HSBC USA Inc 06 10-K Pt 1c/10

HSBC Holdings PLC 05 March 2007 Part 3 of 5 HSBC USA INC. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS Year Ended December 31, 2006 2005 2004 ------------------------------------------------------------------------------------------------------------- (in millions) Cash flows from operating activities Net income ......................................................... $ 1,036 $ 976 $ 1,258 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation, amortization and deferred taxes .................... 503 442 428 Provision (credit) for credit losses ............................. 823 674 (17) Net change in other assets and liabilities ....................... 29 495 (1,444) Net change in loans held for sale to HSBC Markets (USA) Inc. (HMUS): Loans acquired from originators ................................ (16,089) (5,061) -- Sales of loans to HMUS ......................................... 15,867 2,188 -- Net change in other loans held for sale .......................... 63 63 (427) Net change in loans attributable to tax refund anticipation loans program: Originations of loans .......................................... (16,100) (15,100) -- Sales of loans to HSBC Finance Corporation, including premium ...................................................... 15,888 15,100 -- Net change in trading assets and liabilities ..................... (2,255) (2,774) (3,267) Net change in fair value of derivatives and hedged items ......... 689 (248) 166 --------- -------- -------- Net cash provided by (used in) operating activities ............ 454 (3,245) (3,303) --------- -------- -------- Cash flows from investing activities Net change in interest bearing deposits with banks ................. 681 (225) (1,933) Net change in federal funds sold and securities purchased under resale agreements ................................................ (9,207) (1,442) (680) Net change in securities available for sale: Purchases of securities available for sale ....................... (8,043) (12,301) (11,311) Proceeds from sales of securities available for sale ............. 2,611 3,825 5,868 Proceeds from maturities of securities available for sale ........ 3,203 4,273 5,578 Net change in securities held to maturity: Purchases of securities held to maturity ......................... (166) (694) (1,190) Proceeds from maturities of securities held to maturity .......... 364 1,401 1,815 Net change in loans: Originations, net of collections ................................. 23,083 19,405 (19,482) Loans purchased from HSBC Finance Corporation .................... (23,908) (23,084) (16,227) Net cash used for acquistions of properties and equipment .......... (81) (29) (11) Net change in other investments and related accounts ............... (193) (240) (255) --------- -------- -------- Net cash used in investing activities .......................... (11,656) (9,111) (37,828) --------- -------- -------- Cash flows from financing activities Net change in deposits ............................................. 12,735 11,834 16,546 Net change in short-term borrowings ................................ (1,293) (2,936) 2,811 Net change in long-term debt: Issuance of long-term debt ....................................... 6,860 6,127 20,762 Repayment of long-term debt ...................................... (8,019) (706) (1,083) Preferred stock issuance, net of issuance costs .................... 365 794 -- Other increases in capital surplus ................................. 15 (278) 2,391 Dividends paid ..................................................... (543) (720) (148) --------- -------- -------- Net cash provided by financing activities ...................... 10,120 14,115 41,279 --------- -------- -------- Net change in cash and due from banks ................................. (1,082) 1,759 148 Cash and due from banks at beginning of year .......................... 4,441 2,682 2,534 --------- -------- -------- Cash and due from banks at end of year ................................ $ 3,359 $ 4,441 $ 2,682 ========= ======== ======== Cash paid for: Interest ............................................... $ 4,811 $ 2,785 $ 1,195 Income taxes ........................................... 504 566 569 The accompanying notes are an integral part of the consolidated financial statements. Pending settlement receivables/payables related to securities and trading assets and liabilities are treated as non-cash items for cash flow reporting. 97 HSBC BANK USA, NATIONAL ASSOCIATION -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET December 31, 2006 2005 ----------------------------------------------------------------------------------------------------- (in millions) Assets Cash and due from banks ................................................... $ 3,297 $ 4,440 Interest bearing deposits with banks ...................................... 2,193 2,917 Federal funds sold and securities purchased under resale agreements ....... 13,704 4,562 Trading assets ............................................................ 24,751 19,807 Securities available for sale ............................................. 19,500 17,548 Securities held to maturity (fair value $2,926 and $3,126) December 31, 2006 and 2005, respectively .................................. 2,864 3,044 Loans ..................................................................... 90,125 90,214 Less - allowance for credit losses ........................................ 894 845 ---------- ---------- Loans, net ............................................................. 89,231 89,369 ---------- ---------- Properties and equipment, net ............................................. 538 536 Intangible assets ......................................................... 521 462 Goodwill .................................................................. 2,111 2,090 Other assets .............................................................. 6,963 5,904 ---------- ---------- Total assets .............................................................. $ 165,673 $ 150,679 ========== ========== Liabilities Deposits in domestic offices: Noninterest bearing .................................................... $ 12,818 $ 12,002 Interest bearing ....................................................... 63,878 55,566 Deposits in foreign offices: Noninterest bearing .................................................... 727 320 Interest bearing ....................................................... 29,842 27,160 ---------- ---------- Total deposits ....................................................... 107,265 95,048 ---------- ---------- Trading liabilities ....................................................... 14,033 10,644 Short-term borrowings ..................................................... 2,698 3,383 Interest, taxes and other liabilities ..................................... 3,253 3,167 Long-term debt ............................................................ 26,166 26,549 ---------- ---------- Total liabilities ......................................................... 153,415 138,791 ---------- ---------- Shareholder's equity Common shareholder's equity: Common stock ($100 par; 50,000 shares authorized; 20,005 and 20,004 shares issued and outstanding) ....................................... 2 2 Capital surplus ........................................................ 10,124 9,709 Retained earnings ...................................................... 2,348 2,192 Accumulated other comprehensive loss ................................... (216) (15) ---------- ---------- Total shareholder's equity ................................................ 12,258 11,888 ---------- ---------- Total liabilities and shareholder's equity ................................ $ 165,673 $ 150,679 ========== ========== 98 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Organization -------------------------------------------------------------------------------- HSBC USA Inc., incorporated under the laws of Maryland, is a New York State based bank holding company, and an indirect wholly owned subsidiary of HSBC North America Holdings Inc. (HNAH). HSBC USA Inc. and its subsidiaries are collectively referred to as "HUSI". HNAH is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC). Effective January 1, 2004, HSBC created a new North American organizational structure, HNAH, as the top-tier bank holding company parent. HUSI routinely conducts transactions in the normal course of business with HNAH's other principal direct and indirect subsidiaries, which include: o HSBC Finance Corporation, a consumer finance company; o HSBC Bank USA, National Association (HBUS), HUSI's principal banking subsidiary; o HSBC Bank Canada (HBCA), a Canadian banking subsidiary; o HSBC Markets (USA) Inc. (HMUS), a holding company for investment banking and markets subsidiaries in the U.S.; and o HSBC Technology & Services (USA) Inc. (HTSU), a provider of information technology services for other HNAH subsidiaries and to other subsidiaries of HSBC. On July 1, 2004, HUSI consolidated its then existing banking operations under a single national charter, following approval from the Office of the Comptroller of the Currency (the OCC). Note 2. Summary of Significant Accounting Policies and New Accounting Pronouncements -------------------------------------------------------------------------------- Significant Accounting Policies Basis of Presentation The accounting and reporting policies of HUSI conform to accounting principles generally accepted in the United States of America (U.S. GAAP). The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts in the financial statements and accompanying notes. Actual results could differ from those estimates. Certain reclassifications have been made to prior year amounts to conform with the current year's presentation. Principles of Consolidation The consolidated financial statements include the accounts of HUSI and its subsidiaries. HUSI consolidates subsidiaries in which it holds, directly or indirectly, more than 50% of the voting rights, or where it exercises control. HUSI, in the ordinary course of business, makes use of Variable Interest Entity (VIE) structures in a variety of business activities, primarily to facilitate client needs. VIE structures are utilized after careful consideration of the most appropriate structure needed to achieve HUSI's control and risk management objectives and to help ensure an efficient and appropriate structure from a regulatory and taxation perspective. HUSI determines whether a VIE should be consolidated by evaluating if it is the primary beneficiary of the VIE as defined by Financial Accounting Standards Board Interpretation No. 46 (Revised) (FIN 46R). The primary beneficiary generally maintains control over the VIE, and will generally receive the majority of the risks and rewards of the assets of the VIE. Based upon this assessment, HUSI has determined that it is the primary beneficiary of certain VIEs, and has therefore consolidated these VIEs into its consolidated financial statements. 99 Unaffiliated trusts to which HUSI has transferred securitized receivables which are qualifying special purpose entities (QSPEs), as defined by Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities (SFAS 140), are not consolidated. All material intercompany accounts and transactions have been eliminated. Investments in companies in which the percentage of ownership is at least 20%, but not more than 50%, are generally accounted for under the equity method and reported as equity method investments in other assets. Foreign Currency Translation HUSI has foreign operations in several countries. The accounts of HUSI's foreign operations are measured using local currency as the functional currency. Assets and liabilities are translated into United States dollars at the rate of exchange in effect on the balance sheet date. Income and expenses are translated at average monthly exchange rates. Net exchange gains or losses resulting from such translation are included in common shareholder's equity as a component of accumulated other comprehensive income. Foreign currency denominated transactions in other than the local functional currency are translated using the period end exchange rate with any foreign currency transaction gain or loss recognized currently in income. Cash and Cash Equivalents For the purpose of reporting cash flows, cash and cash equivalents include cash on hand and amounts due from banks. Resale and Repurchase Agreements HUSI enters into purchases and borrowings of securities under agreements to resell (resale agreements) and sales of securities under agreements to repurchase (repurchase agreements) substantially identical securities. Resale agreements and repurchase agreements are generally accounted for as secured lending and secured borrowing transactions, respectively. The amounts advanced under resale agreements and the amounts borrowed under repurchase agreements are carried on the consolidated balance sheet at the amount advanced or borrowed, plus accrued interest to date. Interest earned on resale agreements is reported as interest income. Interest paid on repurchase agreements is reported as interest expense. HUSI offsets resale and repurchase agreements executed with the same counterparty under legally enforceable netting agreements that meet the applicable netting criteria as permitted by U.S. GAAP. Repurchase agreements may require HUSI to deposit cash or other collateral with the lender. In connection with resale agreements, it is the policy of HUSI to obtain possession of collateral, which may include the securities purchased, with market value in excess of the principal amount loaned. The market value of the collateral subject to the resale and repurchase agreements is regularly monitored, and additional collateral is obtained or provided when appropriate, to ensure appropriate collateral coverage of these secured financing transactions. Collateral HUSI pledges assets as collateral as required for various transactions involving security repurchase agreements, public deposits, Treasury tax and loan notes, derivative agreements, short-term borrowings and long-term borrowings. Assets that have been pledged as collateral, including those that can be sold or repledged by the secured party, continue to be reported on HUSI's consolidated balance sheet. HUSI also accepts collateral, primarily as part of various transactions involving security resale agreements. Collateral accepted by HUSI, including collateral that can be sold or repledged by HUSI, is excluded from HUSI's consolidated balance sheet. 100 The market value of collateral accepted or pledged by HUSI is regularly monitored and additional collateral is obtained or provided as necessary to ensure appropriate collateral coverage in these transactions. Trading Assets and Liabilities Financial instruments utilized in trading activities are stated at fair value. Fair value is generally based on quoted market prices. If quoted market prices are not available, fair values are estimated based on dealer quotes, pricing models or quoted prices for instruments with similar characteristics. Realized and unrealized gains and losses are recognized in trading revenues. Securities Debt securities that HUSI has the ability and intent to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to yield over the expected lives of the related securities. Securities acquired principally for the purpose of selling them in the near term are classified as trading assets and reported at fair value with unrealized gains and losses included in earnings. Equity securities that are not quoted on a recognized exchange are not considered to have a readily determinable fair value, and are recorded at cost, less any provisions for impairment. Unquoted equity securities, which include Federal Home Loan Bank (FHLB) stock, Federal Reserve Bank (FRB) stock and MasterCard Class B securities, are recorded in other assets. All other securities are classified as available for sale and carried at fair value, with unrealized gains and losses, net of related income taxes, recorded as adjustments to common shareholder's equity as a component of accumulated other comprehensive income. The fair value of securities is based on current market quotations where available, or internal valuation models that approximate market pricing. The validity of internal pricing models is regularly substantiated by reference to actual market prices realized upon sale or liquidation of these instruments. Realized gains and losses on sales of securities not classified as trading assets are computed on a specific identified cost basis and are reported in other revenues as security gains, net. HUSI regularly evaluates its securities to identify declines in fair value that are considered other than temporary. Any decline in the fair value of investments which is deemed to be other than temporary is charged against current earnings in other revenues and a new cost basis is established for the security. Fair value adjustments to trading securities and gains and losses on the sale of such securities are reported in other revenues as trading revenues. Loans Loans are stated at their amortized cost, which represents the principal amount outstanding, net of unearned income, charge offs, unamortized purchase premium or discount, unamortized nonrefundable fees and related direct loan origination costs and purchase accounting fair value adjustments. Loans are further reduced by the allowance for credit losses. Loans held for sale are carried at the lower of aggregate cost or market value and remain presented as loans in the consolidated balance sheet. Fair market value is determined based on quoted fair market prices for similar loans, outstanding investor commitments or discounted cash flow analysis using market assumptions. Increases in the valuation allowance utilized to adjust loans held for sale to market value, and subsequent recoveries of prior allowances recorded, are recorded in other income in the consolidated income statement. Premiums and discounts, including purchase accounting fair value adjustments on receivables, are recognized as adjustments to yield over the expected lives of the related loans. Interest income is recorded based on methods that result in level rates of return over the terms of the loans. 