HSBC USA Inc 10-Q Part 2
HSBC Holdings PLC
14 November 2007
PART 2
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (MD&A)
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FORWARD-LOOKING STATEMENTS
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The MD&A should be read in conjunction with the consolidated financial
statements, notes and tables included elsewhere in this Form 10-Q and with
HUSI's 2006 Form 10-K. The MD&A may contain certain statements that are
forward-looking in nature within the meaning of the Private Securities
Litigation Reform Act of 1995. HUSI's results may differ materially from those
noted in the forward-looking statements. Words such as "may", "should", "would",
"could", "intends", "appears", "believe", "expects", "estimates", "targeted",
"plans", "anticipates", "goal" and similar expressions are intended to identify
forward-looking statements but should not be considered as the only means
through which these statements may be made. Statements that are not historical
facts, including statements about management's beliefs and expectations, are
forward-looking statements that involve inherent risks and uncertainties and are
based on current views and assumptions. A number of factors could cause actual
results to differ materially from those contained in any forward-looking
statements. For a list of important risk factors that may affect HUSI's actual
results, see Cautionary Statement on Forward-Looking Statements and Risk Factors
in Part I of HUSI's 2006 Form 10-K.
EXECUTIVE OVERVIEW
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Challenging market conditions, particularly in the U.S. mortgage and credit
markets, led to significant declines in trading and other income, which resulted
in income before income tax expense of $4 million in the third quarter, and $822
million for the nine months ended September 30, 2007, a decrease of 99% and 35%,
respectively, from the same periods in 2006. Net income decreased 91% to $21
million for the third quarter and 30% to $585 million for the first nine months
of 2007 from the same periods in 2006.
Net interest income was $923 million for the third quarter and $2,520 million
for the first nine months of 2007, an increase of 19% and 10% from the same
periods in 2006. These increases primarily resulted from:
o higher interest income from growth in the private label credit card
portfolio, and reduced amortization of the initial premium paid for the
portfolio as the purchased balances pay down;
o higher accrued income as a result of a more robust income recognition
methodology on private label credit card promotional transactions; and
o business expansion initiatives, including continued focus on the Online
Savings product, new branches and expansion of services and products to
small business customers, which led to growth in consumer and commercial
deposits and in commercial loans.
The increases in net interest income were partially offset by:
o continued narrowing of interest spreads primarily due to competitive
pressures as customers migrated to higher yielding deposit products; and
o lower interest income from residential mortgage loans due to the impact of
balance sheet initiatives to reduce prepayment risk and improve liquidity
by selling the majority of residential mortgage loan originations through
the secondary markets and by allowing the existing residential mortgage
loan portfolio to run off.
The provision for credit losses increased for the third quarter and for the
first nine months of 2007, primarily due to higher average credit card
receivable balances and to growing delinquencies within the credit card
portfolio. In addition, consumer provision expense was unusually low for the
first nine months of 2006, due to the impact of bankruptcy legislation enacted
in 2005, which resulted in accelerated consumer charge offs and higher provision
expense during the fourth quarter of 2005.
27
Other revenues fell as market conditions surrounding sub-prime mortgages
resulted in significantly wider credit spreads and less liquidity in the market.
These adverse market conditions resulted in substantial valuation adjustments in
several asset classes, including available for sale and trading securities,
residential mortgage loans held for sale, leveraged acquisition finance loans,
and credit derivative products. Other revenues also reflect the decrease in
value of derivative trading instruments used to hedge an investment in Class B
shares issued by MasterCard, Incorporated, the fair value of which has increased
significantly but which cannot be recognized until the investment is sold. These
losses were partially offset by:
o increased credit card fees from growing credit card receivable portfolios;
o increased trading revenue from structured derivative product transactions
and from foreign exchange and precious metals trading desks; and
o gains on the sale of HUSI's investment in MasterCard Class B shares.
Increased operating expenses for 2007 resulted mainly from higher salaries,
marketing and other direct expenses related to business expansion initiatives,
and to higher technology and other costs to support the build out of enhanced
product and service platforms.
During the first quarter of 2007, after a thorough review of its deferred income
taxes, HUSI increased the carrying value of its deferred tax assets by $28
million, with a corresponding decrease in income tax expense. The remaining
decrease in income tax expense and the related decrease in the effective tax
rate was mainly due to a concentration of normal tax credits and an adjustment
of the tax provision to reflect the actual tax return liabilities.
Income Before Income Tax Expense - Significant Trends
Analysis of the components of HUSI's income before income tax expense begins on
page 36 of this Form 10-Q. Income before income tax expense, and various trends
and activity affecting operations, are summarized in the following table.
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Three months Nine months
ended ended
September 30 September 30
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(in millions)
Income before income tax expense for 2006 .......................................... $ 365 $ 1,267
---------- ----------
Increase (decrease) in income before income tax expense attributable to:
Balance sheet management activities (1) ...................................... (11) (55)
Trading related activities (2) ............................................... (29) (33)
Private label receivable portfolio (3) ....................................... 35 111
Loans held for sale (4) ...................................................... (218) (299)
Residential mortgage banking revenue (5) ..................................... (19) (49)
Earnings from equity investments (6) ......................................... (31) (31)
All other activity (7) ....................................................... (88) (89)
---------- ----------
(361) (445)
---------- ----------
Income before income tax expense for 2007 .......................................... $ 4 $ 822
========== ==========
(1) Balance sheet management activities are comprised primarily of net
interest income and, to a lesser extent, gains on sales of investments and
trading revenues, resulting from management of interest rate risk
associated with the repricing characteristics of balance sheet assets and
liabilities. Refer to commentary regarding CIBM net interest income,
trading revenues, and the CIBM business segment beginning on page 54 of
this Form 10-Q, respectively.
(2) Refer to commentary regarding trading revenues beginning on page 41 of
this Form 10-Q. Amounts in the table exclude trading related revenues from
hedging activities associated with loans held for sale to an HSBC
affiliate, which are reported in a separate line of the table.
(3) Refer to commentary regarding the CF business segment beginning on page 52
of this Form 10-Q.
(4) Refer to commentary regarding loans held for sale beginning on page 39 of
this Form 10-Q.
(5) Refer to commentary regarding residential mortgage banking revenue
beginning on page 43 of this Form 10-Q.
(6) Refer to commentary regarding other income beginning on page 41 of this
Form 10-Q.
(7) Represents core banking and other activities that have been impacted by
recent business expansion initiatives. Refer to business segments
commentary beginning on page 50 of this Form 10-Q.
28
Selected Financial Data
The following tables present a summary of selected financial information.
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Three months ended Nine months ended
September 30 September 30
-------------------------- --------------------------
2007 2006 2007 2006
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($ in millions)
Income statement:
Net interest income ................................. $ 923 $ 777 $ 2,520 $ 2,287
Provision for credit losses ......................... (402) (207) (871) (586)
Total other revenues ................................ 374 614 1,785 1,946
Total operating expenses ............................ (891) (819) (2,612) (2,380)
Income tax credit (expense) ......................... 17 (121) (237) (429)
--------- --------- --------- ---------
Net income .......................................... $ 21 $ 244 $ 585 $ 838
========= ========= ========= =========
Balances at period end:
Loans, net of allowance ............................. $ 91,608 $ 89,134
Total assets ........................................ 185,421 167,497
Total tangible assets ............................... 182,663 164,754
Total deposits ...................................... 110,808 96,827
Common shareholder's equity ......................... 10,323 10,411
Tangible common shareholder's equity ................ 7,916 7,884
Total shareholders' equity .......................... 12,013 12,101
Selected financial ratios:
Total shareholders' equity to total assets,
at period end ..................................... 6.48% 7.22%
Tangible common shareholder's equity to total
tangible assets, at period end .................... 4.33% 4.79%
Rate of return on average (1):
Total assets .................................. 0.05% .59% 0.47% .69%
Total common shareholder's equity ............. (0.15) 8.28 6.51 9.89
Net interest margin to average (1):
Earning assets ................................ 2.53% 2.22% 2.37% 2.26%
Total assets .................................. 2.14 1.88 2.02 1.90
Average total shareholders' equity to average
total assets (1) .................................. 6.99% 7.37% 7.24% 7.39%
Efficiency ratio (1) ................................ 68.69 58.88 60.67 56.21
(1) Selected financial ratios are defined in the Glossary of Terms beginning
on page 87 of HUSI's 2006 Form 10-K.
