HSBC USA Inc 10Q Part 1

HSBC Holdings PLC 16 November 2004 The following is a Current Report on Form 10-Q containing selected financial information for the quarter ended 30 September 2004 filed with the United States Securities and Exchange Commission by HSBC USA Inc., a subsidiary of HSBC Holdings plc. Copies of the Form 10-Q are available on HSBC USA Inc.'s website at www.US.HSBC.com and on the SEC website at www.sec.gov. CONFORMED 1. ================================================================================ 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, 2004 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 (State of Incorporation) 13-2764867 (IRS Employer Identification No.) 452 Fifth Avenue, New York, New York 10018 (Address of principal executive offices) (212) 525-3735 (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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X| At October 31, 2004, all voting stock (705 shares of Common Stock, $5 par value) is owned by an indirect wholly owned subsidiary of HSBC Holdings plc. ================================================================================ HSBC USA Inc. Form 10-Q TABLE OF CONTENTS Part I FINANCIAL INFORMATION -------------------------------------------------------------------------------- Page ---- Item 1. Consolidated Financial Statements Statement of Income 3 Balance Sheet 4 Statement of Changes in Shareholders' Equity 5 Statement of Cash Flows 6 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) Average Balances and Interest Rates 18 Forward-Looking Statements 20 Executive Overview 20 Basis of Reporting 22 Results of Operations 26 Business Segments 38 Credit Quality 42 Derivative Instruments and Hedging Activities 44 Off-Balance Sheet Arrangements 45 Special Purpose and Variable Interest Entities 46 Capital 46 Risk Management 47 Item 3. Quantitative and Qualitative Disclosures About Market Risk 53 Item 4. Controls and Procedures 53 Part II OTHER INFORMATION -------------------------------------------------------------------------------- Item 1. Legal Proceedings 54 Item 5. Other Information 54 Item 6. Exhibits and Reports on Form 8-K 54 Signature 55 2 Part I. Financial Information Item 1. Consolidated Financial Statements HSBC USA Inc. ------------------------------------------------------------------------------------------------------------------------ CONSOLIDATED STATEMENT OF INCOME Three months ended September 30, Nine months ended September 30, 2004 2003 2004 2003 ------------------------------------------------------------------------------------------------------------------------ in millions Interest income: Loans ................................................ $ 779 $ 573 $ 2,060 $ 1,769 Securities ........................................... 220 217 651 669 Trading assets ....................................... 43 30 114 104 Short-term investments ............................... 27 18 63 61 Other ................................................ 5 4 13 18 -------- -------- -------- -------- Total interest income .................................... 1,074 842 2,901 2,621 -------- -------- -------- -------- Interest expense: Deposits ............................................. 226 150 544 511 Short-term borrowings ................................ 59 13 112 72 Long-term debt ....................................... 91 50 204 155 -------- -------- -------- -------- Total interest expense ................................... 376 213 860 738 -------- -------- -------- -------- Net interest income ...................................... 698 629 2,041 1,883 Provision for credit losses .............................. 27 (1) 7 86 -------- -------- -------- -------- Net interest income after provision for credit losses .... 671 630 2,034 1,797 -------- -------- -------- -------- Other revenues: Trust income ......................................... 23 24 71 70 Service charges ...................................... 54 54 158 157 Other fees and commissions ........................... 110 110 341 334 Other income ......................................... 200 37 283 129 Residential mortgage banking revenue (expense) ....... (64) (74) (105) (80) Trading revenues ..................................... 21 52 188 212 Security gains, net .................................. 18 2 59 51 -------- -------- -------- -------- Total other revenues ..................................... 362 205 995 873 -------- -------- -------- -------- Operating expenses: Salaries and employee benefits ....................... 216 290 707 846 Occupancy expense, net ............................... 38 40 110 115 Other expenses ....................................... 226 193 672 539 -------- -------- -------- -------- Total operating expenses ................................. 480 523 1,489 1,500 -------- -------- -------- -------- Income before income tax expense ......................... 553 312 1,540 1,170 Income tax expense ....................................... 