HSBC USA 10-Q - Part 2

HSBC Holdings PLC 31 July 2006 PART 2 OF 2 ----------------------------------------------------------------------------------------------------------- Increase (Decrease) ------------------- Six months ended June 30 2006 2005 Amount % ----------------------------------------------------------------------------------------------------------- ($ in millions) Trust income $ 44 $ 45 $ (1) (2) Service charges: HSBC affiliate income 7 8 (1) (13) Other service charges 97 97 -- -- ------- ------- ------- ------- 104 105 (1) (1) ------- ------- ------- ------- Credit card fees 261 118 143 121 Other fees and commissions: Letter of credit fees 36 35 1 3 Wealth and tax advisory services 48 29 19 66 HSBC affiliate income 23 36 (13) (36) Other fee-based income, net of referral fees 109 71 38 54 ------- ------- ------- ------- 216 171 45 26 ------- ------- ------- ------- Securitization revenue 19 69 (50) (72) Other income: Insurance 24 32 (8) (25) HSBC affiliate income 102 23 79 343 Additional valuation allowance for reductions in market value of loans held for sale to HMUS (152) -- (152) * Gains on sale of property and other financial assets 16 46 (30) (65) Other 89 54 35 65 ------- ------- ------- ------- 79 155 (76) (49) ------- ------- ------- ------- Residential mortgage banking revenue 50 10 40 400 Trading revenues 548 131 417 318 Securities gains, net 10 87 (77) (89) ------- ------- ------- ------- Total other revenues $ 1,331 $ 891 $ 440 49 ======= ======= ======= ======= * Not meaningful. All increases and decreases referred to below for the second quarter and for the first six months of 2006 represent comparisons with the same 2005 periods. Credit Card Fees Increased credit card fees in the second quarter and in the first six months of 2006 primarily resulted from the following private label credit card portfolio activity: o increased number of accounts and average receivable balances associated with the private label credit card portfolio; o increased late fees and other fees; and o lower payments to merchant partners due to terminations and revisions to certain merchant agreements. Other Fees and Commissions Increased wealth and tax advisory services revenue in the second quarter and in the first six months of 2006 resulted from expansion of services offered to high net worth individuals within the PB business segment. The increase in other fee-based income is due to: o new service fees recorded within the CIBM business segment generated by a subsidiary transferred to HUSI from HSBC in March 2005, which provides accounting and valuation services for hedge fund clients; and o various growth initiatives undertaken in 2005 and 2006, which resulted in general increases in fee income recorded within the PFS, CMB and CIBM business segments. 42 Securitization Revenue Securitization revenue is comprised of servicing revenue and excess servicing spread from residual interests in securitized private label credit card receivables. Existing securitized trusts require replenishments of receivables to support previously issued securities. Receivables will continue to be sold to these trusts until their revolving periods end, the last of which is expected to occur in 2007. All collateralized funding transactions have been structured as secured financings since the third quarter of 2004. Therefore, there were no new securitization transactions during 2005 or 2006. The decrease in securitization revenue for the second quarter and for the first six months of 2006 is attributable to decreased levels of receivables maintained within existing securitized trusts. As the balance requirements of these trusts have decreased, receivables maintained on HUSI's consolidated balance sheet have increased, resulting in increased net interest income. Additional analysis of securitization activities is provided in Off-Balance Sheet Arrangements beginning on page 64 of this Form 10-Q. Other Income Increased HSBC affiliate income for the second quarter and for the first six months of 2006 primarily resulted from gains realized from sales of residential mortgage loans to HMUS. Additional valuation adjustments for reductions in market value of residential mortgage loans held for resale to HMUS also relate to this program, which began in the third quarter of 2005. Additional revenues related to this program are recorded in trading revenues (refer to pages 47-48 of this Form 10-Q). Additional information regarding these loan sales is provided in the Executive Overview on page 28 of this Form 10-Q. Gains on sale of property and other financial assets include the following material transactions for 2006 and 2005: o gains for the second quarter of 2006 include a $13 million gain from the redemption of Brady Bonds (refer to commentary on page 29 of this Form 10-Q); and o gains for the second quarter of 2005 included a gain of $26 million from the sale of property, as well as additional gains of $6 million from sales of various branches. Other includes the following material transactions and/or activity for 2006 and 2005: o in the second quarter of 2006, MasterCard International, Inc. completed an initial public offering, which resulted in redemption of shares held by HUSI and by other financial institutions. Proceeds of $7 million from this redemption of shares was recorded in other income in the quarter; and o earnings from various equity investments, which were recorded in the first quarter of 2006, were $16 million higher than those recorded for 2005. 43 Residential Mortgage Banking Revenue The following table presents the components of residential mortgage banking revenue. Net interest income includes interest earned/paid on assets and liabilities of the residential mortgage banking business as well as an allocation of the funding cost or benefit associated with these balances. The net interest income component in the table is included in net interest income in the consolidated statement of income and reflects actual interest earned, net of cost of funds, and adjusted for corporate transfer pricing. ---------------------------------------------------------------------------------------------------------- Increase (Decrease) ------------------- Three months ended June 30 2006 2005 Amount % ---------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income $ 87 $ 118 $ (31) (26) ----- ----- ------- ------ Servicing related income: Servicing fee income 24 19 5 26 Changes in fair value of MSRs due to (1): Changes in valuation inputs or assumptions used in valuation model 30 -- 30 * Realization of cash flows (18) -- (18) * MSRs amortization (2) -- (18) 18 * MSRs temporary impairment provision (2) -- (35) 35 * Trading - Derivative instruments used to offset changes in value of MSRs (23) 24 (47) (196) ----- ----- ------- ------ 13 (10) 23 * ----- ----- ------- ------ Originations and sales related income: Gains on sales of residential mortgages 8 11 (3) (27) Trading and fair value hedge activity (3) -- (19) 19 * ----- ----- ------- ------ 8 (8) 16 * ----- ----- ------- ------ Other mortgage income 6 5 1 20 ----- ----- ------- ------ Total residential mortgage banking revenue (expense) included in other revenues 27 (13) 40 * ----- ----- ------- ------ Total residential mortgage banking related revenue $ 114 $ 105 $ 9 9 ===== ===== ======= ====== (1) Based upon adoption of SFAS 156 effective January 1, 2006. Refer to Note 6 of the consolidated financial statements, beginning on page 13 of this Form 10-Q for further discussion. (2) Based upon methodology existing prior to adoption of SFAS 156. (3) Includes SFAS 133 qualifying fair value adjustments related to residential mortgage banking warehouse fair value hedging activity, which was discontinued in 2005, and other immaterial activity. * Not meaningful. 44 -------------------------------------------------------------------------------------------------------------- Increase (Decrease) ------------------- Six months ended June 30 2006 2005 Amount % -------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income $ 182 $ 246 $ (64) (26) ------- ------- ------- -------- Servicing related income: Servicing fee income 48 37 11 30 Changes in fair value of MSRs due to (1): Changes in valuation inputs or assumptions used in valuation model 75 -- 75 * Realization of cash flows (39) -- (39) * MSRs amortization (2) -- (37) 37 * MSRs temporary impairment provision (2) -- (18) 18 * Trading - Derivative instruments used to offset changes in value of MSRs (57) 19 (76) (400) ------- ------- ------- -------- 27 1 26 2,600 ------- ------- ------- -------- Originations and sales related income: Gains on sales of residential mortgages 11 15 (4) (27) Trading and fair value hedge activity (3) 1 (15) 16 * ------- ------- ------- -------- 12 -- 12 * ------- ------- ------- -------- Other mortgage income 11 9 2 22 ------- ------- ------- -------- Total residential mortgage banking revenue included in other revenues 50 10 40 400 ------- ------- ------- -------- Total residential mortgage banking related revenue $ 232 $ 256 $ (24) (9) ======= ======= ======= ======== (1) Based upon adoption of SFAS 156 effective January 1, 2006. Refer to Note 6 of the consolidated financial statements, beginning on page 13 of this Form 10-Q for further discussion. (2) Based upon methodology existing prior to adoption of SFAS 156. (3) Includes SFAS 133 qualifying fair value adjustments related to residential mortgage banking warehouse fair value hedging activity, which was discontinued in 2005, and other immaterial activity. * Not meaningful. All increases and decreases referenced below for the second quarter and for the first six months of 2006 represent comparisons with the same 2005 periods. Net Interest Income Decreased net interest income for the second quarter and for the first six months of 2006 resulted from the following activity: o in 2005, HUSI commenced a strategic balance sheet initiative to sell the majority of new loan production to government sponsored enterprises and private investors, which continued into 2006, and which decreased average residential mortgage loan outstandings. The held loan portfolio is expected to continue to decline for the remainder of 2006 as a result of this initiative; and o despite a rising residential mortgage interest rate environment, interest rate spreads narrowed slightly during 2006 due to higher funding costs. Additional commentary regarding residential mortgage interest income is provided on page 37 of this Form 10-Q. 45 Servicing Related Income Increased net servicing related income for the second quarter and for the first six months of 2006 resulted from: o increased volume of loans included within the average serviced loans portfolio, which increased approximately 25% for the first six months of 2006 due to the following factors: - HUSI sold a higher proportion of adjustable rate loans in 2005 and 2006, which previously would have been held on the balance sheet; - in the fourth quarter of 2005, HUSI commenced servicing a portfolio of loans previously serviced by a third party; and - also in the fourth quarter of 2005, HUSI completed a sale of loans, which were previously held in portfolio, to a government agency for which it continues to provide servicing. o increased value of MSRs, net of economic hedges. The generally increasing residential mortgage interest rate environment has resulted in a reduction in prepayments in 2006, which has increased the long-term value of MSRs. In addition, HUSI's adoption of SFAS 156 (refer to Note 6 of the consolidated financial statements, beginning on page 13 of this Form 10-Q) resulted in the recognition of higher fair market values for MSRs recorded on the consolidated balance sheet. Additional commentary regarding risk management associated with the MSRs hedging program is provided on pages 70-71 of this Form 10-Q. Originations and Sales Related Income (Expense) Increased originations and sales related income for the second quarter and for the first six months of 2006 resulted from: o higher basis point gains on individual sales of residential mortgages; and o increased volume of residential mortgages originated with the intention to sell, which increased 24% for the first six months of 2006. 