Significant trends and transactions that impacted pre-tax net income for the
three month and nine month periods ending September 30, 2007 and 2006 are
summarized on page 28 of this Form 10-Q.
29
BASIS OF REPORTING
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HUSI's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America (U.S.
GAAP).
International Financial Reporting Standards (IFRS)
Effective January 1, 2007, corporate goals of HUSI are based upon results
reported under IFRS (a non-U.S. GAAP measure). Operating results for HUSI are
now monitored and reviewed, trends are being evaluated, and decisions are being
made about allocating certain resources on an IFRS basis. In addition, HSBC
reports its results in accordance with IFRS and IFRS results are used by HSBC in
measuring and rewarding performance of employees. The following table reconciles
HUSI's net income on a U.S. GAAP basis to net income on an IFRS basis.
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Three months ended Nine months ended
September 30 September 30
-------------------------- --------------------------
2007 2006 2007 2006
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(in millions)
Net income - U.S. GAAP basis .................... $ 21 $ 244 $ 585 $ 838
Adjustments, net of tax:
Unquoted equity securities ................ (15) -- 29 --
Fair value option ......................... 85 (31) 49 (34)
Servicing assets .......................... 9 13 (12) (3)
Loan origination .......................... 2 -- 12 --
Loans held for trading purposes ........... (5) 1 (1) 12
Other ..................................... 2 4 6 (2)
--------- --------- --------- ---------
Net income - IFRS basis ......................... $ 99 $ 231 $ 668 $ 811
========= ========= ========= =========
Differences between U.S. GAAP and IFRS are as follows:
Unquoted equity securities
HUSI holds certain equity securities whose market price is not quoted on a
recognized exchange, but for which the fair value can be reliably measured
either through an active market, comparison to similar equity securities which
are quoted, or by using discounted cash flow calculations.
IFRS
o Under IAS 39, equity securities which are not quoted on a recognized
exchange, but for which fair value can be reliably measured, are required
to be measured at fair value. Accordingly, such securities are measured at
fair value and classified as either available-for-sale securities, with
changes in fair value recognized in other comprehensive income, or as
trading securities, with changes in fair value recognized in income.
U.S. GAAP
o Under SFAS 115, equity securities that are not quoted on a recognized
exchange are not considered to have a readily determinable fair value and
are required to be measured at cost, less any provisions for impairment.
Unquoted equity securities are reported within "Other assets".
Impact
o Changes in fair values of equity securities for which IFRS requires
recognition of the change and U.S. GAAP requires the securities to be held
at cost, impact net income and shareholders' equity when the security is
classified as trading under IFRS and impact shareholders' equity when the
security is classified as available-for-sale under IFRS.
30
Fair value option
IFRS
o Under IAS 39, a financial instrument, other than one held for trading, is
classified in this category if it meets the criteria set out below, and is
so designated by management. An entity may designate financial instruments
at fair value where the designation:
- eliminates or significantly reduces a measurement or recognition
inconsistency that would otherwise arise from measuring financial
assets or financial liabilities or recognizing the gains and losses
on them on different bases; or
- applies to a group of financial assets, financial liabilities or
both that is managed and its performance evaluated on a fair value
basis, in accordance with a documented risk management or investment
strategy, and where information about that group of financial
instruments is provided internally on that basis to management; or
- relates to financial instruments containing one or more embedded
derivatives that significantly modify the cash flows resulting from
those financial instruments.
o Financial assets and financial liabilities so designated are recognized
initially at fair value, with transaction costs taken directly to the
income statement, and are subsequently remeasured at fair value. This
designation, once made, is irrevocable in respect of the financial
instruments to which it is made. Financial assets and financial
liabilities are recognized using trade date accounting.
o Gains and losses from changes in the fair value of such assets and
liabilities are recognized in the income statement as they arise, together
with related interest income and expense and dividends.
U.S. GAAP
o Generally, for financial assets to be measured at fair value with gains
and losses recognized immediately in the income statement, they must meet
the definition of trading securities in SFAS 115, Accounting for Certain
Investments in Debt and Equity Securities. Financial liabilities are
generally reported at amortized cost under U.S. GAAP.
o Since January 1, 2006, HUSI has accounted for hybrid financial instruments
under the provisions of SFAS 155, Accounting for Certain Hybrid Financial
Instruments. Hybrid financial instruments that contain an embedded
derivative that would otherwise require bifurcation are, where designated
through an irrevocable election, initially and subsequently measured at
fair value, with changes in fair value recognized through net income.
Impact
o HUSI has principally used the fair value designation for certain fixed
rate long-term debt issues whose interest rate characteristic has been
changed to floating through interest rate swaps as part of a documented
interest rate management strategy. Approximately $2 billion of HUSI's debt
issues have been accounted for using the option. The movement in fair
value of these debt issues includes the effect of changes in the credit
spread and any ineffectiveness in the economic relationship between the
related swaps and this debt. Such ineffectiveness arises from the
different credit characteristics of the swap and the debt coupled with the
sensitivity of the floating leg of the swap to changes in short-term
interest rates. In addition, the economic relationship between the swap
and the debt can be affected by relative movements in market factors, such
as bond and swap rates, and the relative bond and swap rates at inception.
The size and direction of the accounting consequences of changes in credit
spread and ineffectiveness can be volatile from period to period, but do
not alter the cash flows anticipated as part of the documented interest
rate management strategy.
o Under U.S. GAAP, debt issues are generally reported at amortized cost.
There are circumstances, by virtue of different technical requirements and
the transition arrangements to IFRS, where derivatives providing an
economic hedge for an asset or liability, and so designated under IFRS,
are not so treated under U.S. GAAP, thereby creating a reconciliation
difference and asymmetrical accounting between the asset and liability and
the offsetting derivative.
31
Servicing assets
IFRS
o Under IAS 38, servicing assets are initially recorded on the balance sheet
at cost and amortized over the projected life of the assets.
o Servicing assets are periodically tested for impairment with impairment
adjustments charged against current earnings.
o Subsequent recoveries of impairment, if any, are credited to current
earnings only to the extent of previous write-downs.
U.S. GAAP
o Under U.S. GAAP, servicing assets are initially recorded on the balance
sheet at fair value.
o All subsequent adjustments to fair value are reflected in current period
earnings.
Impact
o HUSI's mortgage subsidiary currently holds $534 million of residential
mortgage servicing rights (MSRs), primarily related to loans sold to
governmental agencies.
o For certain pools of MSRs, fair value recorded under U.S. GAAP exceeds
amortized cost recorded under IFRS. Therefore, current earnings under U.S.
GAAP exceeded earnings under IFRS for the first nine months of 2007.
Loan origination
IFRS
o Certain loan fee income and incremental directly attributable loan
origination costs are amortized to the income statement over the life of
the loan as part of the effective interest calculation under IAS 39.
U.S. GAAP
o Certain loan fee income and direct but not necessarily incremental loan
origination costs, including an apportionment of overheads, are amortized
to the income statement over the life of the loan as an adjustment to
interest income (SFAS No. 91, "Accounting for Nonrefundable Fees and Costs
Associated with Originating or Acquiring Loans and Initial Direct Costs of
Leases").
Impact
During the first nine months of 2007, the net costs amortized against earnings
under U.S. GAAP exceeded net costs amortized under IFRS.
Loans held for trading purposes
IFRS
o Under IAS 39, loans originated or acquired with the intent to sell them
are treated as trading assets.
o As trading assets, loans held for resale are initially recorded at fair
value, with changes in fair value being recognized in current period
earnings.
o Any gains realized on sales of such loans are recognized in current period
earnings on the trade date.
U.S. GAAP
o Under U.S. GAAP, loans held for resale are designated as loans on the
balance sheet.
o Such loans are recorded at the lower of amortized cost or market value
(LOCOM). Therefore, recorded value cannot exceed amortized cost.
o Subsequent gains on sale of such loans are recognized in current period
earnings on the settlement date.
