54 $ 168 Other comprehensive income for period: Net unrealized holding gains (losses) arising during period, net of tax of $(34) million, $29 million and $67 million, respectively............................. 57 (56) (106) Reclassification adjustment for gains realized in net income, net of taxes of $45 million, $- million and $4 million, respectively................................. (78) - (8) ----- ----- ----- Total other comprehensive income for period............... (21) (56) (114) ----- ----- ----- Balance at end of period.................................. (23) (2) 54 ----- ----- ----- Unrealized gains (losses) on cash flow hedging instruments: Balance at beginning of period............................ 260 119 (11) Other comprehensive income for period: Net gains (losses) arising during period, net of tax of $124 million, $(92) million and $(34) million respectively.......................................... (204) 173 72 Reclassification adjustment for gains (losses) realized in net income, net of tax of $68 million, $18 million and $(27) million, respectively....................... (117) (32) 58 ----- ----- ----- Total other comprehensive income for period............... (321) 141 130 ----- ----- ----- Balance at end of period.................................. (61) 260 119 ----- ----- ----- Pension liability: Balance at beginning of period............................ - (4) - Other comprehensive income for period: Pension liability settlement adjustment, net of tax of $- million, $(2) million and $2 million, respectively.......................................... - 4 (4) ----- ----- ----- Adjustment to initially apply FASB Statement No. 158, net of tax of $(1) million.................................. (1) - - Total other comprehensive income for period............... (1) 4 (4) ----- ----- ----- Balance at end of period.................................. (1) - (4) ----- ----- ----- Foreign currency translation adjustments: Balance at beginning of period............................ 221 474 286 Other comprehensive income for period: Translation gains (losses), net of tax of $9 million, $6 million and $(12) million, respectively............... 223 (253) 188 ----- ----- ----- Total other comprehensive income for period............... 223 (253) 188 ----- ----- ----- Balance at end of period.................................. 444 221 474 ----- ----- ----- Total accumulated other comprehensive income (loss) at end of period................................................. $ 359 $ 479 $ 643 ===== ===== ===== 151 18. RELATED PARTY TRANSACTIONS -------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and its subsidiaries. These transactions occur at prevailing market rates and terms and include funding arrangements, derivative execution, purchases and sales of receivables, servicing arrangements, information technology services, item and statement processing services, banking and other miscellaneous services. The following tables present related party balances and the income and (expense) generated by related party transactions: AT DECEMBER 31, 2006 2005 --------------------------------------------------------------------------------- (IN MILLIONS) ASSETS, (LIABILITIES) AND EQUITY: Derivative financial assets (liability), net................ $ 234 $ (260) Affiliate preferred stock received in sale of U.K. credit card business(1).......................................... 294 261 Other assets................................................ 528 518 Due to affiliates........................................... (15,172) (15,534) Other liabilities........................................... (506) (271) Premium on sale of European Operation in 2006 and U.K. credit card business in 2005 to affiliates recorded as an increase to additional paid in capital.................... 13 182 --------------- (1) Balance will fluctuate due to foreign currency exchange rate impact. FOR THE YEAR ENDED DECEMBER 31, 2006 2005 2004 ------------------------------------------------------------------------------------- INCOME/(EXPENSE): Interest expense on borrowings from HSBC and subsidiaries... $ (929) $(713) $(343) Interest income on advances to HSBC affiliates.............. 25 37 5 Dividend income from affiliate preferred stock.............. 18 - - HSBC Bank USA: Real estate secured servicing, sourcing, underwriting and pricing revenues....................................... 12 19 17 Gain on bulk sales of real estate secured receivables..... 17 - 15 Gain on bulk sale of domestic private label receivable portfolio.............................................. - - 663 Gain on daily sale of domestic private label receivable originations........................................... 367 379 3 Gain on daily sale of credit card receivables............. 38 34 21 Taxpayer financial services loan origination and other fees................................................... (18) (15) - Domestic private label receivable servicing and related fees................................................... 393 368 3 Other servicing, processing, origination and support revenues............................................... 