46 Trading Revenues Trading revenues are generated by HUSI's participation in foreign exchange, credit derivative and precious metals markets; from trading derivative contracts, including interest rate swaps and options; and from trading securities. During 2005, HUSI's CIBM business segment expanded operations and products offered to clients, which resulted in increased trading activity and improved trading results in 2005 and 2006. Decreased net interest income for 2006 was primarily due to steadily rising short-term interest rates during 2005 and 2006, which had an adverse impact on interest rate spreads. Trading related revenues generated by the CIBM business segment, summarized by type of product, are provided in the following table. The data in the table includes interest income earned on trading instruments, net of allocated funding cost associated with the trading positions. The net interest income component is included in net interest income on the consolidated statement of income. Trading revenues related to the residential mortgage banking business are included in residential mortgage banking revenue. ------------------------------------------------------------------------------- Increase (Decrease) ------------------- Three months ended June 30 2006 2005 Amount % ------------------------------------------------------------------------------- ($ in millions) Trading revenues $ 269 $ 35 $ 234 669 Net interest (expense) income (17) 4 (21) (525) ------- ------- ------- --------- Trading related revenues $ 252 $ 39 $ 213 546 ======= ======= ======= ========= Business: Derivatives instruments $ 83 $ 18 $ 65 361 Economic hedges of loans held for sale to HMUS 70 -- 70 * Treasury (primarily securities) 4 (11) 15 * Foreign exchange and banknotes 52 26 26 100 Precious metals 36 8 28 350 Other trading 7 (2) 9 * ------- ------- ------- --------- Trading related revenues $ 252 $ 39 $ 213 546 ======= ======= ======= ========= * Not meaningful. ------------------------------------------------------------------------------- Increase (Decrease) ------------------- Six months ended June 30 2006 2005 Amount % ------------------------------------------------------------------------------- ($ in millions) Trading revenues $ 548 $ 131 $ 417 318 Net interest (expense) income (31) 21 (52) (248) ------- ------- ------- --------- Trading related revenues $ 517 $ 152 $ 365 240 ======= ======= ======= ========= Business: Derivatives instruments $ 173 $ 59 $ 114 193 Economic hedges of loans held for sale to HMUS 154 -- 154 * Treasury (primarily securities) 9 3 6 200 Foreign exchange and banknotes 95 63 32 51 Precious metals 71 25 46 184 Other trading 15 2 13 650 ------- ------- ------- --------- Trading related revenues $ 517 $ 152 $ 365 240 ======= ======= ======= ========= * Not meaningful. 47 Derivative Instruments Net interest income related to derivatives businesses decreased $26 million and $51 million for the second quarter and for the first six months of 2006 respectively, as compared with the same 2005 periods, due to the rising short-term interest rate environment. HUSI recognizes gain or loss at the inception of derivative transactions only when the fair value of the transaction can be verified to market transactions or if all significant pricing model assumptions can be verified to observable market data. Gain or loss not recognized at inception is recorded in trading liabilities and recognized over the term of the derivative contract in correlation with outstanding risk and valuation characteristics. In addition, derivatives trading revenues increased during 2006 as a result of increased revenue from the credit derivatives trading and structured transactions businesses, which were significantly expanded during 2005. Economic Hedges of Loans Held for Sale to HMUS Effective from the third quarter of 2005, HUSI maintains a portfolio of derivative instruments that are utilized as economic hedges to offset changes in market values of loans held for sale to HMUS. During the second quarter of 2006, HUSI realized $52 million of trading revenues and $18 million of net interest income related to this portfolio. During the first six months of 2006, HUSI realized $116 million of trading revenues and $38 million of net interest income. Further analysis and commentary regarding these loans and the associated hedges is provided on page 28 of this Form 10-Q. Precious Metals Precious metals trading income increased due to increased client and proprietary trading activity from both domestic and foreign trading desks, which resulted from higher precious metals prices. Partially offsetting increased trading revenues was decreased net interest income resulting from rising short-term interest rates. Securities Gains, Net HUSI maintains various securities portfolios as part of its strategies for overall liquidity, balance sheet diversification and risk management. The following tables summarize net securities gains resulting from various strategies. ------------------------------------------------------------------------------- 2006 2005 ------------------------------------------------------------------------------- (in millions) Three months ended June 30 Balance sheet diversity and reduction of risk $ -- $ 15 Sale of foreign equity fund -- 48 Other 6 1 ------- ------- Total securities gains, net $ 6 $ 64 ======= ======= Six months ended June 30 Balance sheet diversity and reduction of risk $ 4 $ 27 Reduction of Latin American exposure -- 10 Sale of foreign equity fund -- 48 Other 6 2 ------- ------- Total securities gains, net $ 10 $ 87 ======= ======= 48 Operating Expenses The following table presents the components of operating expenses. ------------------------------------------------------------------------------------------------ Increase (Decrease) ------------------- Three months ended June 30 2006 2005 Amount % ------------------------------------------------------------------------------------------------ ($ in millions) Salaries and employee benefits: Salaries $ 218 $ 185 $ 33 18 Employee benefits 103 69 34 49 -------- --------- --------- ------- 321 254 67 26 -------- --------- --------- ------- Occupancy expense, net 57 43 14 33 Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation for loan servicing and other administrative support 109 100 9 9 Treasury and traded markets services and other fees 89 67 22 33 Fees paid to HTSU for technology services 49 51 (2) (4) -------- --------- --------- ------- 247 218 29 13 -------- --------- --------- ------- Other expenses: Equipment and software 18 22 (4) (18) Marketing 25 18 7 39 Outside services 31 30 1 3 Professional fees 14 15 (1) (7) Telecommunications 5 5 -- -- Postage, printing and office supplies 9 7 2 29 Insurance business 6 3 3 100 Other 42 69 (27) (39) -------- --------- --------- ------- 150 169 (19) (11) -------- --------- --------- ------- Total operating expenses $ 775 $ 684 $ 91 13 ======== ========= ========= ======= Personnel - average number 12,313 11,134 1,179 11 ------------------------------------------------------------------------------------------------ Increase (Decrease) ------------------- Six months ended June 30 2006 2005 Amount % ------------------------------------------------------------------------------------------------ ($ in millions) Salaries and employee benefits: Salaries $ 437 $ 368 $ 69 19 Employee benefits 199 152 47 31 -------- --------- --------- ------- 636 520 116 22 -------- --------- --------- ------- Occupancy expense, net 108 85 23 27 Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation for loan servicing and other administrative support 225 204 21 10 Treasury and traded markets services and other fees 180 132 48 36 Fees paid to HTSU for technology services 106 100 6 6 -------- --------- --------- ------- 511 436 75 17 -------- --------- --------- ------- Other expenses: Equipment and software 38 46 (8) (17) Marketing 46 33 13 39 Outside services 60 55 5 9 Professional fees 31 29 2 7 Telecommunications 10 10 -- -- Postage, printing and office supplies 16 13 3 23 Insurance business 11 9 2 22 Other 93 102 (9) (9) -------- --------- --------- ------- 305 297 8 3 -------- --------- --------- ------- Total operating expenses $ 1,560 $ 1,338 $ 222 17 ======== ========= ========= ======= Personnel - average number 12,224 10,982 1,242 11 49 All increases and decreases referred to below for the second quarter and for the first six months of 2006 represent comparisons with the same 2005 periods. Overview Increased expenses for the second quarter and for the first six months of 2006 were driven largely by the rollout of various business growth initiatives affecting all business segments, and by increased fees charged by HSBC affiliates for various services. Salaries and Employee Benefits Increased salary expense for the second quarter and for the first six months of 2006 was primarily due to the increased number of personnel employed to support various business growth initiatives within the PFS, CMB, CIBM and PB business segments. Increased employee benefits expenses primarily resulted from increased salary expense and staff counts. In addition, in light of impressive and sustained performance and shareholder returns by the consolidated HSBC group over the three years covered by 2003 awards granted under the HSBC Group Share Option Plan (refer to page 126 of HUSI's 2005 Form 10-K for a description of this plan), HSBC's Remuneration Committee has exercised its discretion to waive the Total Shareholder Return performance condition, as permitted by the plan. This modification resulted in an additional charge to operating expenses of $9 million during the first six months of 2006. This is a non-cash item and economically has no impact on shareholders. Support Services from HSBC Affiliates Fees are charged by various HSBC affiliates for technology services, for underwriting and broker-dealer services, for treasury and traded markets services, for loan origination and servicing, and for other operational and administrative support functions. The overall increases in HSBC affiliate charges for the second quarter and for the first six months of 2006 are due primarily to the following activity: o fees charged by HMUS and other HSBC affiliates for treasury and traded markets services have increased in 2006 due primarily to business expansion initiatives within the CIBM segment; and o fees charged by HSBC Finance Corporation for loan origination and servicing have increased as a result of an increased number of accounts and increased balances associated with various loan portfolios and other loan balances serviced by HSBC Finance Corporation on behalf of HUSI. Fees charged by HSBC Finance Corporation for various administrative services have also increased as a result of continued initiatives to centralize administrative functions. Other Expenses For the first six months of 2006, business expansion initiatives within PFS, CMB, CIBM and PB business segments have resulted in general increases in various expense categories. Increased marketing and promotional expenses resulted from investment in HSBC brand activities, promotion of the internet savings account and marketing support for branch expansion initiatives. Other expenses includes the following material activity for 2006 and 2005: o during the second quarter of 2006, HUSI settled certain prior year income tax liabilities. Taxes and interest related to this settlement were fully reserved for prior to December 31, 2005. As a result of this settlement, approximately $13 million of accrued interest was released and reversed from other expenses; and o errors and losses decreased $14 million and $21 million for the second quarter and for the first six months of 2006 respectively. Unusual losses associated with the private label receivable portfolio were recorded in 2005. 