32
Impact
o HUSI holds $6.4 billion of loans held for resale on the balance sheet at
September 30, 2007 for various business purposes. These include
residential mortgage loans held for resale to HSBC affiliates for
securitization purposes, residential mortgage loans held for resale to
various governmental agencies, leveraged acquisition finance loans held
for sale to third parties, and other types of consumer loans.
o Because of differences between fair value and LOCOM accounting, the
recorded value of certain pools of loans held for resale under IFRS may
exceed the value recorded under U.S. GAAP.
o The timing difference between trade date accounting for IFRS and
settlement date accounting under U.S. GAAP also results in higher current
earnings under IFRS.
Other
Other includes the net impact of differences relating to various adjustments,
none of which were individually material for the third quarter and first nine
months of 2007 and 2006, respectively.
BALANCE SHEET REVIEW
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HUSI utilizes borrowings from various sources to fund balance sheet growth, to
meet cash and capital needs, and to fund investments in subsidiaries. Balance
sheet totals at September 30, 2007, and movements in comparison with prior
periods, are summarized in the following table.
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Increase (Decrease) from
-------------------------------------------------------------
December 31, 2006 September 30,2006
September 30, --------------------------- ---------------------------
2007 Amount % Amount %
---------------------------------------------------------------------------------------------------------------------
($ in millions)
Period end assets:
Short-term investments ....... $ 21,781 $ 2,726 14 $ 1,135 5
Loans, net ................... 91,608 2,268 3 2,474 3
Trading assets ............... 31,582 7,952 34 6,345 25
Securities ................... 24,555 1,800 8 1,655 7
Other assets ................. 15,895 5,858 58 6,315 66
---------- ---------- ---------- ---------- ----------
$ 185,421 $ 20,604 13 $ 17,924 11
========== ========== ========== ========== ==========
Funding sources:
Total deposits ............... $ 110,808 $ 8,662 8 $ 13,981 14
Trading liabilities .......... 16,819 4,505 37 2,914 21
Short-term borrowings ........ 9,404 4,331 85 2,411 34
All other liabilities ........ 8,246 4,475 119 3.478 73
Long-term debt ............... 28,131 (1,121) (4) (4,772) (15)
Shareholders' equity ......... 12,013 (248) (2) (88) (1)
---------- ---------- ---------- ---------- ----------
$ 185,421 $ 20,604 13 $ 17,924 11
========== ========== ========== ========== ==========
Short-Term Investments
Short-term investments include cash and due from banks, interest bearing
deposits with banks, Federal funds sold and securities purchased under resale
agreements. Increases in these asset balances resulted from an increase in
HUSI's excess liquidity position, which was primarily due to deposit growth in
2006 and 2007.
33
Loans, Net
Loan balances at September 30, 2007, and movements in comparison with prior
periods, are summarized in the following table.
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Increase (Decrease) from
----------------------------------------------------
December 31, 2006 September 30, 2006
September 30, ----------------------- ---------------------
2007 Amount % Amount %
-----------------------------------------------------------------------------------------------------------------------
($ in millions)
Total commercial loans ........................ $ 35,446 $ 5,964 20 $ 6,103 21
-------- -------- -------- -------- --------
Consumer loans:
Residential mortgages ................... 36,729 (3,079) (8) (4,261) (10)
Credit card receivables:
Private label ........................ 16,339 (634) (4) 726 5
MasterCard/Visa ...................... 1,705 418 32 531 45
Other consumer .......................... 2,447 (240) (9) (453) (16)
-------- -------- -------- -------- --------
Total consumer loans .................... 57,220 (3,535) (6) (3,457) (6)
-------- -------- -------- -------- --------
Total loans ................................... 92,666 2,429 3 2,646 3
Allowance for credit losses ................... 1,058 161 18 172 19
-------- -------- -------- -------- --------
Loans, net .................................... $ 91,608 $ 2,268 3 $ 2,474 3
======== ======== ======== ======== ========
Increased commercial loan balances were partly due to expansion of middle market
activities, as well as an increase in previously unfunded commitments.
Additionally, in the third quarter of 2007, HUSI began originating commercial
loans in connection with its participation in a number of leveraged acquisition
finance syndicates. A majority of these loans were originated with the intent of
selling them to third parties.
Beginning in 2005, as a result of balance sheet initiatives to reduce prepayment
risk and improve HBUS's structural liquidity, HUSI decided to sell a majority of
its residential loan originations through the secondary markets and allow the
existing loan portfolio to run off, resulting in reductions in loan balances
throughout 2006 and the first nine months of 2007.
The addition of new merchant and customer relationships to the private label
credit card portfolio and decreased balance requirements of off-balance sheet
securitized receivable trusts (refer to pages 64-65 of this Form 10-Q) have
resulted in higher on-balance sheet credit card receivable balances from
September 30, 2006 to September 30, 2007.
Trading Assets and Liabilities
Trading assets and liabilities balances at September 30, 2007, and movements in
comparison with prior periods, are summarized in the following table.
-----------------------------------------------------------------------------------------------------------------------
Increase (Decrease) from
--------------------------------------------------
December 31, 2006 September 30, 2006
September 30, ----------------------- ----------------------
2007 Amount % Amount %
-----------------------------------------------------------------------------------------------------------------------
($ in millions)
Trading assets:
Securities (1) ............................... $ 13,661 $ 1,737 15 $ (33) --
Precious metals .............................. 4,659 1,943 72 1,184 34
Fair value of derivatives .................... 13,262 4,272 48 5,194 64
--------- --------- --------- --------- ---------
$ 31,582 $ 7,952 34 $ 6,345 25
========= ========= ========= ========= =========
Trading liabilities:
Securities sold, not yet purchased ........... $ 1,804 $ (110) (6) $ (1,695) (48)
Payables for precious metals ................. 1,814 478 36 131 8
Fair value of derivatives .................... 13,201 4,137 46 4,479 51
--------- --------- --------- --------- ---------
$ 16,819 $ 4,505 37 $ 2,915 21
========= ========= ========= ========= =========
(1) Includes U.S. Treasury securities, securities issued by U.S. Government
agencies and U.S. Government sponsored enterprises, other asset backed
securities, corporate bonds and debt securities.
34
Growth in securities balances from December 31, 2006 and from September 30, 2006
was attributable to purchases of hybrid adjustable rate prime mortgages during
2007, due to increased hedging opportunities to capitalize on the current spread
environment in these assets. Also contributing to the increase were purchases of
emerging market securities for hedging of credit swap derivative credit risk
exposure. Higher derivative balances resulted from increased values on various
derivative products including credit default swaps, foreign currency forward
contracts and equity swaps as a result of increasing credit spreads during the
quarter. Higher precious metals balances were due to higher levels of trading
activity, and to generally higher market prices for various metals, specifically
gold and platinum.
Deposits
Deposit balances by major depositor categories at September 30, 2007, and
movements in comparison with prior periods, are summarized in the following
table.
-----------------------------------------------------------------------------------------------------------------------
Increase (Decrease) from
---------------------------------------------------
December 31, 2006 September 30, 2006
September 30, ----------------------- -----------------------
2007 Amount % Amount %
-----------------------------------------------------------------------------------------------------------------------
($ in millions)
Individuals ..................................... $ 48,344 $ 5,078 12 $ 7,351 18
Partnerships and corporations ................... 40,867 1,329 3 324 1
Domestic and foreign banks ...................... 17,225 982 6 5,360 45
U.S. Government, states and political
subdivisions .................................. 2,292 365 19 457 25
Foreign government and official
institutions .................................... 2,080 908 77 489 31
--------- --------- --------- --------- ---------
Total deposits .................................. $ 110,808 $ 8,662 8 $ 13,981 14
========= ========= ========= ========= =========
Total core deposits (1) ......................... $ 63,363 $ 5,787 10 $ 7,545 14
========= ========= ========= ========= =========
(1) HUSI monitors "core deposits" as a key measure for assessing results of
its core banking network. Core deposits generally include all domestic
demand, money market and other savings accounts, as well as time deposits
with balances not exceeding $100,000.
