HSBC USA Inc 10-Q

HSBC Holdings PLC 14 November 2007 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2007 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number 1-7436 HSBC USA Inc. (Exact name of registrant as specified in its charter) Maryland 13-2764867 (State of Incorporation) (I.R.S. Employer Identification No.) 452 Fifth Avenue, New York, New York 10018 (Address of principal executive offices) (Zip Code) (716) 841-2424 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of "accelerated filer and a large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer |_| Accelerated filer |_| Non-accelerated filer |X| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes |_| No |X| At October 31, 2007, there were 706 shares of the registrant's Common Stock outstanding, all of which are owned by HSBC North America Inc. DOCUMENTS INCORPORATED BY REFERENCE None ================================================================================ HSBC USA Inc. Form 10-Q TABLE OF CONTENTS Part I FINANCIAL INFORMATION -------------------------------------------------------------------------------- Page ---- Item 1. Consolidated Financial Statements Statements of Income ...................................... 3 Balance Sheets ............................................ 4 Statements of Changes in Shareholders' Equity ............. 5 Statements of Cash Flows .................................. 6 Notes to Consolidated Financial Statements ................ 7 Management's Discussion and Analysis of Financial Condition Item 2. and Results of Operations (MD&A) Forward-Looking Statement ................................. 27 Executive Overview ........................................ 27 Basis of Reporting ........................................ 30 Balance Sheet Review ...................................... 33 Results of Operations ..................................... 36 Segment Results ........................................... 50 Credit Quality ............................................ 57 Off-Balance Sheet Arrangements ............................ 64 Risk Management ........................................... 65 Average Balances and Interest Rates ....................... 72 Item 3. Quantitative and Qualitative Disclosures About Market Risk .... 74 Item 4. Controls and Procedures ....................................... 74 Part II OTHER INFORMATION -------------------------------------------------------------------------------- Item 1A. Risk Factors .................................................. 75 Item 6. Exhibits ...................................................... 75 Signature ................................................................ 76 2 HSBC USA Inc. Consolidated Statements of Income (Unaudited) -------------------------------------------------------------------------------- Three months ended Nine months ended September 30, September 30, ------------------------ ------------------------ 2007 2006 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Interest income: Loans ................................................... $ 1,586 $ 1,444 $ 4,505 $ 4,112 Securities .............................................. 317 289 879 826 Trading assets .......................................... 167 107 476 317 Short-term investments .................................. 241 209 719 528 Other ................................................... 60 27 135 64 --------- --------- --------- --------- Total interest income ....................................... 2,371 2,076 6,714 5,847 --------- --------- --------- --------- Interest expense: Deposits ................................................ 993 828 2,841 2,246 Short-term borrowings ................................... 90 91 266 237 Long-term debt .......................................... 365 380 1,087 1,077 --------- --------- --------- --------- Total interest expense ...................................... 1,448 1,299 4,194 3,560 --------- --------- --------- --------- Net interest income ......................................... 923 777 2,520 2,287 Provision for credit losses ................................. 402 207 871 586 --------- --------- --------- --------- Net interest income after provision for credit losses ....... 521 570 1,649 1,701 --------- --------- --------- --------- Other revenues: Trust income ............................................ 26 22 73 66 Service charges ......................................... 53 52 158 149 Credit card fees ........................................ 225 148 601 409 Other fees and commissions .............................. 118 110 312 302 HSBC affiliate income ................................... 46 61 134 182 Other (loss) income ..................................... (187) 157 (135) 165 Residential mortgage banking revenue .................... 6 6 69 57 Trading revenues ........................................ 28 52 477 600 Securities gains, net ................................... 59 6 96 16 --------- --------- --------- --------- Total other revenues ........................................ 374 614 1,785 1,946 --------- --------- --------- --------- Operating expenses: Salaries and employee benefits .......................... 337 317 1,016 953 Occupancy expense, net .................................. 63 54 181 163 Support services from HSBC affiliates ................... 280 273 844 785 Other expenses .......................................... 211 175 571 479 --------- --------- --------- --------- Total operating expenses .................................... 891 819 2,612 2,380 --------- --------- --------- --------- Income before income tax expense ............................ 4 365 822 1,267 Income tax (credit) expense ................................. (17) 121 237 429 --------- --------- --------- --------- Net income .................................................. $ 21 $ 244 $ 585 $ 838 ========= ========= ========= ========= The accompanying notes are an integral part of the consolidated financial statements. 3 HSBC USA Inc. Consolidated Balance Sheets (Unaudited) -------------------------------------------------------------------------------- September 30, December 31, 2007 2006 --------------------------------------------------------------------------------------------------------------------- (in millions) Assets Cash and due from banks .............................................................. $ 2,585 $ 3,359 Interest bearing deposits with banks ................................................. 8,126 1,921 Federal funds sold and securities purchased under resale agreements .................. 11,070 13,775 Trading assets ....................................................................... 31,582 23,630 Securities available for sale ........................................................ 21,609 19,783 Securities held to maturity (fair value $2,973 million and $3,040 million at September 30, 2007 and December 31, 2006, respectively) ......................... 2,946 2,972 Loans ................................................................................ 92,666 90,237 Less - allowance for credit losses ................................................... 1,058 897 --------- --------- Loans, net ...................................................................... 91,608 89,340 --------- --------- Properties and equipment, net ........................................................ 557 540 Intangible assets .................................................................... 579 521 Goodwill ............................................................................. 2,716 2,716 Other assets ......................................................................... 12,043 6,260 --------- --------- Total assets ......................................................................... $ 185,421 $ 164,817 ========= ========= Liabilities Deposits in domestic offices: Noninterest bearing ............................................................. $ 12,027 $ 12,813 Interest bearing (includes $1,754 million and $1,322 million of deposits recorded at fair value at September 30, 2007 and December 31, 2006, respectively) ..... 67,592 61,538 Deposits in foreign offices: Noninterest bearing ............................................................. 1,261 727 Interest bearing ................................................................ 29,928 27,068 --------- --------- Total deposits ............................................................... 110,808 102,146 --------- --------- Trading liabilities .................................................................. 16,819 12,314 Short-term borrowings ................................................................ 9,404 5,073 Interest, taxes and other liabilities ................................................ 8,246 3,771 Long-term debt ....................................................................... 28,131 29,252 --------- --------- Total liabilities .................................................................... 173,408 152,556 --------- --------- Shareholders' equity Preferred stock ...................................................................... 1,690 1,690 Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 706 shares issued and outstanding at September 30, 2007 and December 31, 2006) ................. --(1) --(1) Capital surplus ................................................................. 8,123 8,124 Retained earnings ............................................................... 2,536 2,661 Accumulated other comprehensive loss ............................................ (336) (214) --------- --------- Total common shareholder's equity ............................................ 10,323 10,571 --------- --------- Total shareholders' equity ........................................................... 12,013 12,261 --------- --------- Total liabilities and shareholders' equity ........................................... $ 185,421 $ 164,817 ========= ========= The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 4 HSBC USA Inc. Consolidated Statements of Changes in Shareholders' Equity (Unaudited) -------------------------------------------------------------------------------- Nine months ended September 30, 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Preferred stock Balance, January 1, ................................................................. $ 1,690 $ 1,316 Preferred stock issuance ............................................................ -- 374 ---------- ---------- Balance, September 30, .............................................................. 1,690 1,690 ---------- ---------- Common stock Balance, January 1 and September 30, ................................................ --(1) --(1) ---------- ---------- Capital surplus Balance, January 1, ................................................................. 8,124 8,118 Capital contribution from parent .................................................... 