73 28 16 Support services from HSBC affiliates, primarily HSBC Technology and Services (USA) Inc. ("HTSU")............... (1,087) (889) (750) HTSU: Rental revenue............................................ 45 42 33 Administrative services revenue........................... 12 14 18 Servicing and other fees from other HSBC affiliates....... 16 11 3 Stock based compensation expense with HSBC.................. (100) (66) (45) The notional value of derivative contracts outstanding with HSBC subsidiaries totaled $87.4 billion at December 31, 2006 and $72.2 billion at December 31, 2005. Beginning in the second quarter of 2006, when the fair value of our agreements with affiliate counterparties requires the posting of collateral by the affiliate, it is provided in the form of cash and recorded on our balance sheet, consistent with third party arrangements. Previously, the posting of collateral by affiliates was provided in the form of securities, which were not recorded on our balance sheet. Also during 2006, we lowered the level of the fair value of our agreements with affiliate counterparties above which collateral is required to be posted to $75 million. At December 31, 2006, 152 the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $1.0 billion which is recorded in our balance sheet as a component of derivative related liabilities. At December 31, 2005, the fair value of our agreements with affiliate counterparties was below the level requiring posting of collateral. As such, at December 31, 2005, we were not holding any swap collateral from HSBC affiliates in the form of cash or securities. We extended a line of credit of $2 billion to HSBC USA Inc. at interest rates comparable to third-party rates for a line of credit with similar terms. This line expired in July of 2006 and was not renewed. No balances were outstanding under this line at December 31, 2005. Interest income associated with this line of credit is recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above. We extended a revolving line of credit of $.5 billion to HTSU on June 28, 2005 at interest rates comparable to third-party rates for a line of credit with similar terms. The balance outstanding under this line of credit was $.5 billion and $.4 billion at December 31, 2006 and 2005 respectively and is included in other assets. Interest income associated with this line of credit is recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above. We extended a promissory note of $.5 billion to HSBC Securities (USA) Inc. ("HSI") on June 27, 2005 at interest rates comparable to third-party rates for a line of credit with similar terms. This promissory note was repaid during July 2005. We also extended a promissory note of $.5 billion to HSI on September 29, 2005. This promissory note was repaid during October 2005. We extended an additional promissory note of $.2 billion to HSI on December 28, 2005. This note was repaid during January 2006. At each reporting date these promissory notes were included in other assets. Interest income associated with this line of credit is recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above. On March 31, 2005, we extended a line of credit of $.4 billion to HINO which was repaid during the second quarter of 2005. This line of credit was at interest rates comparable to third-party rates for a line of credit with similar terms. During the second quarter of 2004, we made advances to our immediate parent, HINO, totaling $266 million which were repaid during the third quarter of 2004. Interest income associated with these lines of credit is recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above. Due to affiliates includes amounts owed to subsidiaries of HSBC (other than preferred stock). This funding was at interest rates (both the underlying benchmark rate and credit spreads) comparable to third-party rates for debt with similar maturities. At December 31, 2006, we had a commercial paper back stop credit facility of $2.5 billion from HSBC supporting domestic issuances and a revolving credit facility of $5.7 billion from HBEU to fund our operations in the U.K. At December 31, 2005, we had a commercial paper back stop credit facility of $2.5 billion from HSBC supporting domestic issuances and a revolving credit facility of $5.3 billion from HBEU to fund our operations in the U.K. As of December 31, 2006, $4.3 billion was outstanding under the U.K. lines and no balances were outstanding on the domestic lines. As of December 31, 2005, $4.2 billion was outstanding on the U.K. lines and no balances were outstanding on the domestic lines. Annual commitment fee requirements to support availability of these lines totaled $1 million in 2006 and $2 million in 2005 and are included as a component of Interest expense on borrowings from HSBC and subsidiaries. On November 9, 2006, as part of our continuing evaluation of strategic alternatives with respect to our U.K. and European operations, we sold all of the capital stock of our operations in the Czech Republic, Hungary, and Slovakia (the "European Operations") to a wholly owned subsidiary of HBEU for an aggregate purchase price of approximately $46 million. Because the sale of this business is between affiliates under common control, the premium received in excess of the book value of the stock transferred was recorded as an increase to additional paid-in capital and was not reflected in earnings. The assets consisted primarily of $199 million of receivables and goodwill which totaled approximately $13 million. The liabilities consisted primarily of debt which totaled $179 million. HBEU assumed all the liabilities of the European Operations as a result of this transaction. We do not anticipate that the net effect of this sale will result in a material reduction of net income of our consolidated results. 