Beginning in 2004, HUSI implemented a growth strategy for its retail banking
network, which includes building deposits over a three to five year period
across multiple geographic markets, channels and customer segments and utilizing
multiple delivery systems. Since inception, the following initiatives have been
launched:
o deployment of new personal and business checking and savings products, with
an emphasis on relationship based products that offer more competitive
pricing;
o new internet based products offered through the HSBC Direct website,
particularly Online Savings accounts, which have grown significantly since
2005. Since their introduction, Online Savings balances have grown to
$12.4 billion at September 30, 2007, of which $5.2 billion was raised
during the first nine months of 2007;
o a retail branch expansion strategy within our existing footprint as well
as in new geographic markets;
o improved delivery systems, including internet, call center and ATM
capabilities; and
o refined marketing and customer analytics to drive increased utilization of
products and improve customer retention.
Total deposit growth of $13 billion and $12 billion during calendar years 2006
and 2005, respectively, has been followed by growth of $9 billion in the first
nine months of 2007.
35
RESULTS OF OPERATIONS
--------------------------------------------------------------------------------
Net Interest Income
An analysis of consolidated average balances and interest rates on a taxable
equivalent basis is presented on pages 72-73 of this Form 10-Q. Significant
components of HUSI's net interest margin are summarized in the following table.
-----------------------------------------------------------------------------------------------------------------------
Three months ended Nine months ended
September 30 September 30
-------------------- ---------------------
2007 2006 2007 2006
-----------------------------------------------------------------------------------------------------------------------
Yield on total earning assets ..................................... 6.47% 5.91% 6.28% 5.75%
Rate paid on interest bearing liabilities ......................... 4.41 4.23 4.40 3.96
------- ------- ------- -------
Interest rate spread .............................................. 2.06 1.68 1.88 1.79
Benefit from net non-interest earning or paying funds ............. .47 .54 .49 .47
------- ------- ------- -------
Net interest margin to earning assets (1) ......................... 2.53% 2.22% 2.37% 2.26%
======= ======= ======= =======
(1) Selected financial ratios are defined in the Glossary of Terms beginning
on page 87 of HUSI's 2006 Form 10-K.
Significant trends affecting the comparability of 2007 and 2006 net interest
income and interest rate spread are summarized in the following table. Net
interest income in the table is presented on a taxable equivalent basis (refer
to pages 72-73 of this Form 10-Q).
----------------------------------------------------------------------------------------------------------------------
Three months ended Nine months ended
September 30 September 30
------------------------ ------------------------
Interest Interest
Amount Rate Spread Amount Rate Spread
----------------------------------------------------------------------------------------------------------------------
($ in millions)
Net interest income/interest rate spread for 2006 .......... $ 783 1.68% $ 2,306 1.79%
======== ========
Increase (decrease) in net interest income associated with:
Balance sheet management activities (1) .............. (2) (42)
Private label receivable portfolio ................... 88 177
Residential mortgage banking ......................... (19) (61)
All other core banking activity ...................... 80 161
-------- --------
Net interest income/interest rate spread for 2007 .......... $ 930 2.06% $ 2,541 1.88%
======== ======== ======== ========
(1) Represents HUSI's activities to manage interest rate risk associated with
the repricing characteristics of balance sheet assets and liabilities.
Interest rate risk, and HUSI's approach to manage such risk, are described
beginning on page 70 of HUSI's 2006 Form 10-K.
Balance Sheet Management Activities
Lower net interest income from balance sheet management activities continued to
impact results for the CIBM business segment during the third quarter and first
nine months of 2007. A relatively flat yield curve continued to limit available
opportunities to generate additional net funds income within the CIBM business
segment.
The CIBM business segment expanded its operations and products offered to
clients, which has resulted in increased trading and lending activity. The
resulting increases in average trading assets and average commercial loan
balances were partially offset by the impact of the relatively flat yield curve.
Private Label Receivable Portfolio (PLRP)
Higher net interest income for the PLRP for the third quarter and for the first
nine months of 2007 resulted from:
o increased credit card receivable balances, due to the addition of new PLRP
merchant relationships during 2006 and 2007, and to decreased balance
requirements of off-balance sheet securitized PLRP receivable trusts;
o higher accrued income as a result of a more robust income recognition
methodology on private label credit card promotional transactions; and
36
o lower amortization of premiums paid for purchases of receivables included
within the PLRP. Although premiums associated with daily purchases of
receivables from HSBC Finance Corporation continue to be recorded and
amortized, premium amortization associated with the initial portfolio
acquisition in 2004 was $63 million lower for the first nine months of
2007.
Residential Mortgage
Lower net interest income from residential mortgage activities primarily
resulted from continued narrowing of interest rate spreads and from contraction
of the residential mortgage loan portfolio. As a result of a continuing strategy
to reduce prepayment risk and improve HBUS's structural liquidity, HUSI
continues to sell a majority of its residential mortgage loan originations and
allow the residential mortgage loan portfolio to runoff.
Other Core Banking Activity
Higher net interest income from other core banking activity mostly resulted from
business expansion initiatives, which have led to increased deposits and loans.
Personal deposits continued to grow in 2007 as a result of continued success of
the Online Savings product and expansion of the branch network. However,
customers continued to migrate to higher yielding deposit products such as the
Online Savings product, leading to a change in product mix and narrowing of
deposit spreads, which partly offset the benefit of higher deposit balances.
Refer to page 35 of this Form 10-Q for commentary regarding HUSI's deposit
strategy and growth.
Significant resources have been dedicated to expansion of various commercial
lending businesses and regional offices, which has resulted in increased loan
and deposit balances. The average yield earned on commercial loans was also
higher for the first nine months of 2007.
Provision for Credit Losses
The provision for credit losses associated with various loan portfolios is
summarized in the following table.
--------------------------------------------------------------------------------------------------------------
Increase (Decrease)
-----------------------
2007 2006 Amount %
--------------------------------------------------------------------------------------------------------------
($ in millions)
Three months ended September 30:
Commercial ....................................... $ 57 $ 34 $ 23 68
-------- -------- -------- --------
Consumer:
Residential mortgages ...................... 24 3 21 *
Credit card receivables .................... 301 150 151 101
Other consumer ............................. 20 20 -- --
-------- -------- -------- --------
Total consumer ............................. 345 173 172 99
-------- -------- -------- --------
Total provision for credit losses ................ $ 402 $ 207 $ 195 94
======== ======== ======== ========
Nine months ended September 30:
Commercial ....................................... $ 122 $ 110 $ 12 11
-------- -------- -------- --------
Consumer:
Residential mortgages ...................... 48 18 30 167
Credit card receivables .................... 645 417 228 55
Other consumer ............................. 56 41 15 37
-------- -------- -------- --------
Total consumer ............................. 749 476 273 57
-------- -------- -------- --------
Total provision for credit losses ................ $ 871 $ 586 $ 285 49
======== ======== ======== ========
* Not meaningful.
37
Higher provision expense associated with credit card receivables for the third
quarter and first nine months of 2007 primarily resulted from higher
delinquencies and charge offs within the private label credit card portfolio. In
addition, provision expense for the first nine months of 2006 was unusually low
due to the impact of bankruptcy legislation enacted in 2005, which resulted in
accelerated credit card receivable and other consumer loan charge offs during
the fourth quarter of 2005. During the first quarter of 2007, HUSI refined its
allowance methodology associated with MasterCard/Visa credit card receivables,
resulting in a $13 million reduction in the allowance balance and provision
expense, which partially offset overall increases in credit card allowances.
Refer to additional commentary regarding credit card receivables credit quality
on page 61of this Form 10-Q.
Commercial loan provision expense increased $23 million for the third quarter of
2007, as compared with the same 2006 period. During the second quarter of 2006,
provision expense of $29 million was recorded due to a combination of charge
offs and increased allowances related to a specific commercial real estate
investment loan for which no specific allowance for credit losses was previously
recorded. Excluding this specific 2006 provision, commercial loan provision
expense increased $41 million for the first nine months of 2007, as compared
with the same 2006 period. Higher provision expense for the first nine months of
2007 was primarily due to higher criticized asset balances. Refer to additional
commentary regarding commercial loan credit quality beginning on page 60 of this
Form 10-Q.