2 15 Preferred stock issuance costs ...................................................... -- (9) Employee benefit plans and other .................................................... (3) 4 ---------- ---------- Balance, September 30, .............................................................. 8,123 8,128 ---------- ---------- Retained earnings Balance, January 1, ................................................................. 2,661 2,172 Net income .......................................................................... 585 838 Cash dividends declared on preferred stock .......................................... (75) (62) Cash dividends declared on common stock ............................................. (635) (455) Cumulative effect of change in accounting for mortgage servicing assets ............. -- (4) ---------- ---------- Balance, September 30, .............................................................. 2,536 2,489 ---------- ---------- Accumulated other comprehensive income Balance, January 1, ................................................................. (214) (12) ---------- ---------- Net change in net unrealized losses on securities available for sale, net of tax .... (45) (113) Net change in net unrealized (losses) gains on derivatives classified as cash flow hedges, net of tax ..................................... (90) (73) Net change in net unrealized gains on interest only strip receivables, net of tax .................................................. -- (6) Unrecognized actuarial gains, transition obligation and prior service costs relating to pension and postretirement benefits, net of tax .............. 10 -- Foreign currency translation adjustments, net of tax ................................ 3 (2) ---------- ---------- Other comprehensive loss, net of tax ................................................ (122) (194) ---------- ---------- Balance, September 30, .............................................................. (336) (206) ---------- ---------- Total shareholders' equity, September 30, ........................................... $ 12,013 $ 12,101 ========== ========== Comprehensive income Net income .......................................................................... $ 585 $ 838 Other comprehensive loss ............................................................ (122) (194) ---------- ---------- Comprehensive income ................................................................ $ 463 $ 644 ========== ========== The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 5 HSBC USA Inc. Consolidated Statements of Cash Flows (Unaudited) -------------------------------------------------------------------------------- Nine months ended September 30, 2007 2006 (in millions) ---------------------------------------------------------------------------------------------------------------------- Cash flows from operating activities Net income ........................................................................ $ 585 $ 838 Adjustments to reconcile net income to net cash (used in) provided by operating activities: Depreciation, amortization and deferred taxes ................................ 69 294 Provision for credit losses .................................................. 871 586 Net change in other assets and liabilities ................................... (4,529) 1,452 Net change in loans held for sale to HSBC Markets (USA) Inc. (HMUS): Loans acquired from originators ......................................... (5,295) (13,024) Sales of loans to HMUS .................................................. 5,749 12,657 Net change in other loans held for sale ...................................... (2,154) 132 Net change in loans attributable to tax refund anticipation loans program: Originations of loans ................................................... (17,433) (16,100) Sales of loans to HSBC Finance Corporation, including premium ........... 17,645 16,100 Net change in trading assets and liabilities ................................. (52) (1,803) Net change in fair value of derivatives and hedged items ..................... 642 733 ---------- ---------- Net cash (used in) provided by operating activities ..................... (3,902) 1,865 ---------- ---------- Cash flows from investing activities Net change in interest bearing deposits with banks ................................ (6,205) (2) Net change in federal funds sold and securities purchased under resale agreements . 2,705 (10,126) Net change in securities available for sale: Purchases of securities available for sale ................................... (12,947) (5,981) Proceeds from sales of securities available for sale ......................... 3,736 2,366 Proceeds from maturities of securities available for sale .................... 7,332 1,799 Net change in securities held to maturity: Purchases of securities held to maturity ..................................... (187) (761) Proceeds from maturities of securities held to maturity ...................... 213 941 Net change in loans: Originations, net of collections ............................................. 15,491 16,616 Loans purchased from HSBC Finance Corporation ................................ (17,136) (16,849) Net cash used for acquisitions of properties and equipment ........................ (71) (51) Other, net ........................................................................ (123) (211) ---------- ---------- Net cash used in investing activities ................................... (7,192) (12,259) ---------- ---------- Cash flows from financing activities Net change in deposits ............................................................ 8,662 6,536 Net change in short-term borrowings ............................................... 4,331 676 Net change in long-term debt: Issuance of long-term debt ................................................... 5,019 5,685 Repayment of long-term debt .................................................. (6,981) (3,113) Preferred stock issuance, net of issuance costs ................................... -- 365 Other (decreases) increases in capital surplus .................................... (1) 19 Dividends paid .................................................................... (710) (517) ---------- ---------- Net cash provided by financing activities ............................... 10,320 9,651 ---------- ---------- Net change in cash and due from banks ................................................. (774) (743) Cash and due from banks at beginning of period ........................................ 3,359 4,441 ---------- ---------- Cash and due from banks at end of period .............................................. $ 2,585 $ 3,698 ========== ========== The accompanying notes are an integral part of the consolidated financial statements. 6 Notes to Consolidated Financial Statements Note 1. Organization and Basis of Presentation -------------------------------------------------------------------------------- HSBC USA Inc. is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. (HNAH), which is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC). The accompanying unaudited interim consolidated financial statements of HSBC USA Inc. and its subsidiaries (collectively, HUSI), including its principal subsidiary, HSBC Bank USA, National Association (HBUS), have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim financial information, as well as in accordance with predominant practices within the banking industry. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. These unaudited interim financial statements should be read in conjunction with HUSI's Annual Report on Form 10-K for the year ended December 31, 2006 (the 2006 Form 10-K). Certain reclassifications have been made to prior period amounts to conform to the current period presentations. The accounting and reporting policies of HUSI are consistent, in all material respects, with those used to prepare the 2006 Form 10-K, except for the impact of new accounting pronouncements summarized in Note 15 of these unaudited interim consolidated financial statements. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods. Note 2. Trading Assets and Liabilities -------------------------------------------------------------------------------- Trading assets and liabilities are summarized in the following table. ----------------------------------------------------------------------------------------- September 30, December 31, 2007 2006 ----------------------------------------------------------------------------------------- (in millions) Trading assets: U.S. Treasury .................................. $ 408 $ 646 U.S. Government agency ......................... 3,178 1,902 Asset backed securities ........................ 2,926 3,053 Corporate bonds ................................ 1,362 1,420 Other securities ............................... 5,787 4,903 Precious metals ................................ 4,659 2,716 Fair value of derivatives ...................... 13,262 8,990 ----------- ---------- Total .......................................... $ 31,582 $ 23,630 =========== ========== Trading liabilities: Securities sold, not yet purchased ............. $ 1,804 $ 1,914 Payables for precious metals ................... 1,814 1,336 Fair value of derivatives ...................... 13,201 9,064 ----------- ---------- Total .......................................... $ 16,819 $ 12,314 =========== ========== During the second quarter of 2007, HUSI adopted the reporting requirements of FASB Staff Position No. FIN 39-1, Amendment of FASB Interpretation No. 39 (refer to Note 15 of these consolidated financial statements). In accordance with this standard, HUSI offsets fair value amounts recognized for the obligation to return cash collateral or the right to reclaim cash collateral against the fair value of derivative instruments executed with the same counterparty under a master netting agreement. As a result of application of this standard, certain reclassifications have been made to the December 31, 2006 consolidated balance sheet, as noted below. At September 30, 2007 and December 31, 2006, the fair value of derivatives included in trading assets have been reduced by $3.9 billion and $2.4 billion, respectively, of amounts recognized for the obligation to return cash collateral received under master netting agreements with derivative counterparties. At December 31, 2006, these amounts were originally reported as interest bearing deposits. 