101 Restructured loans are loans for which the original contractual terms have been permanently modified to provide for terms that are less than HUSI would be willing to accept for new loans with comparable risk because of deterioration in the borrower's financial condition. Interest on these loans is accrued at the renegotiated rates. Loan Charge Off Policies and Practices Commercial loan balances are charged off at the time all or a portion of the balance is deemed uncollectible. Consumer loan charge off policies, which vary by product, are summarized below. Residential Mortgage Loans Carrying values in excess of net realizable value are charged off at or before the time foreclosure is completed or when settlement is reached with the borrower. If foreclosure is not pursued, and there is no reasonable expectation for recovery, the account is generally charged off no later than the end of the month in which the account becomes six months contractually delinquent. Auto Finance Carrying values in excess of net realizable value are generally charged off no later than the month in which the account becomes four months contractually delinquent. MasterCard/Visa and Private Label Credit Card Loans Loan balances are generally charged off by the end of the month in which the account becomes six months contractually delinquent. Other Consumer Loans Loan balances are generally charged off the month following the month in which the account becomes four months contractually delinquent. Nonaccruing Loan Policies and Practices HUSI's nonaccruing policies vary by product and are summarized below. Commercial Commercial loans are categorized as nonaccruing when, in the opinion of management, reasonable doubt exists with respect to the ultimate collectibility of interest or principal based on certain factors including period of time past due and adequacy of collateral. At the time a loan is classified as nonaccruing, any accrued interest recorded on the loan is generally deemed uncollectible and charged against income. Interest income on these loans is subsequently recognized only to the extent of cash received or until the loan is placed on accrual status. In those instances where there is doubt as to collectibility of principal, any interest payments received are applied to principal. Loans are not reclassified as accruing until interest and principal payments are brought current and future payments are reasonably assured. Consumer Residential mortgage loans are generally designated as nonaccruing when contractually delinquent for more than three months. Credit card receivables and other consumer loans generally accrue interest until charge off. 102 Loan Fees and Costs Nonrefundable fees and related direct costs associated with the origination of loans are deferred and netted against outstanding loan balances. The amortization of net deferred fees, which include points on real estate secured loans and costs, is recognized in interest income, generally by the interest method, based on the estimated or contractual lives of the related loans. Amortization periods are periodically adjusted for loan prepayments and changes in other market assumptions. MasterCard/Visa annual fees, net of direct lending costs, are deferred and amortized on a straight-line basis over one year. Nonrefundable fees related to lending activities other than direct loan origination are recognized as other revenues over the period in which the related service is provided. This includes fees associated with the issuance of loan commitments where the likelihood of the commitment being exercised is considered remote. In the event of the exercise of the commitment, the remaining unamortized fee is recognized in interest income over the loan term using the interest method. Other credit-related fees, such as standby letter of credit fees, loan syndication and agency fees are recognized as other operating income over the period the related service is performed. Net deferred costs totaled $356 million at December 31, 2006 and $402 million at December 31, 2005. Allowance for Credit Losses HUSI maintains an allowance for credit losses that is, in the judgment of management, adequate to absorb estimated probable losses of principal, interest and fees inherent in its commercial and consumer loan portfolios. The adequacy of the allowance for credit losses is assessed within the context of appropriate U.S. GAAP guidance, and is based, in part, upon an evaluation of various factors including: o an analysis of individual exposures where applicable; o current and historical loss experience; o changes in the overall size and composition of the portfolio; and o specific adverse situations and general economic conditions. HUSI also assesses the overall adequacy of the allowance by considering key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge offs in developing its loss reserve estimates. Loss estimates are reviewed periodically and adjustments are reported in earnings when they become known. These estimates are influenced by factors outside of the control of HUSI management, such as consumer payment patterns and economic conditions, and there is uncertainty inherent in these estimates, making it reasonably possible that they could change. For commercial and select consumer loan assets, HUSI conducts a periodic assessment on a loan-by-loan basis of losses it believes to be inherent in the loan portfolio. When it is deemed probable, based upon known facts and circumstances, that full contractual interest and principal on an individual loan will not be collected in accordance with its contractual terms, the loan is considered impaired. An impairment reserve is established based upon the present value of expected future cash flows, discounted at the loan's original effective interest rate, or as a practical expedient, the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Generally, impaired loans include loans in nonaccruing status, loans which have been assigned a specific allowance for credit losses, loans which have been partially charged off, and loans designated as troubled debt restructures. Problem commercial loans are assigned various criticized facility grades under the allowance for credit losses methodology. 103 Formula-based reserves are also established against commercial loans when, based upon an analysis of relevant data, it is probable that a loss has been incurred and the amount of that loss can be reasonably estimated, even though an actual loss has yet to be identified. A separate reserve for credit losses associated with off-balance sheet exposures including letters of credit, guarantees to extend credit and financial guarantees is also maintained and included in other liabilities, which incorporates estimates of the probability that customers will actually draw upon off-balance sheet obligations. This estimation methodology uses the probability of default from the customer rating assigned to each counterparty, the "Loss Given Default" rating assigned to each transaction or facility based on the collateral securing the transaction, and the measure of exposure based on the transaction. These reserves are determined by reference to continuously monitored and updated historical loss rates or factors, derived from a migration analysis which considers net charge off experience by loan and industry type in relation to internal credit grading. Probable losses for pools of homogeneous consumer loans are generally estimated using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge off. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured, rewritten, or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. The allowance for credit losses on consumer receivables also takes into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. In addition, loss estimates on consumer receivables are maintained to reflect HUSI's judgment of portfolio risk factors, which may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing loss reserves on consumer loans include recent growth, product mix, bankruptcy trends, geographic concentrations, economic conditions, portfolio seasoning, account management policies and practices and current levels of charge offs and delinquencies. Repossessed Collateral Real estate owned with the intent to sell within a reasonable period is classified as held for sale at the date of foreclosure and is valued at the lower of cost or fair value less estimated costs to sell and recorded in other assets. These values are periodically reviewed and reduced, if necessary. Costs of holding real estate and related gains and losses on disposition are credited or charged to operations as incurred as a component of operating expense. Properties and Equipment, Net Properties and equipment are recorded at cost, net of accumulated depreciation. Depreciation is recorded on a straight-line basis over the estimated useful lives of the related assets, which generally range from 3 to 40 years. Leasehold improvements are depreciated over the lesser of the economic useful life of the improvement or the term of the lease. Costs of maintenance and repairs are expensed as incurred. Mortgage Servicing Rights Effective January 1, 2006, upon adoption of SFAS 156 (refer to New Accounting Pronouncements on page 109), mortgage servicing rights (MSRs) are initially measured at fair value at the time that the related loans are sold and periodically re-measured using the fair value measurement method. This method requires that MSRs be measured at fair value at each reporting date with changes in fair value reflected in income in the period that the changes occur. Prior to January 1, 2006, MSRs were recorded at the lower of cost or fair value as required by previous accounting requirements. MSRs are subject primarily to interest rate risk, in that their fair value will fluctuate as a result of changes in the interest rate environment. Fair value is determined based upon the application of valuation models and other inputs. The valuation models incorporate assumptions market participants would use in estimating future cash flows. These assumptions include expected prepayments, default rates and market based option adjusted spreads. 104 HUSI uses certain derivative financial instruments including options and interest rate swaps to protect against the decline in economic value of MSRs. These instruments have not been designated as qualifying hedges in accordance with U.S. GAAP guidelines and are therefore recorded as trading instruments that are marked to market through earnings. Goodwill Goodwill, representing the excess of purchase price over the fair value of identifiable net assets acquired, results from purchase business combinations. Goodwill is not amortized, but is reviewed for impairment annually using a discounted cash flow methodology. Impairment may be reviewed earlier if circumstances indicate that the carrying amount may not be recoverable. HUSI considers significant and long-term changes in industry and economic conditions to be primary indicators of potential impairment. Receivables Sold and Serviced with Limited Recourse and Securitization Revenue Certain private label credit card receivables have been securitized and sold to investors with limited recourse. Recourse is limited to HUSI's rights to future cash flow and any subordinated interest that HUSI may retain. Upon sale, the receivables are removed from the balance sheet and a gain on sale is recognized for the difference between the carrying value of the receivables and the adjusted sales proceeds. The adjusted sales proceeds include cash received and the present value estimate of future cash flows to be received over the lives of the sold receivables. Future cash flows are based on estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and other factors. The resulting gain is also adjusted by a provision for estimated probable losses under the recourse provision. This provision, and the related reserve for receivables serviced with limited recourse, are established at the time of sale to cover all probable credit losses over the life of the receivables sold based on historical experience and estimates of expected future performance. The methodologies vary depending upon the type of receivables sold, using either historical net charge off rates applied to the expected balances to be received over the remaining life of the receivable or a historical static pool analysis. The reserves are reviewed periodically by evaluating the estimated future cash flows of each securitized pool to ensure that there is sufficient remaining cash flow to cover estimated future credit losses. Any changes to the estimates for the reserve for receivables serviced with limited recourse are made in the period they become known. Gains on sales net of recourse provisions, servicing income and excess spread relating to securitized receivables are reported in the accompanying consolidated statement of income as securitization revenue. In connection with these transactions, HUSI records an interest-only strip receivable, representing HUSI's contractual right to receive interest and other cash flows from the securitization trusts. HUSI's interest-only strip receivables are reported at fair value using discounted cash flow estimates as a separate component of receivables net of HUSI's estimate of probable losses under the recourse provisions. Cash flow estimates include estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and estimated probable losses under the recourse provisions. Unrealized gains and losses are recorded as adjustments to common shareholder's equity in accumulated other comprehensive income, net of income taxes. The interest-only strip receivables are reviewed for impairment quarterly or earlier if events indicate that the carrying value may not be recovered. Any decline in the fair value of the interest-only strip receivable which is deemed to be other than temporary is charged against current earnings. HUSI has also, in certain cases, retained other subordinated interests in these securitizations. Neither the interest-only strip receivables nor the other subordinated interests are in the form of securities. Prior to the third quarter of 2004, private label credit card collateralized funding transactions were structured as sales to revolving trusts that required replenishments to support previously issued securities. Since the third quarter of 2004, all new collateralized funding transactions have been structured as secured financings. HUSI has also continued to replenish, at reduced levels, certain non-public private label securities issued to conduits in order to manage liquidity. 105 Income Taxes HNAH files a consolidated federal income tax return, which includes HUSI. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as the estimated future tax consequences attributable to net operating loss and tax credit carryforwards. These deferred tax assets and liabilities are measured using the tax rates and laws that are expected to be in effect. A valuation allowance is established if, based on available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. Foreign taxes paid are applied as credits to reduce federal income taxes payable, to the extent that such credits can be utilized. Derivative Financial Instruments Derivative financial instruments are recognized on the balance sheet at their fair value. On the date a derivative contract is entered into, HUSI designates it as either: o a qualifying hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge); o a qualifying hedge of the variability of cash flows to be received or paid related to a recognized asset, liability or forecasted transaction (cash flow hedge); or o as a trading or non-qualifying hedge. Changes in the fair value of a derivative that has been designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk (including losses or gains on firm commitments), are recorded in current period earnings. Changes in the fair value of a derivative that has been designated and qualifies as a cash flow hedge, to the extent effective as a hedge, are recorded in accumulated other comprehensive income, net of income taxes, and reclassified into earnings in the period during which the hedged item affects earnings. Ineffectiveness is reflected in current earnings. Changes in the fair value of derivatives held for trading purposes or which do not qualify for hedge accounting are reported in current period earnings. At the inception of each hedge, HUSI formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions, the nature of the hedged risk, and how hedge effectiveness and ineffectiveness will be measured. This process includes linking all derivatives that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. HUSI also formally assesses, both at inception and on a recurring basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items and whether they are expected to continue to be highly effective in future periods. This assessment is conducted using statistical regression analysis. Earnings volatility may result from the on-going mark to market of certain economically viable derivative contracts that do not satisfy the hedging requirements under U.S. GAAP, as well as from the hedge ineffectiveness associated with the qualifying contracts. 