38
Other Revenues
Decreased revenue for the three months and nine months ended September 30, 2007,
was mostly driven by reduced liquidity and higher volatility in the credit and
sub-prime markets which led to substantial valuation losses being recorded. This
was partially offset by increased credit card fees, other fees and commissions
from affiliates, and increased security gains.
The components of other revenues are summarized in the following tables.
-----------------------------------------------------------------------------------------------------------------------
Increase/(Decrease)
-------------------
Three months ended September 30 2007 2006 Amount %
-----------------------------------------------------------------------------------------------------------------------
(in millions)
Trust income .......................................................... $ 26 $ 22 $ 4 18
------- ------- ------- -------
Service charges ....................................................... 53 52 1 2
------- ------- ------- -------
Credit card fees ...................................................... 225 148 77 52
------- ------- ------- -------
Other fees and commissions:
Letter of credit fees ........................................... 19 19 -- --
Wealth and tax advisory services ................................ 28 25 3 12
Other fee-based income, net of referral fees .................... 71 66 5 8
------- ------- ------- -------
118 110 8 7
------- ------- ------- -------
HSBC affiliate income:
Service charges ................................................. 1 4 (3) (75)
Other fees and commissions ...................................... 28 13 15 115
Gain on sale of residential mortgage loans to HMUS (1) .......... 14 40 (26) (65)
Gain on sale of refund anticipation loans to HSBC Finance
Corporation ................................................... -- -- -- --
Other affiliate income .......................................... 3 4 (1) (25)
------- ------- ------- -------
46 61 (15) (25)
------- ------- ------- -------
Other income:
Securitization revenue .......................................... -- -- -- --
Insurance ....................................................... 13 11 2 18
Valuation allowance (increase) decrease for changes in market
value of loans held for sale .................................. (218) 43 (261) *
Gains (loss) on sale of property and other financial assets ..... (16) 34 (50) (147)
Earnings from equity investments ................................ 22 53 (31) (58)
Miscellaneous income ............................................ 12 16 (4) (25)
------- ------- ------- -------
(187) 157 (344) *
------- ------- ------- -------
Residential mortgage banking revenue .................................. 6 6 -- --
Trading revenues ...................................................... 28 52 (24) (46)
Securities gains, net ................................................. 59 6 53 *
------- ------- ------- -------
Total other revenues .................................................. $ 374 $ 614 $ (240) (39)
======= ======= ======= =======
(1) Refer to tables and commentary regarding "Residential Mortgage Loans Held
for Sale to an HSBC Affiliate" on pages 41-42 of this Form 10-Q.
* Not meaningful.
39
-----------------------------------------------------------------------------------------------------------------------
Increase/(Decrease)
----------------------
Nine months ended September 30 2007 2006 Amount %
-----------------------------------------------------------------------------------------------------------------------
($ in millions)
Trust income ............................................... $ 73 $ 66 $ 7 11
------- ------- ------- -------
Service charges ............................................ 158 149 9 6
------- ------- ------- -------
Credit card fees ........................................... 601 409 192 47
------- ------- ------- -------
Other fees and commissions:
Letter of credit fees ................................ 55 55 -- --
Wealth and tax advisory services ..................... 80 72 8 11
Other fee-based income, net of referral fees ......... 177 175 2 1
------- ------- ------- -------
312 302 10 3
------- ------- ------- -------
HSBC affiliate income:
Service charges ...................................... 9 11 (2) (18)
Other fees and commissions ........................... 69 36 33 92
Gain on sale of residential mortgage loans to HMUS (1) 24 105 (81) (77)
Gain on sale of refund anticipation loans to HSBC Finance
Corporation ........................................ 23 21 2 10
Other affiliate income ............................... 9 9 -- --
------- ------- ------- -------
134 182 (48) (26)
------- ------- ------- -------
Other income:
Securitization revenue ............................... -- 19 (19) (100)
Insurance ............................................ 38 35 3 9
Valuation allowance increase for changes in market
value of loans held for sale ....................... (299) (114) (185) (162)
Gains on sale of property and other financial assets . 6 50 (44) (88)
Earnings from equity investments ..................... 63 95 (32) (34)
Miscellaneous income ................................. 57 80 (23) (29)
------- ------- ------- -------
(135) 165 (300) (182)
------- ------- ------- -------
Residential mortgage banking revenue ....................... 69 57 12 21
Trading revenues ........................................... 477 600 (123) (21)
Securities gains, net ...................................... 96 16 80 *
------- ------- ------- -------
Total other revenues ....................................... $ 1,785 $ 1,946 $ (161) (8)
======= ======= ======= =======
(1) Refer to tables and commentary regarding "Residential Mortgage Loans Held
for Sale to an HSBC Affiliate" on pages 41-42 of this Form 10-Q.
* Not meaningful.
Credit Card Fees
Higher credit card fees in 2007 from private label and co-brand credit card
portfolio activity were primarily due to the following factors:
o credit card receivables included in off-balance sheet securitization
transactions for the first nine months of 2006 were included in on-balance
sheet credit card receivables for the first nine months of 2007. Late fees
associated with these receivables, which were recorded in securitization
revenue in 2006 (refer to other income commentary), are recorded in
credit card fees for 2007;
o the number of accounts, volume of customer transaction activity and
average receivable balances included within the private label portfolio
all were higher for 2007, due to the addition of merchant and customer
relationships and to expansion of credit card products offered. Product
repricing also resulted in higher fees; and
o higher late fees due to increased delinquencies within the private label
portfolio.
40
HSBC Affiliate Income
Higher fees and commissions from HSBC affiliates was primarily due to increased
customer referral and other fees from HMUS and HSBC associated with current
expansion of the payments and cash management business and previous expansion of
various trading businesses. Fees from HSBC Finance Corporation for loan
servicing have also increased in 2007.
Other Income
In the third quarter of 2006, the last remaining securitization trust agreement
related to the private label credit card receivable portfolio was amended. As a
result, the trust no longer qualified for sale treatment and all assets and
liabilities of the trust were returned to HUSI's consolidated balance sheet. In
addition, all new collateralized funding transactions have been structured as
secured financings since the third quarter of 2004. The loss of securitization
revenue for 2007 was offset by higher net interest income and higher fee revenue
(refer to previous credit card fees commentary) from the receivables and
liabilities that were returned to the consolidated balance sheet.
HUSI holds an equity investment in a non-consolidated foreign HSBC affiliate.
During the third quarter of 2006, this affiliate sold a portion of its
investment in a foreign equity fund to another HSBC affiliate. During the second
quarter of 2007, the same affiliate sold its remaining investment in the foreign
equity fund. This decrease in equity investment holdings resulted in lower
equity earnings for the first nine months of 2007.
Valuation Allowance on Residential Mortgage Loans Held for Sale to an HSBC
Affiliate
In 2005, HUSI began acquiring residential mortgage loans from unaffiliated third
parties with the intent of selling these loans to an HSBC affiliate, HSBC
Markets (USA) Inc. (HMUS). HMUS in turn sells these loans to securitization
vehicles. During 2006, HUSI also began acquiring residential mortgage loans from
HSBC Finance Corporation under this program. Loans acquired from unaffiliated
third parties and HSBC Finance Corporation primarily include sub-prime
residential mortgage loans. In addition, a number of prime adjustable rate
mortgage loans originated by HUSI have been identified for this program and are
being held with the intent of selling these loans to HMUS. HMUS in turn sells
these loans to securitization vehicles. Loans held for sale are recorded by HUSI
at the lower of their aggregate cost or market value, with adjustments to market
value being recorded as a valuation allowance. HUSI maintains a portfolio of
derivatives and securities, which are used as economic hedges to offset changes
in market values of the loans held for sale to HMUS. Gains on sales associated
with these loans result from incremental value realized on pools of loans sold
to HMUS for securitization.
The activity related to this program affects various consolidated financial
statement line items, as summarized in the following table. Lower results and
activity for this program for the third quarter and the first nine months of
2007 generally resulted from the overall weakness and illiquidity in the U.S.
residential mortgage market, and specifically from significantly reduced fair
values of sub-prime loans.