7 At September 30, 2007 and December 31, 2006, the fair value of derivatives included in trading liabilities have been reduced by $4.1 billion and $1.7 billion, respectively, of amounts recognized for the right to reclaim cash collateral paid under master netting agreements with derivative counterparties. At December 31, 2006, $.4 billion of these amounts were originally reported as interest bearing deposits with banks and $1.3 billion were reported as other assets. Note 3. Securities -------------------------------------------------------------------------------- At September 30, 2007 and December 31, 2006, HUSI held no securities of any single issuer (excluding the U.S. Treasury, U.S. Government agencies and U.S. Government sponsored enterprises) with a book value that exceeded 10% of shareholders' equity. The amortized cost and fair value of the securities available for sale and securities held to maturity portfolios are summarized in the following tables. ----------------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair September 30, 2007 Cost Gains Losses Value ----------------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury .................................. $ 607 $ -- $ (5) $ 602 U.S. Government sponsored enterprises (1) ...... 12,105 37 (363) 11,779 U.S. Government agency issued or guaranteed .... 3,489 4 (77) 3,416 Obligations of U.S. states and political subdivisions ................................... 670 1 (8) 663 Asset backed securities ........................ 1,691 2 (20) 1,673 Other domestic debt securities ................. 2,701 11 (23) 2,689 Foreign debt securities ........................ 760 1 (4) 757 Equity securities .............................. 29 2 (1) 30 ---------- --------- -------- ---------- Total .......................................... $ 22,052 $ 58 $ (501) $ 21,609 ========== ========= ======== ========== Securities held to maturity: U.S. Government sponsored enterprises (1) ...... $ 1,854 $ 34 $ (25) $ 1,863 U.S. Government agency issued or guaranteed .... 539 18 (3) 554 Obligations of U.S. states and political subdivisions ................................... 274 14 (5) 283 Other domestic debt securities ................. 174 -- (6) 168 Foreign debt securities ........................ 105 -- -- 105 ---------- --------- -------- ---------- Total .......................................... $ 2,946 $ 66 $ (39) $ 2,973 ========== ========= ======== ========== ----------------------------------------------------------------------------------------------------------------------- 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 --------- --------- -------- ---------- Total .......................................... $ 20,081 $ 65 $ (363) $ 19,783 ========= ========= ======== ========== Securities held to maturity: 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 --------- --------- -------- ---------- Total .......................................... $ 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). 8 Gross unrealized losses and related fair values, classified as to the length of time the losses have existed, are summarized in the following tables. ----------------------------------------------------------------------------------------------------------------------- One Year or Less Greater Than One Year --------------------------------------- ----------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value September 30, 2007 Securities Losses of Investment Securities Losses of Investment ----------------------------------------------------------------------------------------------------------------------- ($ in millions) Securities available for sale: U.S. Treasury ............... 1 $ (1) $ 154 3 $ (4) $ 447 U.S. Government sponsored enterprises (1) ........... 75 (71) 1,940 634 (292) 6,811 U.S. Government agency issued or guaranteed ...... 139 (12) 608 739 (65) 2,246 Obligations of U.S. states and political subdivisions .. 76 (8) 496 2 * 22 Asset backed securities ..... 37 (17) 1,070 17 (3) 210 Other domestic debt securities 28 (8) 579 55 (15) 848 Foreign debt securities ..... 6 (2) 81 6 (2) 144 Equity securities ........... -- -- -- 1 (1) 23 ------- ------- ------- ------- ------- ------- Total ....................... 362 $ (119) $ 4,928 1,457 $ (382) $10,751 ======= ======= ======= ======= ======= ======= Securities held to maturity: U.S. Government sponsored enterprises (1) ........... 17 $ (3) $ 237 24 $ (22) $ 377 U.S. Government agency issued or guaranteed ............. 2 * 51 106 (3) 40 Obligations of U.S. states and political subdivisions .... 5 (5) 2 -- -- -- Other domestic debt securities 5 (2) 96 8 (4) 71 Foreign debt securities ..... 5 -- 105 -- -- -- ------- ------- ------- ------- ------- ------- Total ....................... 34 $ (10) $ 491 138 $ (29) $ 488 ======= ======= ======= ======= ======= ======= ----------------------------------------------------------------------------------------------------------------------- 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 ------- ------- ------- ------- ------- ------- Total ..................... 944 $ (158) $ 6,529 845 $ (205) $ 8,141 ======= ======= ======= ======= ======= ======= Securities held to maturity: 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 sand political subdivisions .. 1 * * 9 * 4 Other domestic debt securities 2 * 22 4 (2) 33 Foreign debt securities ... 2 * 51 -- -- -- ------- ------- ------- ------- ------- ------- Total ..................... 77 $ * $ 109 204 $ (21) $ 461 ======= ======= ======= ======= ======= ======= (1) Included primarily mortgaged-backed securities issued by FNMA and FHLMC. * Less than $500 thousand 9 Gross unrealized losses within the available for sale securities portfolio increased during the nine months ended September 30, 2007 due to the impact of general increases in market interest rates on HUSI's portfolios, which are primarily fixed rate securities. 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. Note 4. Loans -------------------------------------------------------------------------------- A distribution of the loan portfolio, including loans held for sale, is summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- September 30, 2007 December 31, 2006 -------------------------------------- -------------------------------------- Loans Held All Other Total Loans Held All Other Total for Sale Loans Loans for Sale Loans Loans ----------------------------------------------------------------------------------------------------------------------- (in millions) Commercial loans: Construction and other real estate $ 382 $ 8,526 $ 8,908 $ 102 $ 8,816 $ 8,918 Other commercial ............. 1,892 24,646 26,538 -- 20,564 20,564 ------- ------- ------- ------- ------- ------- 2,274 33,172 35,446 102 29,380 29,482 ------- ------- ------- ------- ------- ------- Consumer loans: Sub-prime residential mortgages held for sale to HMUS ...... 2,120 -- 2,120 2,582 -- 2,582 Other residential mortgages .. 1,532 33,077 34,609 1,645 35,581 37,226 Credit card receivables ...... -- 18,044 18,044 -- 18,260 18,260 Other consumer ............... 497 1,950 2,447 394 2,293 2,687 ------- ------- ------- ------- ------- ------- 4,149 53,071 57,220 4,621 56,134 60,755 ------- ------- ------- ------- ------- ------- Total loans ....................... $ 6,423 $86,243 $92,666 $ 4,723 $85,514 $90,237 ======= ======= ======= ======= ======= ======= Loans pledged as collateral are summarized in Note 14 beginning on page 21 of this Form 10-Q. 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 other commercial loans held for sale at September 30, 2007. Commercial loans held for sale under this program were $1.9 billion at September 30, 2007. Residential mortgage loans held for sale include sub-prime residential mortgage loans acquired from unaffiliated third parties and from HSBC Finance Corporation, with the intent of selling the loans to an HSBC affiliate, HSBC Markets (USA) Inc. (HMUS). Also included in residential mortgage loans held for sale are prime mortgage loans originated and held for sale to HMUS, and various governmental agencies. Residential mortgage loans held for sale to HMUS were $2.8 billion at September 30, 2007 and $3.1 billion at December 31, 2006, of which $2.1 billion and $2.6 billion respectively were sub-prime loans. Student loans held for sale to government agencies are included in other consumer loans. 10 Commercial loans held for sale are recorded at the lower of cost or market value. Residential mortgage loans and student loans held for sale are recorded at the lower of aggregate cost or market value. The cost of commercial loans held for sale exceeded market value at September 30, 2007. The aggregate cost of consumer loans held for sale exceeded market value at September 30, 2007 and December 31, 2006. Changes in the valuation allowance utilized to adjust loans held for sale to market value, that is included in the determination of net income, are summarized in the following table and reflect the recording of substantial valuation adjustments as a result of adverse conditions in the corporate credit and U.S. residential mortgage markets. Also, see commentary regarding changes in the valuation allowance included in the Management's Discussion and Analysis of Financial Condition and Results of Operation (MD&A) on pages 41 and 42 of this Form 10-Q. ----------------------------------------------------------------------------------------------------------------------- 2007 2006 -------------------------------------------- -------------------------------------------- Valuation Allowance Related to Valuation Allowance Related to ------------------------------ ------------------------------ Residential Residential Mortgages Mortgages Loans Loans Held for All Other Held for All Other Sale Loans Held Sale Loans Held to HMUS for Sale Total to HMUS for Sale Total ----------------------------------------------------------------------------------------------------------------------- (in millions) Three months ended September 30: Balance at beginning of period ....................... $ (49) $ (9) $ (58) $ (83) $ (20) $ (103) Valuation allowance increase for changes in market value .. (146) (72) (218) 29 14 43 Releases of valuation allowance for loans sold ..... 3 2 5 53 -- 53 -------- -------- -------- -------- -------- -------- Balance at end of period ....... $ (192) $ (79) $ (271) $ (1) $ (6) $ (7) ======== ======== ======== ======== ======== ======== Nine months ended September 30: Balance at beginning of period ....................... $ (26) $ (3) $ (29) $ (11) $ (15) $ (26) Valuation allowance increase for changes in market value .. (221) (78) (299) (123) 9 (114) Releases of valuation allowance for loans sold ..... 