106 Embedded Derivatives HUSI may acquire or originate a financial instrument that contains a derivative instrument "embedded" within it. Upon origination or acquisition of any such instrument, HUSI assesses whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the principal component of the financial instrument (i.e., the host contract) and whether a separate instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument. With the adoption of Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155), the election now exists to account for an entire financial instrument at fair value through profit and loss if the financial instrument contains an embedded derivative that would otherwise require bifurcation. Hybrid financial instruments that HUSI has elected to carry at fair value continue to be reported in their existing balance sheet classification. When it is determined that: (1) the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract; and (2) a separate instrument with the same terms would qualify as a derivative instrument, the embedded derivative is either separated from the host contract (bifurcated), carried at fair value, and designated as a trading instrument or the entire financial instrument is carried at fair value with all changes in fair value recorded to current period earnings. If bifurcation is elected, any gain recognized at inception related to the derivative is effectively embedded in the host contract and is recognized over the life of the financial instrument. Hedge Discontinuation HUSI discontinues hedge accounting prospectively when: o the derivative is no longer effective or expected to be effective in offsetting changes in the fair value or cash flows of a hedged item (including firm commitments or forecasted transactions); o the derivative expires or is sold, terminated, or exercised; o it is unlikely that a forecasted transaction will occur; o the hedged firm commitment no longer meets the definition of a firm commitment; or o the designation of the derivative as a hedging instrument is no longer appropriate. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair value or cash flow hedge, the derivative will continue to be carried on the balance sheet at fair value. In the case of a fair value hedge of a recognized asset or liability, as long as the hedged item continues to exist on the balance sheet, the hedged item will no longer be adjusted for changes in fair value. The basis adjustment that had previously been recorded to the hedged item during the period from the designation date to the hedge discontinuation date is recognized as an adjustment to the yield of the hedged item over the remaining life of the hedged item. In the case of a cash flow hedge of a recognized asset or liability, as long as the hedged item continues to exist on the balance sheet, the effective portion of the changes in fair value of the hedging derivative will no longer be reclassified into other comprehensive income. The balance applicable to the discontinued hedging relationship will be recognized in earnings over the remaining life of the hedged item as an adjustment to yield. If the hedged item was a firm commitment or forecasted transaction that is not expected to occur, any amounts recorded on the balance sheet related to the hedged item, including any amounts recorded in other comprehensive income, are reclassified to current period earnings. In the case of either a fair value hedge or a cash flow hedge, if the previously hedged item is sold or extinguished, the basis adjustment to the underlying asset or liability or any remaining unamortized other comprehensive income balance will be reclassified to current period earnings. In all other situations in which hedge accounting is discontinued, the derivative will be carried at fair value on the balance sheet, with changes in its fair value recognized in current period earnings unless redesignated as a qualifying hedge. 107 Day One Revenue Recognition HUSI recognizes gains and losses at the inception of derivative transactions only when the fair value of the transaction can be verified to similar market transactions or if all significant pricing model assumptions can be verified to observable market data. If profit or loss is not recognized at inception due to market observability, the net unrealized gain or loss associated with these transactions is recorded in trading and is offset by a reserve until the transaction can be verified to observable market data. Interest Rate Lock and Purchase Agreements HUSI enters into commitments to originate residential mortgage loans whereby the interest rate on the loan is set prior to funding (rate lock commitments). HUSI also enters into commitments to purchase residential mortgage loans through its correspondent channel (purchase commitments). Both rate lock and purchase commitments for residential mortgage loans that are classified as held for sale are considered to be derivatives. Rate lock and purchase commitments that are considered to be derivatives are recorded at fair value in other assets or other liabilities in the consolidated balance sheet. Changes in fair value are recorded in other income in the consolidated statement of income. Pension and Other Post-Retirement Benefits At December 31, 2006, as a result of the adoption of SFAS 158 (see New Accounting Pronouncements on the following page), HUSI recognized the funded status of pension and other post retirement benefits on the balance sheet with the offset to accumulated other comprehensive income. Prior to 2006, the funded status of these plans was not recognized on the balance sheet. Net pension and post-retirement benefit cost charged to current earnings related to these plans is based on various actuarial assumptions regarding expected future experience. Certain HUSI employees are participants in various defined contribution and other non-qualified supplemental retirement plans. HUSI's contributions to these plans are charged to current earnings. Through various subsidiaries, HUSI maintains various 401(k) plans covering substantially all employees. Employer contributions to the plan, which are charged to current earnings, are based on employee contributions. Stock-Based Compensation HUSI uses the fair value method of accounting for stock awards granted to employees under various stock option and employee stock purchase plans. Stock compensation costs are recognized prospectively for all new awards granted under these plans. Compensation expense relating to share options is calculated using a binomial lattice methodology that is based on the underlying assumptions of the Black-Scholes option pricing model and is charged to expense over the vesting period, generally three to five years. When modeling awards with vesting dependent on performance targets, these performance targets are incorporated into the model using Monte Carlo simulation. The expected life of these awards depends on the behavior of the award holders, which is incorporated into the model consistent with historic observable data. Compensation expense relating to restricted stock rights (RSRs) is based upon the market value of the RSRs on the date of grant and is charged to earnings over the vesting period of the RSRs, generally three to five years. Transactions With Related Parties In the normal course of business, HUSI enters into transactions with HSBC and its subsidiaries. These transactions occur at prevailing market rates and terms and include funding arrangements, administrative and operational support, and other miscellaneous services. All material related party balances and transactions among various direct and indirect subsidiaries of HUSI are eliminated in consolidation. 108 New Accounting Pronouncements During 2006, the following additional accounting pronouncements were adopted. Effective January 1, 2006, HUSI adopted Statement of Financial Accounting Standards No. 123 (Revised), Share-Based Payment, (SFAS 123R). Because HUSI had previously adopted the fair value method of accounting for all equity based awards, the adoption of SFAS 123R did not have a material impact on HUSI's financial position or results of operations. Effective January 1, 2006, HUSI adopted Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3 (SFAS 154). The adoption of SFAS 154 did not have any impact on HUSI's financial position or results of operations. In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155). SFAS 155 permits companies to elect to measure at fair value entire financial instruments containing embedded derivatives that would otherwise have to be bifurcated and accounted for separately. SFAS 155 also requires companies to identify interests in securitized financial assets that are free standing derivatives or contain embedded derivatives that would have to be accounted for separately, clarifies which interest-only and principal-only strip receivables are subject to Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), and amends Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140) to revise the conditions of a qualifying special purpose entity. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of a company's first fiscal year that begins after September 15, 2006. Early adoption is permitted as of the beginning of a company's fiscal year, provided the company has not yet issued financial statements for that fiscal year. HUSI elected to early adopt SFAS 155 effective January 1, 2006. The adoption of SFAS 155 did not have a material impact on HUSI's financial position or results of operations. In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets (SFAS 156). SFAS 156 amends previously issued guidance with respect to accounting for separately recognized loan servicing rights. HUSI early adopted this standard as of January 1, 2006 and elected to account for residential mortgage servicing rights at fair value prospectively. Refer to Notes 6 and 11 of the consolidated financial statements for information relating to the adoption of SFAS 156. In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, Employer's Accounting for Defined Benefit Pension and Other Postretirement Plans (SFAS 158). SFAS 158 requires balance sheet recognition of the funded status of pension and other postretirement benefits with the offset to accumulated other comprehensive income. Employers will recognize actuarial gains and losses, prior service cost, and any remaining transition amounts when recognizing a plan's funded status. SFAS 158 is effective for fiscal years ending after December 15, 2006. The adoption of SFAS 158 did not have a material impact on HUSI's financial position or results of operations. In September 2006, the United States Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB 108 requires companies to quantify misstatements using both the balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. SAB 108 is effective for fiscal years ending after November 15, 2006. The adoption of SAB 108 did not have any impact on HUSI's financial position or results of operations. 109 The following additional accounting pronouncements were issued in 2006 and 2007 and will be effective for HUSI in future periods. In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 establishes threshold and measurement attributes for financial statement measurement and recognition of tax positions taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The adoption of FIN 48 on January 1, 2007 did not have a material impact on HUSI's financial position or results of operations. In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). SFAS 157 establishes a single authoritative definition of fair value, sets out a framework for measuring fair value, and requires additional disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those years. Early application is permissible only if no annual or interim financial statements have been issued for the earlier periods. HUSI is currently evaluating the impact that adoption of SFAS 157 will have on its financial position and results of operations. In December 2006, the FASB issued proposed FASB Staff Position No. FIN 39-a, Amendment of FASB Interpretation No. 39 (Proposed FSP FIN39-a). Proposed FSP FIN 39-a would allow entities that are party to a master netting arrangement to offset the receivable or payable recognized upon payment or receipt of cash collateral against fair value amounts recognized for derivative instruments that have been offset under the same master netting arrangement in accordance with FASB Interpretation No. 39. The guidance in this proposed FSP will be effective for fiscal years beginning after December 15, 2006. Entities will be required to recognize the effects of applying this FSP as a change in accounting principle through retrospective application for all financial statements presented unless it is impracticable to do so. HUSI is currently evaluating the impact that adoption will have on its financial position. In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159), which creates an alternative measurement method for certain financial assets and liabilities. SFAS 159 permits fair value to be used for both the initial and subsequent measurements on a contract-by-contract election, with changes in fair value to be recognized in earnings as those changes occur. This election is referred to as the "fair value option". SFAS 159 also requires additional disclosures to compensate for the lack of comparability that will arise from the use of the fair value option. SFAS 159 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted as of the beginning of a company's fiscal year, provided the company has not yet issued financial statements for that fiscal year. HUSI is currently evaluating the impact the adoption of SFAS 159 will have on its financial position and results of operations. Note 3. Acquisitions and Divestitures -------------------------------------------------------------------------------- 2006 and 2005 There were no material business acquisitions or divestitures during 2006 or 2005. 2004 On December 29, 2004, HUSI purchased approximately $12 billion of private label loans, primarily credit card receivables, from HSBC Finance Corporation at fair value. HSBC Finance Corporation retained the customer relationships associated with these balances. This portfolio acquisition resulted in creation of the Consumer Finance business segment in 2005. See Note 24 beginning page 147 of this Form 10-K for a summary of HUSI's results by business segment. 110 Note 4. Federal Funds Sold and Securities Purchased Under Resale Agreements -------------------------------------------------------------------------------- Federal funds sold and securities borrowed or purchased under agreements to resell are summarized in the following table. -------------------------------------------------------------------------------- December 31 2006 2005 -------------------------------------------------------------------------------- (in millions) Federal funds sold ...................................... $ 6,781 $ -- Securities purchased under agreements to resell ......... 6,994 4,568 ------- ------- Total ................................................... $13,775 $ 4,568 ======= ======= Funds generated from deposits growth during 2006 were primarily invested in short-term investments such as Federal funds sold and securities purchased under resale agreements. Note 5. Trading Assets and Liabilities -------------------------------------------------------------------------------- Trading assets and liabilities are summarized in the following table. -------------------------------------------------------------------------------- December 31 2006 2005 -------------------------------------------------------------------------------- (in millions) Trading assets: U.S. Treasury ...................................... $ 646 $ 148 U.S. Government agency ............................. 1,902 1,238 Asset backed securities ............................ 3,053 1,981 Corporate bonds .................................... 1,420 2,786 Other securities ................................... 4,903 4,626 Precious metals .................................... 2,716 2,286 Fair value of derivatives .......................... 11,398 8,155 -------- -------- $ 26,038 $ 21,220 ======== ======== Trading liabilities: Securities sold, not yet purchased ................. $ 1,914 $ 1,808 Payables for precious metals ....................... 1,336 1,161 Fair value of derivatives .......................... 10,796 7,741 -------- -------- $ 14,046 $ 10,710 ======== ======== 111 Note 6. Securities -------------------------------------------------------------------------------- At December 31, 2006 and 2005, HUSI held no securities of any single issuer (excluding the U.S. Treasury, U.S. Government sponsored enterprises and U.S. Government agencies) with a book value that exceeded 10% of shareholders' equity. The amortized cost and fair value of the available for sale and held to maturity securities portfolios are summarized in the following table. ---------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair December 31, 2006 Cost Gains Losses Value ---------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury ........................................... $ 1,535 $ 3 $ (8) $ 1,530 U.S. Government sponsored enterprises (1) ............... 