HSBC Finance Corp 10-Q Part 2
HSBC Holdings PLC
14 November 2007
BASIS OF REPORTING
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Our consolidated financial statements are prepared in accordance with accounting
principles generally accepted in the United States ("U.S. GAAP"). Unless noted,
the discussion of our financial condition and results of operations included in
MD&A are presented on a U.S. GAAP basis of reporting. Certain reclassifications
have been made to prior year amounts to conform to the current year
presentation.
EQUITY RATIOS Tangible shareholder's equity to tangible managed assets
("TETMA"), tangible shareholder's equity plus owned loss reserves to tangible
managed assets ("TETMA + Owned Reserves") and tangible common equity to tangible
managed assets are non-U.S. GAAP financial measures that are used by HSBC
Finance Corporation management and certain rating agencies to evaluate capital
adequacy. These ratios exclude the equity impact of SFAS No. 115, "Accounting
for Certain Investments in Debt and Equity Securities," the equity impact of
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities,"
and the impact of the adoption of SFAS No. 159 including the subsequent changes
in fair value recognized in earnings associated with credit risk on debt for
which we elected the fair value option. Preferred securities issued by certain
non-consolidated trusts are also considered equity in the TETMA and TETMA +
Owned Reserves calculations because of their long-term subordinated nature and
our ability to defer dividends. Managed assets include owned assets plus loans
which we have sold and service with limited recourse. We and certain rating
agencies also monitor our equity ratios excluding the impact of the HSBC
acquisition purchase accounting adjustments. We do so because we believe that
the HSBC acquisition purchase accounting adjustments represent non-cash
transactions which do not affect our business operations, cash flows or ability
to meet our debt obligations. These ratios may differ from similarly named
measures presented by other companies. The most directly comparable U.S. GAAP
financial measure is the common and preferred equity to owned assets ratio. For
a quantitative reconciliation of these non-U.S. GAAP financial measures to our
common and preferred equity to owned assets ratio, see "Reconciliations to U.S.
GAAP Financial Measures."
INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results in
accordance with IFRSs and IFRSs results are used in measuring and rewarding
performance of employees, our management also separately monitors
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net income under IFRSs (a non-U.S. GAAP financial measure). The following table
reconciles our net income on a U.S. GAAP basis to net income on an IFRSs basis:
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER ENDED
30, SEPTEMBER 30,
--------------- --------------
2007 2006 2007 2006
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(DOLLARS ARE IN MILLIONS)
Net income - U.S. GAAP basis........................ $(1,102) $ 551 $(498) $2,007
Adjustments, net of tax:
Securitizations................................... 1 2 9 36
Derivatives and hedge accounting (including fair
value adjustments)............................. (2) (147) (1) (237)
Intangible assets................................. 26 25 77 87
Purchase accounting adjustments................... 9 14 30 27
Loan origination.................................. 10 (12) (5) (53)
Loan impairment................................... 6 10 (21) 29
Loans held for resale............................. (3) - (25) 18
Interest recognition.............................. 13 (12) 39 109
Lower of cost or market adjustment for U.K.
Insurance Operations........................... - - (6) -
Goodwill impairment related to Mortgage Services.. (468) - (468) -
Other............................................. 3 (40) 48 13
------- ----- ----- ------
Net income - IFRSs basis............................ $(1,507) $ 391 $(821) $2,036
======= ===== ===== ======
Significant differences between U.S. GAAP and IFRSs are as follows:
SECURITIZATIONS
IFRSs
- The recognition of securitized assets is governed by a three-step
process, which may be applied to the whole asset, or a part of an asset:
- If the rights to the cash flows arising from securitized assets have
been transferred to a third party and all the risks and rewards of the
assets have been transferred, the assets concerned are derecognized.
- If the rights to the cash flows are retained by HSBC but there is a
contractual obligation to pay them to another party, the securitized
assets concerned are derecognized if certain conditions are met such
as, for example, when there is no obligation to pay amounts to the
eventual recipient unless an equivalent amount is collected from the
original asset.
- If some significant risks and rewards of ownership have been
transferred, but some have also been retained, it must be determined
whether or not control has been retained. If control has been retained,
HSBC continues to recognize the asset to the extent of its continuing
involvement; if not, the asset is derecognized.
- The impact from securitizations resulting in higher net income under
IFRSs is due to the recognition of income on securitized receivables
under U.S. GAAP in prior periods.
U.S. GAAP
- SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and
Extinguishments of Liabilities" requires that receivables that are sold
to a special purpose entity ("SPE") and securitized can only be
derecognized and a gain or loss on sale recognized if the originator has
surrendered control over the securitized assets.
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- Control is surrendered over transferred assets if, and only if, all of
the following conditions are met:
- The transferred assets are put presumptively beyond the reach of the
transferor and its creditors, even in bankruptcy or other receivership.
- Each holder of interests in the transferee (i.e. holder of issued
notes) has the right to pledge or exchange their beneficial interests,
and no condition constrains this right and provides more than a trivial
benefit to the transferor.
- The transferor does not maintain effective control over the assets
through either an agreement that obligates the transferor to repurchase
or to redeem them before their maturity or through the ability to
unilaterally cause the holder to return specific assets, other than
through a clean-up call.
- If these conditions are not met the securitized assets should continue to
be consolidated.
- When HSBC retains an interest in the securitized assets, such as a
servicing right or the right to residual cash flows from the SPE, HSBC
recognizes this interest at fair value on sale of the assets to the SPE.
DERIVATIVES AND HEDGE ACCOUNTING
IFRSs
- Derivatives are recognized initially, and are subsequently remeasured, at
fair value. Fair values of exchange-traded derivatives are obtained from
quoted market prices. Fair values of over-the-counter ("OTC") derivatives
are obtained using valuation techniques, including discounted cash flow
models and option pricing models.
- In the normal course of business, the fair value of a derivative on
initial recognition is considered to be the transaction price (that is
the fair value of the consideration given or received). However, in
certain circumstances the fair value of an instrument will be evidenced
by comparison with other observable current market transactions in the
same instrument (without modification or repackaging) or will be based on
a valuation technique whose variables include only data from observable
markets, including interest rate yield curves, option volatilities and
currency rates. When such evidence exists, HSBC recognizes a trading gain
or loss on inception of the derivative. When unobservable market data
have a significant impact on the valuation of derivatives, the entire
initial change in fair value indicated by the valuation model is not
recognized immediately in the income statement but is recognized over the
life of the transaction on an appropriate basis or recognized in the
income statement when the inputs become observable, or when the
transaction matures or is closed out.
- Derivatives may be embedded in other financial instruments; for example,
a convertible bond has an embedded conversion option. An embedded
derivative is treated as a separate derivative when its economic
characteristics and risks are not clearly and closely related to those of
the host contract, its terms are the same as those of a stand-alone
derivative, and the combined contract is not held for trading or
designated at fair value. These embedded derivatives are measured at fair
value with changes in fair value recognized in the income statement.
- Derivatives are classified as assets when their fair value is positive,
or as liabilities when their fair value is negative. Derivative assets
and liabilities arising from different transactions are only netted if
the transactions are with the same counterparty, a legal right of offset
exists, and the cash flows are intended to be settled on a net basis.
- The method of recognizing the resulting fair value gains or losses
depends on whether the derivative is held for trading, or is designated
as a hedging instrument and, if so, the nature of the risk being hedged.
All gains and losses from changes in the fair value of derivatives held
for trading are recognized in the income statement. When derivatives are
designated as hedges, HSBC classifies them as either: (i) hedges of the
change in fair value of recognized assets or liabilities or firm
commitments ("fair value hedge"); (ii) hedges of the variability in
highly probable future cash flows attributable to a recognized asset or
liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges
of net investments in a foreign operation ("net investment hedge"). Hedge
accounting is applied to derivatives designated as hedging instruments in
a fair value, cash flow or net investment hedge provided certain criteria
are met.
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Hedge Accounting:
- It is HSBC's policy to document, at the inception of a hedge, the
relationship between the hedging instruments and hedged items, as well
as the risk management objective and strategy for undertaking the
hedge. The policy also requires documentation of the assessment, both
at hedge inception and on an ongoing basis, of whether the derivatives
used in the hedging transactions are highly effective in offsetting
changes in fair values or cash flows of hedged items attributable to
the hedged risks.
Fair value hedge:
- Changes in the fair value of derivatives that are designated and
qualify as fair value hedging instruments are recorded in the income
statement, together with changes in the fair values of the assets or
liabilities or groups thereof that are attributable to the hedged
risks.
- If the hedging relationship no longer meets the criteria for hedge
accounting, the cumulative adjustment to the carrying amount of a
hedged item is amortized to the income statement based on a
recalculated effective interest rate over the residual period to
maturity, unless the hedged item has been derecognized whereby it is
released to the income statement immediately.
Cash flow hedge:
- The effective portion of changes in the fair value of derivatives that
are designated and qualify as cash flow hedges are recognized in
equity. Any gain or loss relating to an ineffective portion is
recognized immediately in the income statement.
- Amounts accumulated in equity are recycled to the income statement in
the periods in which the hedged item will affect the income statement.
However, when the forecast transaction that is hedged results in the
recognition of a non-financial asset or a non-financial liability, the
gains and losses previously deferred in equity are transferred from
equity and included in the initial measurement of the cost of the asset
or liability.
- When a hedging instrument expires or is sold, or when a hedge no longer
meets the criteria for hedge accounting, any cumulative gain or loss
existing in equity at that time remains in equity until the forecast
transaction is ultimately recognized in the income statement. When a
forecast transaction is no longer expected to occur, the cumulative
gain or loss that was reported in equity is immediately transferred to
the income statement.
Net investment hedge:
- Hedges of net investments in foreign operations are accounted for in a
similar manner to cash flow hedges. Any gain or loss on the hedging
instrument relating to the effective portion of the hedge is recognized
in equity; the gain or loss relating to the ineffective portion is
recognized immediately in the income statement. Gains and losses
accumulated in equity are included in the income statement on the
disposal of the foreign operation.
Hedge effectiveness testing:
- IAS 39 requires that at inception and throughout its life, each hedge
must be expected to be highly effective (prospective effectiveness) to
qualify for hedge accounting. Actual effectiveness (retrospective
effectiveness) must also be demonstrated on an ongoing basis.
- The documentation of each hedging relationship sets out how the
effectiveness of the hedge is assessed.
- For prospective effectiveness, the hedging instrument must be expected
to be highly effective in achieving offsetting changes in fair value or
cash flows attributable to the hedged risk during the period for which
the hedge is designated. For retrospective effectiveness, the changes
in fair value or cash flows must offset each other in the range of 80
per cent to 125 per cent for the hedge to be deemed effective.
Derivatives that do not qualify for hedge accounting:
- All gains and losses from changes in the fair value of any
derivatives that do not qualify for hedge accounting are recognized
immediately in the income statement.
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U.S. GAAP
- The accounting under SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities" is generally consistent with that under IAS 39,
which HSBC has followed in its IFRSs reporting from January 1, 2005, as
described above. However, specific assumptions regarding hedge
effectiveness under U.S. GAAP are not permitted by IAS 39.
- The requirements of SFAS No. 133 have been effective from January 1,
2001.
- The U.S. GAAP 'shortcut method' permits an assumption of zero
ineffectiveness in hedges of interest rate risk with an interest rate
swap provided specific criteria have been met. IAS 39 does not permit
such an assumption, requiring a measurement of actual ineffectiveness at
each designated effectiveness testing date. As of September 30, 2007, we
do not have any hedges accounted for under the shortcut method.
- In addition, IFRSs allows greater flexibility in the designation of the
hedged item. Under U.S. GAAP, all contractual cash flows must form part
of the designated relationship, whereas IAS 39 permits the designation of
identifiable benchmark interest cash flows only.
- Under U.S. GAAP, derivatives receivable and payable with the same
counterparty may be reported net on the balance sheet when there is an
executed ISDA Master Netting Arrangement covering enforceable
jurisdictions. These contracts do not meet the requirements for offset
under IAS 32 and hence are presented gross on the balance sheet under
IFRSs.
DESIGNATION OF FINANCIAL ASSETS AND LIABILITIES AT FAIR VALUE THROUGH PROFIT AND
LOSS
IFRSs
- Under IAS 39, a financial instrument, other than one held for trading, is
classified in this category if it meets the criteria set out below, and
is so designated by management. An entity may designate financial
instruments at fair value where the designation:
- eliminates or significantly reduces a measurement or recognition
inconsistency that would otherwise arise from measuring financial
assets or financial liabilities or recognizing the gains and losses on
them on different bases; or
- applies to a group of financial assets, financial liabilities or a
combination of both that is managed and its performance evaluated on a
fair value basis, in accordance with a documented risk management or
investment strategy, and where information about that group of
financial instruments is provided internally on that basis to
management; or
- relates to financial instruments containing one or more embedded
derivatives that significantly modify the cash flows resulting from
those financial instruments.
- Financial assets and financial liabilities so designated are recognized
initially at fair value, with transaction costs taken directly to the
income statement, and are subsequently remeasured at fair value. This
designation, once made, is irrevocable in respect of the financial
instruments to which it relates. Financial assets and financial
liabilities are recognized using trade date accounting.
- Gains and losses from changes in the fair value of such assets and
liabilities are recognized in the income statement as they arise,
together with related interest income and expense and dividends.
U.S. GAAP
- Prior to the adoption of SFAS No. 159, generally, for financial assets to
be measured at fair value with gains and losses recognized immediately in
the income statement, they were required to meet the definition of
trading securities in SFAS 115, "Accounting for Certain Investments in
Debt and Equity Securities". Financial liabilities were usually reported
at amortized cost under U.S. GAAP.
- SFAS No. 159 was issued in February 2007, which provides for a fair value
option election that allows companies to irrevocably elect fair value as
the initial and subsequent measurement attribute for certain financial
assets and liabilities, with changes in fair value recognized in earnings
as they occur. SFAS No. 159 permits the fair value option election on an
instrument by instrument basis at the initial recognition of an asset or
liability or upon an event that gives rise to a new basis of accounting
for that instrument. We adopted SFAS No. 159 retroactive to January 1,
2007.