50 Efficiency Ratio -------------------------------------------------------------------------------- Three months ended Six months ended June 30 June 30 --------------------- -------------------- 2006 2005 2006 2005 -------------------------------------------------------------------------------- Efficiency ratio (1) 53.49% 57.11% 54.91% 54.59% (1) Represents the ratio of total operating expenses, reduced by minority interests and certain non-recurring expense items, to the sum of net interest income and other revenues. Improvement in the efficiency ratio for the second quarter of 2006 was primarily due to increased trading revenues (refer to commentary beginning on page 47 of this Form 10-Q), which was partially offset by increased operating expenses (refer to commentary on the preceding page). For the first six months of 2006, the efficiency ratio was relatively unchanged, as increased trading revenues were offset by increased operating expenses and decreased net interest income. 51 SEGMENT RESULTS -------------------------------------------------------------------------------- HUSI has five distinct segments that are utilized for management reporting and analysis purposes. The segments, which are based upon customer groupings, as well as products and services offered, are described in Note 13 of the consolidated financial statements, beginning on page 19 of this Form 10-Q. All increases and decreases referenced below for the second quarter and for the first six months of 2006 represent comparisons to the same 2005 periods. Personal Financial Services (PFS) Overview Additional resources and investment continue to be directed towards expansion of the core retail banking business, including investment in the HSBC brand, expansion of the core branch network in existing and new geographic areas, and continued rollout of the internet savings business. As expected during the build-out phase, these initiatives have resulted in growth of expenses during the first six months of 2006 that has outpaced growth in revenues. Balance sheet growth during the first six months of 2006 was highlighted by a significant increase in deposits resulting from successful rollout of a strategy to build deposits across multiple markets and business segments, utilizing multiple delivery systems. Operating Results The following table summarizes results for the PFS segment. ------------------------------------------------------------------------------- 2006 Compared to 2005 Increase (Decrease) --------------------- 2006 2005 Amount % ------------------------------------------------------------------------------- ($ in millions) Three months ended June 30 Net interest income $ 311 $ 302 $ 9 3 Other revenues 99 86 13 15 --------- --------- --------- --------- Total revenues 410 388 22 6 Operating expenses 276 248 28 11 --------- --------- --------- --------- 134 140 (6) (4) Provision for credit losses 12 22 (10) (45) --------- --------- --------- --------- Income before income tax expense $ 122 $ 118 $ 4 3 ========= ========= ========= ========= Six months ended June 30 Net interest income $ 620 $ 602 $ 18 3 Other revenues 234 214 20 9 --------- --------- --------- --------- Total revenues 854 816 38 5 Operating expenses 581 499 82 16 --------- --------- --------- --------- 273 317 (44) (14) Provision for credit losses 28 44 (16) (36) --------- --------- --------- --------- Income before income tax expense $ 245 $ 273 $ (28) (10) ========= ========= ========= ========= Increased net interest income in 2006 was primarily due to higher interest rate spreads on a growing personal deposit base, which was partially offset by a migration by customers toward higher yielding deposit products, and by lower net interest income from a decreasing residential mortgage loan portfolio. Increased other revenues for 2006 is primarily due to increased non-interest residential mortgage banking revenues. Additional commentary regarding residential mortgage banking revenue begins on page 44 of this Form 10-Q. 52 Operating expenses increased for the second quarter of 2006 due to: o increased personnel, marketing and other direct costs associated with expansion of the core banking network and other consumer lending operations have resulted in additional expenses of approximately $34 million for the first six months of 2006; o increased fees paid to HSBC Finance Corporation, as HUSI continued to leverage its relationship to centralize various loan servicing and administrative support functions; and o allocations to the PFS business segment of various increased expenses, including share option costs. Consumer Finance (CF) Overview The CF segment includes the private label receivable portfolio (the PLRP) acquired from HSBC Finance Corporation and its correspondents. Results of the CF segment have been positively impacted by growth of private label credit card receivables included within the PLRP and by decreased amortization of premiums paid to HSBC Finance Corporation for those receivables. Refer to commentary regarding the PLRP on page 27 of this Form 10-Q. Operating Results The following table summarizes results for the CF segment. ------------------------------------------------------------------------------------- 2006 Compared to 2005 Increase (Decrease) --------------------- 2006 2005 Amount % ------------------------------------------------------------------------------------- ($ in millions) Three months ended June 30 Net interest income $ 190 $ 166 $ 24 14 Other revenues 117 67 50 75 -------- -------- -------- ---------- Total revenues 307 233 74 32 Operating expenses 106 110 (4) (4) -------- -------- -------- ---------- 201 123 78 63 Provision for credit losses 155 152 3 2 -------- -------- -------- ---------- Income (loss) before income tax expense $ 46 $ (29) $ 75 * ======== ======== ======== ========== Six months ended June 30 Net interest income $ 343 $ 296 $ 47 16 Other revenues 236 147 89 61 -------- -------- -------- ---------- Total revenues 579 443 136 31 Operating expenses 216 217 (1) -- -------- -------- -------- ---------- 363 226 137 61 Provision for credit losses 290 261 29 11 -------- -------- -------- ---------- Income (loss) before income tax expense $ 73 $ (35) $ 108 * ======== ======== ======== ========== * Not meaningful. 53 The following table summarizes the impact of the PLRP on earnings for the CF segment in comparison with the other portfolios. --------------------------------------------------------------------------- Three months ended June 30 PLRP Other Total --------------------------------------------------------------------------- (in millions) 2006 Net interest income $ 153 $ 37 $ 190 Other revenues 117 -- 117 -------- -------- -------- Total revenues 270 37 307 Operating expenses 103 3 106 -------- -------- -------- 167 34 201 Provision for credit losses 150 5 155 -------- -------- -------- Income before income tax expense $ 17 $ 29 $ 46 ======== ======== ======== 2005 Net interest income $ 110 $ 56 $ 166 Other revenues 67 -- 67 -------- -------- -------- Total revenues 177 56 233 Operating expenses 106 4 110 -------- -------- -------- 71 52 123 Provision for credit losses 139 13 152 -------- -------- -------- (Loss) income before income tax expense $ (68) $ 39 $ (29) ======== ======== ======== --------------------------------------------------------------------------- Six months ended June 30 PLRP Other Total --------------------------------------------------------------------------- (in millions) 2006 Net interest income $ 263 $ 80 $ 343 Other revenues 236 -- 236 -------- -------- -------- Total revenues 499 80 579 Operating expenses 208 8 216 -------- -------- -------- 291 72 363 Provision for credit losses 278 12 290 -------- -------- -------- Income before income tax expense $ 13 $ 60 $ 73 ======== ======== ======== 2005 Net interest income $ 181 $ 115 $ 296 Other revenues 147 -- 147 -------- -------- -------- Total revenues 328 115 443 Operating expenses 208 9 217 -------- -------- -------- 120 106 226 Provision for credit losses 248 13 261 -------- -------- -------- (Loss) income before income tax expense $ (128) $ 93 $ (35) ======== ======== ======== Increased net interest income for the PLRP is due to increased average credit card receivable balances for the quarter, and to decreased amortization of premiums paid for purchases of receivables from HSBC Finance Corporation (refer to page 38 of this Form 10-Q). Increased other revenues for the PLRP are directly related to increased credit card fees (refer to page 42 of this Form 10-Q), which were partially offset by decreased securitization revenue (refer to page 43 of this Form 10-Q). Increased provision for credit losses for the PLRP portfolio resulted from increased average credit card receivable balances as well as from increased past due balances (refer to page 40 of this Form 10-Q). 54 New domestic private label credit card receivables are acquired from HSBC Finance Corporation on a daily basis. In accordance with Federal Financial Institutions Examination Council (FFIEC) guidance, HUSI adopted a plan to phase in changes to the required minimum monthly payment amount for domestic private label credit card accounts. The implementation of these new requirements began in the fourth quarter of 2005 and was completed in the first quarter of 2006, resulting in an immaterial impact on second quarter and six month results. Estimates of the potential impact to the business are based on numerous assumptions and take into account a number of factors which are difficult to predict such as changes in customer behavior, which will not be fully known or understood until the changes have been in place for a period of time. The impact of these changes, if any, is not expected to be material to HUSI's consolidated results. Commercial Banking (CMB) Overview Improved operating results for 2006, which resulted from the continued rollout of planned expansion initiatives, were offset by increased provisions for credit losses in the second quarter of 2006 as compared with unusually low provisions in 2005. Office locations and staffing levels were expanded in 2005 and 2006, as were loan and deposit products offered to small businesses and middle-market commercial customers, in conjunction with increased marketing efforts. HUSI continues to leverage its status as one of the top ranked small business lenders in New York State. Operating Results The following table summarizes results for the CMB segment. ------------------------------------------------------------------------------------- 2006 Compared to 2005 Increase (Decrease) --------------------- 2006 2005 Amount % ------------------------------------------------------------------------------------- ($ in millions) Three months ended June 30 Net interest income $ 178 $ 155 $ 23 15 Other revenues 77 51 26 51 -------- -------- -------- ---------- Total revenues 255 206 49 24 Operating expenses 135 90 45 50 -------- -------- -------- ---------- 120 116 4 3 Provision for credit losses 26 4 22 550 -------- -------- -------- ---------- Income before income tax expense $ 94 $ 112 $ (18) (16) ======== ======== ======== ========== Six months ended June 30 Net interest income $ 356 $ 309 $ 47 15 Other revenues 126 91 35 38 -------- -------- -------- ---------- Total revenues 482 400 82 21 Operating expenses 245 188 57 30 -------- -------- -------- ---------- 237 212 25 12 Provision (credit) for credit losses 30 (1) 31 * -------- -------- -------- ---------- Income before income tax expense $ 207 $ 213 $ (6) (3) ======== ======== ======== ========== * Not meaningful. Increased net interest income and other revenues for the second quarter of 2006 resulted from the successful rollout of planned expansion of various small business, middle-market and real estate commercial lending programs, which resulted in increased actual and average commercial loan balances. Net interest income growth was partially offset by narrowing deposit spreads, as customers migrated to higher yielding deposit products in 2006. Higher operating expenses primarily resulted from branch expansion initiatives and new lending offices and, to a lesser extent, to allocation to CMB of various increased expenses, such as share option costs. 