10,682 30 (257) 10,455 U.S. Government agency issued or guaranteed ............. 3,793 6 (72) 3,727 Obligations of U.S. states and political subdivisions ... 515 4 (1) 518 Asset backed securities ................................. 578 1 (3) 576 Other domestic debt securities .......................... 1,343 3 (19) 1,327 Foreign debt securities ................................. 860 7 (3) 864 Equity securities ....................................... 775 11 -- 786 ---------- ---------- ---------- ---------- Securities available for sale ........................... $ 20,081 $ 65 $ (363) $ 19,783 ========== ========== ========== ========== Securities held to maturity: U.S. Treasury ........................................... $ -- $ -- $ -- $ -- U.S. Government sponsored enterprises (1) ............... 1,845 43 (17) 1,871 U.S. Government agency issued or guaranteed ............. 584 25 (2) 607 Obligations of U.S. states and political subdivisions ... 325 19 -- 344 Other domestic debt securities .......................... 167 2 (2) 167 Foreign debt securities ................................. 51 -- -- 51 ---------- ---------- ---------- ---------- Securities held to maturity ............................. $ 2,972 $ 89 $ (21) $ 3,040 ========== ========== ========== ========== (1) Includes primarily mortgage backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). ---------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair December 31, 2005 Cost Gains Losses Value ---------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury ........................................... $ 711 $ -- $ (4) $ 707 U.S. Government sponsored enterprises (1) ............... 10,850 25 (251) 10,624 U.S. Government agency issued or guaranteed ............. 2,466 10 (48) 2,428 Obligations of U.S. states and political subdivisions ... 487 -- (5) 482 Asset backed securities ................................. 1,165 2 (4) 1,163 Other domestic debt securities .......................... 1,700 6 (15) 1,691 Foreign debt securities ................................. 611 8 (5) 614 Equity securities ....................................... 49 6 -- 55 ---------- ---------- ---------- ---------- Securities available for sale ........................... $ 18,039 $ 57 $ (332) $ 17,764 ========== ========== ========== ========== Securities held to maturity: U.S. Treasury ........................................... $ 83 $ -- $ -- $ 83 U.S. Government sponsored enterprises (1) ............... 1,860 57 (21) 1,896 U.S. Government agency issued or guaranteed ............. 644 31 (1) 674 Obligations of U.S. states and political subdivisions ... 369 25 -- 394 Other domestic debt securities .......................... 164 1 (1) 164 Foreign debt securities ................................. 51 -- -- 51 ---------- ---------- ---------- ---------- Securities held to maturity ............................. $ 3,171 $ 114 $ (23) $ 3,262 ========== ========== ========== ========== (1) Includes primarily mortgage backed securities issued by the FNMA and FHLMC. 112 HUSI adopted Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets (SFAS 156) effective January 1, 2006 (refer to New Accounting Pronouncements on page 109 of this Form 10-K). In accordance with SFAS 156, HUSI elected to reclassify securities used to offset changes in economic value of mortgage servicing rights from the available for sale portfolio to trading assets at the effective date. At December 31, 2005, these securities had an amortized cost of $115 million and a fair value of $111 million. The cumulative effect of $4 million was recorded as an adjustment to retained earnings in 2006. A summary of gross unrealized losses and related fair values, classified as to the length of time the losses have existed, is presented in the following table. ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year --------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value December 31, 2006 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury ................... 8 $ (1) $ 527 6 $ (7) $ 566 U.S. Government sponsored enterprises (1) .............. 211 (114) 3,158 482 (143) 5,042 U.S. Government agency issued or guaranteed ......... 691 (40) 2,334 268 (32) 1,076 Obligations of U.S. states and political subdivisions ....... 12 (1) 85 3 * 27 Asset backed securities ......... 6 * 81 19 (3) 293 Other domestic debt securities .. 10 (1) 153 56 (18) 910 Foreign debt securities ......... 6 (1) 191 11 (2) 227 ---------- ---------- ------------- ---------- ---------- ------------- Securities available for sale ... 944 $ (158) $ 6,529 845 $ (205) $ 8,141 ========== ========== ============= ========== ========== ============= Securities held to maturity: U.S. Treasury ................... -- $ -- $ -- -- $ -- $ -- U.S. Government sponsored enterprises (1) .............. 23 * 15 22 (17) 389 U.S. Government agency issued or guaranteed ......... 49 * 21 169 (2) 35 Obligations of U.S. states and political subdivisions ....... 1 * * 9 * 4 Other domestic debt securities .. 2 * 22 4 (2) 33 Foreign debt securities ......... 2 * 51 -- -- -- ---------- ---------- ------------- ---------- ---------- ------------- Securities held to maturity ..... 77 $ * $ 109 204 $ (21) $ 461 ========== ========== ============= ========== ========== ============= (1) Includes primarily mortgaged-backed securities issued by FNMA and FHLMC. * Less than $500 thousand. 113 ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year --------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value December 31, 2005 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury ................... 7 $ (4) $ 619 -- $ -- $ -- U.S. Government sponsored enterprises (1) .............. 560 (176) 7,313 46 (75) 1,434 U.S. Government agency issued or guaranteed ......... 288 (22) 1,346 82 (26) 434 Obligations of U.S. states and political subdivisions ....... 61 (5) 436 -- -- -- Asset backed securities ......... 22 (4) 464 31 * 23 Other domestic debt securities .. 6 (14) 1,089 7 (1) 34 Foreign debt securities ......... 17 (5) 336 1 * 25 ---------- ---------- ------------- ---------- ---------- ------------- Securities available for sale ... 961 $ (230) $ 11,603 167 $ (102) $ 1,950 ========== ========== ============= ========== ========== ============= Securities held to maturity: U.S. Treasury ................... 3 $ * $ 83 -- $ -- $ -- U.S. Government sponsored enterprises (1) .............. 28 (14) 397 3 (7) 41 U.S. Government agency issued or guaranteed ......... 181 (1) 34 -- -- -- Obligations of U.S. states and political subdivisions ....... 2 * * 10 * 4 Other domestic debt securities 4 * 33 2 (1) 5 Foreign debt securities ......... 2 * 51 -- -- -- ---------- ---------- ------------- ---------- ---------- ------------- Securities held to maturity ..... 220 $ (15) $ 598 15 $ (8) $ 50 ========== ========== ============= ========== ========== ============= (1) Includes primarily mortgage-backed securities issued by FNMA and FHLMC. * Less than $500 thousand. Gross unrealized losses have increased within the available for sale securities portfolio during 2006, due to changes in interest rates. Since substantially all of these securities are high credit grade (i.e., AAA or AA), and HUSI has the ability and intent to hold these securities until maturity or a market price recovery, they are not considered to be other than temporarily impaired. 114 The following table summarizes realized gains and losses on investment securities transactions attributable to available for sale and held to maturity securities. Amounts in the table include net realized (losses) gains of $(11) million and $8 million reported in residential mortgage banking revenue in the consolidated statement of income for 2005 and 2004, respectively. ----------------------------------------------------------------------------------- Net Gross Gross Realized Realized Realized Gains Year Ended December 31 Gains (Losses) (Losses) ----------------------------------------------------------------------------------- (in millions) 2006 Securities available for sale .................... $ 34 $ (6) $ 28 Securities held to maturity: Maturities, calls and mandatory redemptions ... 1 -- 1 -------- -------- -------- $ 35 $ (6) $ 29 ======== ======== ======== 2005 Securities available for sale .................... $ 107 $ (13) $ 94 Securities held to maturity: Maturities, calls and mandatory redemptions ... 1 -- 1 -------- -------- -------- $ 108 $ (13) $ 95 ======== ======== ======== 2004 Securities available for sale .................... $ 100 $ (8) $ 92 Securities held to maturity: Maturities, calls and mandatory redemptions ... 1 -- 1 -------- -------- -------- $ 101 $ (8) $ 93 ======== ======== ======== The amortized cost and fair values of securities available for sale and securities held to maturity at December 31, 2006, by contractual maturity are summarized in the following table. Expected maturities differ from contractual maturities because borrowers have the right to prepay obligations without prepayment penalties in certain cases. Available for sale amounts exclude equity securities with a fair value of $786 million ($775 million cost) that do not have stated maturities. 115 The following table also reflects the distribution of maturities of debt securities held at December 31, 2006, together with the approximate taxable equivalent yield of the portfolio. The yields shown are calculated by dividing annual interest income, including the accretion of discounts and the amortization of premiums, by the amortized cost of securities outstanding at December 31, 2006. Yields on tax-exempt obligations have been computed on a taxable equivalent basis using applicable statutory tax rates. ------------------------------------------------------------------------------------------------------------------------ Within After One After Five After One But Within But Within Ten Taxable Year Five Years Ten Years Years Equivalent ---------------- ----------------- ------------------ ------------------ Basis Amount Yield Amount Yield Amount Yield Amount Yield ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Available for sale: U.S. Treasury ..................... $ 225 4.09% $ 1,187 4.41% $ 123 4.38% $ -- --% U.S. Government sponsored enterprises ..................... 50 2.63 582 3.56 852 4.76 9,198 4.89 U.S. Government agency issued or guaranteed ...................... * 7.00 320 6.07 35 5.21 3,438 4.92 Obligations of U.S. states and political subdivisions ...... -- -- -- -- 6 5.34 509 5.03 Asset backed securities ........... 1 5.96 329 3.95 159 4.92 89 5.33 Other domestic debt securities .... 21 5.96 63 4.23 44 5.02 1,215 5.14 Foreign debt securities ........... 152 6.57 200 5.79 242 6.08 266 7.62 ------- ------- -------- -------- Total amortized cost ................ $ 449 4.86% $ 2,681 4.47% $ 1,461 4.98% $ 14,715 4.97% ======= ======= ======== ======== Total fair value .................... $ 448 $ 2,656 $ 1,429 $ 14,464 ======= ======= ======== ======== Held to maturity: U.S. Treasury ..................... $ -- --% $ -- --% $ -- --% $ -- --% U.S. Government sponsored enterprises ..................... 3 7.00 8 7.34 93 6.10 1,741 5.90 U.S. Government agency issued or guaranteed ...................... 1 7.10 9 6.97 4 8.65 570 6.49 Obligations of U.S. states and political subdivisions .......... 14 6.95 46 5.82 45 5.00 220 5.16 Other domestic debt securities .... -- -- -- -- -- -- 167 5.80 Foreign debt securities ........... 51 3.22 -- -- -- -- -- -- ------- ------- -------- -------- Total amortized cost ................ $ 69 4.16% $ 63 6.19% $ 142 5.83% $ 2,698 5.96% ======= ======= ======== ======== Total fair value .................... $ 69 $ 66 $ 149 $ 2,756 ======= ======= ======== ======== * Less than $500 thousand. Investments in Federal Home Loan Bank (FHLB) stock, Federal Reserve Bank (FRB) stock, and MasterCard Class B securities of $360 million, $306 million and $57 million, respectively, were included in other assets at December 31, 2006. Investments in FHLB and FRB stock of $360 million and $292 million, respectively, were included in other assets at December 31, 2005. 116 Note 7. Loans -------------------------------------------------------------------------------- A distribution of the loan portfolio, including loans held for sale, is summarized in the following table. ----------------------------------------------------------------------------------------------------------------- 2006 2005 ------------------------------- -------------------------------- Total Held for Sale Total Held for Sale Loans Included in Total Loans Included in Total ----------------------------------------------------------------------------------------------------------------- (in millions) Commercial: Construction and other real estate ..... $ 8,918 $ 102 $ 9,122 $ 68 Other commercial ....................... 20,564 -- 18,596 -- ---------- ----------------- ----------- ----------------- 29,482 102 27,718 68 ---------- ----------------- ----------- ----------------- Consumer: Residential mortgage ................... 39,808 4,227 43,986 4,107 Credit card receivables ................ 18,260 -- 15,514 -- Other consumer loans ................... 2,687 394 3,124 390 ---------- ----------------- ----------- ----------------- 60,755 4,621 62,624 4,497 ---------- ----------------- ----------- ----------------- Total loans ............................... $ 90,237 $ 4,723 $ 90,342 $ 4,565 ========== ================= =========== ================= In December 2004, HUSI acquired a $12 billion private label loan portfolio from HSBC Finance Corporation. The portfolio consisted of approximately $11 billion of private label credit card receivables and $1 billion of other consumer and commercial loans. The customer relationships were retained by HSBC Finance Corporation. By agreement, HUSI is purchasing additional credit card receivables generated from customer accounts at fair value on a daily basis. During 2006 and 2005, underlying customer balances included within the private label portfolio have revolved, and new relationships have been added, bringing the total private label credit card portfolio balance to approximately $17 billion at December 31, 2006. Higher quality nonconforming residential mortgage loans were acquired from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs from December 2003 until September 2005. Purchases of these loans were discontinued as a result of strategic balance sheet initiatives to enhance HUSI's liquidity position and to address interest rate risk. Residential mortgage loan originations generally declined during 2006 and 2005 due to a rising interest rate environment. In addition, originations of various adjustable rate residential mortgage loan products that would have been retained on the balance sheet prior to 2005 were being sold in the secondary market beginning in 2005 and throughout 2006, also as a result of strategic balance sheet initiatives to enhance liquidity and to address interest rate risk. These factors contributed to the overall decrease in residential mortgage loans during 2006. HUSI has loans outstanding to certain executive officers and directors. The loans were made on substantially the same terms, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other persons and do not involve more than normal risk of collectibility. The aggregate amount of such loans did not exceed 5% of shareholders' equity at December 31, 2006 and 2005. 117 Loans Held for Sale Beginning in June 2005, loans held for sale include residential mortgage loans acquired from unaffiliated third parties and from HSBC Finance Corporation, with the intent of selling the loans to HMUS. Loans held for sale to HMUS increased $244 million in 2006 to $3.1 billion at December 31, 2006. Loans held for sale are recorded at the lower of aggregate cost or market value. Aggregate cost exceeded market value at December 31, 2006 and December 31, 2005. Changes in the valuation allowance utilized to adjust loans held for sale to market value are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- 2006 2005 ------------------------------------ ------------------------------------ Valuation Allowance Related to Valuation Allowance Related to ------------------------------ ------------------------------ Loans Held Other Loans Held Other for Sale Loans Held for Sale Loans Held Year Ended December 31 to HMUS for Sale Total to HMUS for Sale Total ----------------------------------------------------------------------------------------------------------------------- (in millions) Balance at beginning of period ......... $ (11) $ (15) $ (26) $ -- $ (4) $ (4) (Increased) decreased allowance for net reductions in market value ... (133) 12 (121) (32) (11) (43) Releases of valuation allowance for loans sold ....................... 