41
-----------------------------------------------------------------------------------------------------------------------
Three months ended September 30 2007 2006
-----------------------------------------------------------------------------------------------------------------------
(in millions)
Residential mortgage loans held for sale to HMUS:
Balance at beginning of period ..................................................... $ 3,059 $ 4,795
Loans acquired from originators .................................................... 1,009 3,088
Loans sold to HMUS ................................................................. (1,061) (4,501)
Other, primarily loans resold to originators and other third parties ............... (177) (157)
---------- ----------
Balance at end of period ........................................................... $ 2,830 $ 3,225
========== ==========
Valuation allowance for changes in market value of loans held for sale to HMUS:
Balance at beginning of period ..................................................... $ (49) $ (83)
Valuation allowance (increase) decrease for changes in market value ................ (146) 29
Releases of valuation allowance for loans sold to HMUS ............................. 3 53
---------- ----------
Balance at end of period ........................................................... $ (192) $ (1)
========== ==========
Impact on income before income taxes:
Net interest income associated with loans held for sale to HMUS (1) ................ $ 6 $ 13
Gains on sale of residential mortgage loans sold to HMUS, recorded in HSBC affiliate
income ........................................................................... 14 40
Valuation allowance (increase) decrease for changes in market value of
loans held for sale to
HMUS, recorded in other income ................................................... (146) 29
Trading revenues recognized from economic hedges held to offset changes
in market values
of loans held for sale to HMUS (1) ............................................... (30) (57)
Net program costs included in other expenses ....................................... (3) (6)
---------- ----------
Net impact on income before income taxes ........................................... $ (159) $ 19
========== ==========
-----------------------------------------------------------------------------------------------------------------------
Nine months ended September 30 2007 2006
-----------------------------------------------------------------------------------------------------------------------
(in millions)
Residential mortgage loans held for sale to HMUS:
Balance at beginning of period ..................................................... $ 3,126 $ 2,882
Loans acquired from originators .................................................... 6,028 13,218
Loans sold to HMUS ................................................................. (5,749) (12,657)
Other, primarily loans resold to originators and other third parties ............... (575) (218)
---------- ----------
Balance at end of period ........................................................... $ 2,830 $ 3,225
========== ==========
Valuation allowance for changes in market value of loans held for sale to HMUS:
Balance at beginning of period ..................................................... $ (26) $ (11)
Valuation allowance increase for changes in market value ........................... (221) (123)
Releases of valuation allowance for loans sold to HMUS ............................. 55 133
---------- ----------
Balance at end of period ........................................................... $ (192) $ (1)
========== ==========
Impact on income before income taxes:
Net interest income associated with loans held for sale to HMUS (1) ................ $ 39 $ 51
Gains on sale of residential mortgage loans sold to HMUS, recorded in HSBC affiliate
income ........................................................................... 24 105
Valuation allowance increase for changes in market value of loans held for sale to
HMUS, recorded in other income ................................................... (221) (123)
Trading revenues recognized from economic hedges held to offset changes
in market values
of loans held for sale to HMUS (1) ............................................... (7) 59
Net program costs included in other expenses ....................................... (15) (9)
---------- ----------
Net impact on income before income taxes ........................................... $ (180) $ 83
========== ==========
(1) Refer to trading revenues commentary beginning on page 45 of this Form
10-Q.
Valuation Allowance for Leveraged Acquisition Finance Loans Held for Sale
HUSI originates commercial loans in connection with its participation in a
number of leveraged acquisition finance syndicates. A substantial majority of
these loans were originated with the intent of selling them to unaffiliated
third parties and are classified as held for sale at September 30, 2007.
Commercial loans held for sale, including those related to the leveraged lending
program, are recorded at the lower of cost or market value with valuation
adjustments recorded to a valuation allowance and reflected in Other Income.
Adverse conditions in the corporate credit markets resulted in a substantial
increase in the valuation allowance for commercial loans held for sale.
42
Residential Mortgage Banking Revenue
The following tables present the components of residential mortgage banking
revenue. Net interest income includes interest earned/paid on assets and
liabilities of the residential mortgage banking business, as well as the funding
cost or benefit associated with these balances. The net interest income
component in the table is included in net interest income in the consolidated
statement of income and reflects actual interest earned, net of cost of funds,
and adjusted for corporate transfer pricing.
-----------------------------------------------------------------------------------------------------------------------
Increase (Decrease)
---------------------
Three months ended September 30 2007 2006 Amount %
-----------------------------------------------------------------------------------------------------------------------
($ in millions)
Net interest income ............................................... $ 59 $ 78 $ (19) (24)
======= ======= ======= =======
Servicing related income:
Servicing fee income ........................................ 29 25 4 16
Changes in fair value of MSRs due to:
Changes in valuation inputs or assumptions
used in valuation model ................................ (28) (43) 15 35
Realization of cash flows ................................ (14) (21) 7 33
Trading - Derivative instruments used to offset
changes in value of MSRs .................................. 19 38 (19) (50)
------- ------- ------- -------
6 (1) 7 *
------- ------- ------- -------
Originations and sales related income:
(Losses) gains on sales of residential mortgages ............ (5) 3 (8) *
Trading and fair value hedge activity ....................... (1) (1) -- --
------- ------- ------- -------
(6) 2 (8) *
------- ------- ------- -------
Other mortgage income ............................................. 6 5 1 20
------- ------- ------- -------
Total residential mortgage banking revenue included
in other revenues ............................................... 6 6 -- --
------- ------- ------- -------
Total residential mortgage banking related revenue ................ $ 65 $ 84 $ (19) (23)
======= ======= ======= =======
-----------------------------------------------------------------------------------------------------------------------
Increase (Decrease)
---------------------
Nine months ended September 30 2007 2006 Amount %
-----------------------------------------------------------------------------------------------------------------------
($ in millions)
Net interest income ............................................... $ 199 $ 260 $ (61) (23)
======= ======= ======= =======
Servicing related income:
Servicing fee income ........................................ 85 74 11 15
Changes in fair value of MSRs due to:
Changes in valuation inputs or assumptions
used in valuation model ................................ 35 31 4 13
Realization of cash flows ................................ (60) (60) -- --
Trading - Derivative instruments used to offset
changes in value of MSRs .................................. (34) (19) (15) (79)
------- ------- ------- -------
26 26 -- --
------- ------- ------- -------
Originations and sales related income:
Gains on sales of residential mortgages ..................... 23 14 9 64
Trading and fair value hedge activity ....................... -- 1 (1) *
------- ------- ------- -------
23 15 8 53
------- ------- ------- -------
Other mortgage income ............................................. 20 16 4 25
------- ------- ------- -------
Total residential mortgage banking revenue included
in other revenues ............................................... 69 57 12 21
------- ------- ------- -------
Total residential mortgage banking related revenue ................ $ 268 $ 317 $ (49) (15)
======= ======= ======= =======
* Not meaningful.
43
Net Interest Income
Decreased net interest income for the third quarter and first nine months of
2007 resulted from lower average residential mortgage loans outstanding as well
as a slight narrowing of interest rate spreads. During 2007, HUSI continued to
sell the majority of new loan originations to government sponsored enterprises
and private investors and allow existing loans to runoff. The held loans
portfolio is expected to continue to decline for the remainder of 2007 as a
result of this initiative.
Servicing Related Income
Higher servicing fee income for the third quarter and first nine months of 2007
resulted from a higher volume of loans included within the average serviced
loans portfolio. The average serviced loans portfolio increased approximately
13% in the third quarter and first nine months of 2007 due to the following
factors:
o the volume of loans sold in the third quarter and first nine months of
2007 was consistent with the same timeframes in 2006; and
o in 2007, HUSI commenced servicing a portfolio of loans previously serviced
by a third party.
The increased serviced loans portfolio, and its positive impact on service fee
income, was partially offset by a decrease in value of the hedged MSRs portfolio
including an increase in realization of cash flows on the growing portfolio of
loans serviced for others for the first nine months of 2007.
44
Trading Revenues
Trading revenues are generated by HUSI's participation in the foreign exchange,
credit derivative and precious metal markets; from trading derivative contracts,
including interest rate swaps and options; from trading securities; and as a
result of certain residential mortgage banking activities.