55 Increased provision for credit losses for 2006 resulted from growth in commercial loan portfolio balances and from increased allowance requirements associated with small business lending portfolios. In addition, unusually low net charge offs were recorded during 2005. Further commentary regarding credit quality begins on page 58 of this Form 10-Q. Corporate, Investment Banking and Markets (CIBM) Overview Various treasury and traded markets activities were expanded in 2005 and 2006. Increased products offered to customers, increased marketing efforts for those products, and an expanded infrastructure to support growth initiatives have resulted in increased non-interest revenues and income before income tax expense during 2006. The CIBM segment has recorded strong trading results in 2006, which were partially offset by steadily rising short-term interest rates, which limited opportunities to profit from placing funds generated from operations. While increased short-term rates have a positive impact on interest rate spreads for deposit generating businesses, such as the PFS and CMB segments, they have an adverse impact on the CIBM segment, which does not generate significant low cost deposit funding. Operating Results The following table summarizes results for the CIBM segment. ------------------------------------------------------------------------------- 2006 Compared to 2005 Increase (Decrease) --------------------- 2006 2005 Amount % ------------------------------------------------------------------------------- ($ in millions) Three months ended June 30 Net interest income $ 49 $ 123 $ (74) (60) Other revenues 313 98 215 219 --------- --------- --------- --------- Total revenues 362 221 141 64 Operating expenses 184 172 12 7 --------- --------- --------- --------- 178 49 129 263 Provision (credit) for credit losses -- (7) 7 * --------- --------- --------- --------- Income before income tax expense $ 178 $ 56 $ 122 218 ========= ========= ========= ========= Six months ended June 30 Net interest income $ 102 $ 277 $ (175) (63) Other revenues 586 265 321 121 --------- --------- --------- --------- Total revenues 688 542 146 27 Operating expenses 368 306 62 20 --------- --------- --------- --------- 320 236 84 36 Provision (credit) for credit losses 2 (25) 27 * --------- --------- --------- --------- Income before income tax expense $ 318 $ 261 $ 57 22 ========= ========= ========= ========= * Not meaningful. Decreased net interest income primarily resulted from steadily rising short-term interest rates during 2005 and 2006, which had an adverse impact on CIBM interest rate spreads. Net interest income from balance sheet management activity decreased approximately $66 million and $169 million for the second quarter and for the first six months of 2006 respectively. Rising interest rates also tightened interest rate spreads related to higher trading activity, which contributed to lower net interest income. Increased other revenues mainly resulted from: o increased trading revenues (refer to page 47 of this Form 10-Q); o new service fees generated by a subsidiary transferred to HUSI from HSBC in March 2005, which provides accounting and valuation services for hedge fund clients; and o increased fee-based income within the transaction banking business, resulting from business expansion initiatives. 56 Partially offsetting these increases were decreased realized gains on sales of securities (refer to page 48 of this Form 10-Q). Operating expenses growth slowed in the second quarter, as evidenced by expenses increasing 20% for the first half of 2006, but increasing only 8% for the second quarter. Increases in operating expenses resulted from: o increased direct expenses associated with foreign exchange, risk management products, and transaction banking businesses; and o increased expenses associated with development of an infrastructure to support the growing complexity of the CIBM business. The net provision credit for 2005 resulted from continuation of relatively low charge offs and higher than normal recoveries of amounts previously charged off. Although recoveries have decreased during 2006, charge offs remain low and credit quality remains good and well managed. Private Banking (PB) Overview During 2005 and 2006, additional resources have been allocated to expand products and services provided to high net worth customers served by this business segment, resulting in increased net interest income, service fee income and operating expenses associated with core PB operations. 2006 results were negatively impacted by increased provision expense. 2005 other revenues included a one-time gain on sale of an investment. Operating Results The following table summarizes results for the PB segment. -------------------------------------------------------------------------------- 2006 Compared to 2005 Increase (Decrease) --------------------- 2006 2005 Amount % -------------------------------------------------------------------------------- ($ in millions) Three months ended June 30 Net interest income $ 48 $ 42 $ 6 14 Other revenues 60 103 (43) (42) --------- --------- --------- --------- Total revenues 108 145 (37) (26) Operating expenses 74 64 10 16 --------- --------- --------- --------- 34 81 (47) (58) Provision (credit) for credit losses 29 (1) 30 * --------- --------- --------- --------- Income before income tax expense $ 5 $ 82 $ (77) (94) ========= ========= ========= ========= Six months ended June 30 Net interest income $ 96 $ 82 $ 14 17 Other revenues 136 161 (25) (16) --------- --------- --------- --------- Total revenues 232 243 (11) (5) Operating expenses 150 128 22 17 --------- --------- --------- --------- 82 115 (33) (29) Provision (credit) for credit losses 29 (2) 31 * --------- --------- --------- --------- Income before income tax expense $ 53 $ 117 $ (64) (55) ========= ========= ========= ========= * Not meaningful. Increased net interest income for the second quarter of 2006 resulted from increased average interest earning assets, primarily loans. 57 In the second quarter of 2005, shares in a foreign equity fund were sold to an HSBC affiliate, resulting in a gain of approximately $48 million. Decreased other revenues for the second quarter and for the first six months of 2006 was a direct result of this 2005 activity. Excluding this transaction, other revenues have increased during 2006, due to: o increased fee income from wealth and tax advisory services provided to high net worth individuals; and o increased equity earnings from a foreign equity investment. Increased operating expenses for the second quarter and for the first six months of 2006 resulted from additional resources being allocated to this segment to expand the services provided. Increased provision for credit losses during 2006 directly relates to a specific commercial real estate investment loan relationship for which a combination of charge offs and increased allowances for credit losses resulted in a $29 million provision. CREDIT QUALITY -------------------------------------------------------------------------------- Overview The allowance for credit losses increased $32 million (4%) during the second quarter and increased $23 million (3%) during the first six months of 2006, due to: o increased allowance requirements associated with increased balances within various commercial loan portfolios; o increased allowance requirements associated with specific small business commercial loan portfolios within the CMB business segment (refer to additional commentary below); and o an additional allowance requirement for a specific commercial real estate investment loan relationship within the PB business segment. The allowance for credit losses increased $79 million (10%) from June 30, 2005 to June 30, 2006 due to: o increased allowance requirements associated with increased balances within the private label credit card receivable portfolio; o increased allowance requirements associated with increased balances within various commercial loan portfolios; and o increased allowance requirements associated with small business commercial loan portfolios within the CMB business segment and a specific commercial real estate investment loan relationship within the PB business segment. The provision for credit losses increased $52 million (31%) for the second quarter of 2006 and increased $102 million (37%) for the first six months of 2006, as compared with the same 2005 periods. Increased provisions related to various commercial loan portfolios and, to a lesser extent, to the private label credit card portfolio were the primary drivers of the overall increase. The provision for credit losses associated with various loan portfolios is summarized on page 40 of this Form 10-Q. Policies and critical estimates associated with the allowance for credit losses are summarized on pages 23-24 and 57-60 of HUSI's 2005 Form 10-K. There have been no material revisions to policies or methodologies during the first six months of 2006. Credit quality statistics are summarized in Note 4 of the consolidated financial statements, beginning on page 10 of this Form 10-Q. 58 The following table provides an analysis of changes in the allowance for credit losses and related ratios. ----------------------------------------------------------------------------------------------------------------------- June 30, March 31, December 31, September 30, June 30, Quarter ended 2006 2006 2005 2005 2005 ----------------------------------------------------------------------------------------------------------------------- ($ in millions) Balance at beginning of quarter $ 837 $ 846 $ 852 $ 790 $ 773 Allowance related to disposition of certain credit card relationships -- (6) -- -- -- Charge offs: Commercial 44 20 36 16 17 Consumer: Residential mortgages 7 11 8 6 6 Credit card receivables 165 170 186 154 160 Other consumer loans 23 29 34 26 23 -------- --------- ------------ ------------- -------- Total consumer loans 195 210 228 186 189 -------- --------- ------------ ------------- -------- Total charge offs 239 230 264 202 206 -------- --------- ------------ ------------- -------- Recoveries on loans charged off: Commercial 6 15 15 26 7 Consumer: Residential mortgages -- -- -- 1 -- Credit card receivables 28 46 35 30 37 Other consumer loans 15 9 10 8 9 -------- --------- ------------ ------------- -------- Total consumer loans 43 55 45 39 46 -------- --------- ------------ ------------- -------- Total recoveries 49 70 60 65 53 -------- --------- ------------ ------------- -------- Total net charge offs 190 160 204 137 153 -------- --------- ------------ ------------- -------- Provision charged to income 222 157 198 199 170 -------- --------- ------------ ------------- -------- Balance at end of quarter $ 869 $ 837 $ 846 $ 852 $ 790 ======== ========= ============ ============= ======== Allowance ratios: Annualized net charge offs to average loans: Commercial .55% .08% .33% (.16)% .17% Consumer: Residential mortgages .07 .10 .07 .04 .05 Credit card receivables 3.61 3.32 4.02 3.51 3.87 Other consumer loans 1.04 2.50 2.82 2.09 1.51 -------- --------- ------------ ------------- -------- Total consumer 1.00 1.01 1.13 .90 .90 -------- --------- ------------ ------------- -------- Total loans .86% .73% .90% .61% .71% ======== ========= ============ ============= ======== Quarter-end allowance to: Quarter-end total loans .95% .94% .94% .95% .90% Quarter-end total nonaccruing loans 330.42% 341.63% 351.04% 362.55% 351.11% 59 An analysis of 2006 changes in the allowance for credit losses by general loan categories, is provided in the following tables. ------------------------------------------------------------------------------------------------------------- Residential Credit Other Commercial Mortgage Card Consumer Unallocated Total ------------------------------------------------------------------------------------------------------------- (in millions) Quarter ended June 30, 2006 Balance at beginning of period $ 171 $ 30 $ 589 $ 32 $ 15 $ 837 ---------- ----------- ------ -------- ----------- ----- Allowance related to dispositions -- -- -- -- -- -- Charge offs 44 7 165 23 -- 239 Recoveries 6 -- 28 15 -- 49 ---------- ----------- ------ -------- ----------- ----- Net charge offs 38 7 137 8 -- 190 ---------- ----------- ------ -------- ----------- ----- Provision charged to income 59 8 148 5 2 222 ---------- ----------- ------ -------- ----------- ----- Balance at end of period $ 192 $ 31 $ 600 $ 29 $ 17 $ 869 ========== =========== ====== ======== =========== ===== Six months ended June 30, 2006 Balance at beginning of period $ 162 $ 34 $ 600 $ 36 $ 14 $ 846 ---------- ----------- ------ -------- ----------- ----- Allowance related to dispositions -- -- (6) -- -- (6) Charge offs 64 18 335 52 -- 469 Recoveries 21 -- 74 24 -- 119 ---------- ----------- ------ -------- ----------- ----- Net charge offs 43 18 261 28 -- 350 ---------- ----------- ------ -------- ----------- ----- Provision charged to income 73 15 267 21 3 379 ---------- ----------- ------ -------- ----------- ----- Balance at end of period $ 192 $ 31 $ 600 $ 29 $ 17 $ 869 ========== =========== ====== ======== =========== ===== Commercial Loan Credit Quality Components of the commercial allowance for credit losses are summarized in the following table. ----------------------------------------------------------------------------- June 30, December 31, June 30, Balance at 2006 2005 2005 ----------------------------------------------------------------------------- (in millions) On-balance sheet allowance: Specific $ 16 $ 9 $ 16 Collective 176 149 143 Transfer risk -- 4 3 -------- ------------ -------- 192 162 162 Unallocated 17 14 14 -------- ------------ -------- Total on-balance sheet allowance 209 176 176 Off-balance sheet allowance 85 88 91 -------- ------------ -------- Total commercial allowances $ 294 $ 264 $ 267 ======== ============ ======== Continuing with the trend of growth over the past few reporting periods in the size and complexity of HUSI's commercial loan portfolio, commercial loans increased $1.9 billion from December 31, 2005 to June 30, 2006. In addition, as certain segments of the economy show signs of slowing, there has been a net increase in credit downgrades in 2006, reflecting higher probabilities of default, a key driver of the commercial loan collective allowance. As a result, the collective allowance has increased $30 million (11%) during the first six months of 2006. Increased allowances are spread across a number of industries, notably commercial real estate, auto and small business. Criticized assets increased during the second quarter of 2006 (refer to Note 4 of the consolidated financial statements, beginning on page 12 of this Form 10-Q), primarily within the special mention category. Several specific real estate, auto industry and other commercial credits, as well as loans in the small business portfolio which were not previously criticized, were downgraded to special mention, substandard and doubtful categories, as appropriate, during the quarter based on recent credit assessments. These recently criticized credits were partially offset by credits which were previously criticized but were no longer considered to be criticized at June 30, 2006. 60 During the second quarter of 2006, commercial net charge offs increased $33 million from the previous quarter, and increased $28 million from the second quarter of 2005. The increase resulted primarily from a specific private banking commercial real estate investment loan relationship that was charged off during the quarter. Excluding this specific activity, net charge offs continued to run at levels consistent with those experienced for several recent quarters dating back to 2004, which is well below historical experience for years prior to 2004. Increased provisions and allowances for credit losses are expected in the near term due to growing portfolio risk resulting from: o HUSI's continued geographic expansion; o increased borrower concentrations; o increased number and complexity of products offered; and o continued signs of stress within certain segments of the economy. HUSI management continues to monitor and reduce exposures to those industries considered to be higher risk. During the second quarter of 2006, HUSI management began to make more extensive use of available tools to more actively manage net exposure within its corporate loan portfolios with an increased syndication capacity as well as increased use of credit default swaps to reduce certain exposures. Any sudden and/or unexpected adverse economic events or trends could significantly affect credit quality and increase provisions for credit losses. For example, HUSI management is monitoring rising interest rates and record-high energy prices, which could potentially lead to a deceleration of U.S. economic activity. Recent events in the Middle East may also worsen the overall energy picture. Credit Card Receivable Credit Quality The allowance for credit losses associated with credit card receivables increased $11 million (2%) during the second quarter of 2006, and was unchanged for the six months ended June 30, 2006. The net charge off and provision activity during the second quarter of 2006, as well as the allowance balance at June 30, 2006, which primarily relates to the private label credit card portfolio, are generally consistent with recent trends for this portfolio. Receivables included in the private label credit card portfolio are generally maintained in accruing status until being charged off six months after delinquency. The following table provides credit quality data for credit card receivables. -------------------------------------------------------------------------------- June 30, December 31, June 30, 2006 2005 2005 -------------------------------------------------------------------------------- (in millions) Accruing balances contractually past due 90 days or more: Balance at end of quarter $ 283 $ 248 $ 206 As a percent of total credit card receivables 1.85% 1.60% 1.60% Allowance for credit losses associated with credit card receivables: Balance at end of quarter $ 600 $ 600 $ 565 As a percent of total credit card receivables 3.92% 3.87% 4.39% Net charge offs of credit card receivables: Total for the quarter ended $ 137 $ 151 $ 123 Annualized net charge offs as a percent of average credit card receivables 3.61% 4.02% 3.89% 61 DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES -------------------------------------------------------------------------------- HUSI is party to various derivative financial instruments as an end user, as an international dealer in derivative instruments, and for purely trading purposes in order to realize profits from short-term movements in interest rates, commodity prices, foreign exchange rates and credit spreads. Additional information regarding the use of various derivative instruments is included on page 26 and pages 95-97 of HUSI's 2005 Form 10-K. Credit and Market Risk Associated with Derivative Contracts Credit (or repayment) risk in derivative instruments is minimized by entering into transactions with high quality counterparties, including other HSBC group entities. Counterparties include financial institutions, government agencies, both foreign and domestic, corporations, funds (mutual funds, hedge funds, etc.), insurance companies and private clients. These counterparties are subject to regular credit review by the credit risk management department. Most derivative contracts are governed by an International Swaps and Derivatives Association Master Agreement. Depending on the type of counterparty and the level of expected activity, bilateral collateral arrangements may be required as well. The total risk in a derivative contract is a function of a number of variables, such as: o whether counterparties exchange notional principal; o volatility of interest rates, currencies, equity or corporate reference entity used as the basis for determining contract payments; o maturity and liquidity of contracts; o credit worthiness of the counterparties in the transaction; and o existence and value of collateral received from counterparties to secure exposures. The following table presents credit risk exposure associated with derivative contracts. In the table, current credit risk exposure is the recorded fair value of derivative receivables, which represents revaluation gains from the marking to market of derivative contracts held for trading purposes, for all counterparties with an International Swaps and Derivatives Association Master Agreement in place. Future credit risk exposure in the following table is measured using rules contained in the risk-based capital guidelines published by U.S. banking regulatory agencies. The risk exposure calculated in accordance with the risk-based capital guidelines potentially overstates actual credit exposure, because: o the risk-based capital guidelines ignore collateral that may have been received from counterparties to secure exposures; and o the risk-based capital guidelines compute exposures over the life of derivative contracts. However, many contracts contain provisions that allow a bank to close out the transaction if the counterparty fails to post required collateral. As a result, these contracts have potential future exposures that are often much smaller than the future exposures derived from the risk-based capital guidelines. The net credit risk exposure amount in the following table does not reflect the impact of bilateral netting (i.e., netting with a single counterparty when a bilateral netting agreement is in place). However, the risk-based capital guidelines recognize that bilateral netting agreements reduce credit risk and therefore allow for reductions of exposures when netting requirements have been met. In addition, risk-based capital rules require that netted exposures of various counterparties be assigned risk-weightings, which result in risk-weighted amounts for regulatory capital purposes that are a fraction of the original netted exposures. ------------------------------------------------------------------------------- June 30, December 31, 2006 2005 ------------------------------------------------------------------------------- (in millions) Risk associated with derivative contracts: Current credit risk exposure $ 11,955 $ 8,155 Future credit risk exposure 58,721 61,548 ------------ ------------ Total risk exposure 70,676 69,703 Less: collateral held against exposure (3,699) (1,850) ------------ ------------ Net credit risk exposure $ 66,977 $ 67,853 ============ ============ 