55 2 57 133 -- 133 -------- -------- -------- -------- -------- -------- Balance at end of period ....... $ (192) $ (79) $ (271) $ (1) $ (6) $ (7) ======== ======== ======== ======== ======== ======== Loans held for sale are subject to credit risk and interest rate risk, in that their value will fluctuate as a result of changes in market conditions as well as the interest rate and credit environment. Interest rate risk for the residential mortgage loans held for sale to HMUS is partially mitigated through an economic hedging program to offset changes in the fair value of the loans held for sale. Trading related revenues related to this economic hedging program, which include net interest income and trading revenues, were $32 million and $110 million for the first nine months of 2007 and 2006, respectively. Note 5. Allowance for Credit Losses and Credit Quality Statistics -------------------------------------------------------------------------------- Changes in the allowance for credit losses are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 ----------------------- ----------------------- 2007 2006 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Beginning balance ......................................... $ 902 $ 869 $ 897 $ 846 -------- -------- -------- -------- Allowance related to disposition of certain private label credit card relationships ............................... -- -- -- (6) Net charge offs: Charge offs ......................................... 305 253 903 722 Recoveries .......................................... 59 63 193 182 -------- -------- -------- -------- 246 190 710 540 -------- -------- -------- -------- Provision for credit losses ............................... 402 207 871 586 -------- -------- -------- -------- -------- Ending balance ............................................ $ 1,058 $ 886 $ 1,058 $ 886 ======== ======== ======== ======== 11 Credit Quality Statistics Nonaccruing loans are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- September 30, December 31, 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Nonaccruing loans: Commercial: Construction and other real estate ....................................... $ 40 $ 33 Other commercial ......................................................... 93 69 -------- -------- Total commercial ......................................................... 133 102 -------- -------- Consumer: Residential mortgages .................................................... 512 182 Other consumer ........................................................... 1 1 -------- -------- Total consumer ........................................................... 513 183 -------- -------- Total nonaccruing loans ..................................................... $ 646 $ 285 ======== ======== Interest income on nonaccruing loans is summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- Nine months ended September 30 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (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 .......................... $ 32 $ 16 Amount actually recorded ........................................................ 6 7 Additional credit quality statistics are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- September 30, December 31, 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Accruing loans contractually past due 90 days or more as to principal or interest: Total commercial loans ...................................................... $ 62 $ 22 -------- -------- Consumer: Residential mortgages .................................................... 3 11 Credit card receivables .................................................. 357 339 Other consumer loans ..................................................... 24 16 -------- -------- Total consumer loans ..................................................... 384 366 -------- -------- Total ....................................................................... $ 446 $ 388 ======== ======== Impaired loans: Balance at end of period .................................................... $ 133 $ 100 Amount with impairment reserve .............................................. 59 35 Impairment reserve .......................................................... 18 13 Other real estate and owned assets: Balance at end of period .................................................... $ 63 $ 53 Note 6. Intangible Assets -------------------------------------------------------------------------------- The composition of intangible assets is summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- September 30, December 31, 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Mortgage servicing rights ......................................................... $ 537 $ 474 Other ............................................................................. 42 47 -------- -------- Total intangible assets ........................................................... $ 579 $ 521 ======== ======== 12 Mortgage Servicing Rights (MSRs) HUSI recognizes the right to service mortgage loans as a separate and distinct asset at the time they are acquired or when originated loans are sold. Servicing fees collected by HUSI are included in residential mortgage banking revenue, and were $85 million and $74 million for the first nine months of 2007 and 2006, respectively. MSRs are subject to credit 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 beginning on page 65 of this Form 10-Q. 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. 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. ----------------------------------------------------------------------------------------------------------------------- September 30, December 31, 2007 2006 ----------------------------------------------------------------------------------------------------------------------- Annualized constant prepayment rate (CPR) 17.30% 20.80 % Constant discount rate 10.75% 10.34 % Weighted average life 5.5 years 4.8 years MSRs activity is summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Three months ended September 30: Fair value of MSRs: Beginning balance $ 552 $ 499 Additions related to loan sales 28 24 Changes in fair value due to: Change in valuation inputs or assumptions used in the valuation models (29) (43) Realization of cash flows (14) (21) --------- -------- Ending balance $ 537 $ 459 ========= ======== Nine months ended September 30: Fair value of MSRs: Beginning balance $ 474 $ 418 Additions related to loan sales 89 69 Changes in fair value due to: Change in valuation inputs or assumptions used in the valuation models 34 32 Realization of cash flows (60) (60) --------- -------- Ending balance $ 537 $ 459 ========= ======== 13 Note 7. Goodwill -------------------------------------------------------------------------------- During the third quarter of 2007, HUSI completed its annual impairment test of goodwill. At the testing date, HUSI determined that the fair value of each of its reporting units exceeded its carrying value. As a result, no impairment loss was required to be recognized. During the nine months ended September 30, 2007, there were no material events or transactions which warranted consideration for their impact on recorded book values assigned to goodwill. Note 8. Income Taxes -------------------------------------------------------------------------------- The following table presents HUSI's effective tax rates. ----------------------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 ------------------------ ------------------------ 2007 2006 2007 2006 -------------------------------------------------------- Statutory federal income tax rate ....................... 35.0% 35.0% 35.0% 35.0% Increase (decrease) in rate resulting from State and local taxes, net of federal benefit ......... 66.1 1.1 2.0 2.4 Tax exempt income ..................................... (129.6) (1.9) (1.9) (1.1) Validation of deferred tax balances ................... -- -- (3.4) -- Tax credits ........................................... (256.5) (1.8) (3.7) (1.7) Effects of foreign operations ......................... (71.8) -- (.2) -- Uncertain tax provision ............................... (49.6) .3 1.0 (1.0) Other ................................................. (18.6) .5 -- .3 -------- -------- -------- -------- Effective tax rate ...................................... (425.0)% 33.2% 28.8% 33.9% ======== ======== ======== ======== HUSI adopted FASB Interpretation No. 48 (FIN 48) effective January 1, 2007 (refer to Note 15 of these consolidated financial statements). The adoption resulted in the recognition of additional current tax liabilities and offsetting deferred tax assets of $11 million. The total amount of unrecognized tax benefits as of January 1, 2007 was $86 million. The state tax portion of this amount is reflected gross and not reduced by federal tax effect. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $54 million. Major taxing jurisdictions for HUSI and tax years for each that remain subject to examination are as follows: U.S. Federal 2004 and later New York State 1992 and later New York City 1995 and later HUSI does not anticipate that any significant tax positions have a reasonable possibility of being effectively settled within the next 12 months. HUSI recognizes accrued interest related to unrecognized tax benefits in other operating expenses. As of January 1, 2007, HUSI had accrued $16 million for the payment of interest. 14 Note 9. Long-Term Debt -------------------------------------------------------------------------------- Long-term debt is summarized in the following table. ------------------------------------------------------------------------------------------------------------------ September 30, December 31, 2007 2006 ------------------------------------------------------------------------------------------------------------------ (in millions) Senior debt ............................................................... $ 22,524 $ 23,913 Subordinated debt ......................................................... 5,592 5,322 All other ................................................................. 15 17 ------------ ---------- Total long-term debt ...................................................... $ 28,131 $ 29,252 ============ ========== Senior Debt Senior debt includes $1.5 billion Floating Rate Extendible Notes, which 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 twelve months from the election date. Refer to page 128 of HUSI's 2006 Form 10-K for additional information regarding these notes. In August 2007, noteholders of $749,500,000 of this debt exercised their option not to extend the maturity date of their notes. These notes will mature on August 15, 2008. In September 2007, noteholders of $690,000,000 of this debt exercised their option not to extend the maturity date of their notes. These notes will mature on September 15, 2008. On the October 2007 election date, noteholders of the remaining $60,500,000 of this debt elected not to extend the maturity date of their notes. Therefore, these notes will mature on October 15, 2008. Senior debt includes $1,637 million and $902 million of debt instruments recorded at fair value at September 30, 2007 and December 31, 2006, respectively. Subordinated Debt During August 2007, HBUS issued $500,000,000 of subordinated notes under its Global Bank Note Program. These notes mature in 2017 and bear interest at 6.00%. Interest is paid semiannually in February and August, beginning in 2008. During September 2007, HUSI exercised its right to redeem $206 million of 7.53% Junior Subordinated Debt Securities with an original maturity date of December 4, 2026. 