The following table summarizes trading related revenues by business. The data in
the table includes net interest income earned on trading instruments, as well as
funds transfer charges and credits associated with these trading positions. The
trading related net interest income component is included in net interest income
on the consolidated income statement. Trading revenues related to the mortgage
banking business are included in residential mortgage banking revenue.
----------------------------------------------------------------------------------------------------------------------
Increase (Decrease)
----------------------
2007 2006 Amount %
----------------------------------------------------------------------------------------------------------------------
($ in millions)
Three months ended September 30:
Trading revenues .............................................. $ 28 $ 52 $ (24) (46)
Net interest expense .......................................... (1) (16) 15 94
-------- -------- -------- --------
Trading related revenues ...................................... $ 27 $ 36 $ (9) (25)
======== ======== ======== ========
Business:
Derivatives instruments ................................. $ (33) $ 48 $ (81) (169)
Economic hedges of loans held for sale to HMUS .......... (24) (44) 20 45
Treasury (primarily securities) ......................... (28) (7) (21) *
Foreign exchange and banknotes .......................... 77 37 40 108
Precious metals ......................................... 24 3 21 *
Other trading ........................................... 11 (1) 12 *
-------- -------- -------- --------
Trading related revenues ...................................... $ 27 $ 36 $ (9) (25)
======== ======== ======== ========
Nine months ended September 30:
Trading revenues .............................................. $ 477 $ 600 $ (123) (21)
Net interest expense .......................................... (30) (42) 12 29
-------- -------- -------- --------
Trading related revenues ...................................... $ 447 $ 558 $ (111) (20)
======== ======== ======== ========
Business:
Derivatives instruments ................................. $ 201 $ 221 $ (20) (9)
Economic hedges of loans held for sale to HMUS .......... 32 110 (78) (71)
Treasury (primarily securities) ......................... (33) 7 (40) *
Foreign exchange and banknotes .......................... 191 132 59 45
Precious metals ......................................... 47 74 (27) (36)
Other trading ........................................... 9 14 (5) (36)
-------- -------- -------- --------
Trading related revenues ...................................... $ 447 $ 558 $ (111) (20)
======== ======== ======== ========
* Not meaningful.
During the first nine months of 2006, a wider range of product offerings and
enhanced sales capabilities within the CIBM business segment, along with
favorable market conditions in certain sectors, drove significant trading gains
across all major client-related activities. Successful launches of new products
and increased sales of structured products that are tailored to specific
customer needs led to strong derivatives trading revenues. Gains in the precious
metals business reflected volume growth driven by a surge in demand arising from
strong commodities markets. Income streams in the foreign exchange business
remained robust against the backdrop of a weakening U.S. dollar.
During the third quarter of 2007, trading revenue was affected by reduced
liquidity, widening spreads and higher volatility in the credit and sub-prime
lending markets which impacted trading in mortgage backed securities and credit
derivatives. The market turmoil has caused a significant fall in revenues in
both the third quarter and the first nine months of 2007 as compared with the
same 2006 periods. Precious metals revenue also experienced a decline in the
first nine months of 2007, as compared to prior year, as a result of lower price
volatility. Partially offsetting this, the foreign exchange business has
continued to contribute solid revenues as a result of ongoing market volatility
and the performance for the first nine months benefited from structured credit
and emerging markets derivatives activity in the first half of the year.
45
Effective during the third quarter of 2006, HUSI maintains a portfolio of
MasterCard, Incorporated Class B shares as part of structured product
transactions for customers. In addition, HUSI uses derivative instruments to
offset changes in the fair value of the MasterCard Class B shares. The increase
in value of the derivative instruments, which totaled $22 million for the third
quarter and the decrease in value of the derivative instruments, which totaled
$56 million for the first nine months of 2007, are reflected in trading revenue
from derivative instruments. Under U.S. GAAP, the increased value of the
MasterCard Class B shares is not recognized until they are sold.
HUSI also maintains a portfolio of derivative instruments that are utilized as
economic hedges to offset changes in market values of loans held for sale to
HMUS. Lower revenues from economic hedges of loans held for sale to HMUS
resulted from the overall weakness of the U.S. housing market. Lower trading
results related to this program are generally offset by the changes in the
valuation allowance related to loans held for sale to HMUS, which is recorded in
other revenues. Further analysis and commentary regarding these loans and the
associated hedges is provided beginning on page 41 of this Form 10-Q.
HUSI recognizes gains or losses at the inception of derivative transactions only
when the fair value of the transaction can be verified to market transactions or
if all significant pricing model assumptions can be verified to observable
market data. Gain or loss not recognized at inception is recorded in trading
assets and recognized over the term of the derivative contract, or when market
data becomes observable. The availability of observable market data resulted in
recognition of $7 million and $40 million in trading revenues for the first nine
months of 2007 and 2006, respectively.
Securities Gains, Net
HUSI maintains various securities portfolios as part of its overall balance
sheet diversification and risk management strategies. The following table
summarizes net securities gains resulting from various strategies.
------------------------------------------------------------------------------------------------
2007 2006
------------------------------------------------------------------------------------------------
(in millions)
Three months ended September 30:
Sales of MasterCard Class B Shares ........................... $ 55 $ --
Balance sheet diversity and reduction of risk ................ -- (5)
Management of Latin American investment exposure ............. 3 3
Sales of securities to an HSBC affiliate (1) ................ -- --
Other ........................................................ 1 8
--------- ---------
Securities gains, net ........................................ $ 59 $ 6
========= =========
Nine months ended September 30:
Sales of MasterCard Class B Shares ........................... $ 55 $ --
Balance sheet diversity and reduction of risk ................ 9 (2)
Management of Latin American investment exposure ............. 23 3
Sales of securities to an HSBC affiliate (1) ................. 9 --
Other ........................................................ -- 15
--------- ---------
Securities gains, net ........................................ $ 96 $ 16
========= =========
(1) Represents net gains realized from transfers of various available for sale
securities, other non-marketable securities and equity investments as part
of a strategy to consolidate certain investments into common HSBC
entities.
46
Operating Expenses
The components of operating expenses are summarized in the following tables.
----------------------------------------------------------------------------------------------------------------------
Increase (Decrease)
-----------------------
Three months ended September 30 2007 2006 Amount %
----------------------------------------------------------------------------------------------------------------------
($ in millions)
Salaries and employee benefits:
Salaries .................................................. $ 241 $ 234 $ 7 3
Employee benefits ......................................... 96 83 13 16
--------- --------- --------- ---------
Total salaries and employee benefits ...................... 337 317 20 6
--------- --------- --------- ---------
Occupancy expense, net .......................................... 63 54 9 17
--------- --------- --------- ---------
Support services from HSBC affiliates:
Fees paid to HSBC Finance Corporation for loan
servicing and other administrative support .............. 115 111 4 4
Fees paid to HMUS ......................................... 58 58 -- --
Fees paid to HTSU for technology services ................. 63 64 (1) (2)
Fees paid to other HSBC affiliates ........................ 44 40 4 10
--------- --------- --------- ---------
Total support services from HSBC affiliates ............... 280 273 7 3
--------- --------- --------- ---------
Other expenses:
Equipment and software .................................... 13 17 (4) (24)
Marketing ................................................. 34 28 6 21
Outside services .......................................... 44 29 15 52
Professional fees ......................................... 19 17 2 12
Telecommunications ........................................ 5 6 (1) (17)
Postage, printing and office supplies ..................... 9 9 -- --
Insurance business ........................................ 15 5 10 200
Miscellaneous ............................................. 72 64 8 13
--------- --------- --------- ---------
Total other expenses ...................................... 211 175 36 21
--------- --------- --------- ---------
Total operating expenses ........................................ $ 891 $ 819 $ 72 9
========= ========= ========= =========
Personnel - average number ...................................... 12,329 12,216 113 1
-----------------------------------------------------------------------------------------------------------------------
Increase (Decrease)
-----------------------
Nine months ended September 30 2007 2006 Amount %
-----------------------------------------------------------------------------------------------------------------------
($ in millions)
Salaries and employee benefits:
Salaries ................................................... $ 731 $ 671 $ 60 9
Employee benefits .......................................... 285 282 3 1
--------- --------- --------- ---------
Total salaries and employee benefits ....................... 1,016 953 63 7
--------- --------- --------- ---------
Occupancy expense, net ........................................... 181 163 18 11
--------- --------- --------- ---------
Support services from HSBC affiliates:
Fees paid to HSBC Finance Corporation for loan
servicing and other administrative support ............... 347 336 11 3
Fees paid to HMUS .......................................... 181 165 16 10
Fees paid to HTSU for technology services .................. 185 170 15 9
Fees paid to other HSBC affiliates ......................... 131 114 17 15
--------- --------- --------- ---------
Total support services from HSBC affiliates ................ 844 785 59 8
--------- --------- --------- ---------
Other expenses:
Equipment and software ..................................... 42 56 (14) (25)
Marketing .................................................. 97 74 23 31
Outside services ........................................... 115 89 26 29
Professional fees .......................................... 52 48 4 8
Telecommunications ......................................... 15 15 -- --
Postage, printing and office supplies ...................... 27 25 2 8
Insurance business ......................................... 27 15 12 80
Miscellaneous .............................................. 196 157 39 25
--------- --------- --------- ---------
Total other expenses ....................................... 571 479 92 19
--------- --------- --------- ---------
Total operating expenses ......................................... $ 2,612 $ 2,380 $ 232 10
========= ========= ========= =========
Personnel - average number ....................................... 12,324 12,094 230 2
47
Overview
Increased expenses for the third quarter and for the first nine months of 2007
were largely driven by higher personnel, marketing, technology and other expense
growth associated with continued rollout of various business growth initiatives
affecting all business segments.