62 Notional Values of Derivative Contracts The following table summarizes the notional values of derivative contracts. ------------------------------------------------------------------------------- June 30, December 31, 2006 2005 ------------------------------------------------------------------------------- (in millions) Interest rate: Futures and forwards $ 125,028 $ 106,826 Swaps 1,881,843 1,674,091 Options written 343,910 199,676 Options purchased 391,968 217,095 ------------ ------------ 2,742,749 2,197,688 ------------ ------------ Foreign exchange: Swaps, futures and forwards 361,436 308,264 Options written 37,698 40,213 Options purchased 38,739 40,959 Spot 46,501 21,099 ------------ ------------ 484,374 410,535 ------------ ------------ Commodities, equities and precious metals: Swaps, futures and forwards 51,838 48,702 Options written 14,910 14,378 Options purchased 17,797 16,127 ------------ ------------ 84,545 79,207 ------------ ------------ Credit derivatives 621,874 391,814 ------------ ------------ Total $ 3,933,542 $ 3,079,244 ============ ============ 63 OFF-BALANCE SHEET ARRANGEMENTS -------------------------------------------------------------------------------- The following table provides maturity information related to off-balance sheet arrangements. Descriptions of these arrangements are found on pages 60-62 of HUSI's 2005 Form 10-K. ------------------------------------------------------------------------------------------------ Balance at June 30, 2006 ------------------------------------------- One Over One Over Balance at Year Through Five December 31, or Less Five Years Years Total 2005 ------------------------------------------------------------------------------------------------ (in millions) Standby letters of credit, net of participations (1) $ 4,111 $ 2,461 $ 129 $ 6,701 $ 6,114 Commercial letters of credit 1,034 57 -- 1,091 806 Loan sales with recourse (2) -- 1 8 9 9 Credit derivative contracts (3) 10,277 199,889 122,451 332,617 222,419 Commitments to extend credit: Commercial 19,180 30,871 4,180 54,231 51,284 Consumer 8,698 -- -- 8,698 8,305 Securities lending indemnifications -- -- -- -- 4,135 -------- ---------- -------- -------- ------------ Total $ 43,300 $ 233,279 $126,768 $403,347 $ 293,072 ======== ========== ======== ======== ============ (1) Includes $528 million and $523 million issued for the benefit of related parties at June 30, 2006 and December 31, 2005 respectively. (2) $8 million and $7 million is indemnified by third parties at June 30, 2006 and December 31, 2005 respectively. (3) Includes $60,267 million and $51,202 million issued for the benefit of related parties at June 30, 2006 and December 31, 2005 respectively. Letters of Credit Fees are charged for issuing letters of credit commensurate with the customer's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of the "stand ready obligation to perform" under these guarantees, amounting to $23 million and $19 million at June 30, 2006 and December 31, 2005 respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $19 million and $20 million at June 30, 2006 and December 31, 2005 respectively. Credit Derivatives HUSI enters into credit derivative contracts primarily to satisfy the needs of its customers and, in certain cases, for its own benefit. Credit derivatives are arrangements that provide for one party (the "protection buyer") to transfer the credit risk of a "reference asset" to another party (the "protection seller"). Under this arrangement the protection seller assumes the credit risk associated with the reference asset without directly purchasing it. The protection buyer agrees to pay a specified fee to the protection seller. In return, the protection seller agrees to pay the protection buyer an agreed upon amount if there is a default during the term of the contract. In accordance with its policy, HUSI offsets most of the risk it assumes in selling credit protection through a credit derivative contract with another counterparty. Credit derivatives are recorded at fair value. The commitment amount included in the table is the maximum amount that HUSI could be required to pay, without consideration of the approximately equal amount receivable from third parties and any associated collateral. Securities Lending Indemnifications Through December 31, 2005, HUSI occasionally lent securities of customers, on a fully collateralized basis, as an agent to third party borrowers. Customers were indemnified against the risk of loss, and collateral was obtained from the borrower with a market value exceeding the value of the loaned securities. Securities lending activities were terminated during the first quarter of 2006. 64 Securitizations and Secured Financings On December 29, 2004, HUSI acquired a domestic private label loan portfolio from HSBC Finance Corporation, without recourse, which included securitized private label credit card receivables, and retained interest assets related to these securitizations. These credit card securitization transactions were structured to receive sale treatment under Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of FASB Statement No. 125, (SFAS 140). In a securitization, a designated pool of receivables is removed from the balance sheet and transferred to an unaffiliated revolving trust. This unaffiliated revolving trust is a qualifying special purpose entity (QSPE) as defined by SFAS 140 and, therefore, is not consolidated. The QSPE funds its receivable purchase through the issuance of securities to investors, entitling them to receive specified cash flows during the life of the securities. The securities are collateralized by the underlying receivables transferred to the QSPE. These revolving securitization trusts require replenishments of receivables to support previously issued securities. HUSI will continue to sell receivables to securitization trusts until their revolving periods end, the last of which is expected in 2007. Balance requirements of HUSI's securitized trusts continue to decrease as they near the end of their revolving periods. Under IFRS, HUSI's securitizations are treated as secured financings. In order to align its accounting treatment with that of HSBC, all of HUSI's collateralized funding transactions have been structured as secured financings since the third quarter of 2004. In a secured financing, a designated pool of receivables are conveyed to a wholly owned limited purpose subsidiary, which in turn transfers receivables to a trust that sells interests to investors. Repayment of the debt issued by the trust is secured by the receivables transferred. The transactions are structured as secured financings under SFAS 140. Therefore, the receivables and the underlying debt of the trust remain on HUSI's balance sheet. HUSI does not recognize a gain in a secured financing transaction. Because the receivables and debt remain on the balance sheet, revenues and expenses are reported consistent with the owned balance sheet portfolio. There have been no new secured financing transactions in the first six months of 2006. HUSI's securitized receivables and secured financings are summarized in the following table. ------------------------------------------------------------------------------- June 30, December 31, 2006 2005 ------------------------------------------------------------------------------- (in millions) Securitized private label credit card receivables at period end $ 738 $ 1,343 ========= ============ Secured financings included in long-term debt: Balance at period end $ 988 $ 1,500 ========= ============ Private label credit card receivables collaterizing secured financings at period end $ 1,972 $ 2,221 ========= ============ 65 RISK MANAGEMENT -------------------------------------------------------------------------------- Overview Some degree of risk is inherent in virtually all of HUSI's activities. For the principal activities undertaken by HUSI, the most important types of risks are considered to be credit, interest rate, market, liquidity, operational, fiduciary and reputational. Market risk broadly refers to price risk inherent in mark to market positions taken on trading and non-trading instruments. Operational risk technically includes legal and compliance risk. However, since compliance risk, including anti-money laundering (AML) risk, has such broad scope within HUSI's businesses, it is addressed as a separate functional discipline. During the first six months of 2006, there have been no significant changes in policies or approach for managing various types of risk. Regulatory Capital Basel Capital Standards (Basel II) The status of HNAH's and HUSI's preparations relative to Basel II as of December 31, 2005 was summarized on pages 10 and 64 of HUSI's 2005 Form 10-K. In its 2005 Form 10-K, HUSI reported that it must have in place, by January 1, 2008, a Basel II framework meeting the requirements of HSBC's principal regulator, the Financial Services Authority in the United Kingdom. However, U.S. requirements for HUSI and other U.S. mandatory banks have continued to evolve in 2006. A Notice of Proposed Rulemaking by U.S. regulators is expected to be published in the second half of 2006, and is expected to be finalized in early 2007. Implementation by U.S. mandatory banks will be expected within 3 years. The different implementation time tables, as well as possible differences in requirements of regulators in the U.S. and the U.K., may affect the cost and difficulty of implementing Basel II. Liquidity Management HUSI's approach to address liquidity risk is summarized on pages 67-68 of HUSI's 2005 Form 10-K. There have been no changes in HUSI's approach toward liquidity risk management during 2006. HUSI's ability to regularly attract wholesale funds at a competitive cost is enhanced by strong ratings from the major credit rating agencies. Standard and Poor's upgraded credit ratings for HUSI and HBUS in June 2006. At June 30, 2006, HUSI and HBUS maintained the following debt and preferred stock ratings. ------------------------------------------------------------------------------- At June 30, 2006 Moody's S&P Fitch ------------------------------------------------------------------------------- HUSI: Short-term borrowings P-1 A-1+ F1+ Long-term debt Aa3 AA- AA Preferred stock A2 A AA- HBUS: Short-term borrowings P-1 A-1+ F1+ Long-term debt Aa2 AA AA 66 HUSI periodically issues capital instruments to fund balance sheet growth, to meet cash and capital needs, or to fund investments in subsidiaries. In December 2005, the United States Securities and Exchange Commission (SEC) amended its rules regarding registration, communications and offerings under the Securities Act of 1933. The amended rules facilitate access to capital markets by well-established public companies, provide more flexibility regarding restrictions on corporate communications during a securities offering and further integrate disclosures under the Securities Act of 1933 and the Securities Exchange Act of 1934. The amended rules provide the most flexibility to "well-known seasoned issuers", including the option of automatic effectiveness upon filing of shelf registration statements and relief under the liberalized communications rules. HUSI currently satisfies the eligibility requirements for designation as a "well-known seasoned issuer", and has an effective shelf registration statement with the SEC under which it may issue debt securities, preferred stock, either separately or represented by depositary shares, warrants, purchase contracts and units. In May 2006, HUSI issued 14,950,000 depositary shares, each representing one-fortieth of a share of 6.50% Non-Cumulative Preferred Stock, Series H. Total proceeds of this issuance, net of transaction fees, were approximately $365 