15 Note 10. Related Party Transactions -------------------------------------------------------------------------------- In the normal course of business, HUSI conducts transactions with HSBC and its subsidiaries (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. Related party balances and the income and expense generated by related party transactions are summarized in the following table. ------------------------------------------------------------------------------------------------------------------ September 30, December 31, 2007 2006 ------------------------------------------------------------------------------------------------------------------ (in millions) Assets: Cash and due from banks ................................................ $ 77 $ 179 Interest bearing deposits with banks ................................... 107 59 Federal funds sold and securities purchased under resale agreements .... 277 141 Trading assets (1) ..................................................... 10,857 6,895 Loans .................................................................. 1,316 813 Other .................................................................. 3,763 242 --------- --------- Total assets ........................................................... $ 16,397 $ 8,329 ========= ========= Liabilities: Deposits ............................................................... $ 12,951 $ 12,233 Trading liabilities (1) ................................................ 12,593 6,473 Short-term borrowings .................................................. 643 464 Other .................................................................. 939 254 --------- --------- Total liabilities ...................................................... $ 27,126 $ 19,424 ========= ========= (1) Trading assets and liabilities exclude the impact of netting in accordance with FASB Interpretation No. 39 and FSP FIN 39-1. ----------------------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 ---------------------- ---------------------- 2007 2006 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Interest income ............................................... $ 44 $ 13 $ 109 $ 36 Interest expense .............................................. 108 102 317 299 HSBC affiliate income: Other fees and commissions: HSBC ................................................. 19 8 43 20 HSBC Finance Corporation ............................. 5 3 13 8 HMUS ................................................. 2 1 8 4 Other HSBC affiliates ................................ 2 1 5 4 Service charges ......................................... 1 4 9 11 Gains on sales of loans to HMUS ......................... 14 40 24 105 Gains on sales of refund anticipation loans to HSBC Finance Corporation ........................................... -- -- 23 21 Other HSBC affiliates income ............................ 3 4 9 9 Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation ................... 115 111 347 336 Fees paid to HMUS ....................................... 58 58 181 165 Fees paid to HSBC Technology & Services (USA) Inc. (HTSU) for technology services ........................ 63 64 185 170 Fees paid to other HSBC affiliates ...................... 44 40 131 114 16 Transactions Conducted with HSBC Finance Corporation o HUSI services a portfolio of residential mortgage loans owned by HSBC Finance Corporation. The related service fee income was $2.9 million and $7.6 million for the three months and nine months ended September 30, 2007, respectively. o By agreement, HUSI purchases receivables generated by private label and MasterCard(1)/Visa(2) credit card relationships on a daily basis at a value that approximates fair value, as determined by an independent third party. Premiums paid are amortized to interest income over the estimated life of the receivables purchased. Activity related to these portfolios is summarized in the following table. ----------------------------------------------------------------------------------------------------------------- Private Label MasterCard/Visa ------------------------- ------------------------- Nine months ended September 30 2007 2006 2007 2006 ----------------------------------------------------------------------------------------------------------------- (in millions) Receivables acquired from HSBC Finance Corporation: Balance at beginning of period ............... $ 16,973 $ 14,355 $ 1,287 $ 1,159 Receivables acquired ......................... 15,127 15,168 2,009 1,681 Customer payments, net charge offs and other activity ............................. (15,761) (13,910) (1,591) (1,666) ---------- ---------- ---------- ---------- Balance at end of period ..................... $ 16,339 $ 15,613 $ 1,705 $ 1,174 ========== ========== ========== ========== Unamortized premiums paid to HSBC Finance Corporation: Balance at beginning of period ............... $ 188 $ 320 $ 15 $ 12 Premiums paid ................................ 240 257 74 26 Amortization ................................. (314) (390) (50) (25) ---------- ---------- ---------- ---------- Balance at end of period ..................... $ 114 $ 187 $ 39 $ 13 ========== ========== ========== ========== o Support services from HSBC affiliates includes charges by HSBC Finance Corporation under various service level agreements for loan origination and servicing as well as other operational and administrative support. o HUSI's wholly-owned subsidiaries HBUS and HSBC Trust Company (Delaware), N.A. (HTCD) are the originating lenders for a federal income tax refund anticipation loan program for clients of various third party tax preparers, which are managed by HSBC Finance Corporation. By agreement, HBUS and HTCD process applications, fund and subsequently sell these loans to HSBC Finance Corporation. During the nine months ended September 30, 2007, approximately $17 billion of loans were originated by HBUS and HTCD and sold to HSBC Finance Corporation, resulting in gains of $23 million. For the same 2006 period, $16 billion of loans were sold to HSBC Finance Corporation, resulting in gains of $21 million. o Certain of HUSI's consolidated subsidiaries have secured lines of credit totaling $2.3 billion with HSBC Finance Corporation. There were no balances outstanding under any of these lines of credit at September 30, 2007 or December 31, 2006. o In 2006, HUSI began acquiring residential mortgage loans at fair value from HSBC Finance Corporation for the purpose of selling these loans to HMUS (see "Transactions Conducted with HMUS" below). During the nine months ended September 30, 2007, HUSI acquired $645 million of loans from HSBC Finance Corporation for a net discount of $12 million. Transactions Conducted with HMUS o HUSI utilizes HMUS for broker dealer, debt and preferred stock underwriting, customer referrals, loan syndication and other treasury and traded markets related services, pursuant to service level agreements. Fees charged by HMUS for broker dealer, loan syndication services, treasury and traded markets related services are included in support services from HSBC affiliates. 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. ---------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated. (2) Visa is a registered trademark of Visa USA, Inc. 17 o In 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties and from HSBC Finance Corporation and subsequently selling these acquired loans to HMUS (refer to Note 4 of these consolidated financial statements). HUSI maintains no ownership interest in the residential mortgage loans after sale. Under this program, HUSI sold $5.8 billion and $12.7 billion of loans to HMUS during the first nine months of 2007 and 2006, respectively. Total gains on sale were $24 million and $105 million during the first nine months of 2007 and 2006, respectively. o During the first quarter of 2007, as part of a strategy to consolidate certain investments into a common HSBC entity in North America, HUSI sold certain non-marketable investments to HMUS resulting in total net gains of $6 million. The carrying value of these investments totaled $10 million at the time of the sale. Support Services from HSBC Technology & Services (USA) Inc. 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. HTSU also charges for software development costs, which generally are capitalized by HUSI. Other Transactions with HSBC Affiliates HUSI has a $2 billion line of credit with HSBC which was unused at September 30, 2007 and December 31, 2006. HUSI has extended loans and lines of credit to various other HSBC affiliates totaling $2.1 billion, of which $431 million and $172 million was outstanding at September 30, 2007 and December 31, 2006, respectively. HUSI utilizes other HSBC affiliates primarily for global outsourcing initiatives and, to a lesser extent, for treasury and traded markets services. Fees billed to HUSI for these services are included in support services from HSBC affiliates. 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 and derivative contracts with unaffiliated third parties. The fair value of derivative receivables related to these contracts was approximately $11 billion and $7 billion at September 30, 2007 and December 31, 2006, respectively. HUSI, within its Corporate, Investment Banking and Markets business segment, 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 11 of these consolidated financial statements. 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 first nine months of 2007 and 2006 was approximately $50 million and $58 million, respectively. As of September 30, 2007, HUSI's share of compensation cost related to nonvested stock compensation plans was approximately $101 million, which is expected to be recognized over a weighted-average period of 1.5 years. A description of these stock compensation plans begins on page 140 of HUSI's 2006 Form 10-K. During the first nine months of 2007 and 2006, HUSI declared and paid dividends of $635 million and $455 million, respectively, to its parent company, HSBC North America Inc. 18 Note 11. Pensions and Other Postretirement Benefits of HUSI and HSBC Finance Corporation -------------------------------------------------------------------------------- Effective January 1, 2005, the separate U.S. defined benefit pension and health and life insurance plans were merged into a single defined benefit pension plan, under the sponsorship of HNAH, which facilitated the development of a unified employee benefit policy and unified employee benefit plan administration for HSBC affiliates operating in the U.S. The following table presents the components of net periodic benefit cost as allocated to HUSI from HNAH. ----------------------------------------------------------------------------------------------------------------------- Other Pension Benefits Postretirement Benefits ----------------------- ----------------------- 2007 2006 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Three months ended September 30: Net periodic benefit cost: Service cost - benefits earned during the period ... $ 7 $ 8 $ -- $ -- Interest cost ...................................... 