Salaries and Employee Benefits
Higher salaries expenses for the first nine months of 2007 are mainly due to:
o higher staff counts and a changing mix of staffing to support various
business growth initiatives, primarily within the PFS, CIBM and PB
business segments;
o higher average salaries and pay rates, due to normal annual pay increases;
and
o higher personnel costs within the CIBM segment associated with the
expansion of various businesses that are better positioned to leverage
HSBC's global markets capabilities, and with repositioning certain other
businesses in order to focus on building a financing and emerging markets
led wholesale banking business.
During the second quarter of 2006, the HSBC Remuneration Committee exercised its
discretion to waive the Total Shareholder Return performance condition related
to 2003 share option awards under the HSBC Group Share Option Plan (refer to
page 141 of HUSI's 2006 Form 10-K for a description of this plan). This
modification resulted in an additional charge to employee benefits expense of $9
million for the second quarter of 2006. No similar charge was recorded during
2007. Excluding this 2006 charge, higher employee benefit costs directly
associated with increased salaries expenses were offset by lower pension costs.
Occupancy Expense, Net
Expansion of the core banking and commercial lending networks within the PFS and
CMB business segments has been a key component of recent business expansion
initiatives. New branches have been opened and lending operations have been
expanded, which have resulted in higher rental expenses, depreciation of
leasehold improvements, utilities and other occupancy expenses during the first
nine months of 2007.
Support Services from HSBC Affiliates
HUSI has routinely purchased private label credit card receivables from HSBC
Finance Corporation since December 2004. In addition, higher quality
nonconforming residential mortgage loans were acquired from HSBC Finance
Corporation's correspondent network from December 2003 until September 2005. In
most cases, HSBC Finance Corporation retained the right to service these
portfolios. Fees charged by HSBC Finance Corporation for loan origination and
servicing expenses, which are primarily recorded in the CF segment, have
increased moderately for 2007 due to an increased number of private label credit
card receivables serviced.
Fees charged by HMUS pursuant to service level agreements for broker dealer,
loan syndication, treasury and traded markets related services are included in
support services from HSBC affiliates. Higher fees charged by HMUS for the first
nine months of 2007 primarily relate to increased loan syndication services.
HSBC's technology services in North America are centralized within HSBC
Technology & Services (USA) Inc. (HTSU). Technology related assets and software
acquired for HUSI are generally purchased and owned by HTSU. Pursuant to a
master service level agreement, HTSU charges HUSI for equipment related costs
and technology services. Fees charged by HTSU to HUSI for technology services
are higher in 2007, as HUSI continues to upgrade its technology environment
within all business segments.
HUSI also utilizes other HSBC affiliates in support of global outsourcing
initiatives and, to a lesser extent, for treasury and traded markets services.
Higher expense for 2007 primarily resulted from expanded data processing and
other global outsourcing services.
48
Other Expenses
Higher marketing and promotional expenses resulted from continuing investment in
HSBC brand activities, promotion of the internet savings account and marketing
support for branch expansion initiatives, primarily within the PFS business
segment.
As a result of a decision to discontinue operations of HBUS's real estate
settlement services company, certain deferred start-up costs and other
contractual costs totaling $6 million were included in outside services for the
second quarter of 2007. Employment agency and staff recruitment fees, also
included in outside services, have increased in 2007, primarily to support
business expansion and ongoing technology enhancement projects.
The increase in Insurance business expense in the third quarter of 2007
primarily relates to the costs incurred to terminate a portion of the annuity
reinsurance business. Additionally, there was a nominal increase in claims for
the quarter.
Miscellaneous expenses for the first nine months of 2006 were unusually low,
mainly due to reversal of a charge for the accrued interest related to
settlement of certain income tax liabilities during the second quarter of 2006.
Excluding this 2006 adjustment, higher miscellaneous expenses for 2007 were
primarily due to increased insurance costs and higher expenses associated with
business expansion.
Efficiency Ratio
--------------------------------------------------------------------------------------------------------
Three months ended Nine months ended
September 30 September 30
----------------------- ----------------------
2007 2006 2007 2006
--------------------------------------------------------------------------------------------------------
Efficiency ratio (1) ................................ 68.69% 58.88% 60.67% 56.21%
(1) Ratio of total operating expenses, reduced by minority interests, to the
sum of net interest income and other revenues.
Higher net interest income was more than offset by a decrease in other revenues
and increased operating expenses for the third quarter and the first nine months
of 2007, resulting in an increase in the efficiency ratio for both periods.
49
SEGMENT RESULTS
--------------------------------------------------------------------------------
HUSI has five distinct segments that are utilized for management reporting and
analysis purposes. The segments, which are based upon customer groupings as well
as products and services offered, are described on pages 19-20 of HUSI's Form
10-Q for the quarterly period ended March 31, 2007.
Effective January 1, 2007, corporate goals of HUSI are based upon results
reported under International Financial Reporting Standards (IFRS), which are
utilized by HSBC to prepare its consolidated financial statements. Operating
results for HUSI are now being monitored and reviewed, trends are being
evaluated, and decisions are being made about allocating certain resources on an
IFRS basis. As a result, business segment results are reported on an IFRS basis
to align with the revised internal reporting mechanism for monitoring
performance. Results for 2007 and 2006 in the tables that follow are reflected
on an IFRS basis.
Results for each business segment on an IFRS basis are summarized in the
following tables.
Personal Financial Services (PFS)
Overview
Resources continue to be directed towards expansion of the core retail banking
business, including investment in the HSBC brand, expansion of the branch
network in existing and new geographic areas, and continued rollout of HSBC
Direct, the internet banking channel. Significant expense growth from these
initiatives for the third quarter and the first nine months of 2007 has been
partially offset by growth in revenues from key investments. Net interest income
from core banking activities has decreased in 2007 due to continued narrowing of
interest rate spreads, as well as customer migration to higher yielding deposit
products such as Online Savings and CDs and was partially offset by the positive
impact of new customers and product sales.
Balance sheet growth for core retail banking for the first nine months of 2007
was highlighted by a 24.5% increase in average deposits, as compared with the
same 2006 period. This was driven by a successful strategy to build deposits
across multiple markets and business segments and utilizing various delivery
channels.
PFS business segment results for 2007 also have been impacted by lower
residential mortgage banking revenue, primarily due to loan portfolio runoff.
During 2007, as part of a continuing effort to manage prepayment risk and
liquidity, HUSI made the decision to sell a majority of its residential mortgage
loan originations and allow the residential mortgage loan portfolio to run off.
50
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