153 In December 2005, we sold our U.K. credit card business, including $2.5 billion of receivables, the associated cardholder relationships and the related retained interests in securitized credit card receivables to HBEU for an aggregate purchase price of $3.0 billion. The purchase price, which was determined based on a comparative analysis of sales of other credit card portfolios, was paid in a combination of cash and $261 million of preferred stock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assets referred to above, the sale also included the account origination platform, including the marketing and credit employees associated with this function, as well as the lease associated with the credit card call center and related leaseholds and call center employees to provide customer continuity after the transfer as well as to allow HBEU direct ownership and control of origination and customer service. We have retained the collection operations related to the credit card operations and have entered into a service level agreement for a period of not less than two years to provide collection services and other support services, including components of the compliance, financial reporting and human resource functions, for the sold credit card operations to HBEU for a fee. We received $30 million in 2006 under this service level agreement. Additionally, the management teams of HBEU and our remaining U.K. operations will be jointly involved in decision making involving card marketing to ensure that growth objectives are met for both businesses. Because the sale of this business is between affiliates under common control, the premium received in excess of the book value of the assets transferred of $182 million, including the goodwill assigned to this business, has been recorded as an increase to additional paid in capital and has not been included in earnings. In December 2004, we sold our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business), including the retained interests associated with our securitized domestic private label receivables to HSBC Bank USA for $12.4 billion. We recorded an after-tax gain on the sale of $423 million in 2004. See Note 4, "Sale of Domestic Private Label Receivable Portfolio and Adoption of FFIEC Policies." We continue to service the sold private label receivables and receive servicing and related fee income from HSBC Bank USA for these services. As of December 31, 2006, we were servicing $18.1 billion of domestic private label receivables and as of December 31, 2005, we were servicing $17.1 billion of domestic private label receivables for HSBC Bank USA. We received servicing and related fee income from HSBC Bank USA of $393 million in 2006 and $368 million during December 2005. Servicing and related fee income is reflected as Domestic private label receivable servicing and related fees in the table above. We continue to maintain the related customer account relationships and, therefore, sell new domestic private label receivable originations (excluding retail sales contracts) to HSBC Bank USA on a daily basis. We sold $21.6 billion of private label receivables to HSBC Bank USA in 2006 and $21.1 billion during 2005. The gains associated with the sale of these receivables are reflected in the table above and are recorded in Gain on daily sale of domestic private label receivable originations. In the fourth quarter of 2006 we sold approximately $669 million of real estate secured receivables originated by our subsidiary, Decision One Mortgage Company, LLC, to HSBC Bank USA and recorded a pre-tax gain of $17 million on the sale. In the first quarter of 2004, we sold approximately $.9 billion of real estate secured receivables from our Mortgage Services business to HSBC Bank USA and recorded a pre-tax gain of $15 million on the sale. Under a separate servicing agreement, we have agreed to service all real estate secured receivables sold to HSBC Bank USA including all future business it purchases from our correspondents. As of December 31, 2006, we were servicing $3.3 billion of real estate secured receivables for HSBC Bank USA. We also received fees from HSBC Bank USA pursuant to a service level agreement under which we sourced, underwrote and priced $1.5 billion of real estate secured receivables purchased by HSBC Bank USA during 2005 and $2.8 billion in 2004. The fee revenue associated with these receivables is recorded in servicing fees from HSBC affiliates and are reflected as Real estate secured servicing, sourcing, underwriting and pricing revenues in the above table. Purchases of real estate secured receivables from our correspondents by HSBC Bank USA were discontinued effective September 1, 2005. We continue to service the receivables HSBC Bank USA previously purchased from these correspondents. Under various service level agreements, we also provide various services to HSBC Bank USA. These services include credit card servicing and processing activities through our credit card services business, loan origination and servicing through our auto finance business and other operational and administrative support. 