109 -- 109 21 -- 21 ---------- ---------- -------- ---------- ---------- -------- Balance at end of period ............... $ (35) $ (3) $ (38) $ (11) $ (15) $ (26) ========== ========== ======== ========== ========== ======== Loans held for sale to HMUS are subject to interest rate risk, in that their value will change as a result of changes in the interest rate environment. Interest rate risk is mitigated through an active economic hedging program to offset changes in value of the loans held for sale. Trading related revenues related to this economic hedging program, which includes net interest income and trading revenues were $132 million and $36 million for 2006 and 2005, respectively. Concentrations of Credit Risk A concentration of credit risk is defined as a significant credit exposure with an individual or group engaged in similar activities or affected similarly by economic conditions. HUSI enters into a variety of transactions in the normal course of business that involve both on- and off-balance sheet credit risk. Principal among these activities is lending to various commercial, institutional, governmental and individual customers. HUSI participates in lending activity throughout the United States and internationally. In general, HUSI controls the varying degrees of credit risk involved in on- and off-balance sheet transactions through specific credit policies. These policies and procedures provide for a strict approval, monitoring and reporting process. It is HUSI's policy to require collateral when it is deemed appropriate. Varying degrees and types of collateral are secured depending upon management's credit evaluation. As with any nonconforming and non-prime loan products, HUSI utilizes high underwriting standards and prices these loans in a manner that is appropriate to compensate for higher risk. Certain residential mortgage loans have high loan-to-value (LTV) ratios and no mortgage insurance, which could result in potential inability to recover the entire investment in loans involving foreclosed or damaged properties. HUSI also offers interest-only residential mortgage loans. These interest-only loans allow customers to pay only the accruing interest for a period of time, which results in lower payments during the initial loan period. Depending on a customer's financial situation, the subsequent increase in the required payment attributable to loan principal could affect a customer's ability to repay the loan at some future date when the interest rate resets and/or principal payments are required. 118 Outstanding balances of high LTV and interest-only loans are summarized in the following table. ------------------------------------------------------------------------------------------------ December 31 2006 2005 ------------------------------------------------------------------------------------------------ (in millions) Residential mortgage loans with high LTV and no mortgage insurance ... $ 2,717 $ 3,510 Interest-only residential mortgage loans ............................. 7,537 8,713 ---------- --------- Total ................................................................ $ 10,254 $ 12,223 ========== ========= Concentrations of first and second liens within the residential mortgage loan portfolio are summarized in the following table. Amounts in the table exclude loans held for sale. ------------------------------------------------------------------------------------------------ December 31 2006 2005 ------------------------------------------------------------------------------------------------ (in millions) Closed end: First lien ........................................................ $ 31,876 $ 36,389 Second lien ....................................................... 474 193 Revolving: Second lien ....................................................... 3,231 3,297 ---------- --------- Total ................................................................ $ 35,581 $ 39,879 ========== ========= HUSI also offers adjustable rate residential mortgage loans which allow it to adjust pricing on the loan in line with market movements. At December 31, 2006, HUSI had approximately $21.2 billion in adjustable rate residential mortgage loans. In 2007, approximately $2.5 billion of adjustable rate residential mortgage loans will experience their first interest rate reset. In 2008, approximately $3.6 billion of adjustable rate residential mortgage loans will experience their first interest rate reset. As interest rates have risen over the last three years, many adjustable rate loans are expected to require a significantly higher monthly payment following their first adjustment. A customer's financial situation at the time of the interest rate reset could affect the customer's ability to repay the loan after the adjustment. Regional exposure at December 31, 2006 for certain loan portfolios is summarized in the following table. -------------------------------------------------------------------------------------------------- Commercial Residential Credit Construction and Other Mortgage Card December 31, 2006 Real Estate Loans Loans Receivables -------------------------------------------------------------------------------------------------- New York State ............................. 53% 24% 6% North Central United States ................ 5 12 24 North Eastern United States ................ 7 12 14 Southern United States ..................... 17 24 31 Western United States ...................... 18 28 25 ----- ----- ---- Total ...................................... 100% 100% 100% ===== ===== ==== Sale of Brady Bonds At December 31, 2005, commercial loans included certain bonds issued by the government of Venezuela as part of debt renegotiations (Brady Bonds) with a face value of $178 million, and a recorded carrying value of $165 million. During the second quarter of 2006, the Venezuelan government redeemed all Brady Bonds held by HUSI at their face value resulting in a gain of $13 million, which was recorded in other revenues. 119 Credit Quality Statistics Nonaccruing loans information is summarized in the following table. ------------------------------------------------------------------------------------------------------- 2006 2005 ------------------------------------------------------------------------------------------------------- (in millions) Nonaccruing loans Balance at end of period: Commercial: Construction and other real estate ................................. $ 33 $ 15 Other commercial ................................................... 69 70 --------- --------- Total commercial ................................................... 102 85 --------- --------- Consumer: Residential mortgages .............................................. 182 138 Credit card receivables ............................................ 1 -- Other consumer loans ............................................... -- -- --------- --------- Total consumer loans ............................................... 183 138 --------- --------- Total nonaccruing loans .................................................. $ 285 $ 223 ========= ========= Interest income on nonaccruing loans is summarized in the following table. ------------------------------------------------------------------------------------------------------ Year Ended December 31 2006 2005 2004 ------------------------------------------------------------------------------------------------------ (in millions) Interest income on nonaccruing loans: Amount which would have been recorded had the associated loans been current in accordance with their original terms ....... $ 21 $ 25 $ 23 Amount actually recorded ...................................... 8 12 17 Additional credit quality statistics are summarized in the following table. ------------------------------------------------------------------------------------------------------ December 31 2006 2005 ------------------------------------------------------------------------------------------------------ (in millions) Accruing loans contractually past due 90 days or more as to principal or interest: Total commercial ........................................................... $ 22 $ 19 --------- -------- Consumer: Residential mortgages ................................................... 11 27 Credit card receivables ................................................. 339 248 Other consumer loans .................................................... 16 17 --------- -------- Total consumer loans .................................................... 366 292 --------- -------- Total accruing loans contractually past due 90 days or more ................ $ 388 $ 311 ========= ======== Impaired loans: Balance at end of period ................................................... $ 100 $ 90 Amount with impairment reserve ............................................. 35 27 Impairment reserve ......................................................... 13 10 Other real estate and owned assets: Balance at end of period ................................................... $ 53 $ 35 120 Note 8. Allowance for Credit Losses -------------------------------------------------------------------------------- An analysis of the allowance for credit losses is presented in the following table. ----------------------------------------------------------------------------------------------------- 2006 2005 2004 ----------------------------------------------------------------------------------------------------- (in millions) Balance at beginning of year ................................. $ 846 $ 788 $ 399 Provision charged (credited) to income ....................... 823 674 (17) Charge offs .................................................. (1,012) (871) (157) Recoveries ................................................... 248 255 78 Allowance related to acquisitions and (dispositions), net .... (8) -- 485 ---------- --------- --------- Balance at end of year ....................................... $ 897 $ 846 $ 788 ========== ========= ========= Non--United States transfer risk reserves included in the allowance for credit losses ................................ $ -- $ 4 $ 14 ========== ========= ========= On December 29, 2004, HUSI acquired approximately $12 billion of private label loans from HSBC Finance Corporation, including an allowance for credit losses associated with the purchased loans. Note 9. Securitizations and Secured Financings -------------------------------------------------------------------------------- On December 29, 2004, HUSI acquired a domestic private label loan portfolio from HSBC Finance Corporation, without recourse, which included a consumer private label credit card portfolio, securitized receivables related to this portfolio, and retained interest assets related to these securitizations. These credit card securitization transactions were structured to receive sale treatment under U.S. GAAP. In a securitization, a designated pool of receivables is removed from the balance sheet and transferred to an unaffiliated revolving trust. This unaffiliated trust is a qualifying special purpose entity (QSPE) as defined by SFAS 140 and, therefore, is not consolidated. The QSPE funds its purchase of receivables 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 replenishment of receivables to support previously issued securities. Replenishments for the revolving securitization trusts were $3.6 billion and $8.7 billion in 2006 and 2005, respectively. In the third quarter of 2006, the last remaining securitization trust agreement related to the private label portfolio acquired from HSBC Finance Corporation in 2004 was amended. As a result, the securitization trust no longer qualifies for sale treatment and the transaction is now recorded as a secured financing transaction. At the transaction date, all outstanding investments, credit card receivables and liabilities related to the trust were recorded on HUSI's consolidated balance sheet. All new collateralized funding transactions have been structured as secured financings under U.S. GAAP 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 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 consistently with the owned balance sheet portfolio. There have been no new secured financings in 2006. 121 HUSI's securitized receivables and secured financings are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Year ended December 31 2006 2005 ----------------------------------------------------------------------------------------------------------------------- (in millions) Securitized private label receivables at period end .............................. $ -- $ 1,343 ============ ============ Secured financings in long-term debt: Balance at period end ......................................................... $ 2,134 $ 1,500 ============ ============ Private label credit card receivables and investment securities collateralizing secured financings at period end ........................................... $ 2,439 $ 1,824 ============ ============ Note 10. Properties and Equipment, Net -------------------------------------------------------------------------------- The composition of properties and equipment, net of accumulated depreciation, is summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Depreciable December 31 Life (Years) 2006 2005 ----------------------------------------------------------------------------------------------------------------------- ($ in millions) Land ......................................................... -- $ 79 $ 92 Buildings .................................................... 5-40 754 688 Furniture and equipment ...................................... 3-7 519 503 ------------ ------------ Total ........................................................ 1,352 1,283 Less: accumulated depreciation ............................... (812) (745) ------------ ------------ Properties and equipment, net ................................ $ 540 $ 538 ============ ============ Depreciation expense during the year ......................... $ 79 $ 85 ============ ============ Note 11. Intangible Assets, Net -------------------------------------------------------------------------------- The following table summarizes the composition of intangible assets. ----------------------------------------------------------------------------------------------------------------------- December 31 2006 2005 ----------------------------------------------------------------------------------------------------------------------- (in millions) Mortgage servicing rights ........................................................ $ 474 $ 418 Other ............................................................................ 47 45 ------------ ------------ Intangible assets, net ........................................................... $ 521 $ 463 ============ ============ Mortgage Servicing Rights (MSRs) HUSI has one class of MSRs arising from sales of residential mortgage loans. HUSI recognizes the right to service mortgage loans as a separate and distinct asset at the time the loans are sold. HUSI receives a fee for servicing the related residential mortgage loans. Effective January 1, 2006, HUSI adopted SFAS 156 electing to measure this one class of MSRs at fair value. Upon adoption, HUSI recorded a cumulative effect adjustment to beginning retained earnings of less than $1 million, representing the difference between the fair value and the carrying amount of MSRs as of the date of adoption. MSRs are subject to prepayment and interest rate risk, in that their value will fluctuate as a result of changes in the interest rate environment. Interest rate risk is mitigated through an active economic hedging program that uses securities and derivatives to offset changes in the fair value of MSRs. Since the hedging program involves trading activity, risk is quantified and managed using a number of risk assessment techniques, which are addressed in more detail under Market Risk Management beginning on page 80 of this Form 10-K. 122 With the adoption of SFAS 156, HUSI also made an irrevocable election to reclassify securities used to offset changes in economic value of MSRs from available for sale to trading assets, effective January 1, 2006. At December 31, 2005, these securities had a book value of $115 million and a fair value of $111 million. The accumulated unrealized loss recorded in accumulated other comprehensive income of $4 million was reversed effective January 1, 2006, with the offsetting amount recorded as a cumulative effect adjustment to retained earnings. MSRs are initially measured at fair value at the time that the related loans are sold, and periodically remeasured using the fair value measurement method. This method requires that MSRs be measured at fair value at each reporting date with changes in fair value of the asset reflected in residential mortgage banking revenue in the period that the changes occur. Fair value is determined based upon the application of valuation models and other inputs. The valuation models incorporate assumptions market participants would use in estimating future cash flows. These assumptions include expected prepayments, default rates and market-based option adjusted spreads. The reasonableness of these valuation models is periodically validated by reference to external independent broker valuations and industry surveys. Fair value of MSRs is calculated using the following critical assumptions. ----------------------------------------------------------------------------------------------------------------------- December 31, December 31, 2006 2005 ----------------------------------------------------------------------------------------------------------------------- Annualized constant prepayment rate (CPR) ........................................ 20.80% 16.30% Constant discount rate ........................................................... 10.34% 12.07% Weighted average life ............................................................ 