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GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES
IFRSs
- Prior to 1998, goodwill under U.K. GAAP was written off against equity.
HSBC did not elect to reinstate this goodwill on its balance sheet upon
transition to IFRSs. From January 1, 1998 to December 31, 2003 goodwill
was capitalized and amortized over its useful life. The carrying amount
of goodwill existing at December 31, 2003 under U.K. GAAP was carried
forward under the transition rules of IFRS 1 from January 1, 2004,
subject to certain adjustments.
- IFRS 3 "Business Combinations" requires that goodwill should not be
amortized but should be tested for impairment at least annually at the
reporting unit level by applying a test based on recoverable amounts.
- Quoted securities issued as part of the purchase consideration are fair
valued for the purpose of determining the cost of acquisition at their
market price on the date the transaction is completed.
U.S. GAAP
- Up to June 30, 2001, goodwill acquired was capitalized and amortized over
its useful life which could not exceed 25 years. The amortization of
previously acquired goodwill ceased with effect from December 31, 2001.
- Quoted securities issued as part of the purchase consideration are fair
valued for the purpose of determining the cost of acquisition at their
average market price over a reasonable period before and after the date
on which the terms of the acquisition are agreed and announced.
Goodwill levels are higher under IFRSs than U.S. GAAP as the HSBC purchase
accounting adjustments reflect higher levels of intangible assets under U.S.
GAAP. Consequently, the amount of goodwill allocated to our Mortgage Services
business and written off during the third quarter of 2007 is greater under
IFRSs.
LOAN ORIGINATION
IFRSs
- Certain loan fee income and incremental directly attributable loan
origination costs are amortized to the income statement over the life of
the loan as part of the effective interest calculation under IAS 39.
U.S. GAAP
- Certain loan fee income and direct but not necessarily incremental loan
origination costs, including an apportionment of overheads, are amortized
to the income statement account over the life of the loan as an
adjustment to interest income (SFAS No. 91 "Accounting for Nonrefundable
Fees and Costs Associated with Originating or Acquiring Loans and Initial
Direct Costs of Leases".)
LOAN IMPAIRMENT
IFRSs
- Where statistical models, using historic loss rates adjusted for economic
conditions, provide evidence of impairment in portfolios of loans, their
values are written down to their net recoverable amount. The net
recoverable amount is the present value of the estimated future
recoveries discounted at the portfolio's original effective interest
rate. The calculations include a reasonable estimate of recoveries on
loans individually identified for write-off pursuant to HSBC's credit
guidelines.
U.S. GAAP
- Where the delinquency status of loans in a portfolio is such that there
is no realistic prospect of recovery, the loans are written off in full,
or to recoverable value where collateral exists. Delinquency depends on
the number of days payment is overdue. The delinquency status is applied
consistently across similar loan products in accordance with HSBC's
credit guidelines. When local regulators mandate the delinquency status
at which write-off must occur for different retail loan products and
these regulations reasonably reflect estimated recoveries on individual
loans, this basis of measuring loan impairment is reflected in U.S. GAAP
accounting. Cash recoveries relating to pools of such written-off loans,
if any, are reported as loan recoveries upon collection.
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LOANS HELD FOR RESALE
IFRSs
- Under IAS 39, loans held for resale are treated as trading assets.
- As trading assets, loans held for resale are initially recorded at fair
value, with changes in fair value being recognized in current period
earnings.
- Any gains realized on sales of such loans are recognized in current
period earnings on the trade date.
U.S. GAAP
- Under U.S. GAAP, loans held for resale are designated as loans on the
balance sheet.
- Such loans are recorded at the lower of amortized cost or market value
(LOCOM). Therefore, recorded value cannot exceed amortized cost.
- Subsequent gains on sales of such loans are recognized in current period
earnings on the settlement date.
INTEREST RECOGNITION
IFRSs
- The calculation and recognition of effective interest rates under IAS 39
requires an estimate of "all fees and points paid or received between
parties to the contract" that are an integral part of the effective
interest rate be included.
U.S. GAAP
- FAS 91 also generally requires all fees and costs associated with
originating a loan to be recognized as interest, but when the interest
rate increases during the term of the loan it prohibits the recognition
of interest income to the extent that the net investment in the loan
would increase to an amount greater than the amount at which the borrower
could settle the obligation.
During the second quarter of 2006, we implemented a methodology for calculating
the effective interest rate for introductory rate credit card receivables which
resulted in an increase to interest income under IFRSs of $154 million ($97
million after-tax). Of the amounts recognized, approximately $58 million (after-
tax) would otherwise have been recorded as an IFRSs opening balance sheet
adjustment as at January 1, 2005.
IFRS MANAGEMENT BASIS REPORTING Our segment results are presented on an IFRSs
management basis (a non-U.S. GAAP financial measure) ("IFRS Management Basis")
as operating results are monitored and reviewed, trends are evaluated and
decisions about allocating resources, such as employees, are made almost
exclusively on an IFRS Management Basis as we report results to our parent,
HSBC, who prepares its consolidated financial statements in accordance with
IFRSs. IFRS Management Basis results are IFRSs results adjusted to assume that
the private label and real estate secured receivables transferred to HSBC Bank
USA have not been sold and remain on our balance sheet. Operations are monitored
and trends are evaluated on an IFRS Management Basis because the customer loan
sales to HSBC Bank USA were conducted primarily to appropriately fund prime
customer loans within HSBC and such customer loans continue to be managed and
serviced by us without regard to ownership. However, we continue to monitor
capital adequacy, establish dividend policy and report to regulatory agencies on
a U.S. GAAP basis. A summary of the significant differences between U.S. GAAP
and IFRSs as they impact our results are summarized in Note 11, "Business
Segments."
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RECEIVABLES REVIEW
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The following table summarizes receivables at September 30, 2007 and increases
(decreases) over prior periods:
INCREASES (DECREASES) FROM
--------------------------------
JUNE 30, SEPTEMBER 30,
2007 2006
SEPTEMBER 30, -------------- ---------------
2007 $ % $ %
----------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Real estate secured(1)...................... $ 91,162 $(1,277) (1.4)% $(4,190) (4.4)%
Auto finance................................ 13,128 195 1.5 946 7.8
Credit card................................. 29,103 509 1.8 3,247 12.6
Private label............................... 2,768 215 8.4 337 13.9
Personal non-credit card(2)................. 21,289 12 .1 255 1.2
Commercial and other........................ 148 (4) (2.6) (37) (20.0)
-------- ------- ---- ------- -----
Total owned receivables..................... $157,598 $ (350) (.2)% $ 558 .4%
======== ======= ==== ======= =====
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(1) Mortgage Services has historically purchased receivables originated by other
lenders referred to as correspondents. In December, the business was aligned
under common executive management with our Consumer Lending business. In
March 2007, our Mortgage Services ceased new correspondent channel
acquisitions of receivables. Consumer Lending is a distinct business that
sources, underwrites and closes loans through a network of approximately
1,300 branch offices at September 30, 2007 located throughout the United
States. The Mortgage Services and Consumer Lending businesses comprise the
majority of our real estate secured portfolio as shown in the following
table:
INCREASES (DECREASES) FROM
---------------------------------
JUNE 30, SEPTEMBER 30,
2007 2006
SEPTEMBER 30, -------------- ----------------
2007 $ % $ %
-------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Mortgage Services............................. $36,647 $(2,720) (6.9)% $(12,541) (25.5)%
Consumer Lending.............................. 50,255 1,167 2.4 7,549 17.7
Foreign and all other......................... 4,260 276 6.9 802 23.2
------- ------- ---- -------- -----
Total real estate secured..................... $91,162 $(1,277) (1.4)% $ (4,190) (4.4)%
======= ======= ==== ======== =====
--------
(2) Personal non-credit card receivables are comprised of the following:
INCREASES (DECREASES) FROM
---------------------------
JUNE 30, SEPTEMBER 30,
2007 2006
SEPTEMBER 30, ----------- -------------
2007 $ % $ %
----------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Domestic personal non-credit card................ $14,193 $137 1.0% $ 960 7.3%
Union Plus personal non-credit card.............. 190 (10) (5.0) (62) (24.6)
Personal homeowner loans......................... 4,079 (57) (1.4) (190) (4.5)
Foreign personal non-credit card................. 2,827 (58) (2.0) (453) (13.8)
------- ---- ---- ----- -----
Total personal non-credit card................... $21,289 $ 12 .1% $ 255 1.2%
======= ==== ==== ===== =====
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Real estate secured receivables can be further analyzed as follows:
INCREASES (DECREASES) FROM
--------------------------------
JUNE 30, SEPTEMBER 30,
2007 2006
SEPTEMBER 30, -------------- ---------------
2007 $ % $ %
----------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Real estate secured:
Closed-end:
First lien............................. $73,158 $ (937) (1.3)% $(2,125) (2.8)%
Second lien............................ 14,213 (83) (.6) (786) (5.2)
Revolving:
First lien............................. 473 (26) (5.2) (43) (8.3)
Second lien............................ 3,318 (231) (6.5) (1,236) (27.1)
------- ------- ---- ------- -----
Total real estate secured................... $91,162 $(1,277) (1.4)% $(4,190) (4.4)%
======= ======= ==== ======= =====
The following table summarizes various real estate secured receivables
information for our Mortgage Services and Consumer Lending businesses:
SEPTEMBER 30, 2007 JUNE 30, 2007 SEPTEMBER 30, 2006
------------------- ------------------- -------------------
MORTGAGE CONSUMER MORTGAGE CONSUMER MORTGAGE CONSUMER
SERVICES LENDING SERVICES LENDING SERVICES LENDING
---------------------------------------------------------------------------------------------------
(IN MILLIONS)
Fixed rate........................ $19,555(1) $47,078(2) $20,822(1) $45,672(2) $23,450(1) $40,502(2)
Adjustable rate................... 17,092 3,177 18,545 3,416 25,738 2,204
------- ------- ------- ------- ------- -------
Total............................. $36,647 $50,255 $39,367 $49,088 $49,188 $42,706
======= ======= ======= ======= ======= =======
First lien........................ $29,278 $43,345 $31,225 $42,486 $38,242 $36,836
Second lien....................... 7,369 6,910 8,142 6,602 10,946 5,870
------- ------- ------- ------- ------- -------
Total............................. $36,647 $50,255 $39,367 $49,088 $49,188 $42,706
======= ======= ======= ======= ======= =======
Adjustable rate................... $12,861 $ 3,177 $13,956 $ 3,416 $19,743 $ 2,204
Interest-only..................... 4,231 - 4,589 - 5,995 -
------- ------- ------- ------- ------- -------
Total adjustable rate............. $17,092 $ 3,177 $18,545 $ 3,416 $25,738 $ 2,204
======= ======= ======= ======= ======= =======
Total stated income............... $ 8,691 $ - $ 9,442 $ - $12,405 $ -
======= ======= ======= ======= ======= =======
--------
(1) Includes fixed rate interest-only loans of $455 million at September 30,
2007, $473 million at June 30, 2007 and $489 million at September 30, 2006.
(2) Includes fixed rate interest-only loans of $50 million at September 30,
2007, $52 million at June 30, 2007 and $28 million at September 30, 2006.
The following table summarizes by lien position the Mortgage Services' real
estate secured loans originated and acquired subsequent to December 31, 2004 as
a percentage of the total portfolio which were outstanding as of the following
dates:
MORTGAGE SERVICES' RECEIVABLES ORIGINATED OR ACQUIRED AFTER DECEMBER 31, 2004
---------------------------------------------------------------------------------------
AS OF FIRST LIEN SECOND LIEN
---------------------------------------------------------------------------------------
September 30, 2007........................................... 75% 90%
June 30, 2007................................................ 74% 90%
September 30, 2006........................................... 65% 89%
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RECEIVABLE INCREASES (DECREASES) SINCE SEPTEMBER 30, 2006 Real estate secured
receivables decreased from the year-ago period driven by lower receivable
balances in our Mortgage Services business resulting from the following:
> In the second half of 2006, we reduced purchases of second lien and
selected higher risk products.
> In March 2007, we decided to discontinue new correspondent channel
acquisitions.
> In the second quarter of 2007, we sold $2.2 billion of loans from the
Mortgage Services loan portfolio.
These actions have resulted in a significant reduction in the Mortgage Services
portfolio since September 30, 2006. This attrition was partially offset by a
decline in loan prepayments due to fewer refinancing opportunities for our
customers due to the previously discussed trends impacting the mortgage lending
industry as well as the higher interest rate environment which resulted in fewer
prepayments as fewer alternatives to refinance loans existed for some of our
customers. We anticipate the balance of this portfolio will continue to decrease
going forward. The reduction in our Mortgage Services portfolio was partially
offset by growth in our Consumer Lending branch business. Growth in our branch-
based Consumer Lending business improved due to higher sales volumes and the
decline in loan prepayments discussed above. Also contributing to the increase
in our Consumer Lending business was the acquisition of the $2.5 billion
Champion portfolio in November 2006. However, we anticipate that the actions we
have taken to reduce risk going forward in our Consumer Lending business,
including eliminating ARM loans, capping second lien LTV ratio requirements to
either 80 or 90 percent based on geography and the overall tightening of credit
score and debt-to-income requirements for first lien loans, will significantly
limit growth in the future. We have also experienced strong real estate secured
growth in our foreign real estate secured receivables as a result of Canadian
branch operation expansions since September 30, 2006.