214 114 551 445 -------- -------- -------- -------- Net income ............................................... $ 339 $ 198 $ 989 $ 725 ======== ======== ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 3 HSBC USA Inc. --------------------------------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET September 30, December 31, 2004 2003 --------------------------------------------------------------------------------------------------------- in millions Assets Cash and due from banks ................................................ $ 3,457 $ 2,534 Interest bearing deposits with banks ................................... 2,172 843 Federal funds sold and securities purchased under resale agreements .... 6,192 2,446 Trading assets ......................................................... 15,436 14,646 Securities available for sale .......................................... 14,656 14,143 Securities held to maturity (fair value $4,044 and $4,648) ............. 3,898 4,512 Loans .................................................................. 67,040 48,474 Less - allowance for credit losses ..................................... 340 399 ---------- ---------- Loans, net ....................................................... 66,700 48,075 Properties and equipment, net .......................................... 606 681 Intangible assets, net ................................................. 381 551 Goodwill ............................................................... 2,699 2,777 Other assets ........................................................... 4,742 4,354 ---------- ---------- Total assets ........................................................... $ 120,939 $ 95,562 ========== ========== Liabilities Deposits in domestic offices: Noninterest bearing .................................................. $ 7,727 $ 6,093 Interest bearing ..................................................... 45,093 38,995 Deposits in foreign offices: Noninterest bearing .................................................. 340 453 Interest bearing ..................................................... 21,643 18,414 ---------- ---------- Total deposits ................................................... 74,803 63,955 ---------- ---------- Trading account liabilities ............................................ 10,345 10,460 Short-term borrowings .................................................. 11,467 6,782 Interest, taxes and other liabilities .................................. 3,653 3,089 Long-term debt ......................................................... 12,118 3,814 ---------- ---------- Total liabilities ...................................................... 112,386 88,100 ---------- ---------- Shareholders' equity Preferred stock ........................................................ 500 500 Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 705 shares issued) ............................. --(1) --(1) Capital surplus ...................................................... 6,414 6,027 Retained earnings .................................................... 1,654 807 Accumulated other comprehensive (loss) income ........................ (15) 128 ---------- ---------- Total common shareholder's equity ................................ 8,053 6,962 ---------- ---------- Total shareholders' equity ............................................. 8,553 7,462 ---------- ---------- Total liabilities and shareholders' equity ............................. $ 120,939 $ 95,562 ========== ========== The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 4 HSBC USA Inc. ------------------------------------------------------------------------------------------------------------------------ CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY Nine months ended September 30, 2004 2003 ------------------------------------------------------------------------------------------------------------------------ in millions Preferred stock Balance, January 1 and September 30, ..................................................... $ 500 $ 500 --------- --------- Common stock Balance, January 1 and September 30, ..................................................... --(1) --(1) --------- --------- Capital surplus Balance, January 1, ...................................................................... 6,027 6,056 Capital contribution from parent ......................................................... 408 10 Reduction of capital surplus ............................................................. (21) (44) --------- --------- Balance, September 30, ................................................................... 6,414 6,022 --------- --------- Retained earnings Balance, January 1, ...................................................................... 807 578 Net income ............................................................................... 989 725 Cash dividends declared: Preferred stock ...................................................................... (17) (17) Common stock ......................................................................... (125) (255) --------- --------- Balance, September 30, ................................................................... 1,654 1,031 --------- --------- Accumulated other comprehensive (loss) income Balance, January 1, ...................................................................... 