18 17 1 2 Expected return on plan assets ..................... (23) (22) -- -- Recognized losses .................................. 2 3 -- -- Transition amount amortization ..................... -- -- 1 1 ------- ------- ------- ------- Net periodic benefit cost .......................... $ 4 $ 6 $ 2 $ 3 ======= ======= ======= ======= Nine months ended September 30: Net periodic benefit cost: Service cost - benefits earned during the period ... $ 23 $ 24 $ 1 $ 1 Interest cost ...................................... 53 50 4 5 Expected return on plan assets ..................... (68) (65) -- -- Recognized losses .................................. 5 10 -- -- Transition amount amortization ..................... -- -- 2 2 ------- ------- ------- ------- Net periodic benefit cost .......................... $ 13 $ 19 $ 7 $ 8 ======= ======= ======= ======= During 2007, HUSI expects to make no contribution for pension benefits and expects to contribute approximately $9 million for other postretirement benefits. Note 12. Regulatory Capital -------------------------------------------------------------------------------- Capital amounts and ratios of HUSI and HBUS, calculated in accordance with banking regulations, are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- September 30, 2007 December 31, 2006 -------------------------------------------- ---------------------------------------------- Capital Well-Capitalized Actual Capital Well-Capitalized Actual Amount Minimum Ratio(1) Ratio Amount Minimum Ratio(1) Ratio ----------------------------------------------------------------------------------------------------------------------- ($ in millions) Total capital ratio: HUSI ..... $ 15,583 10.00% 11.82% $ 15,501 10.00% 12.58% HBUS ..... 15,575 10.00 11.87 14,998 10.00 12.23 Tier 1 capital ratio: HUSI ..... 10,263 6.00 7.79 10,577 6.00 8.58 HBUS ..... 10,309 6.00 7.86 10,278 6.00 8.38 Tier 1 leverage ratio: HUSI ...... 10,263 3.00(2) 6.02 10,577 3.00(2) 6.36 HBUS ..... 10,309 5.00 6.15 10,278 5.00 6.29 Risk weighted assets: HUSI ..... 131,785 123,262 HBUS ..... 131,178 122,652 (1) HUSI and HBUS are categorized as "well-capitalized", as defined by their principal regulators. To be categorized as well-capitalized under regulatory guidelines, a banking institution must have the minimum ratios reflected in the above table, and must not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. (2) There is no Tier 1 leverage ratio component in the definition of a well-capitalized bank holding company. The ratio shown is the minimum required ratio. 19 Note 13. Variable Interest Entities (VIEs) -------------------------------------------------------------------------------- HUSI, in the ordinary course of business, makes use of 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. Consolidated VIEs HUSI has entered into a series of transactions with VIEs organized by HSBC affiliates and unrelated third parties. These VIEs were structured as trusts or corporations that issue fixed or floating rate instruments backed by the assets of the issuing entities. HUSI sold trading assets to the VIEs and subsequently entered into total return swaps with the VIEs whereby HUSI receives the total return on the transferred assets and, in return, pays a market rate of return to its counterparties. HUSI is the primary beneficiary of these VIEs and, accordingly, consolidated $7.5 billion and $2.6 billion of trading assets at September 30, 2007 and December 31, 2006, respectively. These assets were pledged as collateral for obligations of the VIEs, which are included in long-term debt. The holders of the instruments issued by the VIEs have no recourse to the general credit of HUSI beyond the assets sold to the VIEs and pledged as collateral. Unconsolidated VIEs HUSI also holds variable interests in various other VIEs which were not consolidated at September 30, 2007 or December 31, 2006, since HUSI is not the primary beneficiary of these VIE structures. Information regarding unconsolidated VIEs is summarized in the following table and commentary. Descriptions of these VIE relationships are included in pages 151-152 of HUSI's 2006 Form 10-K. --------------------------------------------------------------------------------------------------------------------- September 30, 2007 December 31, 2006 -------------------------- -------------------------- Maximum Maximum Total Exposure Total Exposure Assets to Loss Assets to Loss --------------------------------------------------------------------------------------------------------------------- (in millions) Asset backed commercial paper conduits .......... $ 14,633 $ 9,160 $ 14,104 $ 8,048 Securitization vehicles ......................... 6,308 889 2,242 612 Investment funds ................................ 702 -- 717 2 Capital funding vehicles ........................ 903 26 1,093 32 Low income housing tax credits .................. 715 118 406 153 --------- --------- --------- --------- Total ........................................... $ 23,261 $ 10,193 $ 18,562 $ 8,847 ========= ========= ========= ========= HUSI provides liquidity facilities to affiliate sponsored asset backed commercial paper (ABCP) conduits as disclosed in the table above. Although the commercial paper market experienced reduced liquidity during the third quarter, none of these liquidity facilities were drawn upon nor did any other event occur that would cause HUSI to reconsider consolidation. HUSI did extend additional liquidity facilities to affiliate sponsored ABCP conduits during the current quarter. HUSI also provided support to ABCP affiliate sponsored conduits during the quarter by purchasing and holding commercial paper for a limited perod of time. Other Asset Backed Commercial Paper Conduits Certain credit-linked notes structured by HUSI are issued to and held by ABCP conduits sponsored by unrelated third parties. The ABCP conduits issue commercial paper in the capital market to finance the purchase of the credit-linked notes. In certain circumstances, HUSI also provides liquidity facilities to the ABCP conduit investors. The maximum exposure to loss relating to these liquidity facilities at September 30, 2007 is $2.5 billion. HUSI does not perform administrative duties for or service any assets of these conduits. HUSI currently holds commercial paper issued by these conduits. 20 Note 14. Financial Guarantee Arrangements, Pledged Assets and Contingent Liabilities -------------------------------------------------------------------------------- Financial Guarantee Arrangements The maximum potential amounts of future payments required by financial guarantee arrangements are summarized in the following table. ------------------------------------------------------------------------------------------------------------------ September 30, December 31, 2007 2006 ------------------------------------------------------------------------------------------------------------------ (in millions) Standby letters of credit, net of participations(1) ...................... $ 8,478 $ 7,259 Loan sales with recourse ................................................. 6 8 Credit derivative contracts(2) ........................................... 592,200 431,631 ----------- ---------- Total .................................................................... $ 600,684 $ 438,898 =========== ========== (1) Includes $596 million and $542 million issued for the benefit of HSBC affiliates at September 30, 2007 and December 31, 2006, respectively. (2) Includes $90,599 million and $71,908 million issued for the benefit of HSBC affiliates at September 30, 2007 and December 31, 2006, respectively. Standby Letters of Credit Fees are charged for issuing letters of credit commensurate with the customer's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of the "stand ready obligation to perform" under these guarantees, amounting to $23 million and $21 million at September 30, 2007 and December 31, 2006, respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $24 million and $25 million at September 30, 2007 and December 31, 2006, respectively. Credit Derivative Contracts HUSI enters into credit derivative contracts primarily to satisfy the needs of its customers and, in certain cases, for its own benefit. Credit derivatives are arrangements that provide for one party (the "protection buyer") to transfer the credit risk of a "reference asset" to another party (the "protection seller"). Under this arrangement, the protection seller assumes the credit risk associated with the reference asset without directly purchasing it. The protection buyer agrees to pay a specified fee to the protection seller. In return, the protection seller agrees to pay the protection buyer an agreed upon amount if there is a default during the term of the contract. In accordance with its policy, HUSI offsets most of the risk it assumes in selling credit protection through a credit derivative contract with another counterparty. Credit derivatives are recorded at fair value. The commitment amount included in the table is the maximum amount that HUSI could be required to pay, without consideration of the approximately equal amount receivable from third parties and any associated collateral. 21 Pledged Assets Pledged assets included in the consolidated balance sheet are summarized in the following table. ------------------------------------------------------------------------------------------------------------------ September 30, December 31, 2007 2006 ------------------------------------------------------------------------------------------------------------------ (in millions) Interest bearing deposits with banks ....................................... $ 507 $ 764 Trading assets (1) ......................................................... 2,882 2,961 Securities available for sale (2) .......................................... 7,968 6,775 Securities held to maturity ................................................ 224 273 Loans (3) .................................................................. 8,471 8,426 Other assets (4) ........................................................... 