154 Fees received for these services are reported as servicing fees from HSBC affiliates and are reflected as Other servicing, processing, origination and support revenues in the table above. During 2003, Household Capital Trust VIII issued $275 million in mandatorily redeemable preferred securities to HSBC. The terms of this issuance were as follows: (DOLLARS ARE IN MILLIONS) ---------------------------------------------------------------------------------------- Junior Subordinated Notes: Principal balance......................................... $284 Redeemable by issuer...................................... September 26, 2008 Stated maturity........................................... November 15, 2033 Preferred Securities: Rate...................................................... 6.375% Face value................................................ $275 Issue date................................................ September 2003 Interest expense recorded on the underlying junior subordinated notes totaled $18 million in 2006, 2005 and 2004. The interest expense for the Household Capital Trust VIII is included in interest expense - HSBC affiliates in the consolidated statement of income and is reflected as a component of Interest expense on borrowings from HSBC and subsidiaries in the table above. During 2004, our Canadian business began to originate and service auto loans for an HSBC affiliate in Canada. Fees received for these services are included in other income and are reflected in Servicing and other fees from other HSBC affiliates in the above table. Effective October 1, 2004, HSBC Bank USA became the originating lender for loans initiated by our taxpayer financial services business for clients of various third party tax preparers. We purchase the loans originated by HSBC Bank USA daily for a fee. Origination fees paid to HSBC Bank USA totaled $18 million in 2006 and $15 million in 2005. These origination fees are included as an offset to taxpayer financial services revenue and are reflected as Taxpayer financial services loan origination and other fees in the above table. On July 1, 2004, HSBC Bank Nevada, National Association ("HBNV"), formerly known as Household Bank (SB), N.A., purchased the account relationships associated with $970 million of credit card receivables from HSBC Bank USA for approximately $99 million, which are included in intangible assets. The receivables continue to be owned by HSBC Bank USA. We service these receivables for HSBC Bank USA and receive servicing and related fee income from HSBC Bank USA. As of December 31, 2006 we were servicing $1.2 billion of credit card receivables for HSBC Bank USA. Originations of new accounts and receivables are made by HBNV and new receivables are sold daily to HSBC Bank USA. We sold $2,298 million of credit card receivables to HSBC Bank USA in 2006, $2,055 million in 2005 and $1,029 million in 2004. The gains associated with the sale of these receivables are reflected in the table above and are recorded in Gain on daily sale of credit card receivables. Effective January 1, 2004, our technology services employees, as well as technology services employees from other HSBC entities in North America, were transferred to HTSU. In addition, technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by HSBC Finance Corporation prior to January 1, 2004 currently remain in place and were not transferred to HTSU. In addition to information technology services, HTSU also provides certain item processing and statement processing activities to us pursuant to a master service level agreement. Support services from HSBC affiliates includes services provided by HTSU as well as banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. We also receive revenue from HTSU for rent on certain office space, which has been recorded as a reduction of occupancy and equipment expenses, and for certain administrative costs, which has been recorded as other income. Additionally, in a separate transaction in December 2005, we transferred our information technology services employees in the U.K. to a subsidiary of HBEU. Subsequent to the transfer, operating expenses relating to 155 information technology, which have previously been reported as salaries and fringe benefits or other servicing and administrative expenses, are now billed to us by HBEU and reported as support services from HSBC affiliates. Additionally, during the first quarter of 2006, the information technology