128 262 Net change in unrealized (losses) gains on securities .................................... (45) (128) Net change in unrealized (losses) gains on derivatives classified as cash flow hedges .... (95) 25 Foreign currency translation adjustments ................................................. (3) 24 --------- --------- Other comprehensive loss, net of tax ..................................................... (143) (79) --------- ------- -- Balance, September 30, ................................................................... (15) 183 --------- --------- Total shareholders' equity, September 30, ................................................ $ 8,553 $ 7,736 ========= ========= Comprehensive income Net income ............................................................................... $ 989 $ 725 Other comprehensive loss ................................................................. (143) (79) --------- --------- Comprehensive income ..................................................................... $ 846 $ 646 ========= ========= The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 5 HSBC USA Inc. -------------------------------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS Nine months ended September 30, 2004 2003 -------------------------------------------------------------------------------------------------------- in millions Cash flows from operating activities Net income ........................................................ $ 989 $ 725 Adjustments to reconcile net income to net cash provided (used) by operating activities Depreciation, amortization and deferred taxes ................ 314 321 Provision for credit losses .................................. 7 86 Net change in other accrual accounts ......................... 43 582 Net change in loans originated for sale ...................... 1 (315) Net change in trading assets and liabilities ................. (534) 970 Other, net ................................................... (366) (268) ---------- ---------- Net cash provided by operating activities ............... 454 2,101 ---------- ---------- Cash flows from investing activities Net change in interest bearing deposits with banks ................ (1,330) (479) Net change in short-term investments .............................. (3,848) (1,794) Net change in securities available for sale: Purchases of securities available for sale ................... (8,971) (11,871) Proceeds from sales of securities available for sale ......... 4,195 3,461 Proceeds from maturities of securities available for sale .... 4,568 8,827 Net change in securities held to maturity: Purchases of securities held to maturity ..................... (821) (1,924) Proceeds from maturities of securities held to maturity ...... 1,437 2,366 Net change in loans: Net change in credit card receivables ........................ (69) (48) Net change in other short-term loans ......................... (743) (58) Net originations and maturities of long-term loans ........... (15,716) (1,319) Loans purchased .............................................. (3,068) -- Sales of loans/other ......................................... 132 243 Expenditures for properties and equipment ......................... (18) (26) Net cash provided in acquisitions, net of cash acquired ........... 196 79 Other, net ........................................................ (735) (323) ---------- ---------- Net cash used in investing activities ................... (24,791) (2,866) ---------- ---------- Cash flows from financing activities Net change in deposits ............................................ 12,275 2,548 Net change in short-term borrowings ............................... 4,926 (1,286) Net change in long-term debt: Issuance of long-term debt ................................... 8,542 126 Repayment of long-term debt .................................. (720) (37) Capital contribution from parent .................................. 400 -- Reduction of capital surplus ...................................... (21) (44) Dividends paid .................................................... (142) (272) ---------- ---------- Net cash provided by financing activities ............... 25,260 1,035 ---------- ---------- Net change in cash and due from banks ................................. 923 270 Cash and due from banks at beginning of period ........................ 2,534 2,081 ---------- ---------- Cash and due from banks at end of period .............................. $ 3,457 $ 2,351 ========== ========== Pending settlement receivables/payables related to securities and trading assets and liabilities are treated as non cash items for cash flows reporting. The accompanying notes are an integral part of the consolidated financial statements. 