Auto finance receivables increased over the year-ago period due to organic
growth principally in the near-prime portfolio as a result of growth in the
consumer direct loan program and lower securitization levels. As compared to the
year-ago period, continued growth from the expansion of an auto finance program
in Canada also contributed to the increase. Credit card receivables reflect
strong domestic organic growth in our General Motors, Union Privilege, Metris
and non-prime portfolios. Private label receivables increased as compared to
September 30, 2006 as a result of growth in our Canadian and U.K. business and
changes in the foreign exchange rate since September 30, 2006, partially offset
by the termination of new domestic retail sales contract originations in October
2006 by our Consumer Lending business. Personal non-credit card receivables
increased as a result of increased marketing which subsequently has been reduced
in the second half of 2007.
RECEIVABLE INCREASES (DECREASES) SINCE JUNE 30, 2007 Real estate secured
receivables have decreased since June 30, 2007. As discussed above, actions
taken at our Mortgage Services business combined with normal portfolio attrition
have resulted in a decline in the overall portfolio balance at our Mortgage
Services business since June 30, 2007. These decreases were partially offset by
real estate secured growth in our Consumer Lending business. In addition, the
decline in loan prepayments has continued during the third quarter of 2007 which
has resulted in lower run-off rates for our real estate secured portfolio.
Growth in our auto finance portfolio reflects growth in our direct to consumer
business. The increase in our credit card receivables is due to growth in our
Union Privilege, Metris and non-prime portfolios. Private label receivables
increased as a result of growth in our Canadian private label portfolio
partially offset by the termination of new domestic retail sales contract
originations in October 2006. Personal non-credit card receivables increased
primarily due to higher levels of domestic personal non-credit card receivables,
partially offset by reductions in new loan volume due to a tightening in
underwriting.
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RESULTS OF OPERATIONS
--------------------------------------------------------------------------------
Unless noted otherwise, the following discusses amounts reported in our
consolidated statement of income (loss).
NET INTEREST INCOME The following table summarizes net interest income:
INCREASE
(DECREASE)
------------
THREE MONTHS ENDED SEPTEMBER 30, 2007 (1) 2006 (1) AMOUNT %
------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Finance and other interest income......... $4,715 11.71% $4,535 11.43% $180 4.0%
Interest expense.......................... 2,032 5.05 1,933 4.87 99 5.1
------ ----- ------ ----- ---- ---
Net interest income....................... $2,683 6.66% $2,602 6.56% $ 81 3.1%
====== ===== ====== ===== ==== ===
INCREASE
(DECREASE)
-------------
NINE MONTHS ENDED SEPTEMBER 30, 2007 (1) 2006 (1) AMOUNT %
-------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Finance and other interest income....... $14,112 11.55% $12,933 11.27% $1,179 9.1%
Interest expense........................ 6,131 5.02 5,318 4.63 813 15.3
------- ----- ------- ----- ------ ----
Net interest income..................... $ 7,981 6.53% $ 7,615 6.64% $ 366 4.8%
======= ===== ======= ===== ====== ====
--------
(1) % Columns: comparison to average owned interest-earning assets.
The increases in net interest income during the quarter and year-to-date periods
were due to higher average receivables and higher overall yields, partially
offset by higher interest expense. Overall yields increased due to increases in
our rates on fixed and variable rate products which reflected market movements
and various other repricing initiatives. Yields were also favorably impacted by
receivable mix with increased levels of higher yielding products such as credit
cards, due in part to reduced securitization levels and higher levels of average
personal non-credit card receivables. Overall yield improvements were also
impacted during the quarter by a shift in mix to higher yielding Consumer
Lending real estate secured receivables resulting from attrition in the lower
yielding Mortgage Services real estate secured receivable portfolio and the
higher yielding Consumer Lending real estate secured receivables remaining on
the balance sheet longer due to lower run-off rates. Overall yield improvements
were partially offset by the impact of growth in non-performing assets. The
higher interest expense in both periods was due to a higher cost of funds
resulting from the refinancing of maturing debt at higher current rates. This
was partially offset by the adoption of SFAS No. 159, which resulted in $85
million of realized losses in the quarter and $243 million of realized losses in
the year-to-date period on swaps which previously were accounted for as
effective hedges under SFAS No. 133 and reported as interest expense now being
reported in other revenues. In addition, as part of our overall liquidity
management strategy, we continue to extend the maturity of our liability profile
which results in higher interest expense. Our purchase accounting fair value
adjustments include both amortization of fair value adjustments to our external
debt obligations and receivables. Amortization of purchase accounting fair value
adjustments increased net interest income by $87 million during the three months
ended September 30, 2007 and $197 million during the nine month period ended
September 30, 2007. Amortization of purchase accounting fair value adjustments
increased net interest income by $102 million during the three months ended
September 30, 2006 and $331 million during the nine month period ended September
30, 2006.
Net interest margin increased during the three months ended September 30, 2007
as compared to the prior year quarter as the higher funding costs and higher
nonperforming assets in the quarter were more than offset by improvements in the
overall yield, primarily due to a shift in the current quarter due to a higher
mix of higher yielding Consumer Lending real estate secured receivables in the
overall real estate secured receivable portfolio as discussed above. However,
net interest margin decreased in the nine months ended September 30, 2007 as
compared to the year-ago period as the overall yield improvements were more than
offset by the higher funding costs and an
47
HSBC Finance Corporation
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increase in nonperforming assets in the period. The following table shows the
impact of these items on net interest margin at September 30, 2007:
THREE MONTHS NINE MONTHS
ENDED ENDED
--------------------------------------------------------------------------------------
Net interest margin - September 30, 2006.................. 6.56% 6.64%
Impact to net interest margin resulting from:
Receivable pricing...................................... .24 .24
Receivable mix.......................................... .24 .17
Growth in non-performing assets......................... (.17) (.14)
Cost of funds........................................... (.17) (.38)
Other................................................... (.04) -
---- ----
Net interest margin - September 30, 2007.................. 6.66% 6.53%
==== ====
The varying maturities and repricing frequencies of both our assets and
liabilities expose us to interest rate risk. When the various risks inherent in
both the asset and the debt do not meet our desired risk profile, we use
derivative financial instruments to manage these risks to acceptable interest
rate risk levels. See "Risk Management" for additional information regarding
interest rate risk and derivative financial instruments.
PROVISION FOR CREDIT LOSSES The following table summarizes provision for credit
losses:
INCREASE
(DECREASE)
-------------
2007 2006 AMOUNT %
-------------------------------------------------------------------------------------
(DOLLARS ARE IN
MILLIONS)
Three months ended September 30,.................... $3,202 $1,384 $1,818 100+%
Nine months ended September 30,..................... 6,849 3,498 3,351 95.8
Our provision for credit losses increased markedly during both periods
reflecting higher loss estimates in our Consumer Lending, Mortgage Services and
Credit Card Services businesses due to the following:
> Consumer Lending experienced higher loss estimates primarily in its real
estate secured receivable portfolios due to higher levels of charge-off
and delinquency driven by a faster deterioration of portions of the real
estate secured receivable portfolio in the third quarter of 2007.
Weakening early stage delinquency previously reported continued to worsen
and migrate into later stage delinquency due to the marketplace changes
previously discussed. Lower receivable run-off, growth in average
receivables and portfolio seasoning also resulted in a higher real estate
secured credit loss provision. Also contributing to the increase in both
periods was higher loss estimates in Consumer Lending's personal non-
credit card portfolio due to seasoning, a deterioration of 2006 vintages
originated through the direct mail channel in certain geographic regions
and increased levels of personal bankruptcy filings as compared to the
exceptionally low filing levels experienced in 2006 as a result of the
new bankruptcy law in the United States which went into effect in October
2005.
> Mortgage Services experienced higher levels of charge-offs and
delinquency as portions of the portfolio purchased in 2005 and 2006
continue to season and progress as expected into various stages of
delinquency and charge-off. Additionally during the third quarter of
2007, our Mortgage Services portfolio has also experienced higher loss
estimates in these portfolios, particularly in the second lien portfolio,
as receivable run-off continues to slow and the mortgage lending industry
trends we have experienced worsened.
> Credit Card Services' experienced higher loss estimates as a result of
higher average receivable balances due in part in the nine month period
to lower securitization levels, portfolio seasoning, a shift in mix to
higher levels of non-prime receivables as well as the increased levels of
personal bankruptcy filings discussed above.
These increases were partially offset in the quarter by lower loss estimates for
our U.K. operations reflecting improvements in delinquency and charge-offs.
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In 2006, we began to experience a deterioration in the performance of mortgage
loans acquired in 2005 and 2006 by our Mortgage Services business, particularly
in the second lien and portions of the first lien portfolio which resulted in
higher delinquency, charge-offs and loss estimates in these portfolios. In the
first half of 2007, we experienced higher levels of net charge-off in these
components as the higher delinquency we began to experience in the prior year
began to migrate to charge-off. During the third quarter of 2007, there has been
unprecedented turmoil in the mortgage lending industry, including rating agency
downgrades of debt secured by subprime mortgages which resulted in a marked
reduction in secondary market demand for subprime loans. However, none of our
secured financings were downgraded. The lower demand for subprime loans resulted
in reduced liquidity in the marketplace for subprime mortgages. Mortgage lenders
also tightened lending standards which impacted borrower's ability to refinance
existing mortgage loans. It is now generally believed that the slowdown in the
housing market will be deeper in terms of its impact on housing prices and the
duration of this slowdown will be much longer than originally anticipated. The
combination of these factors has further reduced the refinancing opportunities
of some of our customers as the ability to refinance and access any equity in
their homes is no longer an option for many customers as home price appreciation
remains stagnant in some markets and depreciates in others. This impacts both
credit performance and run-off rates and has resulted in rising delinquency
rates for real estate secured loans in our portfolio and across the industry
which has resulted in higher loss estimates in our Mortgage Services business
than previously anticipated. As a result, we increased credit loss reserves for
our Mortgage Services real estate secured portfolios by recording provision in
excess of net charge-offs of $277 million in the three months ended September
30, 2007 and $360 million in the year-to-date period. In 2006, we increased
credit loss reserves for our Mortgage Services real estate secured portfolios by
recording provision in excess of net charge-offs of $121 million in the three
months ended September 30, 2006 and $257 million in the nine months ended
September 30, 2006.
We previously reported in the second quarter of 2007 that we were beginning to
experience weakening in early stage performance in certain Consumer Lending real
estate secured loans originated since late 2005, consistent with the industry
trend. This trend worsened considerably in the third quarter of 2007 largely as
a result of the marketplace conditions discussed above. Credit performance of
our Consumer Lending mortgage portfolio deteriorated across all vintages during
the quarter, including 2007 originations, but in particular in loans which were
originated in 2006 as dollars of two-months-and-over contractual delinquency on
the Consumer Lending real estate portfolio increased $462 million or 40 percent
since June 2007 and $585 million or 57 percent since the beginning of the year.
The deterioration has been most severe in the first lien portions of the
portfolio in the geographic regions most impacted by the decline in home value
appreciation, in particular the states of California, Florida, Arizona,
Virginia, Washington, Maryland, Minnesota, Massachusetts and New Jersey which
account for approximately 70 percent of the increase in dollars of two-months-
and-over contractual delinquency during 2007. This worsening trend and an
outlook for increased charge-offs has resulted in a marked increase in credit
loss reserves for our Consumer Lending real estate secured portfolio during the
third quarter as we recorded provision in excess of net charge-offs of $519
million in the three months ended September 30, 2007 and of $733 million in the
year-to-date period. In 2006, we increased credit loss reserves for our Consumer
Lending real estate secured portfolios by recording provision in excess of net
charge-offs of $11 million in the three months ended September 30, 2006 and
decreased credit loss reserves for the nine months ended September 30, 2006 by
recording provision less than net charge-offs of $34 million.
In addition to the factors discussed above, our provision for credit losses in
the nine months ended September 30, 2007 also reflects higher loss estimates in
second lien loans purchased in 2004 through the third quarter of 2006 by our
Consumer Lending business as part of a second lien bulk acquisition program
which has subsequently been discontinued, which increased credit loss reserves
by $25 million in the three months ended September 30, 2007 and $113 million
during the year-to-date period. At September 30, 2007, the outstanding principal
balance of these second lien loans acquired by the Consumer Lending business was
approximately $1.1 billion. Additionally, the provision for credit losses for
our United Kingdom business in the nine months ended September 30, 2007 also
reflects the impact from a refinement in the methodology used to calculate roll
rate percentages which is consistent with our other businesses and we believe
reflects a better estimate of probable losses currently inherent in the loan
portfolio as well as higher loss estimates for restructured loans.
The provision as a percentage of average receivables, annualized, was 8.10
percent in the current quarter and 5.70 percent year-to-date, compared to 3.55
percent and 3.11 percent in the year-ago periods. In 2007, credit loss
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HSBC Finance Corporation
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reserves increased as the provision for credit losses was $1,462 million greater
than net charge-offs in the third quarter of 2007 and $2,034 million greater
than net charge-offs in the year-to-date period. In 2006, credit loss reserves
increased as the provision for credit losses was $246 million greater than net
charge-offs in the third quarter of 2006 and $352 million greater than net
charge-offs in the year-to-date period.
Net charge-off dollars totaled $1,740 million during the three months ended
September 30, 2007 as compared to $1,138 million in the year-ago quarter and
$4,815 million during the nine months ended September 30, 2007 as compared to
$3,146 million in the year-ago period. This increase was driven by our Mortgage
Services business, as loans originated and acquired in 2005 and early 2006 are
progressing to charge-off as well as higher average receivable levels, seasoning
in our credit card and Consumer Lending portfolios and increased levels of
personal bankruptcy filings as compared to the exceptionally low filing levels
experienced in 2006 as a result of the new bankruptcy law in the United States.
The provision for credit losses may vary from quarter to quarter depending on
the product mix and credit quality of loans in our portfolio. See "Credit
Quality" included in this MD&A for further discussion of factors affecting the
provision for credit losses.