4.8 years 5.5 years The following table summarizes MSRs activity for the year ended December 31, 2006, the reporting period since adoption of SFAS 156. ----------------------------------------------------------------------------------------------------------------------- Year Ended December 31 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Fair value of MSRs: Beginning balance ................................................................................... $ 418 Additions related to loan sales ..................................................................... 100 Changes in fair value due to: Change in valuation inputs or assumptions used in the valuation models ........................... 43 Realization of cash flows ........................................................................ (87) ------------ Ending balance ...................................................................................... $ 474 ============ 123 The following table summarizes activity for MSRs and the related valuation allowance for the year ended December 31, 2005 and December 31, 2004, which was prior to the adoption of SFAS 156. ----------------------------------------------------------------------------------------------------------------------- 2005 2004 ----------------------------------------------------------------------------------------------------------------------- (in millions) MSRs, net of accumulated amortization: Balance, January 1 ............................................................ $ 416 $ 526 Additions related to loan sales ............................................... 136 62 Net MSRs acquisitions (sales) ................................................. -- (54) Permanent impairment charges .................................................. (21) (15) Amortization .................................................................. (74) (103) ------------ ------------ Balance, December 31 .......................................................... 457 416 ------------ ------------ Valuation allowance for MSRs: Balance, January 1 ............................................................ (107) (23) Temporary impairment (provision) recovery ..................................... 47 (102) Permanent impairment charges .................................................. 21 15 Release of allowance related to MSRs sold ..................................... -- 3 ------------ ------------ Balance, December 31 .......................................................... (39) (107) ------------ ------------ MSRs, net of accumulated amortization and valuation allowance at December 31 ..... $ 418 $ 309 ============ ============ Information regarding residential mortgage loans serviced for others, which are not included in the consolidated balance sheet, is summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Year Ended December 31 2006 2005 ----------------------------------------------------------------------------------------------------------------------- (in millions) Outstanding principal balances at period end ..................................... $ 34,736 $ 31,961 ============ ============ Custodial balances maintained and included in noninterest bearing deposits at period end .................................................................... $ 647 $ 628 ============ ============ Servicing fee income recorded in residential mortgage banking revenue during the period ........................................................................ $ 100 $ 76 ============ ============ Other Intangible Assets Other intangible assets include favorable lease arrangements and customer lists. The weighted-average amortization period for these intangible assets is 87 months at December 31, 2006. Total amortization expense was approximately $6 million for 2006 and 2005. Scheduled amortization is approximately $6 million per year for 2007 through 2011. 124 Note 12. Goodwill -------------------------------------------------------------------------------- During the second quarter of 2006, HUSI completed its annual impairment test of goodwill. In order to conform its testing date with that of HSBC and other HSBC affiliates, HUSI changed its accounting policy for the impairment testing date and completed an additional impairment test of goodwill in the third quarter. At both testing dates, HUSI determined that the fair value of each of the reporting units exceeded its carrying value. As a result, no impairment loss was required to be recognized. In subsequent years, the annual impairment test of goodwill will continue to be completed at July 1. During the year ended December 31, 2006, there were no material events or transactions which warranted consideration for their impact on recorded book values assigned to goodwill. The following table presents a summary of changes in goodwill. ----------------------------------------------------------------------------------------------------------------------- Year ended December 31 2006 2005 ----------------------------------------------------------------------------------------------------------------------- (in millions) Balance at beginning of year ..................................................... $ 2,694 $ 2,697 Purchase accounting adjustment ................................................... 22 -- Reductions related to branch disposals ........................................... -- (3) ------------ ------------ Balance at the end of the year ................................................... $ 2,716 $ 2,694 ============ ============ During 2006, a deferred tax asset related to a previous acquisition was adjusted against the related goodwill balance, resulting in the purchase accounting adjustment noted in the table above. Note 13. Deposits -------------------------------------------------------------------------------- The aggregate amounts of time deposit accounts (primarily certificates of deposits) each with a minimum of $100,000 included in domestic office deposits were approximately $19 billion and $23 billion at December 31, 2006 and 2005, respectively. Certain domestic deposits meet the definition of a hybrid financial instrument as defined in SFAS 155. As a result, deposits totaling $1.3 billion at December 31, 2006 are being carried at fair value with all changes in fair value recorded to profit and loss. The scheduled maturities of all time deposits at December 31, 2006 is summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Domestic Foreign Offices Offices Total ----------------------------------------------------------------------------------------------------------------------- (in millions) 2007: 0-90 days ................................................. $ 13,927 $ 9,262 $ 23,189 91-180 days ............................................... 5,039 328 5,367 181-365 days .............................................. 4,312 242 4,554 ----------- ------------ ------------ 23,278 9,832 33,110 2008 ......................................................... 1,528 20 1,548 2009 ......................................................... 144 8 152 2010 ......................................................... 125 -- 125 2011 ......................................................... 75 -- 75 Later years .................................................. 279 -- 279 ----------- ------------ ------------ $ 25,429 $ 9,860 $ 35,289 =========== ============ ============ Overdraft deposits reclassified to loans were approximately $1,727 million and $1,291 million at December 31, 2006 and 2005, respectively. 125 Note 14. Short-Term Borrowings -------------------------------------------------------------------------------- The following table summarizes the components of short-term borrowings. At December 31, 2006 and 2005, there were no categories of short-term borrowings that exceeded 30% of total shareholders' equity. -------------------------------------------------------------------------------- December 31 2006 2005 -------------------------------------------------------------------------------- (in millions) Federal funds purchased (day to day) .................. $ 77 $ 57 Securities sold under repurchase agreements ........... 1,328 1,273 Commercial paper ...................................... 2,414 2,620 Precious metals ....................................... 1,146 1,812 Other ................................................. 108 605 --------- --------- Total short-term borrowings ........................... $ 5,073 $ 6,367 ========= ========= In July 2006, HUSI's unused $2 billion line of credit from HSBC Finance Corporation expired and was not renewed. At December 31, 2006, HUSI had an unused line of credit from HSBC of $2 billion. This line of credit does not require compensating balance arrangements and commitment fees are not significant. The interest rate is comparable to third party rates for a line of credit with similar terms. At December 31, 2006, HUSI had an unused line of credit from its parent, HSBC North America Inc., of $150 million. The interest rate is comparable to third party rates for a line of credit with similar terms. As a member of the New York Federal Home Loan Bank (FHLB), HUSI has a secured borrowing facility, which is collateralized by residential mortgage loans. At December 31, 2006 and 2005, the facility included $5 billion of borrowings included in long-term debt (see Note 15). The facility also allows access to further short-term borrowings based upon the amount of residential mortgage loans pledged as collateral with the FHLB, which were undrawn as of December 31, 2006 and 2005. 126 Note 15. Long-Term Debt -------------------------------------------------------------------------------- The composition of long-term debt is presented in the following table. Interest rates on floating rate notes are determined periodically by formulas based on certain money market rates or, in certain instances, by minimum interest rates as specified in the agreements governing the issues. Interest rates in effect at December 31, 2006 are shown in parentheses. -------------------------------------------------------------------------------------------------------------- December 31 2006 2005 -------------------------------------------------------------------------------------------------------------- (in millions) Issued by HUSI or its subsidiaries other than HBUS: Non-subordinated debt: Medium-Term Floating Rate Notes due 2007-2011 (5.14% - 5.38%) .................... $ 53 $ -- 8.375% Debentures due 2007 ....................................................... 100 101 Floating Rate Extendible Notes due 2008-2011 (5.35%) ............................. 1,499 1,497 --------- --------- 1,652 1,598 Subordinated debt: 7% Subordinated Notes due 2006 ................................................... -- 300 Fixed Rate Subordinated Notes due 2008-2097 (5.88% - 9.70%) ...................... 1,496 1,501 Perpetual Capital Notes (5.69%) .................................................. 127 126 Junior Subordinated Debentures due 2026-2032 (7.53% - 8.38%) ..................... 1,061 1,070 --------- --------- 2,684 2,997 --------- --------- Total issued by HUSI or its subsidiaries other than HBUS ............................ 4,336 4,595 --------- --------- Issued or acquired by HBUS or its subsidiaries: Non-subordinated debt: Global Bank Note Program: Medium-Term Floating Rate Notes due 2007-2040 (5.14% - 5.63%) .................... 2,108 1,544 3.875% Fixed Rate Senior Global Bank Notes due 2009 .............................. 1,943 1,940 5.43% Fixed Rate Senior Global Bank Notes due 2009 ............................... 20 -- Floating Rate Senior Global Bank Notes due 2007-2009 (5.42% - 5.49%) ............. 4,646 8,890 Floating Rate Non-USD Global Bank Notes due 2008-2009 (3.54% - 3.56%) ............ 1,328 1,191 Floating Rate/Fixed Rate Senior Notes due 2012 (5.86%) ........................... 25 25 --------- --------- 10,070 13,590 Federal Home Loan Bank of New York (FHLB) advances: Fixed Rate FHLB advances due 2007-2033 (2.01% - 7.24%) ........................... 10 8 Floating Rate FHLB advances due 2007-2036 (5.36% - 5.38%) ........................ 5,000 5,000 --------- --------- 5,010 5,008 Private Label Credit Card Secured Financing due 2007-2008 (5.49% - 6.52%), refer to Note 9 ........................................................................... 2,134 1,500 Precious Metal Leases due 2007-2014 (0.10%-1.70%) ................................... 729 683 Obligations of consolidated Variable Interest Entities due 2010-2035 (5.26% - 5.96%), refer to Note 27 ................................................................. 2,542 954 Other: 5.99% Fixed Rate Note due 2011 ................................................... 350 -- Floating Rate Note due 2011 (5.86%) .............................................. 4 -- 6.60% Fixed Rate Note due 2021 ................................................... 858 -- 3.99% Non-USD Senior Debt due 2044 ............................................... 530 481 Other ............................................................................ 34 40 --------- --------- 1,776 521 --------- --------- Total non-subordinated debt ......................................................... 22,261 22,256 --------- --------- Subordinated debt: 4.625% Global Subordinated Notes due 2014 ........................................ 995 994 Global Bank Note Program: Fixed Rate Global Bank Notes due 2034-2035 (5.63% - 5.88%) ....................... 1,643 1,731 --------- --------- Total subordinated debt ............................................................. 2,638 2,725 --------- --------- Total issued or acquired by HBUS or its subsidiaries ................................ 24,899 24,981 --------- --------- Obligations under capital leases .................................................... 17 19 --------- --------- Total long-term debt ................................................................ $ 29,252 $ 29,595 ========= ========= 127 The table excludes $1,250 million of debt issued by HBUS or its subsidiaries payable to HUSI. Of this amount, the earliest note is due to mature in October 2008 and the latest note is due to mature in 2097. Debt Issued by HUSI or its Subsidiaries other than HBUS In April 2006, HUSI filed an S-3 Shelf Registration Statement (the 2006 shelf) with the Securities and Exchange Commission. Under the 2006 shelf, HUSI may issue debt securities or preferred stock, either separately or represented by depositary shares, warrants, purchase contracts and units comprised of any combination of one or more of the aforementioned securities. The 2006 shelf, which has no dollar limit, replaced a shelf filed in 2005 in the amount of $2.3 billion. The Medium-Term Floating Rate Notes due 2007-2011 were issued under the 2006 shelf. The $1.5 billion Floating Rate Extendible Notes were issued by HUSI in November 2005. These senior debt securities require the noteholders to decide each month whether or not to extend the maturity date of their notes by one month beyond the initial maturity date of December 15, 2006. In no event will the maturity of the notes be extended beyond December 15, 2011, the final maturity date. If on any election date a noteholder decides not to extend the maturity of all or any portion of the principal amount of his notes, the notes will mature on the previously elected maturity date, which will be the maturity date that is twelve months from the current election date. On the December 2006 election date, all noteholders elected to extend the maturity date of their notes to January 15, 2008. The notes are not subject to redemption by HUSI prior to the final maturity date. Interest is payable on the notes in arrears on the 15th day of each month, commencing December 15, 2005 and ending on the final maturity date. The interest rate will be determined by reference to the one-month LIBOR, plus or minus the applicable spread for that particular interest period. The spread for each interest period ranges from minus 2 basis points for the interest period ending December 15, 2006 to plus 3 basis points for the interest period ending December 15, 2011. Debt Issued by HBUS or its Subsidiaries In December 2006, HBUS increased the size of its Global Bank Note Program from $20 billion to $40 billion. The Global Bank Note Program provides for the issuance of fixed rate and floating rate, senior and subordinated notes. The following debt issues were made under this program in 2006 and 2005. o In November 2006, HBUS issued the $20 million 5.43% Senior Notes due 2009. Interest is paid semiannually on May 20 and November 20 of each year, commencing on May 20, 2007 and ending on the stated maturity date of November 20, 2009. HBUS may redeem the notes, in whole but not in part, on November 20, 2007. o Certain Medium-Term Floating Rate Notes issued in 2006 meet the definition of hybrid financial instruments under SFAS 155, which was adopted in 2006 (see Note 2). Medium-Term Floating Rate Notes totaling $900 million at December 31, 2006 are being carried at fair value. o In June 2005, HBUS issued the $25 million Floating Rate/Fixed Rate Senior Notes due 2012. Interest on the notes is paid quarterly commencing September 29, 2005. For each interest payment period in the period from (and including) June 29, 2005 to (but excluding) the interest payment date falling on June 29, 2007, the interest rate is determined by reference to the three month LIBOR plus 0.50% per annum. For each interest payment period in the period from (and including) June 29, 2007 to (but excluding) the stated maturity date of June 29, 2012, the interest rate is 4.95% per annum. HBUS may redeem the notes, in whole but not in part, on June 29, 2007. o In August 2005, HBUS issued $750 million 5.625% Subordinated Notes due 2035. Interest is paid semiannually on February 15 and August 15 of each year, commencing February 15, 2006 and ending on the stated maturity date of August 15, 2035. These notes may not be redeemed by HBUS. Other includes certain notes totaling $1.2 billion at December 31, 2006, which resulted from a 2006 structured financing transaction. 