6 Notes to Consolidated Financial Statements 1. Organization and Basis of Presentation HSBC USA Inc. is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. (HNAH), which is a wholly owned subsidiary of HSBC Holdings plc (HSBC). The accompanying unaudited consolidated financial statements of HSBC USA Inc. and its subsidiaries (collectively, the Company), including its principal subsidiary, HSBC Bank USA, National Association (the Bank), have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim financial information, with the instructions to Form 10-Q and with Article 10 of Regulation S-X, 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 generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, which are normal and recurring, considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods, have been made. The unaudited interim financial information should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2003 (the 2003 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 the Company are consistent, in all material respects, with those used to prepare the 2003 Form 10-K, except for the impact of new accounting pronouncements summarized in Note 12. 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. Interim financial statement disclosures regarding business segments and off-balance sheet arrangements are included in the Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of this Form 10-Q. In June 2004, the Company filed a Form 8-K with the SEC announcing approval by the Office of the Comptroller of the Currency for the Company to consolidate its banking operations under a single national charter, effective July 1, 2004. As a result, on July 1, 2004, the Bank's legal name was changed from HSBC Bank USA to HSBC Bank USA, National Association. The change to a national charter has not had a material effect on the existing operations of the Company. 7 2. Securities At September 30, 2004 and December 31, 2003, the Company held no securities of any single issuer (excluding the U.S. Treasury and federal agencies) with a book value that exceeded 10% of shareholders' equity. The following tables provide a summary of the amortized cost and fair value of the securities available for sale and securities held to maturity portfolios. ---------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair September 30, 2004 Cost Gains Losses Value ---------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury ..................... $ 203 $ -- $ 2 $ 201 U.S. Government agency (1) ........ 12,153 119 153 12,119 Asset backed securities ........... 1,228 4 1 1,231 Other domestic debt securities .... 210 1 6 205 Foreign debt securities ........... 775 12 2 785 Equity securities ................. 69 50 4 115 --------- --------- --------- --------- $ 14,638 $ 186 $ 168 $ 14,656 ========= ========= ========= ========= Securities held to maturity: U.S. Treasury ..................... $ 46 $ -- $ -- $ 46 U.S. Government agency ............ 3,089 127 23 3,193 Obligations of U.S. states and political subdivisions .......... 485 38 -- 523 Other domestic debt securities .... 254 6 2 258 Foreign debt securities ........... 24 -- -- 24 --------- --------- --------- --------- $ 3,898 $ 171 $ 25 $ 4,044 ========= ========= ========= ========= ---------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair December 31, 2003 Cost Gains Losses Value ---------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Government agency (1) ........ $ 10,778 $ 155 $ 141 $ 10,792 Asset backed securities ........... 1,785 7 6 1,786 Other domestic debt securities .... 415 1 -- 416 Foreign debt securities ........... 904 12 -- 916 Equity securities ................. 187 50 4 233 --------- --------- --------- --------- $ 14,069 $ 225 $ 151 $ 14,143 ========= ========= ========= ========= Securities held to maturity: U.S. Treasury ..................... $ 125 $ -- $ -- $ 125 U.S. Government agency ............ 3,513 123 40 3,596 Obligations of U.S. states and political subdivisions .......... 572 47 -- 619 Other domestic debt securities .... 294 8 2 300 Foreign debt securities ........... 8 -- -- 8 --------- --------- --------- --------- $ 4,512 $ 178 $ 42 $ 4,648 ========= ========= ========= ========= (1) Includes mortgage backed securities issued or guaranteed by U.S. Government agencies. 8 The following tables provide a summary of gross unrealized losses and related fair values, classified as to the length of time the losses have existed. ------------------------------------------------------------------------------------------------------------------------ Less Than One Year Greater Than One Year --------------------------------------- ---------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value September 30, 2004 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Treasury .................. 1 $ 2 $ 201 -- $ -- $ -- U.S. Government agency (1) ..... 197 65 3,800 176 88 2,029 All other securities ........... 28 9 496 32 4 180 -------- -------- -------- -------- -------- -------- 226 $ 76 $ 4,497 208 $ 92 $ 2,209 ======== ======== ======== ======== ======== ======== Securities held to maturity: U.S. Government agency ......... 11 $ 7 $ 195 17 $ 16 $ 316 All other securities ........... 24 2 47 4 -- 10 -------- -------- -------- -------- -------- -------- 35 $ 9 $ 242 21 $ 16 $ 326 ======== ======== ======== ======== ======== ======== ------------------------------------------------------------------------------------------------------------------------ Less Than One Year Greater Than One Year ---------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value December 31, 2003 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Government agency (1) ..... 325 $ 141 $ 4,753 39 $ -- $ 66 All other securities ........... 