equipment in the U.K. was sold to HBEU for a purchase price equal to the book value of these assets of $8 million. In addition, we utilize HSBC Markets (USA) Inc., a related HSBC entity, to lead manage a majority of our ongoing debt issuances. Fees paid for such services totaled approximately $48 million in 2006, $59 million in 2005 and $18 million in 2004. These fees are amortized over the life of the related debt. In consideration of HSBC transferring sufficient funds to make the payments with respect to certain HSBC Finance Corporation preferred stock, we issued the Series A Preferred Stock in the amount of $1.1 billion to HSBC on March 28, 2003. In September 2004, HSBC North America issued a new series of preferred stock totaling $1.1 billion to HSBC in exchange for our outstanding Series A Preferred Stock. In October 2004, our immediate parent, HINO, issued a new series of preferred stock to HSBC North America in exchange for our Series A Preferred Stock. We paid dividends on our Series A Preferred Stock of $66 million in October 2005 and $108 million in October 2004. On December 15, 2005, we issued four shares of common stock to HINO in exchange for the Series A Preferred Stock. Domestic employees of HSBC Finance Corporation participate in a defined benefit pension plan sponsored by HSBC North America. See Note 20, "Pension and Other Postretirement Benefits," for additional information on this pension plan. Employees of HSBC Finance Corporation participate in one or more stock compensation plans sponsored by HSBC. Our share of the expense of these plans was $100 million in 2006, $66 million in 2005 and $45 million in 2004. These expenses are recorded in salary and employee benefits and are reflected in the above table as Stock based compensation expense with HSBC. 19. STOCK OPTION PLANS -------------------------------------------------------------------------------- STOCK OPTION PLANS The HSBC Holdings Group Share Option Plan (the "Group Share Option Plan"), which replaced the former Household stock option plans, was a long-term incentive compensation plan available to certain employees prior to 2005. Grants were usually made annually. At the 2005 HSBC Annual Meeting of Stockholders, HSBC adopted and the shareholders' approved the HSBC Share Plan ("Group Share Plan") to replace this plan. During 2006 and 2005, no further options were granted to employees although stock option grants from previous years remain in effect subject to the same conditions as before. In lieu of options, in 2006 and 2005, these employees received grants of shares of HSBC stock subject to certain vesting conditions as discussed further below. Options granted to employees in 2004 vest 100% upon the attainment of certain company performance conditions in either year 3, 4 or 5 and expire ten years from the date of grant. If the performance conditions are not met in year 5, the options will be forfeited. Options are granted at market value. Compensation expense related to the Group Share Option Plan, which is recognized over the vesting period, totaled $6 million in 2006, $6 million in 2005 and $8 million in 2004. 156 Information with respect to the Group Share Option Plan is as follows: 2006 2005 2004 --------------------- --------------------- --------------------- WEIGHTED- WEIGHTED- WEIGHTED- HSBC AVERAGE HSBC AVERAGE HSBC AVERAGE ORDINARY PRICE PER ORDINARY PRICE PER ORDINARY PRICE PER SHARES SHARE SHARES SHARE SHARES SHARE ---------------------------------------------------------------------------------------------------- Outstanding at beginning of year....................... 6,100,800 $14.97 6,245,800 $14.96 4,069,800 $15.31 Granted...................... - - - - 2,638,000 14.37 Exercised.................... - - - - - - Transferred.................. - - (105,000) 14.64 (462,000) 14.69 Expired or canceled.......... (40,000) 14.37 (40,000) 14.37 - - --------- ------ --------- ------ --------- ------ Outstanding at end of year... 6,060,800 14.97 6,100,800 14.97 6,245,800 14.96 ========= ====== ========= ====== ========= ====== Exercisable at end of year... 2,909,850 $15.31 - $ - - $ - ========= ====== ========= ====== ========= ====== Weighted-average fair value of options granted......... $ - $ - $ 2.68 ====== ====== ====== The transfers shown above relate to employees who have transferred to other HSBC entities during each year. The transfers in 2005 primarily relate to certain of our U.K. employees who were transferred to HBEU as part of the sale of our U.K. credit card business in December 2005. The transfers in 2004 relate to our technology services employees who were transferred to HTSU effective January 1, 2004. MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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HSBC Holdings (HSBA)

Thursday, 23rd May 2024

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HL. QQ. AJB

Another day and another round of takeover talk with Hargreaves Lansdown being eyed by private equity suitors. AJ Bell also advances on upbeat earnings news whilst QinetiQ upgrades its profit guidance, too.

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