2,214 849 --------- --------- Total ...................................................................... $ 22,266 $ 20,048 ========= ========= (1) Trading assets are primarily pledged against liabilities associated with consolidated variable interest entities (refer to Note 13 of the consolidated financial statements, beginning on page 20 of this Form 10-Q). (2) Securities available for sale are primarily pledged against various short-term borrowings. (3) Loans are primarily private label credit card receivables pledged against long-term secured borrowings and residential mortgage loans pledged against long-term borrowings from the Federal Home Loan Bank. (4) Other assets represent cash on deposit with non-banks related to derivative collateral support agreements. Litigation HUSI is named in and is defending legal actions in various jurisdictions arising from its normal business. None of these proceedings are regarded as material litigation. In addition, there were certain proceedings that occurred in the quarter that related to the "Princeton Note Matter", more fully described below. In relation to the Princeton Note Matter, as disclosed in HUSI's 2002 Annual Report on Form 10-K, two of the noteholders were initially excluded from the restitution order that was negotiated with the U.S. Government. Those noteholders were Maruzen Company, Limited and Yakult Honsha Co., Ltd. Those entities were excluded because a senior officer of one of the noteholders was being criminally prosecuted in Japan for his conduct relating to its Princeton Notes and the other noteholder was likely to recover from the Princeton Receiver an amount that exceeded its losses attributable to its funds transfers with Republic New York Securities Corporation, as calculated by the U.S. Government. Both Maruzen and Yakult then commenced separate civil suits. Both of those civil suits sought compensatory, punitive, and treble damages pursuant to RICO and assorted fraud and breach of duty claims arising from unpaid Princeton Notes with face amounts totaling approximately $125 million. No amount of compensatory damages was specified in either complaint. Those two complaints named HUSI, HBUS, and Republic New York Securities Corporation as defendants. The parties to those two cases recently engaged in separate settlement discussions, resulting in the conclusion of both cases. The settlements, individually and collectively, did not have a material impact on HUSI's consolidated results. Note 15. New Accounting Pronouncements -------------------------------------------------------------------------------- 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. The adoption of FIN 48 on January 1, 2007 did not have a material impact on HUSI's financial position or results of operations. Refer to Note 8 beginning on page 14 of this Form 10-Q. 22 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. HUSI is currently evaluating the impact that adoption will have on its financial position and results of operations. In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, Amendment of FASB Interpretation No. 39 (FSP FIN 39-1). FSP FIN 39-1 allows 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 FSP FIN 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. Entities are required to recognize the effects of applying FSP FIN 39-1 as a change in accounting principle through retrospective application for all financial statements presented unless it is impracticable to do so. HUSI adopted FSP FIN 39-1 during the second quarter of 2007, the impact of which is described in Note 2 of these consolidated financial statements. 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. HUSI is currently evaluating the impact the adoption of SFAS 159 will have on its financial position and results of operations. On November 5, 2007, the SEC issued Staff Accounting Bulletin 109 (SAB 109), Written Loan Commitments Recorded at Fair Value Through Earnings, which supersedes SAB 105, Application of Accounting Principles to Loan Commitments. SAB 109 revises the views expressed by the staff of SAB 105 to specify that the expected net future cash flows related to the associated servicing of a loan should be included in the measurement of written loan commitments that are accounted for at fair value through earnings. SAB 109 is effective for derivative loan commitments issued or modified in fiscal quarters beginning after December 15, 2007. HUSI is currently evaluating the impact of SAB 109 on its consolidated financial statements. Note 16. Business Segments -------------------------------------------------------------------------------- HUSI has five distinct segments that it utilizes for management reporting and analysis purposes, which are generally based upon customer groupings, as well as products and services offered. 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 the third quarter and first nine months of 2006 have been restated on an IFRS basis. Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment, adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. The objective of these charges/credits is to transfer interest rate risk from the segments to one centralized unit in Treasury and more appropriately reflect the profitability of segments. Certain other revenue and operating expense amounts are also apportioned among the business segments based upon the benefits derived from this activity or the relationship of this activity to other segment activity. For segment reporting purposes, these inter-segment transactions are accounted for as if they were with third parties and have not been eliminated. Results for each segment on an IFRS basis, as well as a reconciliation of total results under IFRS to U.S. GAAP consolidated totals, are provided in the following tables. Descriptions of the significant differences between IFRS and U.S. GAAP that impact HUSI's results follow the tables. 23 The results for each business segment are summarized in the following tables. Analysis of operating results for each segment begins on page 50 of this Form 10-Q. ----------------------------------------------------------------------------------------------------------------------- IFRS Consolidated Amounts ------------------------------------------------------------------------------------------------------- PFS CF CMB CIBM PB Other Total ----------------------------------------------------------------------------------------------------------------------- (in millions) Three months ended September 30, 2007 Net interest income ........ $ 276 $ 296 $ 208 $ 62 $ 50 $ (4) $ 888 Other revenues 157 86 67 (139) 66 150 387 --------- --------- --------- --------- --------- --------- --------- Total revenues 433 382 275 (77) 116 146 1,275 Provision for credit losses . 35 305 35 17 (1) -- 391 --------- --------- --------- --------- --------- --------- --------- 398 77 240 (94) 117 146 884 Operating expenses .... 313 8 137 197 87 4 746 --------- --------- --------- --------- --------- --------- --------- Income before income tax expense ... 85 69 103 (291) 30 142 138 --------- --------- --------- --------- --------- --------- --------- Income tax expense ..... 26 24 27 (97) 8 51 39 --------- --------- --------- --------- --------- --------- --------- Net income .. $ 59 $ 45 $ 76 $ (194) $ 22 $ 91 $ 99 ========= ========= ========= ========= ========= ========= ========= Balances at end of period: Total assets. $ 36,005 $ 21,747 $ 19,940 $ 152,029 $ 5,210 $ 236 $ 235,167 Total loans .. 31,260 20,574 18,089 21,781 4,376 -- 96,080 Goodwill .... 917 -- 366 494 335 -- 2,112 Total deposits 42,254 37 17,296 41,325 10,965 2 111,879 Three months ended September 30, 2006 Net interest income ...... $ 305 $ 197 $ 201 $ 46 $ 50 $ (9) $ 790 Other revenues 127 22 82 143 108 (31) 451 --------- --------- --------- --------- --------- --------- --------- Total revenues . 432 219 283 189 158 (40) 1,241 Provision for credit losses .. 15 160 31 7 2 (1) 214 --------- --------- --------- --------- --------- --------- --------- 417 59 252 182 156 (39) 1,027 Operating expenses ....... 296 7 136 180 75 (9) 685 --------- --------- --------- --------- --------- --------- --------- Income before income tax expense ..... 121 52 116 2 81 (30) 342 --------- --------- --------- --------- --------- --------- --------- Income tax expense ....... 43 19 38 3 28 (20) 111 --------- --------- --------- --------- --------- --------- --------- Net income .. $ 78 $ 33 $ 78 $ (1) $ 53 $ (10) $ 231 ========= ========= ========= ========= ========= ========= ========= Balances at end of period: Total assets $ 42,212 $ 20,283 $ 17,706 $ 110,084 $ 5,980 $ 338 $ 196,603 Total loans .. 37,657 19,531 14,835 19,200 4,584 -- 95,807 Goodwill ..... 917 -- 366 494 335 -- 2,112 Total deposits 33,241 43 14,777 37,735 9,629 -- 95,425 ------------------------------------------------------------------------------------------------------- (1) (2) U.S. GAAP IFRS IFRS Intersegmental Consolidated Adjustments Reclassifications Revenue Totals ------------------------------------------------------------------------------------------------------- (in millions) Three months ended September 30, 2007 Net interest income ...... $ 9 $ 152 $ (126) $ 923 Other revenues ........... (127) (12) 126 374 --------- --------- --------- --------- Total revenues ........... (118) 140 -- 1,297 Provision for credit losses ................. 14 (3) -- 402 --------- --------- --------- --------- (132) 143 -- 895 Operating expenses ....... 2 143 -- 891 --------- --------- --------- --------- Income before income tax expense ..... (134) -- -- 4 --------- --------- --------- --------- Income tax expense ....... (56) -- -- (17) --------- --------- --------- --------- Net income ............... $ (78) $ -- $ -- $ 21 ========= ========= ========= ========= Balances at end of period: Total assets ............. $ (49,746) $ -- $ -- $ 185,421 Total loans .............. (248) (3,166) -- 92,666 Goodwill ................. 604 -- -- 2,716 Total deposits ........... (3,865) 2,794 -- 110,808 Three months ended September 30, 2006 Net interest income ...... $ (11) $ 84 $ (86) $ 777 Other revenues ........... 38 39 86 614 --------- --------- --------- --------- Total revenues ........... 27 123 -- 1,391 Provision for credit losses ................. 5 (12) -- 207 --------- --------- --------- --------- 22 135 -- 1,184 Operating expenses ....... (1) 135 -- 819 --------- --------- --------- --------- Income before income tax expense ..... 23 -- -- 365 --------- --------- --------- --------- Income tax expense ....... 10 -- -- 121 --------- --------- --------- --------- Net income ............... $ 13 $ -- $ -- $ 244 ========= ========= ========= ========= Balances at end of period: Total assets ............. $ (26,540) $ (2,566) $ -- $ 167,497 Total loans .............. -- (5,787) -- 90,020 Goodwill ................. 582 -- -- 2,694 Total deposits ........... -- 1,402 -- 96,827 (1) Represents adjustments associated with differences between IFRS and U.S. GAAP bases of accounting. These adjustments, which are more fully described beginning on page 25 of this Form 10-Q, consist of the following: ----------------------------------------------------------------------------------------------------------------------- Net Provision Income Interest Other for Credit Operating before Income Total Income Revenues Losses Expenses Tax Expense Assets ----------------------------------------------------------------------------------------------------------------------- (in millions) Three months ended September 30, 2007 Unquoted equity securities ............... $ -- $ 25 $ -- $ -- $ 25 $ -- Fair value option ........................ -- (146) -- -- (146) -- Servicing assets ......................... -- (15) -- -- (15) -- Loan origination ......................... (4) -- -- (1) (3) -- Loans held for trading purposes .......... -- 9 -- -- 9 -- Recording derivative assets and liabilities gross ........................ -- -- -- -- -- (49,746) Other .................................... 13 -- 14 3 (4) -- -------- -------- -------- -------- -------- -------- Total .................................... $ 9 $ (127) $ 14 $ 2 $ (134) $(49,746) ======== ======== ======== ======== ======== ======== Three months ended September 30, 2006 Unquoted equity securities ............... $ -- $ (9) $ -- $ -- $ (9) $ -- Fair value option ........................ -- 53 -- -- 53 -- Servicing assets ......................... -- (23) -- -- (23) -- Loan origination ......................... (11) (1) -- (5) (7) -- Loans held for trading purposes .......... -- (1) -- -- (1) -- Recording derivative assets and liabilities gross ........................ -- -- -- -- -- (26,540) Other .................................... -- 19 5 4 10 -- -------- -------- -------- -------- -------- -------- Total .................................... $ (11) $ 38 $ 5 $ (1) $ 23 $(26,540) ======== ======== ======== ======== ======== ======== (2) Represents differences in financial statement presentation between IFRS and U.S. GAAP. 24 The results for each business segment are summarized in the following tables. Analysis of operating results for each segment begins on page 50 of this Form 10-Q. ----------------------------------------------------------------------------------------------------------------------- IFRS Consolidated Amounts ------------------------------------------------------------------------------------------------- PFS CF CMB CIBM PB Other Total ----------------------------------------------------------------------------------------------------------------------- (in millions) Nine months ended September 30, 2007 Net interest income $ 838 $ 705 $ 606 $ 199 $ 150 $ (9) $ 2,489 Other revenues .... 417 194 196 436 210 90 1,543 ---------- ---------- ---------- --------- -------- --------- ------------ Total revenues .... 1,255 899 802 635 360 81 4,032 Provision for credit losses ... 64 693 72 6 11 1 847 ---------- ---------- ---------- --------- -------- --------- ------------ 1,191 206 730 629 349 80 3,185 Operating expenses 923 26 420 584 255 5 2,213 ---------- ---------- ---------- --------- -------- --------- ------------ Income before income tax expense 268 180 310 45 94 75 972 ---------- ---------- ---------- --------- -------- --------- ------------ Income tax expense . 82 63 92 17 27 23 304 ---------- ---------- ---------- --------- -------- --------- ------------ Net income ....... $ 186 $ 117 $ 218 $ 28 $ 67 $ 52 $ 668 ========== ========== ========== ========= ======== ========= ============ Nine months ended September 30, 2006 Net interest income $ 882 $ 535 $ 550 $ 183 $ 146 $ (19) $ 2,277 Other revenues ... 369 62 205 701 245 (32) 1,550 ---------- ---------- ---------- --------- -------- --------- ------------ Total revenues ... 1,251 597 755 884 391 (51) 3,827 Provision for credit losses ......... 39 459 62 (5) 32 (1) 586 ---------- ---------- ---------- --------- -------- --------- ------------ 1,212 138 693 889 359 (50) 3,241 Operating expenses 875 21 369 535 224 (4) 2,020 ---------- ---------- ---------- --------- -------- --------- ------------ Income before income tax expense 337 117 324 354 135 (46) 1,221 ---------- ---------- ---------- --------- -------- --------- ------------ Income tax expense 115 41 110 126 46 (28) 410 ---------- ---------- ---------- --------- -------- --------- ------------ Net income ....... $ 222 $ 76 $ 214 $ 228 $ 89 $ (18) $ 811 ========== ========== ========== ========= ======== ========= ============ -------------------------------------------------------------------------------------------------------- (1) (2) U.S. GAAP IFRS IFRS Intersegmental Consolidated Adjustments Reclassifications Revenue Totals -------------------------------------------------------------------------------------------------------- Nine months ended September 30, 2007 Net interest income ........ $ 5 $ 482 $ (456) $ 2,520 Other revenues ............. (120) (94) 456 1,785 ----------- ----------- ----------- ------------ Total revenues ............. (115) 388 -- 4,305 Provision for credit losses ................... 19 5 -- 871 ----------- ----------- ----------- ------------ (134) 383 -- 3,434 Operating expenses ......... 16 383 -- 2,612 ----------- ----------- ----------- ------------ Income before income tax expense ....... (150) -- -- 822 ----------- ----------- ----------- ------------ Income tax expense ......... (67) -- -- 237 ----------- ----------- ----------- ------------ Net income ................. $ (83) $ -- $ -- $ 585 =========== =========== =========== ============ Nine months ended September 30, 2006 Net interest income ........ $ (3) $ 459 $ (446) $ 2,287 Other revenues ............. 40 (90) 446 1,946 ----------- ----------- ----------- ------------ Total revenues ............. 37 369 -- 4,233 Provision for credit losses ................... (4) 4 -- 586 ----------- ----------- ----------- ------------ 41 365 -- 3,647 Operating expenses ......... (5) 365 -- 2,380 ----------- ----------- ----------- ------------ Income before income tax expense ....... 46 -- -- 1,267 ----------- ----------- ----------- ------------ Income tax expense ......... 19 -- -- 429 ----------- ----------- ----------- ------------ Net income ................. $ 27 $ -- $ -- $ 838 =========== =========== =========== ============ (1) Represents adjustments associated with differences between IFRS and U.S. GAAP bases of accounting. These adjustments, which are more fully described below, consist of the following: ----------------------------------------------------------------------------------------------------------------------- Net Provision Income Interest Other for Credit Operating before Income Income Revenues Losses Expenses Tax Expense ----------------------------------------------------------------------------------------------------------------------- (in millions) Nine months ended September 30, 2007 Unquoted equity securities ............... $ -- $ (50) $ -- $ -- $ (50) Fair value option ........................ (2) (82) -- -- (84) Servicing assets ......................... -- 21 -- -- 21 Loan origination ......................... (11) (7) -- 2 (20) Loans held for trading purposes .......... -- 2 -- -- 2 Other .................................... 18 (4) 19 14 (19) -------- -------- -------- -------- -------- Total .................................... $ 5 $ (120) $ 19 $ 16 $ (150) ======== ======== ======== ======== ======== Nine months ended September 30, 2006 Unquoted equity securities ............... $ -- $ (7) $ -- $ -- $ (7) Fair value option ........................ -- 61 -- -- 61 Servicing assets ......................... -- 5 -- -- 5 Loan origination ......................... (5) (8) -- (15) 2 Loans held for trading purposes .......... -- (21) -- -- (21) Other .................................... 2 10 (4) 10 6 -------- -------- -------- -------- -------- Total .................................... $ (3) $ 40 $ (4) $ (5) $ 46 ======== ======== ======== ======== ======== (2) Represents differences in financial statement presentation between IFRS and U.S. GAAP. Differences between IFRS and U.S. GAAP Unquoted equity securities - Under IFRS, certain 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. Securities measured at fair value under IFRS are classified as either available for sale securities, with changes in fair value recognized in shareholders' equity, or as trading securities, with changes in fair value recognized in income. Under U.S. GAAP, 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 known impairment, in other assets. Fair value option - Reflects the impact of applying the fair value option under IFRS for certain debt issued, which is accounted for either at amortized cost or is only adjusted for market interest rate risk movements under U.S. GAAP. This impact is primarily recorded as other revenues within the Other business segment. 25 Servicing assets -Servicing assets are initially recorded at allocated cost based on the fair values of assets transferred and assets retained under IFRS and are (1) periodically tested for impairment with impairment adjustments charged against current earnings; and (2) recoveries of impairment are credited to current earnings only to the extent of previous write-downs. Under U.S. GAAP, servicing assets are initially recorded at fair value and all subsequent adjustments to fair value are reflected in current earnings. Loan origination - Certain loan fees and incremental direct loan origination costs, including direct salaries but excluding overhead costs, are deferred and amortized to earnings over the life of the loan under IFRS. Certain loan fees and direct, but not necessarily incremental loan origination costs, including an apportionment of overhead in addition to direct salaries, are deferred and amortized to earnings under U.S. GAAP. For the first nine months of 2007, the net costs amortized under U.S. GAAP exceed net costs amortized under IFRS. Loans held for trading purposes - Under IFRS, loans held for sale are treated as trading assets and are initially recorded at fair value, with changes in fair value being recognized in current period earnings, and any gains on sale recognized on the trade date. Under U.S. GAAP, loans held for sale are recorded at the lower of amortized cost or market value (LOCOM), with gains on sale being recognized on the settlement date. Because of the differences between fair value and LOCOM accounting, the recorded value of certain pools of loans held for sale under IFRS may exceed the recorded value under U.S. GAAP, resulting in higher IFRS earnings. The timing difference between trade date accounting under IFRS and settlement date accounting under U.S. GAAP also results in higher current earnings under IFRS. Recording derivative assets and liabilities gross - Under U.S. GAAP, derivative receivables and payables with the same counterparty may be reported net in the balance sheet when there is an executed International Swaps and Derivatives Association, Inc. (ISDA) Master Netting Arrangement. In addition, under U.S. GAAP, fair value amounts recognized for the obligation to return cash collateral received or the right to reclaim cash collateral paid are offset against the fair value of derivative instruments. Under IFRS, these agreements do not meet the requirements for offset, and therefore such derivative receivables and payables are presented gross on the balance sheet. 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. 26 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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