101 5 388 47 5 257 -------- -------- -------- -------- -------- -------- 426 $ 146 $ 5,141 86 $ 5 $ 323 ======== ======== ======== ======== ======== ======== Securities held to maturity: U.S. Government agency ......... 40 $ 40 $ 905 -- $ -- $ -- All other securities ........... 8 1 11 8 1 6 -------- -------- -------- -------- -------- -------- 48 $ 41 $ 916 8 $ 1 $ 6 ======== ======== ======== ======== ======== ======== (1) Includes mortgage backed securities issued or guaranteed by U.S. Government agencies. Gross unrealized losses for the available for sale securities portfolio have increased during the nine months ended September 30, 2004 due to a general increase in interest rates. The rise in interest rates has also extended the average durations of the portfolios. The securities are high credit grade (i.e. AAA or AA), and no permanent impairment is expected to be realized. 9 3. Loans The following table shows the composition of the loan portfolio. -------------------------------------------------------------------------------- September 30, December 31, 2004 2003 -------------------------------------------------------------------------------- (in millions) Domestic: Commercial: Construction and mortgage loans .............. $ 8,003 $ 7,075 Other business and financial ................. 9,891 8,658 Consumer: Residential mortgages ........................ 42,900 26,294 Credit card receivables ...................... 1,127 1,112 Other consumer loans ......................... 2,086 1,905 International .................................... 3,033 3,430 --------- --------- $ 67,040 $ 48,474 ========= ========= On March 31, 2004, the Company purchased approximately $900 million of domestic residential mortgage loans at fair value from subsidiaries of Household International, Inc. (Household), a related HSBC entity. In addition, during the nine months ended September 30, 2004, approximately $2.2 billion of residential mortgage loans were purchased from originating lenders pursuant to a Household correspondent loan program. The remaining net increase in residential mortgages resulted from growth in the mortgage banking business during the first nine months of 2004. 4. Allowance for Credit Losses The following table provides a summary of changes in the allowance for credit losses. ---------------------------------------------------------------------------------------------------------------------- Three Months Nine Months Ended September 30 Ended September 30 --------------------- ---------------------- 2004 2003 2004 2003 ---------------------------------------------------------------------------------------------------------------------- (in millions) Beginning balance ............................................. $ 347 $ 476 $ 399 $ 493 Allowance related to acquisitions and (dispositions), net ..... (12) -- (20) (8) Provision charged (credited) to income ........................ 27 (1) 7 86 Charge offs: Commercial .................................................. 17 29 31 104 Consumer .................................................... 24 20 68 58 International ............................................... 1 9 8 12 ------- ------- ------- ------- Total charge offs ............................................. 42 58 107 174 ------- ------- ------- ------- Recoveries on loans charged off: Commercial .................................................. 16 10 48 22 Consumer .................................................... 4 3 11 9 International ............................................... -- 5 2 7 ------- ------- ------- ------- Total recoveries .............................................. 20 18 61 38 ------- ------- ------- ------- Total net charge offs ......................................... 22 40 46 136 ------- ------- ------- ------- Ending balance ................................................ $ 340 $ 435 $ 340 $ 435 ======= ======= ======= ======= During the first nine months of 2004, the Company sold certain foreign operations to affiliated HSBC entities resulting in releases of allowance for credit losses totaling approximately $20 million. 10 5. Intangible Assets, Net The following table summarizes the composition of intangible assets. -------------------------------------------------------------------------------------------------------------------- September 30, December 31, 2004 2003 -------------------------------------------------------------------------------------------------------------------- (in millions) Mortgage servicing rights, net of accumulated amortization and valuation allowance .... $ 337 $ 503 Favorable lease arrangements, net of accumulated depreciation ......................... 44 48 ------- ------- Intangible assets, net ................................................................ $ 381 $ 551 ======= ======= Mortgage Servicing Rights (MSRs) The Company recognizes the right to service mortgages as a separate and distinct asset at the time the related loans are sold, or at the time the MSRs are purchased. MSRs are amortized in proportion to net servicing income and carried on the balance sheet at the lower of their initial carrying value, adjusted for amortization, or fair value. The carrying value of MSRs is evaluated for impairment on an ongoing basis through internal modeling. Results of internally prepared MSR valuations are periodically compared with external independent broker valuations. Permanent impairment results in direct write-down of the gross MSRs balance. Temporary impairment is recorded through use of a valuation allowance account. The following table summarizes activity for MSRs and the related valuation allowance. --------------------------------------------------------------------------------------------------------- Three Months Nine Months Ended September 30 Ended September 30 -------------------- -------------------- 2004 2003 2004 2003 --------------------------------------------------------------------------------------------------------- (in millions) MSRs, net of accumulated amortization: Beginning balance .................................. $ 437 $ 459 $ 526 $ 395 Additions related to loan sales .................... 14 102 49 239 Net MSRs acquisitions (sales) ...................... -- 19 (53) 46 Permanent impairment charges ....................... (8) (27) (15) (41) Amortization ....................................... (19) (44) (83) (130) ------- ------- ------- ------- Ending balance ..................................... 424 509 424 509 ------- ------- ------- ------- Valuation allowance for MSRs: Beginning balance .................................. -- (85) (23) (41) Temporary impairment (provision) recovery .......... (95) 7 (82) (51) Permanent impairment charges ....................... 8 27 15 41 Release of allowance related to MSRs sold .......... -- -- 3 -- ------- ------- ------- ------- Ending balance ..................................... (87) (51) (87) (51) ------- ------- ------- ------- MSRs, net of accumulated amortization and valuation allowance .............................................. $ 337 $ 458 $ 337 $ 458 ======= ======= ======= ======= The increase in temporary impairment in the third quarter and first nine months of 2004 resulted primarily from reductions in interest rates, supplemented by changes resulting from the Company's ongoing review of assumptions used in its MSRs valuation model. Normal amortization for the current MSRs portfolios is expected to be approximately $101 million for the year ending December 31, 2004, declining gradually to approximately $41 million for the year ending December 31, 2008. Actual levels of amortization could increase or decrease depending upon changes in interest rates and loan prepayment activity. Actual levels of amortization are also dependent upon future levels of MSRs recorded. Favorable Lease Arrangements Favorable lease arrangements resulted from various business acquisitions. Scheduled amortization of favorable lease arrangements will approximate $5 million per year for 2004 through 2008. 11 6. Goodwill During 2004, the Company sold or transferred certain domestic and foreign operations to affiliated HSBC entities, resulting in reductions of goodwill of approximately $78 million. During the second quarter of 2004, the Company completed its annual impairment test of goodwill and determined that the fair value of each of the reporting units exceeded its carrying value. As a result, no impairment loss was required to be recognized. 7. Long-Term Debt The following table presents a summary of long-term debt. -------------------------------------------------------------------------------- September 30, December 31, 2004 2003 -------------------------------------------------------------------------------- (in millions) Senior debt .................................. $ 7,969 $ 643 Subordinated debt ............................ 4,128 3,149 All other .................................... 21 22 --------- --------- Total long-term debt ......................... $ 12,118 $ 3,814 ========= ========= Senior Debt In June 2004, the Bank issued Senior debt for the Euro equivalent of $500 million, which matures in 2044 and provides for quarterly payments of principal and interest at 3.99%. In June 2004 the Bank finalized a $10 billion Global Bank Note Program, which provided for the issuance of subordinated and senior global notes. In September 2004 this program was replaced by a $20 billion Global Bank Note Program. The new program also replaced the Bank's $4 billion Global Medium-Term Note Program initiated in June 2000. The following senior debt offerings have been made under these programs during the first nine months of 2004. In June the Bank issued $550 million of Floating Rate Senior Notes due 2009. The current interest rate on these notes is 2.01% per annum, payable on December 10, 2004. The rate resets quarterly based on the three month LIBOR rate plus .14% per annum until the final interest payment date on June 10, 2009. In June the Bank also issued $39 million of Fixed Rate Senior Notes due 2006. Interest is paid semi-annually at an initial rate of 2.75% through the interest payment period ending on June 27, 2005 and at 4.10% per annum thereafter. The Bank may redeem these notes, in whole but not in part, on June 27, 2005. In July the Bank issued EUR $1 billion (USD $1,241 million) of Floating Rate Senior Notes due 2008. The initial interest rate on these notes is 