128 As of December 31, 2006, the contractual scheduled maturities for total long-term debt over the next five years are as follows. -------------------------------------------------------------------------------- (in millions) 2007 ........................................................... $ 7,467 2008 ........................................................... 4,070 2009 ........................................................... 4,476 2010 ........................................................... 1,068 2011 ........................................................... 2,144 Note 16. Derivative Instruments and Hedging Activities -------------------------------------------------------------------------------- HUSI is party to various derivative financial instruments as an end user (1) for asset and liability management purposes; (2) in order to offset the risk associated with changes in the value of various assets and liabilities accounted for in the trading account; (3) to protect against changes in value of its mortgage servicing rights portfolio; and (4) for trading in its own account. HUSI is also an international dealer in derivative instruments denominated in U.S. dollars and other currencies which include futures, forwards, swaps and options related to interest rates, foreign exchange rates, equity indices, commodity prices and credit, focusing on structuring of transactions to meet clients' needs. Fair Value Hedges Specifically, interest rate swaps that call for the receipt of a variable market rate and the payment of a fixed rate are utilized under fair value strategies to hedge the risk associated with changes in the risk free rate component of the value of certain fixed rate investment securities. Interest rate swaps that call for the receipt of a fixed rate and payment of a variable market rate are utilized to hedge the risk associated with changes in the risk free rate component of certain fixed rate debt obligations. The regression method is utilized in order to satisfy the retrospective and prospective assessment of hedge effectiveness for SFAS 133. HUSI recognized net gains (losses) of approximately $10 million, $2 million and $(3) million for the years ended December 31, 2006, 2005 and 2004, respectively, (reported as other income in the consolidated statement of income), which represented the ineffective portion of all fair value hedges. Only the time value component of these derivative contracts has been excluded from the assessment of hedge effectiveness. For the years ended December 31, 2006 and 2005, $5 million and $7 million of gains related to the basis adjustment of terminated and/or redesignated fair value hedge relationships were amortized to earnings. During 2007, HUSI expects to amortize $6 million of remaining gains to earnings resulting from these terminated and/or redesignated fair value hedges. Cash Flow Hedges Similarly, interest rate swaps and futures contracts that call for the payment of a fixed rate are utilized under the cash flow strategy to hedge the forecasted repricing of certain deposit liabilities. In order to satisfy the retrospective and prospective assessment of hedge effectiveness for SFAS 133, the regression method is utilized. Ineffectiveness is recorded to the statement of income on a monthly basis. The total ineffectiveness of all cash flow hedges was less than $1 million for each of the years ended December 31, 2006, 2005 and 2004. Only the time value component of these derivative contracts has been excluded from the assessment of hedge effectiveness. 129 Gains or losses on derivative contracts that are reclassified from accumulated other comprehensive income to current period earnings pursuant to this strategy, are included in interest expense on deposit liabilities during the periods that net income is impacted by the underlying liabilities. As of December 31, 2006, approximately $7 million of deferred net gains on derivative instruments accumulated in other comprehensive income are expected to be included in earnings during 2007. At December 31, 2006, the net unrealized loss on derivatives included in accumulated other comprehensive income was $13 million, net of income taxes. Of this amount, the $64 million gain represents the effective portion of the net gains on derivatives that qualify as cash flow hedges, and the $77 million loss relates to terminated and/or redesignated derivatives. For the years ended December 31, 2006 and 2005, respectively, $35 million and $34 million of gains related to terminated and/or redesignated cash flow hedge relationships were amortized to earnings from other comprehensive income. During 2007, HUSI expects to amortize $11 million of remaining gains to earnings resulting from these terminated and/or redesignated cash flow hedges. Trading and Other Activities HUSI enters into certain derivative contracts for purely trading purposes in order to realize profits from short-term movements in interest rates, commodity prices, foreign exchange rates and credit spreads. In addition, certain derivative contracts are accounted for on a full mark to market basis through current earnings even though they were acquired for the purpose of protecting the economic value of certain assets and liabilities. 130 Notional Values of Derivative Contracts The following table summarizes the notional values of derivative contracts. ------------------------------------------------------------------------------------------ December 31 2006 2005 ------------------------------------------------------------------------------------------ (in millions) Interest rate: Futures and forwards .................................... $ 94,204 $ 106,826 Swaps ................................................... 1,906,688 1,674,091 Options written ......................................... 510,023 199,676 Options purchased ....................................... 544,026 217,095 ------------ ------------ 3,054,941 2,197,688 ------------ ------------ Foreign exchange: Swaps, futures and forwards ............................. 394,621 308,264 Options written ......................................... 61,406 40,213 Options purchased ....................................... 63,795 40,959 Spot .................................................... 32,654 21,099 ------------ ------------ 552,476 410,535 ------------ ------------ Commodities, equities and precious metals: Swaps, futures and forwards ............................. 43,620 48,702 Options written ......................................... 12,263 14,378 Options purchased ....................................... 16,115 16,127 ------------ ------------ 71,998 79,207 ------------ ------------ Credit derivatives ......................................... 816,422 391,814 ------------ ------------ Total ...................................................... $ 4,495,837 $ 3,079,244 ============ ============ The total notional amounts in the table above relate primarily to HUSI's trading activities. Notional amounts included in the table related to non-trading fair value, cash flow and economic hedging activities were $27 billion and $26 billion at December 31, 2006 and 2005, respectively. Note 17. Income Taxes -------------------------------------------------------------------------------- Total income taxes were allocated as follows. ------------------------------------------------------------------------------------------------------ Year Ended December 31 2006 2005 2004 ------------------------------------------------------------------------------------------------------ (in millions) To income before income taxes ........................................ $ 530 $ 566 $ 718 To shareholders' equity as tax charge (benefit): Net unrealized losses on securities available for sale ............ (22) (111) (20) Unrealized (losses) gains on derivatives classified as cash flow hedges ............................................................ (106) 78 (30) Unrealized (losses) gains on interest-only strip receivables ...... (4) 4 -- Cumulative adjustment from adoption of new pension accounting pronouncement .................................................. (13) -- -- Foreign currency translation, net ................................. -- (4) 4 ------- ------- ------- $ 385 $ 533 $ 672 ======= ======= ======= The components of income tax expense follow. ------------------------------------------------------------------------------------------------------ Year Ended December 31 2006 2005 2004 ------------------------------------------------------------------------------------------------------ (in millions) Current: Federal ........................................................... $ 466 $ 484 $ 455 State and local ................................................... 51 90 150 Foreign ........................................................... 18 7 17 ------- ------- ------- Total current ........................................................ 535 581 622 Deferred, primarily federal .......................................... (5) (15) 96 ------- ------- ------- Total income tax expense ............................................. $ 530 $ 566 $ 718 ======= ======= ======= 131 The following table is an analysis of the difference between effective rates based on the total income tax provision attributable to pretax income and the statutory U.S. Federal income tax rate. ------------------------------------------------------------------------------------------------------ Year Ended December 31 2006 2005 2004 ------------------------------------------------------------------------------------------------------ Statutory rate ....................................................... 35.0% 35.0% 35.0% Increase (decrease) due to: State and local income taxes ...................................... 2.1 4.2 5.6 Release of tax reserves ........................................... (.7) (.3) (2.9) Tax exempt interest income ........................................ (.9) (.7) (.5) Low income housing and miscellaneous other tax credits ............ (1.8) (1.4) (.5) Other items ....................................................... .1 (.1) (.4) ------- -------- -------- Effective income tax rate ............................................ 33.8% 36.7% 36.3% ======= ======== ======== The components of the net deferred tax position are presented in the following table. ------------------------------------------------------------------------------------------------------ December 31 2006 2005 ------------------------------------------------------------------------------------------------------ (in millions) Deferred tax assets: Allowance for credit losses ................................................. $ 296 $ 322 Benefit accruals ............................................................ 100 96 Accrued expenses not currently deductible ................................... 80 55 Unrealized losses on securities available for sale .......................... 122 100 Net purchase discount on acquired companies ................................. (6) 39 Accrued pension cost ........................................................ 14 3 Premium on purchased receivables ............................................ 4 12 ------- ------- Total deferred tax assets ................................................ 610 627 ------- ------- Less deferred tax liabilities: Lease financing income accrued .............................................. 7 13 Investment securities ....................................................... (20) 90 Accrued income on foreign bonds ............................................. -- 10 Deferred gain recognition ................................................... 34 31 Depreciation and amortization ............................................... 6 24 Interest and discount income ................................................ 168 227 Deferred fees/costs ......................................................... 97 87 Mortgage servicing rights ................................................... 177 137 Other ....................................................................... 40 6 ------- ------- Total deferred tax liabilities ........................................... 509 625 ------- ------- Net deferred tax asset ................................................... $ 101 $ 2 ======= ======= Realization of deferred tax assets is contingent upon the generation of future taxable income or the existence of sufficient taxable income within the carryback period. Based upon the level of historical taxable income and the scheduled reversal of the deferred tax liabilities over the periods in which the deferred tax assets are deductible, management believes that it is more likely than not HUSI would realize the benefits of these deductible differences. In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 establishes threshold and measurement attributes for financial statement recognition of tax positions taken or expected to be taken on a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The adoption of FIN 48 will not have an impact on the financial results of HUSI. The adoption of FIN 48 will result in the recognition of additional current tax liabilities and offsetting deferred tax assets of $11 million. 132 Note 18. Preferred Stock -------------------------------------------------------------------------------- The following table presents information related to the issues of preferred stock outstanding. -------------------------------------------------------------------------------------------------------------------- Amount Shares Dividend Outstanding Outstanding Rate ------------------------ December 31 2006 2006 2006 2005 -------------------------------------------------------------------------------------------------------------------- ($ in millions) Floating Rate Non-Cumulative Preferred Stock, Series F ($25 stated value) ........................................ 20,700,000 5.910% $ 517 $ 517 14,950,000 Depositary Shares each representing a one-fortieth interest in a share of Floating Rate Non-Cumulative Preferred Stock, Series G ($1,000 stated value) ..................................... 373,750 5.910 374 374 14,950,000 Depositary Shares each representing a one-fortieth interest in a share of 6.50% Non-Cumulative Preferred Stock, Series H ($1,000 stated value) ........... 373,750 6.500 374 -- 6,000,000 Depositary shares each representing a one-fourth interest in a share of Adjustable Rate Cumulative Preferred Stock, Series D ($100 stated value) ....................................... 1,500,000 4.500 150 150 $2.8575 Cumulative Preferred Stock ($50 stated value) ........ 3,000,000 5.715 150 150 Dutch Auction Rate Transferable Securities(TM) Preferred Stock (DARTS): Series A ($100,000 stated value) ....................... 625 4.154 63 63 Series B ($100,000 stated value) ....................... 625 4.215 62 62 CTUS Inc. Preferred Stock .................................... 100 -- -- (1) -- (1) --------- --------- $ 1,690 $ 1,316 ========= ========= (1) Less than $500 thousand Preferred Stock 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 ($1,000 stated value). Total issue proceeds, net of $9 million of underwriting fees and other expenses, were $365 million. When and if declared by HUSI's Board of Directors, dividends of 6.50% per annum on the stated value per share will be payable quarterly on the first calendar day of January, April, July and October of each year. The Series H Preferred Stock may be redeemed at the option of HUSI, in whole or in part, on or after July 1, 2011 at $1,000 per share, plus accrued and unpaid dividends for the then-current dividend period. Dividends on the Floating Rate Non-Cumulative Series F Preferred Stock are non-cumulative and will be payable when and if declared by the Board of Directors of HUSI quarterly on the first calendar day of January, April, July and October of each year. Dividends on the stated value per share are payable for each dividend period at a rate equal to a floating rate per annum of .75% above three month LIBOR, but in no event will the rate be less than 3.5% per annum. The Series F Preferred Stock may be redeemed at the option of HUSI, in whole or in part, on or after April 7, 2010 at a redemption price equal to $25 per share, plus accrued and unpaid dividends for the then-current dividend period. Dividends on the Floating Rate Non-Cumulative Series G Preferred Stock are non-cumulative and will be payable when and if declared by the Board of Directors of HUSI quarterly on the first calendar day of January, April, July and October of each year. Dividends on the stated value per share are payable for each dividend period at a rate equal to a floating rate per annum of .75% above three month LIBOR, but in no event will the rate be less than 4% per annum. The Series G Preferred Stock may be redeemed at the option of HUSI, in whole or in part, on or after January 1, 2011 at a redemption price equal to $1,000 per share, plus accrued and unpaid dividends for the then-current dividend period. 