OTHER REVENUES The following table summarizes other revenues:
INCREASE
(DECREASE)
--------------
THREE MONTHS ENDED SEPTEMBER 30, 2007 2006 AMOUNT %
--------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Securitization related revenue...................... $ 15 $ 24 $ (9) (37.5)%
Insurance revenue................................... 244 280 (36) (12.9)
Investment income................................... 34 31 3 9.7
Derivative (expense) income......................... (4) 68 (72) (100+)
Gain on debt designated at fair value and related
derivatives....................................... 519 - 519 100.0
Fee income.......................................... 660 542 118 21.8
Enhancement services revenue........................ 167 129 38 29.5
Taxpayer financial services revenue................. (27) 4 (31) (100+)
Gain on receivable sales to HSBC affiliates......... 94 101 (7) (6.9)
Servicing and other fees from HSBC affiliates....... 133 121 12 9.9
Other (expense) income.............................. (17) 34 (51) (100+)
------ ------ ---- -----
Total other revenues................................ $1,818 $1,334 $484 36.3%
====== ====== ==== =====
INCREASE
(DECREASE)
--------------
NINE MONTHS ENDED SEPTEMBER 30, 2007 2006 AMOUNT %
--------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Securitization related revenue...................... $ 58 $ 146 $ (88) (60.3)%
Insurance revenue................................... 667 750 (83) (11.1)
Investment income................................... 92 99 (7) (7.1)
Derivative (expense) income......................... (50) 118 (168) (100+)
Gain on debt designated at fair value and related
derivatives....................................... 533 - 533 100.0
Fee income.......................................... 1,862 1,353 509 37.6
Enhancement services revenue........................ 465 382 83 21.7
Taxpayer financial services revenue................. 216 258 (42) (16.3)
Gain on receivable sales to HSBC affiliates......... 298 283 15 5.3
Servicing and other fees from HSBC affiliates....... 398 355 43 12.1
Other (expense) income.............................. (65) 186 (251) (100+)
------ ------ ----- -----
Total other revenues................................ $4,474 $3,930 $ 544 13.8%
====== ====== ===== =====
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SECURITIZATION RELATED REVENUE is the result of the securitization of our
receivables and includes the following:
INCREASE
(DECREASE)
--------------
THREE MONTHS ENDED SEPTEMBER 30, 2007 2006 AMOUNT %
--------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net replenishment gains(1).............................. $ 6 $ 4 $ 2 50.0%
Servicing revenue and excess spread..................... 9 20 (11) (55.0)
--- --- ---- -----
Total................................................... $15 $24 $ (9) (37.5)%
=== === ==== =====
INCREASE
(DECREASE)
--------------
NINE MONTHS ENDED SEPTEMBER 30, 2007 2006 AMOUNT %
-------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net replenishment gains(1)............................. $22 $ 23 $ (1) (4.3)%
Servicing revenue and excess spread.................... 36 123 (87) (70.7)
--- ---- ---- -----
Total.................................................. $58 $146 $(88) (60.3)%
=== ==== ==== =====
--------
(1) Net replenishment gains reflect inherent recourse provisions of $4 million
in the three months ended September 30, 2007 and $13 million in the nine
months ended September 30, 2007. Net replenishment gains reflect inherent
recourse provisions of $7 million in the three months ended September 30,
2006 and $37 million in the nine months ended September 30, 2006.
The decline in securitization related revenue in the three and nine months ended
September 30, 2007 was due to decreases in the level of securitized receivables
as a result of our decision in the third quarter of 2004 to structure all new
collateralized funding transactions as secured financings. Because existing
public credit card transactions were structured as sales to revolving trusts
that require replenishments of receivables to support previously issued
securities, receivables continue to be sold to these trusts until the revolving
periods end, the last of which is currently projected to occur in the fourth
quarter of 2007. While the termination of sale treatment on new collateralized
funding activity and the reduction of sales under replenishment agreements
reduced our reported net income, there is no impact on cash received from
operations.
Insurance revenue decreased in the three and nine months ended September 30,
2007 primarily due to lower insurance sales volumes in our U.K. operations,
including a planned phase out of the use of our largest external broker between
January and April 2007. This was partially offset in the nine month period ended
September 30, 2007 by higher insurance revenue in our domestic operations due to
the introduction of lender placed products in our Auto Finance business and the
negotiation of lower commission payments in certain products offered by our
Retail Services business net of the impact of the cancellation of a significant
policy effective January 1, 2007.
Investment income, which includes income on securities available for sale in our
insurance business and realized gains and losses from the sale of securities,
was essentially flat as compared to the prior year quarter but decreased in the
nine months ended September 30, 2007 primarily due to higher amortization of
fair value adjustments.
Derivative (expense) income 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 which are qualifying hedges. Prior to the
election of FVO reporting for certain fixed rate debt, we accounted for the
realized gains and losses on swaps associated with this debt which qualified as
effective hedges under SFAS No. 133 in interest expense and any ineffectiveness
which resulted from changes in the fair value of the swaps as compared to
changes in the interest rate component value of the debt was recorded as a
component of derivative income. With the adoption of SFAS No. 159 beginning in
January 2007, we eliminated hedge accounting on these swaps and as a result,
realized and unrealized gains and losses on these derivatives and changes in the
interest rate component value of the aforementioned debt are now included in
Gain on debt designated at fair value and related derivatives in the
consolidated statement of income (loss) which impacts the comparability of
derivative income between periods.
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Derivative (expense) income is summarized in the table below:
THREE MONTHS ENDED SEPTEMBER 30, 2007 2006
--------------------------------------------------------------------------------
(IN
MILLIONS)
Net realized losses................................................ $(7) $(4)
Mark-to-market on derivatives which do not qualify as effective
hedges........................................................... - 65
Ineffectiveness.................................................... 3 7
--- ---
Total.............................................................. $(4) $68
=== ===
NINE MONTHS ENDED SEPTEMBER 30, 2007 2006
-------------------------------------------------------------------------------
(IN
MILLIONS)
Net realized gains (losses)....................................... $(21) $ 2
Mark-to-market on derivatives which do not qualify as effective
hedges.......................................................... (6) 14
Ineffectiveness................................................... (23) 102
---- ----
Total............................................................. $(50) $118
==== ====
Derivative income decreased during both periods due to changes in the interest
rate curve and to the adoption of SFAS No. 159. Declines in interest rates
resulted in a lower value of our interest rate swaps as compared to the prior
periods. The decrease in income from ineffectiveness is due to a significantly
lower number of interest rate swaps which are accounted for under the long-haul
method of accounting as a result of the adoption of SFAS No. 159. As discussed
above, the mark-to-market on the swaps associated with debt we have now
designated at fair value, as well as the mark-to-market on the interest rate
component of the debt, which accounted for the majority of the ineffectiveness
recorded in 2006, is now reported in the consolidated income statement as Gain
on debt designated at fair value and related derivatives. Additionally, in the
second quarter of 2006, we completed the redesignation of all remaining short
cut hedge relationships as hedges under the long-haul method of accounting.
Redesignation of swaps as effective hedges reduces the overall volatility of
reported mark-to-market income, although re-establishing such swaps as long-haul
hedges creates volatility as a result of hedge ineffectiveness.
Net income volatility, whether based on changes in interest rates for swaps
which do not qualify for hedge accounting, the ineffectiveness recorded on our
qualifying hedges under the long haul method of accounting or the impact from
adopting SFAS No. 159, affects the comparability of our reported results between
periods. Accordingly, derivative income for the three and nine months ended
September 30, 2007 should not be considered indicative of the results for any
future periods.
Gain on debt designated at fair value and related derivatives reflects fair
value changes on our fixed rate debt accounted for under FVO as a result of
adopting SFAS No. 159 effective January 1, 2007 as well as the fair value
changes and realized gains (losses) on the related derivatives associated with
debt designated at fair value. Prior to the election of FVO reporting for
certain fixed rate debt, we accounted for the realized gains and losses on swaps
associated with this debt which qualified as effective hedges under SFAS No. 133
in interest expense and any ineffectiveness which resulted from changes in the
value of the swaps as compared to changes in the interest rate
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component value of the debt was recorded in derivative income. These components
are summarized in the table below:
THREE MONTHS ENDED SEPTEMBER 30, 2007 2006
--------------------------------------------------------------------------------
(IN
MILLIONS)
Mark-to-market on debt designated at fair value:
Interest rate component......................................... $(723) $-
Credit risk component........................................... 608 -
----- --
Total mark-to-market on debt designated at fair value............. (115) -
Mark-to-market on the related derivatives......................... 719 -
Net realized gains (losses) on the related derivatives............ (85) -
----- --
Total............................................................. $ 519 $-
===== ==
NINE MONTHS ENDED SEPTEMBER 30, 2007 2006
--------------------------------------------------------------------------------
(IN
MILLIONS)
Mark-to-market on debt designated at fair value:
Interest rate component......................................... $(350) $-
Credit risk component........................................... 846 -
----- --
Total mark-to-market on debt designated at fair value............. 496 -
Mark-to-market on the related derivatives......................... 280 -
Net realized gains (losses) on the related derivatives............ (243) -
----- --
Total............................................................. $ 533 $-
===== ==
The change in the fair value of the debt and the change in value of the related
derivatives reflects the following:
> Interest rate curve - Interest rates decreased in both the quarter and
year-to-date period. The falling interest rates caused the value of our
fixed rate FVO debt to increase thereby resulting in a loss in the
Interest rate component during the third quarter of 2007. The value of
the receive fixed/pay variable swaps rose in response to these falling
interest rates and resulted in a gain in Mark-to-market on the related
derivatives.
> Credit - Our credit spreads widened significantly during the three month
period ended September 30, 2007, resulting from the general widening of
credit spreads related to the financial and fixed income sectors as well
as the general lack of liquidity in the secondary bond market in the
quarter. The fair value benefit from the change of our own credit spreads
is the result of having historically raised debt at credit spreads which
are not available under today's market conditions.
FVO results are also affected by the differences in cash flows and valuation
methodologies for the debt and related derivative. Cash flows on debt are
discounted using a single discount rate from the bond yield curve while
derivative cash flows are discounted using rates at multiple points along the
LIBOR yield curve. The impacts of these differences vary as the shape of these
interest rate curves change.
Fee income, which includes revenues from fee-based products such as credit
cards, increased in both periods due to higher credit card fees, particularly
relating to our non-prime credit card portfolios due to higher levels of credit
card receivables.
Enhancement services revenue, which consists of ancillary credit card revenue
from products such as Account Secure Plus (debt protection) and Identity
Protection Plan, was higher in both periods primarily as a result of higher
levels of credit card receivables and higher customer acceptance levels.
Taxpayer financial services revenue decreased during the three months ended
September 30, 2007 primarily due to higher loss estimates attributable to
increased levels of fraud detected by the IRS in tax returns filed in the 2007
tax
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season. Additionally, in the nine months ended September 30, 2007, the decrease
was also due to restructured pricing, partially offset by higher loan volume in
the 2007 tax season.
Gain on receivable sales to HSBC affiliates includes the daily sales of domestic
private label receivable originations (excluding retail sales contracts) and
certain credit card account originations to HSBC Bank USA and prior to our
decision to cease its operations, Decision One loan sales to HSBC Bank USA. In
the third quarter of 2007, we sold $274 million of real estate secured
receivables from our Decision One operations to HSBC Bank USA to support the
secondary market activities of our affiliates and realized a loss of $16
million. Excluding the loss on this real estate secured receivable portfolio,
gain on receivable sales to HSBC affiliates increased in both periods reflecting
higher sales volumes of domestic private label receivable and credit card
account originations as well as higher premiums on our credit card sales
volumes.
Servicing and other fees from HSBC represents revenue received under service
level agreements under which we service credit card and domestic private label
receivables as well as real estate secured and auto finance receivables for HSBC
affiliates. The increases primarily relate to higher levels of receivables being
serviced on behalf of HSBC Bank USA.
Other income decreased in both periods primarily due to losses on real estate
secured receivables held for sale by our Decision One mortgage operations of $99
million in the three months ended September 30, 2007 and $189 million in the
year-to-date period. In 2006, Decision One recorded gains on real estate secured
receivables held for sale of $33 million in the three months ended September 30,
2006 and gains of $96 million in the nine months ended September 30, 2006. Loan
sale volumes in our Decision One mortgage operations have decreased from $12.5
billion in the nine months ended September 30, 2006 to $4.3 billion in the nine
months ended September 30, 2007. Losses on real estate secured receivables held
for sale were partially offset by a net gain of $115 million on the sale of a
portion of our portfolio of MasterCard Class B shares during the quarter. Other
income in the nine months ended September 30, 2007 also includes a loss of $20
million on the sale of $2.2 billion of real estate secured receivables by our
Mortgage Services business.
COSTS AND EXPENSES
The following table summarizes total costs and expenses:
INCREASE
(DECREASE)
--------------
THREE MONTHS ENDED SEPTEMBER 30, 2007 2006 AMOUNT %
--------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Salaries and employee benefits...................... $ 582 $ 571 $ 11 1.9%
Sales incentives.................................... 54 94 (40) (42.6)
Occupancy and equipment expenses.................... 77 78 (1) (1.3)
Other marketing expenses............................ 162 197 (35) (17.8)
Other servicing and administrative expenses......... 319 287 32 11.1
Support services from HSBC affiliates............... 300 261 39 14.9
Amortization of intangibles......................... 63 63 - -
Policyholders' benefits............................. 142 123 19 15.4
Goodwill impairment charge.......................... 881 - 881 100.0
------ ------ ---- -----
Total costs and expenses............................ $2,580 $1,674 $906 54.1%
====== ====== ==== =====
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INCREASE
(DECREASE)
--------------
NINE MONTHS ENDED SEPTEMBER 30, 2007 2006 AMOUNT %
--------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Salaries and employee benefits...................... $1,778 $1,716 $ 62 3.6%
Sales incentives.................................... 184 272 (88) (32.4)
Occupancy and equipment expenses.................... 240 240 - -
Other marketing expenses............................ 602 546 56 10.3
Other servicing and administrative expenses......... 824 762 62 8.1
Support services from HSBC affiliates............... 884 783 101 12.9
Amortization of intangibles......................... 189 206 (17) (8.3)
Policyholders' benefits............................. 356 348 8 2.3
Goodwill impairment charge.......................... 881 - 881 100.0
------ ------ ------ -----
Total costs and expenses............................ $5,938 $4,873 $1,065 21.9%
====== ====== ====== =====
Salaries and employee benefits increased in three month period due to increased
collection activities and severance costs of $15 million related to the
decisions to cease Decision One operations and to close the loan underwriting,
processing and collection facility located in Carmel, Indiana. These increases
were partially offset by lower salary expense in our Mortgage Services, Credit
Card Services and United Kingdom operations. Lower salary in our Credit Card
Services operations was due to efficiencies from the integration of the Metris
acquisition which occurred in December 2005 and efficiencies derived from the
use of support services from HSBC affiliates. Salary expense was lower for our
Mortgage Services operations as a result of the termination of employees
associated with loan origination activities resulting from the discontinuance of
correspondent channel acquisitions in March 2007. The lower salary expense in
our United Kingdom operations reflects lower staffing levels. Salaries and
employee benefits were higher in the year-to-date period as a result of
additional staffing, primarily in our Consumer Lending, Retail Services and
Canadian businesses to support the higher levels of average receivables, higher
employee benefit costs and increased collection activities as well as the
aforementioned severance costs. These increases were partially offset by lower
salary expense in our Credit Card Services and Mortgage Services operations as
discussed above.