2.215% per annum, payable on October 9, 2004. The rate then resets quarterly based on the three month EURIBOR plus .10% per annum until the final interest payment date on July 9, 2008. In September the Bank issued $2,750 million of Floating Rate Senior Notes due 2007. The initial interest rate on these notes is 1.98% per annum, payable on December 21, 2004. The rate then resets quarterly based on the three month LIBOR plus .07% per annum until the final interest payment date on September 21, 2007. In September the Bank also issued $1,750 million of 3.875% Senior Notes due 2009. Interest is paid semi-annually in March and September of each year, commencing on March 15, 2005 and ending with the final interest payment date on September 15, 2009. During the nine months ended September 30, 2004 the Bank made net medium-term note advances of $804 million, due 2004 to 2016, and bearing various fixed and variable rates of interest. 12 Subordinated Debt In March 2004 the Bank issued $1 billion of Global Subordinated Notes, which bear interest at a fixed rate of 4.625% and mature in April 2014. 8. Income Taxes The following table presents the effective tax rate for the three months and nine months ended September 30, 2004 and 2003 respectively. -------------------------------------------------------------------------------- Three Months Nine Months Ended September 30 Ended September 30 ------------------- ------------------- 2004 2003 2004 2003 -------------------------------------------------------------------------------- Effective tax rate ............ 38.7% 36.5% 35.8% 38.0% In June 2004, as a result of a recently completed tax audit, approximately $51 million of income tax liability was released, reducing the effective tax rate by 3.6% for the first nine months of 2004. Excluding the impact of this adjustment, moderate increases in the effective tax rate for the three months and nine months ended September 30, 2004 were due to increased levels of taxable income, which were taxed at the full corporate rate. 9. Related Party Transactions In the normal course of business, the Company conducts transactions with HSBC and its subsidiaries (HSBC group). These transactions occur at prevailing market rates and terms. All extensions of credit by the Company to other HSBC affiliates are legally required to be secured by eligible collateral. The following table presents related party balances and the income and expense generated by related party transactions. -------------------------------------------------------------------------------- September 30, December 31, 2004 2003 -------------------------------------------------------------------------------- (in millions) Assets: Interest bearing deposits with banks ........... $ 276 $ 139 Loans .......................................... 576 330 Trading assets ................................. 1,944 1,811 Other .......................................... 76 34 --------- --------- Total assets ................................. $ 2,872 $ 2,314 ========= ========= Liabilities: Deposits ....................................... $ 9,393 $ 7,512 Trading account liabilities .................... 4,094 3,434 Short-term borrowings .......................... 999 735 Other .......................................... 171 79 --------- --------- Total liabilities ............................ $ 14,657 $ 11,760 ========= ========= ---------------------------------------------------------------------------------------------------------------- Three Months Nine Months Ended September 30 Ended September 30 -------------------- -------------------- 2004 2003 2004 2003 ---------------------------------------------------------------------------------------------------------------- (in millions) Interest income ................................................ $ -- $ 4 $ 4 $ 14 Interest expense ............................................... 26 23 65 71 Trading (losses) revenues ...................................... (956) 278 (1,307) 374 Other fees and commissions ..................................... 12 3 20 7 Other expenses: Fees paid to HTSU for technology services .................... 42 -- 124 -- Fees paid to Household for loan origination, loan servicing and other administrative support ............. 8 -- 19 -- Other fees, primarily treasury and traded markets services ... 49 42 148 103 13 Trading losses for the quarter and nine months ended September 30, 2004, primarily represent the mark-to-market of the inter-company leg of interest rate and foreign currency derivative swap transations entered into by Household. Specifically, Household enters into these swap contracts with the Company in order to hedge its interest rate positions. The Company, within its Corporate, Investment Banking and Markets business, accounts for these transactions on a mark-to-market basis, with the change in value on the inter-company leg substantially offset by the mark-to-market of related contracts entered into with third parties. These activities commenced in September of 2003 and had minimal impact on that quarter. During 2004, HSBC has integrated certain North American operations through changes to its organization structure. The following organizational changes have