133 The Adjustable Rate Cumulative Preferred Stock, Series D is redeemable, as a whole or in part, at the option of HUSI at $100 per share (or $25 per depositary share), plus accrued and unpaid dividends. The dividend rate is determined quarterly, by reference to a formula based on certain benchmark market interest rates, but will not be less than 4 1/2% or more than 10 1/2% per annum for any applicable dividend period. The $2.8575 Cumulative Preferred Stock may be redeemed at the option of HUSI, in whole or in part, on or after October 1, 2007 at $50 per share, plus accrued and unpaid dividends. Dividends are paid quarterly. DARTS of each series are redeemable at the option of HUSI, in whole or in part, on any dividend payment date, at $100,000 per share, plus accrued and unpaid dividends. Dividend rates for each dividend period are set pursuant to an auction procedure. The maximum applicable dividend rates on the shares of DARTS range from 110% to 150% of the 60 day "AA" composite commercial paper rate. HUSI acquired CTUS Inc., a unitary thrift holding company in 1997 from CT Financial Services Inc. (the Seller). CTUS owned First Federal Savings and Loan Association of Rochester (First Federal). The acquisition agreement provided that HUSI issue preferred shares to the Seller. The preferred shares provide for, and only for, a contingent dividend or redemption equal to the amount of recovery, net of taxes and costs, if any, by First Federal resulting from the pending action against the United States government alleging breaches by the government of contractual obligations to First Federal following passage of the Financial Institutions Reform, Recovery and Enforcement Act of 1989. HUSI issued 100 preferred shares at a par value of $1.00 per share in connection with the acquisition. 134 Note 19. Retained Earnings and Regulatory Capital Requirements -------------------------------------------------------------------------------- Bank dividends are a major source of funds for payment by HUSI of shareholder dividends and along with interest earned on investments, cover HUSI's operating expenses which consist primarily of interest on outstanding debt. The approval of the OCC is required if the total of all dividends declared by HBUS in any year exceeds the net profits for that year, combined with the retained profits for the two preceding years. Under a separate restriction, payment of dividends is prohibited in amounts greater than undivided profits then on hand, after deducting actual losses and bad debts. Bad debts are debts due and unpaid for a period of six months unless well secured, as defined, and in the process of collection. Under the more restrictive of the above rules, as of December 31, 2006, HBUS can pay dividends to HUSI of approximately $1.6 billion, adjusted by the effect of its net income (loss) for 2007 up to the date of such dividend declaration. Additional information regarding regulation, supervision and capital for HUSI and HBUS begins on page 11 of this Form 10-K. Capital amounts and ratios of HUSI and HBUS, calculated in accordance with banking regulations, are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- 2006 2005 ------------------------------------ -------------------------------------- Capital Well-Capitalized Actual Capital Well-Capitalized Actual December 31 Amount Minimum Ratio Ratio Amount Minimum Ratio Ratio ----------------------------------------------------------------------------------------------------------------------- ($ in millions) Total capital (to risk weighted assets): HUSI ............................ $ 15,501 10.00% 12.58% $ 14,808 10.00% 12.53% HBUS ............................ 14,998 10.00 12.23 14,464 10.00 12.32 Tier 1 capital (to risk weighted assets): HUSI ............................ 10,577 6.00 8.58 9,746 6.00 8.25 HBUS ............................ 10,278 6.00 8.38 9,737 6.00 8.29 Tier 1 capital (to average assets): HUSI ............................ 10,577 3.00 6.36 9,746 3.00 6.51 HBUS ............................ 10,278 5.00 6.29 9,737 5.00 6.61 Risk weighted assets: HUSI ............................ 123,262 118,145 HBUS ............................ 122,652 117,382 135 Note 20. Accumulated Other Comprehensive Income -------------------------------------------------------------------------------- Accumulated other comprehensive income includes certain items that are reported directly within a separate component of shareholders' equity. The following table presents changes in accumulated other comprehensive income balances. ---------------------------------------------------------------------------------------------- 2006 2005 2004 ---------------------------------------------------------------------------------------------- (in millions) Unrealized (losses) gains on available for sale securities: Balance, January 1 ............................................. $ (128) $ 21 $ 61 Increase (decrease) in fair value, net of taxes of $10, $71 and $(19), in 2006, 2005 and 2004, respectively ........... (55) (94) 14 Net gains on sale of securities reclassified to net income, net of taxes of $12, $40 and $39 in 2006, 2005 and 2004, respectively .............................................. (16) (55) (54) ------- ------- ------ Net change .................................................. (71) (149) (40) ------- ------- ------ Balance, December 31 ........................................... (199) (128) 21 ======= ======= ====== Unrealized (losses) gains on derivatives classified as cash flow hedges: Balance, January 1 ............................................. 98 (6) 52 Change in unrealized gain (loss) net of taxes of $106, $(78) and $30 in 2006, 2005 and 2004, respectively .............. (106) 104 (58) ------- ------- ------ Net change .................................................. (106) 104 (58) ------- ------- ------ Balance, December 31 ........................................... (8) 98 (6) ======= ======= ====== Unrealized gains on interest-only strip receivables: Balance, January 1 ............................................. 7 -- -- Change in unrealized gains on interest-only strip receivables, net of taxes of $4 and $(4) in 2006 and 2005, respectively .............................................. (7) 7 -- ------- ------- ------ Net change .................................................. (7) 7 -- ------- ------- ------ Balance, December 31 ........................................... -- 7 -- ======= ======= ====== Foreign currency translation adjustments: Balance, January 1 ............................................. 11 16 15 Translation gains, net of taxes of $4 and $(4) in 2005 and 2004, respectively ........................................ * (5) 1 ------- ------- ------ Net change .................................................. -- (5) 1 ------- ------- ------ Balance, December 31 ........................................... 11 11 16 ======= ======= ====== Unfunded postretirement benefits liability: Balance, January 1 ............................................. -- -- -- Cumulative effect of change in accounting for pension and postretirement benefits, net of taxes of $13 in 2006 ...... (18) -- -- ------- ------- ------ Net change .................................................. (18) -- -- ------- ------- ------ Balance, December 31 ........................................... (18) -- -- ======= ======= ====== Summary of accumulated other comprehensive (loss) income: Accumulated other comprehensive (loss) income, January 1 ....... (12) 31 128 Other comprehensive loss, net of tax ........................... (184) (43) (97) Cumulative effect of change in accounting for pension and postretirement benefits, net of tax .......................... (18) -- -- ------- ------- ------ Accumulated other comprehensive (loss) income, December 31 ..... $ (214) $ (12) $ 31 ======= ======= ====== * Less than $500 thousand. 136 Note 21. Related Party Transactions -------------------------------------------------------------------------------- In the normal course of business, HUSI conducts transactions with HSBC and its affiliates (HSBC affiliates). These transactions occur at prevailing market rates and terms. All extensions of credit by HUSI to other HSBC affiliates are legally required to be secured by eligible collateral. The following table presents related party balances and the income and expense generated by related party transactions. ---------------------------------------------------------------------------------------------------- December 31 2006 2005 2004 ---------------------------------------------------------------------------------------------------- (in millions) Assets: Cash and due from banks ..................................... $ 179 $ 121 $ 182 Interest bearing deposits with banks ........................ 59 67 283 Federal funds sold and securities purchased under resale agreements ................................................ 141 111 47 Trading assets .............................................. 6,895 5,386 3,167 Loans ....................................................... 1,042 1,901 1,378 Other ....................................................... 1,192 78 126 --------- --------- --------- Total assets ................................................ $ 9,508 $ 7,664 $ 5,183 ========= ========= ========= Liabilities: Deposits .................................................... $ 12,232 $ 10,131 $ 9,764 Trading liabilities ......................................... 6,473 4,545 5,748 Short-term borrowings ....................................... 464 698 1,089 Other ....................................................... 255 106 28 --------- --------- --------- Total liabilities ........................................... $ 19,424 $ 15,480 $ 16,629 ========= ========= ========= ---------------------------------------------------------------------------------------------------- December 31 2006 2005 2004 ---------------------------------------------------------------------------------------------------- (in millions) Interest income ................................................ $ 51 $ 40 $ 20 Interest expense ............................................... 408 293 119 Other revenues: Gains on sales of loans to HMUS ............................. 106 18 -- Other HSBC affiliates income ................................ 102 112 147 Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation ....................... 452 415 35 Fees paid to HMUS ........................................... 227 162 114 Fees paid to HSBC Technology & Services (USA) Inc. (HTSU) for technology services ................................... 235 216 172 Fees paid to other HSBC affiliates .......................... 162 126 99 137 Transactions Conducted with HSBC Finance Corporation Credit Card Receivables and Other Loan Transactions o In December 2004, HUSI acquired a private label receivable portfolio from HSBC Finance Corporation, which primarily included credit card receivables and retained interests associated with securitized credit card receivables. HSBC Finance Corporation retained and continues to service the customer relationships, for which they charged HUSI servicing fees of $367 million and $379 million for the year ended December 31, 2006 and 2005, respectively. In July 2004, HUSI sold certain MasterCard(1)/Visa(2) credit card relationships to HSBC Finance Corporation, but retained the receivable balances associated with these relationships. By agreement, HUSI is purchasing receivables generated by these private label and MasterCard/Visa customer relationships at fair value on a daily basis. Premiums paid are being amortized to interest income over the estimated life of the receivables purchased. Since the original private label receivables acquisition and MasterCard/Visa relationship sale, the underlying customer balances included within these portfolios have revolved, and new private label relationships have been added. Activity related to these portfolios is summarized in the following table. ----------------------------------------------------------------------------------------------------- Private Label MasterCard/Visa ----------------------- --------------------- For the year ended December 31 2006 2005 2006 2005 ----------------------------------------------------------------------------------------------------- (in millions) Receivables acquired from HSBC Finance Corporation: Balance at beginning of period .............. $ 14,355 $ 10,936 $ 1,159 $ 1,142 Receivables acquired ........................ 21,591 21,029 2,317 2,055 Customer payments, net charge offs and other activity ............................ (18,973) (17,610) (2,189) (2,038) --------- ---------- --------- --------- Balance at end of period .................... $ 16,973 $ 14,355 $ 1,287 $ 1,159 ========= ========== ========= ========= Premiums paid to HSBC Finance Corporation: Unamortized balance at beginning of period .. $ 320 $ 624 $ 12 $ 11 Premiums paid ............................... 367 411 39 34 Amortization ................................ (499) (715) (36) (33) --------- ---------- --------- --------- Unamortized balance at end of period ........ $ 188 $ 320 $ 15 $ 12 ========= ========== ========= ========= Other Transactions with HSBC Finance Corporation o Support services from HSBC affiliates include charges by HSBC Finance Corporation under various service level agreements for loan origination and servicing as well as other operational and administrative support. o HBUS is the originating lender for a federal income tax refund anticipation loan program for clients of various third party tax preparers, which is managed by HSBC Finance Corporation. By agreement, HBUS processes applications, funds and subsequently sells these loans to HSBC Finance Corporation. During 2006, primarily during the first quarter, approximately $16.1 billion of loans were originated by HBUS and sold to HSBC Finance Corporation, resulting in gains of approximately $22 million and fees paid to HSBC Finance Corporation of $4 million. For 2005, $15.1 billion of loans were sold to HSBC Finance Corporation, resulting in gains of $19 million and fees paid of $4 million. o In July 2006, HUSI's unused $2 billion line of credit with HSBC Finance Corporation expired and was not renewed. ---------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated. (2) Visa is a registered trademark of Visa USA, Inc. 138 Transactions Conducted with HMUS o HUSI utilizes HMUS for broker dealer, debt underwriting, customer referrals and for other treasury and traded markets related services, pursuant to service level agreements. Debt underwriting fees charged by HMUS are deferred as a reduction of long-term debt and amortized to interest expense over the life of the related debt. Preferred stock issuance costs charged by HMUS are recorded as a reduction of capital surplus. Customer referral fees paid to HMUS are netted against customer fee income, which is included in other fees and commissions. All other fees charged by HMUS are included in support services from HSBC affiliates. o In June 2005, HUSI began acquiring residential mortgage loans, excluding servicing, from unaffiliated third parties and subsequently selling these acquired loans to HMUS. HUSI maintains no ownership interest in the residential mortgage loans after sale. During 2006, HUSI sold $16 billion of loans to HMUS for total gains on sale of $106 million, which are included in other revenues. For 2005, HUSI sold approximately $2 billion of loans to HMUS for total gains on sale of $18 million. Refer to page 9 of this Form 10-K for further information regarding this program. Other Transactions with HSBC Affiliates At December 31, 2006, HUSI had an unused line of credit with HSBC of $2 billion. HUSI has extended loans and lines of credit to various other HSBC affiliates totaling $1.4 billion, of which $172 million was outstanding at December 31, 2006. HUSI routinely enters into derivative transactions with HSBC Finance Corporation and other HSBC affiliates as part of a global HSBC strategy to offset interest rate or other market risks associated with debt issues, derivative contracts or other financial transactions with unaffiliated third parties. At December 31, 2006 and December 31, 2005, the aggregate notional amounts of all derivative contracts with other HSBC affiliates were approximately $772 billion and $570 billion, respectively. The net credit risk exposure (defined as the recorded fair value of derivative receivables) related to these contracts was approximately $7 billion and $5 billion at December 31, 2006 and 2005, respectively. HUSI, within its Corporate, Investment Banking and Markets business, accounts for these transactions on a mark to market basis, with the change in value of contracts with HSBC affiliates substantially offset by the change in value of related contracts entered into with unaffiliated third parties. Domestic employees of HUSI participate in a defined benefit pension plan sponsored by HNAH. Additional information regarding pensions is provided in Note 23 of these consolidated financial statements, beginning on page 142 of this Form 10-K. Employees of HUSI participate in one or more stock compensation plans sponsored by HSBC. HUSI's share of the expense of these plans on a pre-tax basis for the year ended December 31, 2006 and 2005 was approximately $74 million and $51 million, respectively. As of December 31, 2006, HUSI's share of compensation cost related to nonvested stock compensation plans was approximately $90 million, which is expected to be recognized over a weighted-average period of 1.6 years. A description of these stock compensation plans begins on page 140 of this Form 10-K. During 2005, HUSI sold shares in a foreign equity fund to an HSBC affiliate for a gain of $48 million. 139 This information is provided by RNS The company news service from the London Stock Exchange More to Follow FR BGGDXDUGGGRU

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