Sales incentives decreased in both periods due to lower origination volumes in
our correspondent and Decision One operations due to the decision to reduce
purchases in the second half of 2006 and the decisions in 2007 to discontinue
correspondent channel acquisitions and cease Decision One operations. As a
result of the decision to cease operations at our Decision One mortgage
operations, sales incentives will continue to decrease in the future. Also
contributing to the decrease were lower loan origination volumes in our Consumer
Lending business.
Occupancy and equipment expenses were essentially flat during both periods as
decreases due to depreciation expense and rental expense were offset by higher
costs for maintenance of our facilities.
Other marketing expenses includes payments for advertising, direct mail programs
and other marketing expenditures. The increase in marketing expense for the nine
months ended September 30, 2007 was primarily related to increased domestic
credit card and co-branded credit card marketing expenses. The decrease in the
three months ended September 30, 2007 reflects the decision in the third quarter
of 2007 to reduce credit card, co-branded credit card and personal non-credit
card marketing expenses in an effort to slow receivable growth in these
portfolios.
Other servicing and administrative expenses increased during both periods
primarily due to higher REO expenses partially offset by lower insurance
operating expenses in our domestic operations. In addition, other servicing and
administrative expenses were also higher in the nine month period ended
September 30, 2007 resulting from a valuation adjustment of $31 million to
record our investment in the U.K. Insurance Operations at the lower of cost or
market as a result of designating this operations as "Held for Sale," partially
offset by an increase in interest income of approximately $74 million in the
year-to-date period relating to various contingent tax items with the taxing
authority.
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Support services from HSBC affiliates includes technology and other services
charged to us by HSBC Technology and Services (USA) Inc. ("HTSU"), which
increased in the three and nine months ended September 30, 2007 primarily to
support higher levels of average receivables.
Amortization of intangibles was flat in the three months ended September 30,
2007 and lower in the year-to-date period as an individual contractual
relationship became fully amortized in the first quarter of 2006.
Policyholders' benefits increased in both periods due to higher policyholders'
benefits in our U.K. operations, partially offset by lower policyholders'
benefits in our domestic operations. The higher policyholder benefits in our
U.K. operations was due to a new reinsurance agreement, partially offset by
lower sales volumes.
Efficiency ratio The following table summarizes our efficiency ratio:
2007 2006
--------------------------------------------------------------------------------
Three months ended September 30.................................. 55.93% 40.68%
Nine months ended September 30................................... 46.14% 40.41%
Our efficiency ratio deteriorated as compared to the prior year quarter and the
year-ago period. Our efficiency ratio was significantly impacted in both the
three and nine month periods ended September 30, 2007 by the goodwill impairment
charge relating to our Mortgage Services business which was partially offset by
the change in the credit risk component of our fair value optioned debt.
Excluding these items, the efficiency ratio deteriorated 83 basis points as
compared to the prior year quarter and 137 basis points as compared to the year-
ago period. The deterioration in the three months ended September 30, 2007 was
primarily due to realized losses on real estate secured receivable sales and
lower derivative income, partially offset by higher fee income and higher net
interest income due to higher levels of average receivables. Excluding the
goodwill impairment charge, costs and expenses during the quarter were
essentially flat as increased collection activities and severance costs recorded
during the quarter were largely offset by lower salary and employee benefits and
sales incentives resulting from the discontinuance of correspondent channel
acquisitions, lower marketing expenses and the impact of cost containment
measures. In the nine month period, realized losses on real estate secured
receivable sales, lower derivative income and higher costs and expenses were
more than offset by higher fee income and higher net interest income due to the
higher levels of average receivables discussed above.
SEGMENT RESULTS - IFRS MANAGEMENT BASIS
--------------------------------------------------------------------------------
We have three reportable segments: Consumer, Credit Card Services and
International. Our Consumer segment consists of our Consumer Lending, Mortgage
Services, Retail Services and Auto Finance businesses. Our Credit Card Services
segment consists of our domestic MasterCard, Visa and Discover credit card
business. Our International segment consists of our foreign operations in the
United Kingdom, Canada, the Republic of Ireland and prior to November 9, 2006,
our operations in Slovakia, the Czech Republic and Hungary. The All Other
caption includes our Insurance and Taxpayer Financial Services and Commercial
businesses, each of which falls below the quantitative threshold test under SFAS
No. 131 for determining reportable segments, as well as our corporate and
treasury activities. There have been no changes in the basis of our segmentation
or any changes in the measurement of segment profit as compared with the
presentation in our 2006 Form 10-K.
Our segment results are presented on an IFRS Management Basis (a non-U.S. GAAP
financial measure) as operating results are monitored and reviewed, trends are
evaluated and decisions about allocating resources such as employees are made
almost exclusively on an IFRS Management Basis since we report results to our
parent, HSBC, who prepares its consolidated financial statements in accordance
with IFRSs. IFRS Management Basis results are IFRSs results adjusted to assume
that the private label and real estate secured receivables transferred to HSBC
Bank USA have not been sold and remain on our balance sheet. Operations are
monitored and trends are evaluated on an IFRS Management Basis because the
customer loan sales to HSBC Bank USA were conducted primarily to appropriately
fund prime customer loans within HSBC and such customer loans continue to be
managed and serviced by us without regard to ownership. However, we continue to
monitor capital adequacy, establish dividend
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policy and report to regulatory agencies on a U.S. GAAP basis. A summary of the
significant differences between U.S. GAAP and IFRSs as they impact our results
are summarized in Note 11, "Business Segments."
CONSUMER SEGMENT The following table summarizes the IFRS Management Basis
results for our Consumer segment:
INCREASE
(DECREASE)
---------------
THREE MONTHS ENDED SEPTEMBER 30 2007 2006 AMOUNT %
---------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income (loss)(1)............................ $ (686) $ 442 $(1,128) (100+)%
Net interest income............................. 2,145 2,187 (42) (1.9)
Other operating income.......................... 60 283 (223) (78.8)
Loan impairment charges......................... 2,585 1,034 1,551 100+
Operating expenses.............................. 720 766 (46) (6.0)
Intersegment revenues........................... 76 61 15 24.6
Customer loans.................................. 138,265 141,620 (3,355) (2.4)
Assets.......................................... 136,157 143,507 (7,350) (5.1)
Net interest margin, annualized................. 6.18% 6.22% - -
Return on average assets........................ (2.00) 1.24 - -
INCREASE
(DECREASE)
---------------
NINE MONTHS ENDED SEPTEMBER 30 2007 2006 AMOUNT %
--------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income (loss)(1)............................... $ (328) $1,700 $(2,028) (100+)%
Net interest income................................ 6,446 6,558 (112) (1.7)
Other operating income............................. 425 870 (445) (51.1)
Loan impairment charges............................ 5,187 2,478 2,709 100+
Operating expenses................................. 2,227 2,296 (69) (3.0)
Intersegment revenues.............................. 199 181 18 9.9
Net interest margin, annualized.................... 6.07% 6.42% - -
Return on average assets........................... (.31) 1.64 - -
--------
(1) The Consumer Segment net income (loss) reported above includes a net loss of
$(472) million in the three months ended September 30, 2007 and a net loss
of $(757) million in the year-to-date period for our Mortgage Services
business which is no longer generating new loan origination volume as a
result of the decisions to discontinue correspondent channel acquisitions
and cease Decision One operations. Our Mortgage Services business
contributed net income of $51 million in the three months ended September
30, 2006 and net income of $263 million in the nine months ended September
30, 2006.
Our Consumer segment reported a net loss in the three months and nine months
ended September 30, 2007 due to higher loan impairment charges, lower net
interest income and lower other operating income, partially offset by lower
operating expenses.
Loan impairment charges for the Consumer segment increased markedly during both
periods reflecting higher loss estimates in our Consumer Lending and Mortgage
Services businesses due to the following:
> Consumer Lending experienced higher loss estimates primarily in its real
estate secured receivable portfolios due to higher levels of charge-off and
delinquency driven by a faster deterioration of portions of the real estate
secured receivable portfolio in the third quarter of 2007. Weakening early
stage delinquency previously reported continued to worsen and migrate into
later stage delinquency due to the marketplace changes previously discussed.
Lower receivable run-off, growth in average receivables and portfolio
seasoning also resulted in a higher real estate secured credit loss provision.
Also contributing to the increase in both periods was higher loss estimates in
Consumer Lending's personal non-credit card portfolio due to seasoning, a
deterioration of 2006 vintages originated through the direct mail channel in
certain geographic regions and increased levels of
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personal bankruptcy filings as compared to the exceptionally low filing levels
experienced in 2006 as a result of the new bankruptcy law in the United States
which went into effect in October 2005.
> Mortgage Services experienced higher levels of charge-offs and delinquency as
portions of the portfolio purchased in 2005 and 2006 continue to season and
progress as expected into various stages of delinquency and charge-off.
Additionally during the third quarter of 2007, our Mortgage Services portfolio
has experienced higher loss estimates in these portfolios, particularly in the
second lien portfolio, as receivable run-off continues to slow and the
mortgage lending industry trends we have experienced worsened.
Also contributing to the increase in both periods was a higher mix of unsecured
loans such as private label and personal non-credit card receivables,
deterioration in credit performance of portions of our Retail Services private
label portfolio and increased levels of personal bankruptcy filings as compared
to the exceptionally low filing levels experienced in 2006 as a result of the
new bankruptcy law in the United States which went into effect in October 2005.
As previously discussed, a marked increase in dollars of delinquency in the
Consumer Lending real estate secured portfolio has been most severe in the first
lien portions of the portfolio in the geographic regions most impacted by the
decline in home value appreciation, in particular the states of California,
Florida, Arizona, Virginia, Washington, Maryland, Minnesota, Massachusetts and
New Jersey which account for approximately 70 percent of the increase in dollars
of two-months-and-over contractual delinquency during 2007. During the quarter,
our Mortgage Services portfolio has also seen higher than anticipated
delinquency and loss estimates in its mortgage loans acquired in 2005 and 2006,
particularly in the second lien. The increase in loan impairment charges in our
Retail Services business reflects higher delinquency levels during the quarter
due to deterioration in credit performance, seasoning of the co-branded credit
card introduced in the third quarter of 2006 and higher bankruptcy levels. The
increase in loan impairment charges at our Consumer Lending business was also
due to higher loss estimates related to second lien loans purchased in 2004
through the third quarter of 2006 as part of a second lien bulk acquisition
program which has subsequently been discontinued, which increased credit loss
reserves $25 million in the quarter and $113 million during the year-to-date
period. At September 30, 2007, the outstanding principal balance of these second
lien loans acquired by the Consumer Lending business was approximately $1.1
billion. In 2007, credit loss reserves increased as loan impairment charges were
$1,297 million greater than net charge-offs in the third quarter of 2007 and
$1,622 million greater than net charge-offs in the year-to-date period. In 2006,
credit loss reserves increased as the provision for credit losses was $188
million greater than net charge-offs in the third quarter of 2006 and $24
million greater than net charge-offs in the year-to-date period.
Net interest income decreased during the three and nine months ended September
30, 2007 as higher finance and other interest income primarily due to higher
average customer loans and higher overall yields was more than offset by higher
interest expense. Overall yields reflect growth in unsecured customer loans at
current market rates. The higher interest expense was due to significantly
higher cost of funds due to a rising interest rate environment. The decrease in
net interest margin in both periods was a result of the cost of funds increasing
more rapidly than our ability to increase receivable yields. However, in the
current quarter net interest margin has shown improvement due to a shift to a
higher mix of higher yielding Consumer Lending real estate secured receivables
in the overall real estate secured receivable portfolio resulting from attrition
in the lower yielding Mortgage Services real estate secured portfolio and the
higher yielding real estate secured loans in our Consumer Lending business
remaining on balance sheet longer due to lower run-off rates. Other operating
income decreased in both the three and nine months ended September 30, 2007
primarily due to losses on loans held for sale by our Decision One mortgage
operations and in the year-to-date period the loss on the sale of $2.2 billion
of loans from the Mortgage Services portfolio, partially offset by higher late
and overlimit fees associated with our co-branded credit card portfolio.
Operating expenses were lower in the three and nine months ended September 30,
2007 due to lower professional fees and lower operating expenses resulting from
lower mortgage origination volumes and the termination of employees as part of
the decision to discontinue new correspondent channel acquisitions, partially
offset by restructuring charges of $23 million in the third quarter of 2007
related to the decision to cease Decision One mortgage operations which consists
primarily of severance and lease termination costs and the decision to close a
loan underwriting, processing and collection facility in Carmel, Indiana.