million. Interest Rate Risk Management Various techniques are utilized to quantify and monitor risks associated with the repricing characteristics of HUSI's assets, liabilities, and derivative contracts. The approach toward managing interest rate risk is summarized on pages 69-71 of HUSI's 2005 Form 10-K. During the first six months of 2006, there were no significant changes in policies or approach for managing interest rate risk. Present Value of a Basis Point (PVBP) Analysis PVBP is the change in value of the balance sheet for a one basis point upward movement in all interest rates. The following table reflects the PVBP position at June 30, 2006. -------------------------------------------------------------------------------- June 30, 2006 Values -------------------------------------------------------------------------------- (in millions) Institutional PVBP movement limit $ 7.5 PVBP position at period end 2.1 Economic Value of Equity Economic value of equity is the change in value of the assets and liabilities (excluding capital and goodwill) for either a 200 basis point gradual rate increase or decrease. The following table reflects the economic value of equity position at June 30, 2006. ------------------------------------------------------------------------------------------------ June 30, 2006 Values (%) ------------------------------------------------------------------------------------------------ Institutional economic value of equity limit +/- 20 Projected change in value (reflects projected rate movements on July 1, 2006): Change resulting from a gradual 200 basis point increase in interest rates (7) Change resulting from a gradual 200 basis point decrease in interest rates 2 The projected decrease in value for a 200 basis point increase in rates is primarily related to the anticipated slowing of prepayments for the held mortgage and mortgage backed securities portfolios in this higher rate environment. This assumes that no management actions are taken to manage exposures to the changing interest rate environment. 67 Dynamic Simulation Modeling Various modeling techniques are utilized to monitor a number of interest rate scenarios for their impact on net interest income. These techniques include both rate shock scenarios which assume immediate market rate movements by as much as 200 basis points, as well as scenarios in which rates rise or fall by as much as 200 basis points over a twelve month period. The following table reflects the impact on net interest income of the scenarios utilized by these modeling techniques. --------------------------------------------------------------------------------------------------------------------- June 30, 2006 Values ---------------------- Amount % --------------------------------------------------------------------------------------------------------------------- ($ in millions) Projected change in net interest income (reflects projected rate movements on July 1, 2006): Institutional base earnings movement limit (10) Change resulting from a gradual 200 basis point increase in the yield curve $ (186) (6) Change resulting from a gradual 200 basis point decrease in the yield curve 234 7 Change resulting from a gradual 100 basis point increase in the yield curve (92) Change resulting from a gradual 100 basis point decrease in the yield curve 125 Other significant scenarios monitored (reflects projected rate movements on July 1, 2006): Change resulting from an immediate 100 basis point increase in the yield curve (149) Change resulting from an immediate 100 basis point decrease in the yield curve 152 Change resulting from an immediate 200 basis point increase in the yield curve (304) Change resulting from an immediate 200 basis point decrease in the yield curve 348 Change resulting from an immediate 100 basis point increase in short-term rates (252) The projections do not take into consideration possible complicating factors such as the effect of changes in interest rates on the credit quality, size and composition of the balance sheet. Therefore, although this provides a reasonable estimate of interest rate sensitivity, actual results will vary from these estimates, possibly by significant amounts. Capital Risk/Sensitivity of Other Comprehensive Income Large movements of interest rates could directly affect some reported capital and capital ratios. The mark to market valuation of available for sale securities is adjusted on a tax effective basis through other comprehensive income in the consolidated statement of changes in shareholders' equity. Although this valuation mark is excluded from Tier 1 and Tier 2 capital ratios, it is included in two important accounting based capital ratios: the tangible common equity to tangible assets and the tangible common equity to risk weighted assets. As of June 30, 2006, HUSI had an available for sale securities portfolio of approximately $20 billion with a net negative mark to market of $704 million included in tangible common equity of $8 billion. An increase of 25 basis points in interest rates of all maturities would lower the mark to market by approximately $162 million to a net loss of $866 million with the following results on the tangible capital ratios. -------------------------------------------------------------------------------- Proforma - Reflecting 25 Basis Points June 30, 2006 Actual Increase in Rates -------------------------------------------------------------------------------- Tangible common equity to tangible assets 4.78% 4.73% Tangible common equity to risk weighted assets 6.73 6.65 Trading Activities Trading portfolios reside primarily in the CIBM and residential mortgage banking areas and include foreign exchange, derivatives, precious metals (gold, silver, platinum), commodities, equities and money market instruments. The trading portfolios have defined limits pertaining to items such as permissible investments, risk exposures, loss review, balance sheet size and product concentrations. Loss review refers to the maximum amount of loss that may be incurred before senior management intervention is required. 68 Trading Activities - Treasury Value at Risk (VAR) VAR analysis is used to measure market risk and to calculate capital required to cover potential losses due to movements in market rates. VAR calculations are performed for all material trading and non-trading portfolios. VAR estimates the potential losses that could occur on risk positions as a result of movements in market rates and prices over a specified time horizon and to a given level of confidence. HUSI calculates VAR daily for a one-day holding period to a 99% confidence level. At a 99% confidence level for a two-year observation period, HUSI is setting as its limit the fifth worst loss performance in the last 500 business days. The VAR methodology used by HUSI is based on historical simulation. The historical simulation model derives plausible future scenarios from historical market rate data, taking account of inter-relationships between different markets and rates. Potential movements in market prices are calculated with reference to market data from the last two years. The model incorporates the impact of option features in the underlying exposures. For reporting purposes, in the second quarter of 2006, HUSI changed the assumed holding period from a ten-day period to a one-day period as this reflects the way HUSI manages its risk positions. Comparative VAR amounts have been restated to reflect this change. Although a valuable guide to risk, VAR should always be viewed in the context of its limitations. For example, o the use of historical data as a proxy for estimating future events may not encompass all potential events, particularly those which are extreme in nature; o the use of a one-day holding period assumes that all positions can be liquidated or hedged in one day. This may not fully reflect the market risk arising at times of severe liquidity shortages, when a one-day holding period may be insufficient to liquidate or hedge all positions fully; o the use of a 99% confidence level, by definition, does not take into account losses that might occur beyond this level of confidence; and o VAR is calculated on the basis of exposures outstanding at the close of business and therefore does not necessarily reflect intra-day exposures. The following table summarizes trading VAR, assuming a 99% confidence level for a two year observation period and a one-day "holding period". ----------------------------------------------------------------------------------------------- Six months ended June 30, 2006 June 30, --------------------------------- December 31, 2006 Minimum Maximum Average 2005 ----------------------------------------------------------------------------------------------- (in millions) Total trading $ 16 $ 11 $ 46 $ 24 $ 17 Commodities 1 -- 3 1 2 Credit derivatives 8 4 11 7 6 Equities -- -- 1 -- -- Foreign exchange 1 1 3 2 1 Interest rate 18 15 56 30 22 69 Trading Volatility The following tables summarize the frequency distribution of daily market risk-related revenues for Treasury trading activities. Market risk-related Treasury trading revenues include realized and unrealized gains (losses) related to Treasury trading activities, but exclude the related net interest income. Analysis of gain (loss) data for the second quarter of 2006 shows that the largest daily gain was $28 million and the largest daily loss was $13 million. ------------------------------------------------------------------------------------------------- Ranges of daily Treasury trading revenue earned Below $ (10) $0 to $10 to Over from market risk-related activities (in millions) $ (10) to $0 $10 $20 $20 ------------------------------------------------------------------------------------------------- Three months ended June 30, 2006: Number of trading days market risk-related revenue was within the stated range 1 10 36 14 2 Six months ended June 30, 2006: Number of trading days market risk-related revenue was within the stated range 3 29 60 26 7 Trading Activities - HSBC Mortgage Corporation (USA) HSBC Mortgage Corporation (USA) is HUSI's mortgage banking subsidiary. Trading occurs in mortgage banking operations as a result of an economic hedging program intended to offset changes in value of mortgage servicing rights and the salable loan pipeline. Economic hedging may include, for example, forward contracts to sell residential mortgages and derivative contracts used to protect the value of MSRs. MSRs are assets that represent the present value of net servicing income (servicing fees, ancillary income, escrow and deposit float servicing costs). MSRs are recognized upon the sale of the underlying loans or at the time that servicing rights are purchased. MSRs are subject to interest rate risk, in that their value will fluctuate as a result of a changing interest rate environment. Interest rate risk is mitigated through an active hedging program that uses trading securities and derivative instruments to offset changes in value of MSRs. Since the hedging program involves trading activity, risk is quantified and managed using a number of risk assessment techniques. Rate Shock Analysis Modeling techniques are used to monitor certain interest rate scenarios for their impact on the economic value of net hedged MSRs, as reflected in the following table. ----------------------------------------------------------------------------------------------------------------- June 30, 2006 Values ----------------------------------------------------------------------------------------------------------------- (in millions) Projected change in net market value of hedged MSRs portfolio (reflects projected rate movements on July 1, 2006): Value of hedged MSRs portfolio $ 499 Change resulting from an