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Customer loans for our Consumer segment can be further analyzed as follows:
INCREASES (DECREASES) FROM
-------------------------------
JUNE 30, SEPTEMBER 30,
2007 2006
SEPTEMBER 30, -------------- --------------
2007 $ % $ %
---------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Real estate secured......................... $ 88,814 $(1,481) (1.6)% $(5,303) (5.6)%
Auto finance................................ 12,860 154 1.2 516 4.2
Private label, including co-branded cards... 18,208 391 2.2 971 5.6
Personal non-credit card.................... 18,383 82 .4 461 2.6
-------- ------- ---- ------- ----
Total customer loans........................ $138,265 $ (854) (.6)% $(3,355) (2.4)%
======== ======= ==== ======= ====
--------
(1) Real estate secured receivables are comprised of the following:
INCREASES (DECREASES) FROM
---------------------------------
JUNE 30, SEPTEMBER 30,
2007 2006
SEPTEMBER 30, -------------- ----------------
2007 $ % $ %
-------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Mortgage Services............................. $38,872 $(2,654) (6.4)% $(12,783) (24.7)%
Consumer Lending.............................. 49,942 1,173 2.4 7,480 17.6
------- ------- ---- -------- -----
Total real estate secured..................... $88,814 $(1,481) (1.6)% $ (5,303) (5.6)%
======= ======= ==== ======== =====
Customer loans decreased 2 percent at September 30, 2007 as compared to $141.6
billion at September 30, 2006. Real estate secured loans decreased at September
30, 2007 as compared to the prior quarter. The decrease in real estate secured
loans in the quarter was primarily in our Mortgage Services portfolio as a
result of revisions to its business plan beginning in the second half of 2006
and continuing into 2007. These decisions have resulted in a significant
decrease in the Mortgage Services portfolio since September 30, 2006. This
attrition was partially offset by a decline in loan prepayments due to fewer
refinancing opportunities for our customers as a result of the previously
discussed trends impacting the mortgage lending industry as well as the higher
interest rate environment. We anticipate the attrition in this portfolio will
continue going forward. The decrease in our Mortgage Services portfolio was
partially offset by growth in our Consumer Lending branch business. Growth in
our branch-based Consumer Lending business improved due to higher sales volumes
and the decline in loan prepayments discussed above. Also contributing to the
increase in our Consumer Lending business was the acquisition of the $2.5
billion Champion portfolio in November 2006. However, we anticipate that the
actions we have taken to reduce risk going forward in our Consumer Lending
business as previously discussed, will significantly limit growth in the future.
Growth in our auto finance portfolio reflects organic growth principally in the
near-prime portfolio as a result of growth in our direct to consumer business.
The increase in our private label portfolio is due to organic growth and growth
in the co-branded card portfolio launched by our Retail Services operations
during the third quarter of 2006. Growth in our personal non-credit card
portfolio was the result of increased marketing in the second half of 2006,
including several large direct mail campaigns.
Compared to the prior quarter, customer loans decreased .6 percent. As discussed
above, actions taken at our Mortgage Services business combined with normal
portfolio attrition have resulted in a decline in the overall portfolio balance
at our Mortgage Services business since June 30, 2007. These decreases were
partially offset by real estate secured loan growth in our Consumer Lending
business. In addition, the rate of decline in loan prepayments has increased
during the third quarter of 2007 which has resulted in lower run-off rates for
our real estate secured portfolio. Growth in our auto finance portfolio reflects
continued growth in our direct to consumer business. The private label portfolio
increased from the prior quarter due to growth in the co-branded card portfolio
launched by our Retail Services operations during the third quarter of 2006.
ROA was (2.00) percent for the three months ended September 30, 2007 and (.31)
percent for the nine months ended September 30, 2007, compared to 1.24 percent
in the three months ended September 30, 2006 and 1.64 percent in
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the nine months ended September 30, 2006. The decrease in the ROA ratio in these
periods is primarily due to the increase in loan impairment charges as discussed
above, as well as higher average assets for the year-to-date period.
CREDIT CARD SERVICES SEGMENT The following table summarizes the IFRS Management
Basis results for our Credit Card Services segment:
INCREASE
(DECREASE)
--------------
THREE MONTHS ENDED SEPTEMBER 30 2007 2006 AMOUNT %
---------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income......................................... $ 377 $ 356 $ 21 5.9%
Net interest income................................ 900 737 163 22.1
Other operating income............................. 916 651 265 40.7
Loan impairment charges............................ 764 393 371 94.4
Operating expenses................................. 446 452 (6) (1.3)
Intersegment revenues.............................. 3 6 (3) (50.0)
Customer loans..................................... 29,585 26,357 3,228 12.2
Assets............................................. 29,162 26,879 2,283 8.5
Net interest margin, annualized.................... 12.03% 10.92% - -
Return on average assets........................... 5.16 5.26 - -
INCREASE
(DECREASE)
--------------
NINE MONTHS ENDED SEPTEMBER 30 2007 2006 AMOUNT %
--------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income.......................................... $1,050 $1,111 $(61) (5.5)%
Net interest income................................. 2,548 2,341 207 8.8
Other operating income.............................. 2,369 1,692 677 40.0
Loan impairment charges............................. 1,824 970 854 88.0
Operating expenses.................................. 1,423 1,321 102 7.7
Intersegment revenues............................... 13 16 (3) (18.8)
Net interest margin, annualized..................... 11.79% 11.92% - -
Return on average assets............................ 4.91 5.58 - -
Our Credit Card Services segment reported higher net income for the three months
ended September 30, 2007 and lower net income for the year-to-date period. The
increase in net income for the three months ended September 30, 2007 was
primarily due to higher net interest income, higher other operating income and
lower operating expenses, partially offset by higher loan impairment charges.
The decrease in net income for the year-to-date period was primarily due to
higher loan impairment charges and higher operating expenses, partially offset
by higher net interest income and higher other operating income. Loan impairment
charges were higher in the three and nine month periods ended September 30, 2007
due to higher delinquency levels as a result of receivable growth, a continued
shift in mix to higher levels of non-prime receivables and portfolio seasoning
as well as an increase in bankruptcy filings as compared to the year-ago periods
which benefited from reduced levels of personal bankruptcy filings following the
enactment of new bankruptcy law in the United States which went into effect in
October 2005. We increased loss reserves by recording loss provision greater
than net charge-off of $279 million in the three months ended September 30, 2007
and $437 million in the year-to-date period. We increased loss reserves by
recording loss provision greater than net charge-off of $121 million in the
three months ended September 30, 2006 and $183 million in the nine months ended
September 30, 2006.
Net interest income increased in both periods due to higher overall yields due
in part to higher levels of near-prime and non-prime customer loans, partially
offset by higher interest expense. Net interest margin increased in the three
months ended September 30, 2007 while net interest margin decreased in the year-
to-date period. Net interest
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margin decreased in the year-to-date period as net interest income during the
nine months ended September 30, 2006 benefited from the implementation of a
methodology for calculating the effective interest rate for introductory rate
credit card customer loans under IFRSs over the expected life of the product. Of
the amount recognized, $131 million increased net interest income during the
nine month period ended September 30, 2006 which otherwise would have been
recorded in prior periods. Excluding the impact of the above from net interest
margin, net interest margin increased in both periods primarily due to higher
overall yields due to increases in non-prime customer loans, higher pricing on
variable rate products and other pricing initiatives, partially offset by a
higher cost of funds.
Increases in other operating income resulted from loan growth which resulted in
higher late fees and overlimit fees and higher enhancement services revenue from
products such as Account Secure Plus (debt protection) and Identity Protection
Plan. Additionally, we recorded a gain of $113 million on the sale of our
portfolio of MasterCard Class B shares during the quarter. Higher operating
expenses for the nine months ended September 30, 2007 were also incurred to
support receivable growth including increases in marketing expenses.
Customer loans increased 12 percent compared to $26.4 billion at September 30,
2006. The increase reflects strong domestic organic growth in our General
Motors, Union Privilege, Metris and non-prime portfolios. Compared to June 30,
2007, customer loans increased 2 percent. The increase during the quarter was
due to growth in our Union Privilege, Metris and non-prime portfolios.
The decrease in ROA in the three and nine months ended September 30, 2007 is due
to higher average assets and for the nine month period the lower net income as
discussed above.
In the fourth quarter of 2007, the Credit Card Services business will be
initiating certain changes related to fee and finance charge billings as a
result of continuing reviews to ensure our practices reflect our brand
principles. Preliminary estimates of the potential impact of these changes are
based on numerous assumptions and take into account factors which are difficult
to predict, such as changes in customer behavior. We estimate that these changes
will reduce fee and finance charge income by approximately $50 million to $60
million in the fourth quarter of 2007 and approximately $225 million to $250
million in 2008.
We are also considering the sale of our General Motors MasterCard and Visa
portfolio to HSBC Bank USA in the future in order to maximize the efficient use
of capital and liquidity at each entity. The sale is subject to obtaining the
necessary regulatory and other approvals. We would, however, maintain the
customer account relationships and, subsequent to the initial receivable sale,
additional volume would be sold to HSBC Bank USA on a daily basis. At September
30, 2007, the GM Portfolio had an outstanding receivable balance of
approximately $6.7 billion. This bulk sale is expected to result in a
significant gain upon completion. In future periods, our net interest income,
fee income and provision for credit losses for GM credit card receivables would
be reduced, while other income would increase due to gains from continuing sales
of GM credit card receivables and receipt of servicing revenue on the portfolio
from HSBC Bank USA.
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INTERNATIONAL SEGMENT The following table summarizes the IFRS Management Basis
results for our International segment:
INCREASE
(DECREASE)
--------------
THREE MONTHS ENDED SEPTEMBER 30 2007 2006 AMOUNT %
---------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income (loss).................................. $ 6 $ (5) $ 11 100+%
Net interest income................................ 219 207 12 5.8
Other operating income............................. 56 59 (3) (5.1)
Loan impairment charges............................ 128 135 (7) (5.2)
Operating expenses................................. 135 118 17 14.4
Intersegment revenues.............................. 6 9 (3) (33.3)
Customer loans..................................... 10,370 9,398 972 10.3
Assets............................................. 11,033 10,864 169 1.6
Net interest margin, annualized.................... 8.65% 8.15% - -
Return on average assets........................... .20 (.17) - -
INCREASE
(DECREASE)
--------------
NINE MONTHS ENDED SEPTEMBER 30 2007 2006 AMOUNT %
--------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income (loss).................................... $ (115) $ 36 $(151) (100+)%
Net interest income.................................. 640 618 22 3.6
Other operating income............................... 151 174 (23) (13.2)
Loan impairment charges.............................. 537 363 174 47.9
Operating expenses................................... 405 349 56 16.0
Intersegment revenues................................ 17 25 (8) (32.0)
Net interest margin, annualized...................... 8.55% 8.21% - -
Return on average assets............................. (1.45) .43 - -
Our International segment reported net income for the three months ended
September 30, 2007 and a net loss for the year-to-date period. The net income in
the current quarter is primarily due to higher net interest income and lower
loan impairment charges, partially offset by higher operating expenses. The
year-to-date net loss reflects higher loan impairment charges, higher operating
expenses and lower other operating income, partially offset by higher net
interest income. Applying constant currency rates, which uses the average rate
of exchange for the 2006 quarter to translate current period net income, the net
income would not have been materially different for the three month period ended
September 30, 2007 and the net loss for the nine months ended September 30, 2007
would have been lower by $6 million.
Loan impairment charges decreased during the three months ended September 30,
2007 due to improvements in delinquency and charge-off in our U.K. operations
partially offset by an increase in delinquency and charge-off in our Canadian
operations due to receivable growth. Loan impairment charges increased during
the nine months ended September 30, 2007 due to receivable growth in our
Canadian operations and in our U.K. operations due to a refinement in the
methodology used to calculate roll rate percentages which is consistent with our
other business and we believe reflects a better estimate of probable losses
currently inherent in the loan portfolio and higher loss estimates for
restructured loans, partially offset by improvements in delinquency and charge-
off.
Net interest income increased during the three and nine months ended September
30, 2007 primarily as a result of higher receivable levels in our Canadian
subsidiary, partially offset by higher interest expense in our Canadian
operations and lower receivable levels in our U.K. operations. The lower
receivable levels in our U.K. subsidiary were due to decreased sales volumes
resulting from a continuing challenging credit environment in the U.K. as well
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as the sale of our European Operations in November 2006. Net interest margin
increased in both periods primarily due to higher yields on customer loans in
our U.K. operations as we have increased pricing on many of our products
reflecting the rising interest rates in the U.K., partially offset by the impact
of the sale of the European Operations in November 2006 as well as a higher cost
of funds in both our U.K. and Canadian operations.
Other operating income decreased in the three and nine months ended September
30, 2007 due to lower insurance revenues in the U.K. due to lower sales volumes
and a planned phase out of the use of a specific broker between January and
April 2007, partially offset by higher credit card fee income in our Canadian
operations. Operating expenses increased in both periods to support receivable
growth in our Canadian operations. In our U.K. operations, operating expenses
were higher due to higher legal fees, higher support services and in the year-
to-date period higher marketing expenses.
Customer loans for our International segment can be further analyzed as follows:
INCREASES (DECREASES) FROM
---------------------------
JUNE 30, SEPTEMBER 30,
2007 2006
SEPTEMBER 30, ----------- -------------
2007 $ % $ %
-------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Real estate secured........................... $ 4,249 $276 6.9% $ 806 23.4%
Auto finance.................................. 354 29 8.9 42 13.5
Credit card................................... 299 24 8.7 82 37.8
Private label................................. 2,613 256 10.9 525 25.1
Personal non-credit card...................... 2,855 (68) (2.3) (483) (14.5)
------- ---- ---- ----- -----
Total customer loans.......................... $10,370 $517 5.2% $ 972 10.3%
======= ==== ==== ===== =====
Customer loans were $10.4 billion at September 30, 2007 and $9.4 billion at
September 30, 2006. The increase was primarily as a result of foreign exchange
impacts. Applying constant currency rates, customer loans at September 30, 2007
would have been approximately $991 million lower. Excluding the positive foreign
exchange impacts, higher customer loans in our Canadian business were offset by
the impact of lower customer loans in our U.K. operations. The increase in our
Canadian business is due to growth in the real estate secured and credit card
portfolios. Lower personal non-credit card loans in the U.K. reflect lower
volumes as the U.K. branch network has placed a greater emphasis on secured
lending. Additionally, receivable levels at September 30, 2007 reflect the sale
in November 2006 of $203 million of customer loans related to our European
operations.
Compared to June 30, 2007, customer loans increased 5.2 percent. Applying
constant currency rates, customer loans at September 30, 2007 would have been
lower by approximately $384 million using June 30, 2007 exchange rates.
Excluding the foreign exchange impact, growth in the real estate secured and
credit card portfolios in our Canadian operations were partially offset by lower
receivable levels in all products in our U.K. operations, particularly personal
non-credit card, primarily due to lower branch sales.
ROA was .20 percent for the three months ended September 30, 2007 and (1.45)
percent for the nine months ended September 30, 2007 compared to (.17) percent
in the three months ended September 30, 2006 and .43 in the nine months ended
September 30, 2006. The increase in the ROA ratio for the three months ended
September 30, 2007 is primarily due to higher net interest income, lower loan
impairment charges and lower average assets. The decrease in the ROA ratio for
the nine months ended September 30, 2007 is primarily due to the increase in
loan impairment charges as discussed above, partially offset by lower average
assets.
As part of our continuing evaluation of strategic alternatives with respect to
our U.K. operations, we have entered into a non-binding agreement to sell the
capital stock of our U.K. Insurance Operations to a third party for cash. The
sales price is determined, in part, based on the actual net book value of the
assets sold at the time the sale is closed. The agreement also provides for the
purchaser to distribute insurance products through our U.K. branch network for
which we will receive commission revenue. The sale was completed November 1,
2007. In the first quarter of 2007, we began to report the U.K. Insurance
Operations as "Held for Sale." At September 30, 2007, we continue to
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classify the U.K. Insurance Operations as "Held for Sale" which included $416
million of assets and liabilities of $190 million within the International
segment. After taking into consideration the goodwill allocated to the U.K.
Insurance Operations of $79 million, which is included in the "All Other"
caption within our segment disclosures, the carrying value of the U.K. Insurance
Operations was higher than the estimated sales price. The adjustment to record
our investment in these operations at the lower of cost or market of $37 million
was recorded in the "All Other" caption in the first quarter of 2007 and no
additional adjustments have occurred subsequent to March 31, 2007. We continue
to evaluate the scope of our other U.K. operations.
CREDIT QUALITY
--------------------------------------------------------------------------------
We maintain credit loss reserves to cover probable losses of principal, interest
and fees, including late, overlimit and annual fees. Credit loss reserves are
based on a range of estimates and are intended to be adequate but not excessive.
We estimate probable losses for consumer receivables using a roll rate migration
analysis that estimates the likelihood that a loan will progress through the
various stages of delinquency, or buckets, and ultimately charge-off. This
analysis considers delinquency status, loss experience and severity and takes
into account whether loans are in bankruptcy, have been restructured or
rewritten, or are subject to forbearance, an external debt management plan,
hardship, modification, extension or deferment. Our credit loss reserves also
take into consideration the loss severity expected based on the underlying
collateral, if any, for the loan in the event of default. Delinquency status may
be affected by customer account management policies and practices, such as the
restructure of accounts, forbearance agreements, extended payment plans,
modification arrangements, external debt management programs, loan rewrites and
deferments. If customer account management policies, or changes thereto, shift
loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this
will be reflected in our roll rate statistics. To the extent that restructured
accounts have a greater propensity to roll to higher delinquency buckets, this
will be captured in the roll rates. Since the loss reserve is computed based on
the composite of all of these calculations, this increase in roll rate will be
applied to receivables in all respective delinquency buckets, which will
increase the overall reserve level. In addition, loss reserves on consumer
receivables are maintained to reflect our judgment of portfolio risk factors
that may not be fully reflected in the statistical roll rate calculation. Risk
factors considered in establishing loss reserves on consumer receivables include
recent growth, product mix, bankruptcy trends, geographic concentrations, loan
product features such as adjustable rate loans, economic conditions, such as
national and local trends in housing markets and interest rates, portfolio
seasoning, account management policies and practices, current levels of charge-
offs and delinquencies, changes in laws and regulations and other items which
can affect consumer payment patterns on outstanding receivables, such as natural
disasters and global pandemics.
While our credit loss reserves are available to absorb losses in the entire
portfolio, we specifically consider the credit quality and other risk factors
for each of our products. We recognize the different inherent loss
characteristics in each of our products as well as customer account management
policies and practices and risk management/collection practices. Charge-off
policies are also considered when establishing loss reserve requirements to
ensure the appropriate reserves exist for products with longer charge-off
periods. We also consider key ratios such as reserves to nonperforming loans,
reserves as a percentage of net charge-offs and number of months charge-off
coverage in developing our loss reserve estimate. Loss reserve estimates are
reviewed periodically and adjustments are reported in earnings when they become
known. As these estimates are influenced by factors outside of our control, such
as consumer payment patterns and economic conditions, there is uncertainty
inherent in these estimates, making it reasonably possible that they could
change.
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The following table summarizes credit loss reserves:
SEPTEMBER 30, JUNE 30, SEPTEMBER 30,
2007 2007 2006
---------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Owned credit loss reserves......................... $8,634 $7,157 $4,885
Reserves as a percent of:
Receivables...................................... 5.48% 4.53% 3.11%
Net charge-offs(1)............................... 124.1 112.7 107.3
Nonperforming loans.............................. 116.9 117.4 96.9
--------
(1) Quarter-to-date, annualized.
Credit loss reserve levels at September 30, 2007 increased as compared to June
30, 2007 as we recorded loss provision in excess of net charge-offs of $1,462
million during the three months ended September 30, 2007. This increase was
largely due to higher reserve requirements in our domestic real estate secured
portfolios, including second lien loans in our Mortgage Services portfolio and
in particular our Consumer Lending real estate secured portfolio. These
increases were due to a marked deterioration in credit performance across all
vintages, including 2007 originations, but in particular loans which were
originated in 2006, which, as previously discussed, resulted in a substantial
increase in delinquency and loss estimates. Higher reserve requirements were
also required in our Credit Card Services business reflecting higher receivable
balances, higher levels of delinquency due to portfolio seasoning, a shift in
mix to higher levels of non-prime receivables and higher levels of personal
bankruptcy filings.
Credit loss reserves at September 30, 2007 increased as compared to September
30, 2006 primarily as a result of the higher delinquency and loss estimates for
real estate secured and personal non-credit card receivables at our Mortgage
Services and Consumer Lending businesses. In addition, the higher credit loss
reserve levels are the result of higher levels of receivables due in part to
lower securitization levels, higher dollars of delinquency in our other
portfolios driven by growth and portfolio seasoning, higher loss estimates in
second lien loans purchased from 2004 through the third quarter of 2006 by our
Consumer Lending business as part of a second lien bulk acquisition program
which has subsequently been discontinued and increased levels of personal
bankruptcy filings, particularly at our Credit Card Services business, as
compared to the exceptionally low levels experienced in 2006 following enactment
of new bankruptcy legislation in the United States. Higher credit loss reserves
at September 30, 2007 also reflect a higher mix of non-prime receivables in our
Credit Card Services business. Credit loss reserves at our U.K. operations
increased as a result of a refinement in the methodology used to calculate roll
rate percentages which we believe reflects a better estimate of probable losses
currently inherent in the loan portfolio as well as higher loss estimates for
restructured loans.
As previously discussed, we are experiencing higher delinquency and loss
estimates at our Mortgage Services and Consumer Lending businesses as compared
to the prior quarter and the year-ago periods. In establishing reserve levels,
we considered the severity of losses expected to be incurred above our
historical experience given the current housing market trends in the United
States. During the third quarter, unprecedented turmoil in the mortgage lending
industry resulted in reduced liquidity in the marketplace for subprime
mortgages. In response, lenders have markedly tightened underwriting standards
and reduced the availability of subprime mortgages. As fewer financing options
currently exist in the marketplace for subprime customers, properties are
remaining on the market for longer periods of time which contributes to home
price depreciation. Therefore, it is now generally believed that the slowdown in
the housing market will be deeper in terms of its impact on housing prices and
the duration of this slowdown will be much longer than originally anticipated.
The combination of these factors has further reduced the refinancing
opportunities of some of our customers as the ability to refinance and access
any equity in their homes is no longer an option to some of customers as home
price appreciation remains stagnant in many markets and depreciates in others.
As a result, the impact of these industry trends on our portfolio during the
quarter has worsened, resulting in higher charge-off and loss estimates in our
Mortgage Services and Consumer Lending real estate secured receivable
portfolios. We have considered these factors in establishing our credit loss
reserve levels.
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We also considered the ability of borrowers to repay their first lien adjustable
rate mortgage loans at higher contractual reset rates given increases in
interest rates by the Federal Reserve Bank from June 2004 through June 2006, as
well as their ability to repay any underlying second lien mortgage outstanding.
Because first lien adjustable rate mortgage loans are generally well secured,
ultimate losses associated with such loans are dependent to a large extent on
the status of the housing market and interest rate environment. Therefore,
although it is probable that incremental losses will occur as a result of rate
resets on first lien adjustable rate mortgage loans, such losses are estimable
and, therefore, included in our credit loss reserves only in situations where
the payment has either already reset or will reset in the near term.
Additionally, a significant portion of our second lien Mortgage Services
mortgages are subordinate to a first lien adjustable rate loan. For customers
with second lien mortgage loans that are subordinate to a first lien adjustable
rate mortgage loan, the probability of repayment of the second lien mortgage
loan is significantly reduced. The impact of future changes, if any, in the
housing market will not have a significant impact on the ultimate loss expected
to be incurred since these loans, based on history and other factors, are
expected to perform like unsecured loans.
Reserves as a percentage of receivables were higher than at September 30, 2006
and June 30, 2007 due to the impact of the additional reserve requirements
discussed above and, compared to June 30, 2007, lower receivable levels due to
attrition, including refinance and charge-off. Reserves as a percentage of net
charge-offs were higher than at September 30, 2006 and June 30, 2007 as the
increase in reserve levels outpaced the increase in net charge-off during the
period. Reserves as a percentage of nonperforming loans were broadly in line
with June 30, 2007 but increased as compared to September 30, 2006 as reserve
levels increased at a higher rate than the increase in non-accrual loans driven
by an increase in 30-and 60-day delinquency due to seasoning in the Consumer
Lending, Mortgage Services and Credit Card Services businesses.
DELINQUENCY
The following table summarizes two-months-and-over contractual delinquency (as a
percent of consumer receivables):
SEPTEMBER 30, JUNE 30, SEPTEMBER 30,
2007 2007 2006
---------------------------------------------------------------------------------------------
Real estate secured(1)............................. 5.50% 4.28% 2.98%
Auto finance....................................... 3.40 2.93 3.16
Credit card........................................ 5.23 4.45 4.53
Private label...................................... 4.86 5.12 5.61
Personal non-credit card........................... 11.90 10.72 9.69
----- ----- ----
Total consumer..................................... 6.13% 5.08% 4.19%
===== ===== ====
--------
(1) Real estate secured two-months-and-over contractual delinquency (as a
percent of consumer receivables) are comprised of the following:
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SEPTEMBER 30, JUNE 30, SEPTEMBER 30,
2007 2007 2006
---------------------------------------------------------------------------------------------
Mortgage Services:
First lien....................................... 8.27% 6.39% 3.80%
Second lien...................................... 11.20 8.06 3.70
----- ---- ----
Total Mortgage Services............................ 8.86 6.74 3.78
Consumer Lending:
First lien....................................... 2.90 2.13 1.84
Second lien...................................... 5.01 3.57 2.44
----- ---- ----
Total Consumer Lending............................. 3.19 2.33 1.92
Foreign and all other:
First lien....................................... 2.49 2.25 1.52
Second lien...................................... 4.30 4.47 5.56
----- ---- ----
Total Foreign and all other........................ 3.87 3.98 4.72
----- ---- ----
Total real estate secured.......................... 5.50% 4.28% 2.98%
===== ==== ====
Total delinquency increased 105 basis points, compared to the prior quarter.
With the exception of our private label portfolio, we experienced higher
delinquency levels across all products. During the quarter, the real estate
secured two-months-and-over contractual delinquency ratio was negatively
impacted by higher delinquency levels in our Mortgage Services and Consumer
Lending businesses. This increase resulted from the weak housing and mortgage
industry and lower real estate secured receivables growth driven by our strategy
to discontinue new correspondent channel acquisitions by our Mortgage Services
business which reduced the outstanding principal balance of the Mortgage
Services loan portfolio. Our credit card portfolio also reported an increase in
the two-months-and-over contractual delinquency ratio due to a shift in mix to
higher levels of non-prime receivables, and seasoning of a growing portfolio.
Two-months-and-over contractual delinquency as a percentage of consumer
receivables was higher compared to the prior quarter in our auto finance
portfolio reflecting seasoning of a growing portfolio and normal seasonal
patterns. The decrease in delinquency in our private label portfolio (which
primarily consists of our foreign private label portfolio and domestic retail
sales contracts that were not sold to HSBC Bank USA in December 2004) reflects
receivable growth in our foreign portfolios. The increase in delinquency in our
personal non-credit card portfolio ratio reflects maturation of a growing
domestic portfolio, and a deterioration of 2006 vintages originated through the
direct mail channel in certain geographic regions in our domestic portfolio.
Dollars of delinquency increased markedly compared to the prior quarter
reflecting the increases in delinquency in our real estate secured portfolios as
well as lower real estate secured run-off in the quarter as market conditions
have reduced refinancing and liquidation opportunities for our customers. The
increases in other products primarily reflect higher levels of receivables,
higher bankruptcy levels and portfolio seasoning.