immediate 50 basis point decrease in the yield curve: Change limit (no worse than) (16) Calculated change in net market value (5) Change resulting from an immediate 50 basis point increase in the yield curve: Change limit (no worse than) (8) Calculated change in net market value 7 Change resulting from an immediate 100 basis point increase in the yield curve: Change limit (no worse than) (12) Calculated change in net market value 17 70 Economic Value of MSRs The economic value of the net, hedged MSRs portfolio is monitored on a daily basis for interest rate sensitivity. If the economic value declines by more than established limits for one day or one month, various levels of management review, intervention and/or corrective actions are required. Hedge Volatility The following table summarizes the frequency distribution of the weekly economic value of the MSR asset. This includes the change in the market value of the MSR asset net of changes in the market value of the underlying hedging positions used to hedge the asset. The changes in economic value are adjusted for changes in MSR valuation assumptions that were made during the course of the quarter, if applicable. ---------------------------------------------------------------------------------------- Ranges of mortgage economic value from Below $(2) to $0 to $2 to Over market risk-related activities (in millions) $(2) $0 $2 $4 $4 ---------------------------------------------------------------------------------------- Three months ended June 30, 2006: Number of trading weeks market risk-related revenue was within the stated range -- 4 6 3 -- Six months ended June 30, 2006: Number of trading weeks market risk-related revenue was within the stated range 3 8 10 4 1 71 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES The following table shows the quarterly average balances of the principal components of assets, liabilities and shareholders' equity, together with their respective interest amounts and rates earned or paid, presented on a taxable equivalent basis. Three Months Ended June 30, --------------------------------------------------------------- 2006 2005 ------------------------------ ------------------------------ Balance Interest Rate* Balance Interest Rate* --------------------------------------------------------------- (in millions) Assets Interest bearing deposits with banks $ 5,490 $ 74 5.42% $ 3,913 $ 29 2.95% Federal funds sold and securities purchased under resale agreements 9,721 119 4.88 5,285 41 3.14 Trading assets 10,982 102 3.74 6,609 60 3.66 Securities 21,925 281 5.13 19,158 218 4.58 Loans: Commercial 27,932 431 6.20 23,049 289 5.02 Consumer: Residential mortgages 42,461 560 5.27 47,542 581 4.89 Credit cards 15,215 324 8.55 12,688 200 6.32 Other consumer 3,092 67 8.68 3,717 66 7.10 -------- --------- ------- --------- --------- ------ Total consumer 60,768 951 6.28 63,947 847 5.31 -------- --------- ------- --------- --------- ------ Total loans 88,700 1,382 6.25 86,996 1,136 5.24 -------- --------- ------- --------- --------- ------ Other 1,829 24 5.21 638 9 5.12 -------- --------- ------- --------- --------- ------ Total earning assets 138,647 $ 1,982 5.73% 122,599 $ 1,493 4.89% -------- --------- ------- --------- --------- ------ Allowance for credit losses (921) (885) Cash and due from banks 3,808 3,447 Other assets 27,223 20,134 -------- --------- Total assets $168,757 $ 145,295 ======== ========= Liabilities and Shareholders' Equity Deposits in domestic offices: Savings deposits $ 38,134 $ 239 2.51% $ 27,792 $ 69 1.00% Other time deposits 26,574 281 4.25 24,173 177 2.94 Deposits in foreign offices: Foreign banks deposits 7,385 95 5.17 8,297 74 3.58 Other time and savings 15,244 154 4.04 14,381 76 2.12 -------- --------- ------- --------- --------- ------ Total interest bearing deposits 87,337 769 3.53 74,643 396 2.13 -------- --------- ------- --------- --------- ------ Short-term borrowings 11,634 75 2.60 13,176 67 2.01 Long-term debt 28,113 356 5.07 23,889 242 4.07 -------- --------- ------- --------- --------- ------ Total interest bearing liabilities 127,084 1,200 3.79 111,708 705 2.53 -------- --------- ------- --------- --------- ------ Net interest income / Interest rate spread $ 782 1.94% $ 788 2.36% --------- ------- --------- ------ Noninterest bearing deposits 8,784 8,643 Other liabilities 20,858 13,463 Total shareholders' equity 12,031 11,481 -------- --------- Total liabilities and shareholders' equity $168,757 $ 145,295 ======== ========= Net interest margin on average earning assets 2.26% 2.58% ------- ------ Net interest margin on average total assets 1.86% 2.18% ======= ====== * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest for the three months ended June 30, 2006 and 2005 included fees of $16 million and $11 million respectively. 72 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES The following table shows the year to date average balances of the principal components of assets, liabilities and shareholders' equity, together with their respective interest amounts and rates earned or paid, presented on a taxable equivalent basis. Six Months Ended June 30, ---------------------------------------------------------- 2006 2005 ---------------------------- --------------------------- Balance Interest Rate* Balance Interest Rate* ---------------------------------------------------------- (in millions) Assets Interest bearing deposits with banks $ 5,102 $ 127 5.00% $ 3,882 $ 54 2.78% Federal funds sold and securities purchased under resale agreements 8,210 192 4.72 4,467 65 2.94 Trading assets 10,542 210 4.02 6,616 119 3.64 Securities 21,621 550 5.13 18,741 432 4.65 Loans: Commercial 27,146 816 6.07 22,777 539 4.77 Consumer: Residential mortgages 43,161 1,129 5.23 47,503 1,160 4.88 Credit cards 15,188 592 7.86 12,430 358 5.81 Other consumer 3,166 132 8.42 3,681 128 7.02 --------- -------- ----- -------- -------- ----- Total consumer 61,515 1,853 6.07 63,614 1,646 5.22 --------- -------- ----- -------- -------- ----- Total loans 88,661 2,669 6.07 86,391 2,185 5.10 --------- -------- ----- -------- -------- ----- Other 1,256 37 5.98 626 15 4.66 --------- -------- ----- -------- -------- ----- Total earning assets 135,392 $ 3,785 5.64% 120,723 $ 2,870 4.79% --------- -------- ----- -------- -------- ----- Allowance for credit losses (928) (890) Cash and due from banks 3,977 3,729 Other assets 25,205 20,137 --------- -------- Total assets $ 163,646 $143,699 ========= ======== Liabilities and Shareholders' Equity Deposits in domestic offices: Savings deposits $ 35,076 $ 392 2.25% $ 27,283 $ 120 0.89% Other time deposits 27,576 563 4.11 23,987 325 2.73 Deposits in foreign offices: Foreign banks deposits 7,303 172 4.75 9,273 118 2.58 Other time and savings 15,013 292 3.92 13,787 160 2.33 --------- -------- ----- -------- -------- ----- Total interest bearing deposits 84,968 1,419 3.37 74,330 723 1.96 --------- -------- ----- -------- -------- ----- Short-term borrowings 11,198 149 2.68 11,048 119 2.17 Long-term debt 28,154 694 4.97 23,880 461 3.90 --------- -------- ----- -------- -------- ----- Total interest bearing liabilities 124,320 2,262 3.67 109,258 1,303 2.41 --------- -------- ----- -------- -------- ----- Net interest income / Interest rate spread $ 1,523 1.97% $ 1,567 2.38% -------- ----- -------- ----- Noninterest bearing deposits 9,470 9,201 Other liabilities 17,983 14,027 Total shareholders' equity 11,873 11,213 --------- -------- Total liabilities and shareholders' equity $ 163,646 $143,699 ========= ======== Net interest margin on average earning assets 2.27% 2.62% ----- ----- Net interest margin on average total assets 1.88% 2.20% ===== ===== * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest for the six months ended June 30, 2006 and 2005 included fees of $28 million and $19 million respectively. 73 Item 3. Quantitative and Qualitative Disclosures About Market Risk -------------------------------------------------------------------------------- Refer to Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, under the captions "Interest Rate Risk Management" and "Trading Activities", beginning on page 67 of this Form 10-Q. Item 4. Controls and Procedures -------------------------------------------------------------------------------- HUSI maintains a system of internal and disclosure controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, as amended, (the Exchange Act), is recorded, processed, summarized and reported on a timely basis. HUSI's Board of Directors, operating through its Audit Committee, which is composed entirely of independent outside directors, provides oversight to the financial reporting process. An evaluation was conducted, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of HUSI's disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that HUSI's disclosure controls and procedures were effective as of the end of the period covered by this report so as to alert them in a timely fashion to material information required to be disclosed in reports filed under the Exchange Act. There were no changes in HUSI's internal controls over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, HUSI's internal control over financial reporting. HUSI continues the process to complete a thorough review of its internal controls as part of its preparation for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404). Section 404 requires management to report on, and external auditors to attest to, the effectiveness of HUSI's internal control structure and procedures for financial reporting. As a non-accelerated filer under Rule 12b-2 of the Exchange Act, HUSI's first report under Section 404 will be contained in its Form 10-K for the period ended December 31, 2007. 74 Part II - OTHER INFORMATION -------------------------------------------------------------------------------- Item 1A. Risk Factors -------------------------------------------------------------------------------- Risk factors were set forth in HUSI's Form 10-Q for the period ended March 31, 2006. There have been no material changes from the risk factors disclosed in that Form 10-Q. Item 6. Exhibits -------------------------------------------------------------------------------- 3(i) Articles of Incorporation and amendments and supplements thereto (incorporated by reference to Exhibit 3(a) to HSBC USA Inc.'s Annual Report on Form 10-K for the year ended December 31, 1999, filed with the Securities and Exchange Commission on March 30, 2000, Exhibit 3 to HSBC USA Inc.'s Quarterly Report on Form 10-Q for the quarter ended September 30, 2000, filed with the Securities and Exchange Commission on November 9, 2000, Exhibits 3.2 and 3.3 to HSBC USA Inc.'s Current Report on Form 8-K dated March 30, 2005 and filed with the Securities and Exchange Commission on April 4, 2005, Exhibit 3.2 to HSBC USA Inc.'s Current Report on Form 8-K dated October 11, 2005 and filed with the Securities and Exchange Commission on October 14, 2005, and Exhibit 3.2 to HSBC USA Inc.'s Current Report on Form 8-K dated May 18, 2006 and filed with the Securities and Exchange Commission on May 22, 2006). 12 Computation of Ratio of Earnings to Fixed Charges and Earnings to Combined Fixed Charges and Preferred Stock Dividends. 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.0 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 75 SIGNATURE -------------------------------------------------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HSBC USA Inc. ------------- (Registrant) Date: July 31, 2006 /s/ Clive R. Bucknall ---------------------------- Clive R. Bucknall Chief Accounting Officer (On behalf of Registrant) 76 This information is provided by RNS The company news service from the London Stock Exchange

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