Compared to the year-ago period, total delinquency increased 194 basis points
largely due to higher real estate secured delinquency levels primarily at our
Mortgage Services and Consumer Lending businesses. As discussed above, with the
exception of our private label portfolio, we experienced higher delinquency
levels across all products. As compared to the year-ago period, the increase in
the Consumer Lending real estate delinquency ratio also reflects the addition of
the Champion portfolio. While the Champion portfolio carries higher delinquency,
its low loan-to-value ratios are expected to result in lower charge-offs
compared to the existing portfolio. Our credit card portfolio reported a marked
increase in the two-months-and-over contractual delinquency ratio due to a shift
in mix to higher levels of non-prime receivables, seasoning of a growing
portfolio and higher levels of personal bankruptcy filings as compared to the
exceptionally low levels experienced in 2006 following enactment of new
bankruptcy legislation in the United States. The increase in auto finance
portfolio ratio reflects seasoning of a growing portfolio, receivable growth and
weakening performance of certain 2006 originations. The increase in delinquency
in our personal non-credit card portfolio ratio reflects maturation of a growing
domestic portfolio, and a deterioration of 2006 vintages as discussed above.
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NET CHARGE-OFFS OF CONSUMER RECEIVABLES
The following table summarizes net charge-offs of consumer receivables (as a
percent, annualized, of average consumer receivables):
SEPTEMBER 30, JUNE 30, SEPTEMBER 30,
2007 2007 2006
---------------------------------------------------------------------------------------------
Real estate secured(1)............................. 2.47% 2.18% .98%
Auto finance....................................... 4.47 3.16 3.69
Credit card........................................ 7.00 6.85 5.52
Private label...................................... 5.15 5.76 5.65
Personal non-credit card........................... 9.04 8.44 7.77
---- ---- ----
Total.............................................. 4.40% 3.96% 2.92%
==== ==== ====
Real estate secured net charge-offs and REO expense
as a percent of average real estate secured
receivables...................................... 2.89% 2.26% 1.11%
--------
(1) Real estate secured net charge-off of consumer receivables as a percent,
annualized, of average consumer receivables are comprised of the following:
SEPTEMBER 30, JUNE 30, SEPTEMBER 30,
2007 2007 2006
--------------------------------------------------------------------------------------------
Mortgage Services:
First lien...................................... 1.93% 1.20% .75%
Second lien..................................... 13.90 11.82 2.11
----- ----- ----
Total Mortgage Services........................... 4.36 3.32 1.06
Consumer Lending:
First lien...................................... .74 .56 .84
Second lien..................................... 3.58 5.37 1.22
----- ----- ----
Total Consumer Lending............................ 1.13 1.22 .90
Foreign and all other:
First lien...................................... .81 1.30 .38
Second lien..................................... 1.39 2.23 .91
----- ----- ----
Total Foreign and all other....................... 1.25 2.03 .81
----- ----- ----
Total real estate secured......................... 2.47% 2.18% .98%
===== ===== ====
Net charge-offs as a percent, annualized, of average consumer receivables
increased 44 basis points compared to the prior quarter. With the exception of
private label, all products reported higher charge-offs during the quarter, with
the most significant increase occurring in our real estate secured portfolio, in
particular at our Mortgage Services business. Net real estate secured charge-
offs as a percent, annualized, of average real estate secured receivables was
also negatively impacted by lower receivables growth driven largely by our
strategy to discontinue new correspondent channel acquisitions as well as the
sale of $2.2 billion in the second quarter of 2007 which together significantly
reduced the average outstanding principal balance of the Mortgage Services loan
portfolio. The Consumer Lending real estate secured net charge-off ratio
decreased in the quarter as charge-offs were essentially flat while average
receivable balances were higher due to receivable growth and lower run-off. The
increase in auto finance net charge-offs reflects normal seasonal patterns. The
increase in our credit card ratio reflects seasoning of a growing portfolio. The
personal non-credit card charge-off ratio increased reflecting portfolio
seasoning as well as deterioration of 2006 vintages originated through the
direct mail channel in certain geographic regions.
As compared to the prior year quarter, net charge-offs as a percent, annualized,
of average consumer receivables increased 148 basis points primarily due to the
higher charge-offs in our real estate secured portfolios discussed above, as
well as higher charge-offs in our auto finance, credit card and personal non-
credit card portfolios. Net real
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estate secured charge-offs as a percent, annualized, of average real estate
secured receivables was also negatively impacted by lower receivables growth as
discussed above. The increase in charge-offs in the credit card portfolio is due
to increased levels of personal bankruptcy filings as compared to the
exceptionally low levels experienced in 2006 following enactment of the new
bankruptcy law in the United States and higher receivable balances. The increase
in the auto finance portfolio is due to seasoning of a growing portfolio and
weakened performance of certain 2006 originations. The private label charge-off
ratio decreased compared to the prior year quarter primarily due to higher
levels of average receivables in our foreign operations, partially offset by
portfolio seasoning. The personal non-credit card charge-off ratio increased
reflecting portfolio seasoning and receivable growth as well as deterioration of
2006 vintages as discussed above.
NONPERFORMING ASSETS
SEPTEMBER 30, JUNE 30, SEPTEMBER 30,
2007 2007 2006
---------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Nonaccrual receivables(1).......................... $6,292 $5,173 $4,199
Accruing consumer receivables 90 or more days
delinquent....................................... 1,091 924 840
Renegotiated commercial loans...................... - 1 1
------ ------ ------
Total nonperforming receivables.................... 7,383 6,098 5,040
Real estate owned.................................. 977 861 629
------ ------ ------
Total nonperforming assets......................... $8,360 $6,959 $5,669
====== ====== ======
Credit loss reserves as a percent of nonperforming
receivables...................................... 116.9% 117.4% 96.9%
--------
(1) Nonaccrual receivables are comprised of the following:
SEPTEMBER 30, JUNE 30, SEPTEMBER 30,
2007 2007 2006
--------------------------------------------------------------------------------------------
(IN MILLIONS)
Real estate secured:
Closed-end:
First lien...................................... $2,754 $2,139 $1,594
Second lien..................................... 682 520 372
Revolving:
First lien...................................... 19 19 23
Second lien..................................... 297 236 124
------ ------ ------
Total real estate secured......................... 3,752 2,914 2,113
Auto finance...................................... 443 378 383
Credit card....................................... - - -
Private label..................................... 73 72 77
Personal non-credit card.......................... 2,024 1,809 1,626
Commercial and other.............................. - - -
------ ------ ------
Total nonaccrual receivables...................... $6,292 $5,173 $4,199
====== ====== ======
Compared to June 30, 2007, the increase in total nonperforming assets is
primarily due to higher levels of real estate secured nonaccrual receivables at
our Mortgage Services and Consumer Lending businesses due to the higher overall
delinquency levels as previously discussed. Real estate secured nonaccrual loans
included stated income loans at our Mortgage Services business of $894 million
at September 30, 2007, $718 million at June 30, 2007 and $396 million at
September 30, 2006. Consistent with industry practice, accruing consumer
receivables 90 or more days delinquent includes domestic credit card
receivables.
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ACCOUNT MANAGEMENT POLICIES AND PRACTICES
Our policies and practices for the collection of consumer receivables, including
our customer account management policies and practices, permit us to modify the
terms of loans, either temporarily or permanently, and/or to reset the
contractual delinquency status of an account to current, based on indicia or
criteria which, in our judgment, evidence continued payment probability. Such
policies and practices vary by product and are designed to manage customer
relationships, maximize collection opportunities and avoid foreclosure or
repossession if reasonably possible. If the account subsequently experiences
payment defaults, it will again become contractually delinquent.
The tables below summarize approximate restructuring statistics in our managed
basis domestic portfolio. Managed basis assumes that securitized receivables
have not been sold and remain on our balance sheet. We report our restructuring
statistics on a managed basis only because the receivables that we securitize
are subject to underwriting standards comparable to our owned portfolio, are
generally serviced and collected without regard to ownership and result in a
similar credit loss exposure for us. As the level of our securitized receivables
have fallen over time, managed basis and owned basis results have now largely
converged. As previously reported, in prior periods we used certain assumptions
and estimates to compile our restructure statistics. The systemic counters used
to compile the information presented below exclude from the reported statistics
loans that have been reported as contractually delinquent but have been reset to
a current status because we have determined that the loans should not have been
considered delinquent (e.g., payment application processing errors). When
comparing restructuring statistics from different periods, the fact that our
restructure policies and practices will change over time, that exceptions are
made to those policies and practices, and that our data capture methodologies
have been enhanced, should be taken into account.
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TOTAL RESTRUCTURED BY RESTRUCTURE PERIOD - DOMESTIC PORTFOLIO(1)
(MANAGED BASIS)
SEPTEMBER 30, JUNE 30, SEPTEMBER 30,
2007 2007 2006
--------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Never restructured................................ 85.3% 86.8% 89.8%
Restructured:
Restructured in the last 6 months............... 6.3 5.6 3.9
Restructured in the last 7-12 months............ 4.5 3.8 2.6
Previously restructured beyond 12 months........ 3.9 3.8 3.7
------- ------- -------
Total ever restructured(2)...................... 14.7 13.2 10.2
------- ------- -------
Total............................................. 100.0% 100.0% 100.0%
======= ======= =======
TOTAL RESTRUCTURED BY PRODUCT - DOMESTIC
PORTFOLIO(1)
(MANAGED BASIS)
Real estate secured............................... $14,944 $12,923 $ 8,915
Auto finance...................................... 2,019 1,953 1,799
Credit card....................................... 785 799 901
Private label(3).................................. 28 30 28
Personal non-credit card.......................... 3,949 3,825 3,477
------- ------- -------
Total............................................. $21,725 $19,530 $15,120
======= ======= =======
(AS A PERCENT OF MANAGED RECEIVABLES)
Real estate secured............................... 17.2% 14.6% 9.7%
Auto finance...................................... 15.7 15.4 14.6
Credit card....................................... 2.7 2.8 3.4
Private label(3).................................. 16.6 14.1 7.9
Personal non-credit card.......................... 21.4 20.8 19.3
------- ------- -------
Total(2).......................................... 14.7% 13.2% 10.2%
======= ======= =======
--------
(1) Excludes foreign businesses, commercial and other.
(2) Total including foreign businesses was 14.1 percent at September 30, 2007,
12.7 percent at June 30, 2007, and 9.9 percent at September 30, 2006.
(3) Only reflects consumer lending retail sales contracts which have
historically been classified as private label. All other domestic private
label receivables were sold to HSBC Bank USA in December 2004.
(4) The Mortgage Services and Consumer Lending businesses real estate secured
restructures are as shown in the following table:
SEPTEMBER 30, JUNE 30, SEPTEMBER 30,
2007 2007 2006
--------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Mortgage Services................................. $ 6,965 $ 5,728 $2,895
Consumer Lending.................................. 7,979 7,195 6,020
------- ------- ------
Total real estate secured......................... $14,944 $12,923 $8,915
======= ======= ======
The increase in restructured loans was primarily attributable to higher
delinquency due to portfolio growth and seasoning, including our Mortgage
Services and Consumer Lending businesses as we continue to work with our
customers who, in our judgment, evidence continued payment probability.
Additionally, beginning in the fourth quarter of 2006, we expanded the use of
account modification at our Mortgage Services business to modify the rate
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and/or payment on a number of qualifying delinquent loans and restructured
certain of those accounts after receipt of one modified payment and if certain
other criteria were met. Such accounts are included in the above restructure
statistics beginning in the fourth quarter of 2006. At September 30, 2007, we
have approximately 23,000 accounts in our Mortgage Services and Consumer Lending
real estate secured portfolios which have been restructured and delinquency
reset and whose loan terms were also modified. The outstanding receivable
balance of these restructured and modified loans was $2.5 billion at September
30, 2007. These loans are included in the restructure statistics reported above.
See "Credit Quality Statistics" for further information regarding delinquency,
charge-offs and nonperforming loans.
The amount of domestic and foreign managed receivables in forbearance,
modification (excluding Mortgage Services loans for September 30, 2007 and June
30, 2007 discussed in the following paragraph), credit card services approved
consumer credit counseling accommodations, rewrites or other customer account
management techniques for which we have reset delinquency and that is not
included in the restructured or delinquency statistics was approximately $.3
billion or .2 percent of managed receivables at September 30, 2007 and June 30,
2007 and $.4 billion or .2 percent of managed receivables at September 30, 2006.
As part of our risk mitigation efforts relating to the affected components of
the Mortgage Services portfolio, in October 2006 we established a new program
specifically designed to meet the needs of select customers with ARMs. We are
proactively writing and calling customers who have adjustable rate mortgage
loans nearing the first reset that we expect will be the most impacted by a rate
adjustment. Through a variety of means, we assess their ability to make the
adjusted payment and, as appropriate and in accordance with defined policies, we
modify the loans, allowing time for the customer to seek alternative financing
or improve their individual situation. These loan modifications primarily
involve a twelve-month temporary interest rate relief by either maintaining the
current interest rate for the entire twelve-month period or resetting the
interest rate for the twelve-month period to a rate lower than originally
required at the first reset date. At the end of the twelve-month period, the
interest rate on the loan will reset in accordance with the original loan terms
unless the borrower qualifies for and is granted a new modification. Since the
inception of this program, we have made more than 31,000 outbound contacts and
modified more than 8,000 loans with an aggregate balance of $1.2 billion. These
loans are not included in the table above, as we have not reset delinquency on
these loans as they were not contractually delinquent at the time of the
modification. However, if the loan had been restructured in the past for other
reasons, it is included in the table above. We also continue to manage a
Foreclosure Avoidance Program for delinquent Consumer Lending customers designed
to provide relief to qualifying homeowners through either loan restructuring or
modification. We also support a variety of national and local efforts in
homeownership preservation and foreclosure avoidance.
72
This information is provided by RNS
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