resulted in changes in the classification of revenues and/or expenses in 2004, as compared with 2003. - Technology services were centralized by the creation of a new HSBC subsidiary, HSBC Technology and Services (USA) Inc. (HTSU), effective January 1, 2004. The Company's technology services employees, as well as technology services employees from other HSBC entities in the United States, were transferred to HTSU. All technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by the Company prior to January 1, 2004 remain in place and were not transferred to HTSU. Pursuant to a master service level agreement, HTSU charges the Company for its share of technology services and software development costs. As a result, HSBC group charges for 2004 include amounts previously recorded as "salaries and benefits" and "occupancy expense, net" and "other expenses" on the consolidated statement of income for 2003. - The Company obtains certain underwriting, broker-dealer and administrative support services from an affiliated HSBC entity, HSBC Securities (USA) Inc. (HSUI) pursuant to various service level agreements. Effective January 1, 2004, several employees of the Company were transferred to HSUI. As a result, HSBC group charges for 2004 include amounts previously recorded as "salaries and benefits" on the consolidated statement of income for 2003. - On June 1, 2004, The Company transferred its wholly owned subsidiary, HSBC Brokerage (USA) Inc. (HBUI) to a related HSBC entity. The transfer resulted in a decrease in total assets of approximately $201 million and a loss on sale of approximately $9 million which has been reported as a reduction of capital surplus. For the five months ended May 31, 2004, HBUI contributed approximately $14 million of the Company's income before taxes. HSBC group other expenses also include charges by Household under various service level agreements for certain loan origination and servicing as well as other operational and administrative support. Amounts reported in the preceding table do not include fees associated with loan originations that have been deferred and are being amortized over the life of the related loans. On March 31, 2004, the Company purchased approximately $900 million of domestic residential mortgage loan assets at fair value from Household. In addition, during the first nine months of 2004, approximately $2.2 billion of loans were purchased from originating lenders pursuant to a Household correspondent loan program. On July 1, 2004, in order to centralize the servicing of credit card receivables within a common HSBC affiliate in the United States, certain consumer credit card customer relationships were sold to Household, resulting in a third quarter 2004 gain of approximately $99 million. Receivable balances of approximately $970 million associated with these relationships were not sold as part of the transaction. Servicing for the majority of these relationships was transferred to Household in October 2004. Also effective July 1, 2004, new receivable balances generated by these relationships are purchased at fair value from Household on a daily basis. Through September 30, 2004, approximately $515 million of receivables have been purchased from Household at a premium of approximately $10 million. The premium, which is recorded in loans as a component of credit card receivables, is being amortized to interest income over the estimated life of the receivables purchased. It was previously reported that the Company expected to purchase domestic private label credit card receivables and residual interests in securitized private label credit card receivable pools from Household during 2004. Household will maintain the related customer account relationships for the receivables purchased, and charge the Company for ongoing servicing of the accounts. Subsequent to the initial transfer, additional credit card receivables generated from the relationships maintained by Household will be purchased by the Company on a daily basis. The securitized credit card receivable trusts are expected to expire at various times until 2007. As the securitized trusts expire, 14 receivables generated from the underlying relationships will also be purchased from Household. The Company has filed a formal application seeking regulatory approval to acquire these receivables in 2004. Subject to regulatory approval, the private label receivables expected to be purchased from Household by year end will have a principal balance of approximately $12 billion. Residual interests in securitized private label credit card receivable pools of approximately $3 billion will also be acquired. The timing of regulatory approval, and therefore the timing of the asset transfers, cannot be predicted with any degree of certainty. If regulatory approval is received, a premium of approximately $675-$700 million is expected to be recorded on the initial transfer date. The premium will be amortized to interest income over the two year estimated life of the assets purchased. The purchased credit card receivables are expected to decrease net income after taxes by approximately $100-$150 million in 2005 due primarily to year one amortization of the premium paid. For years subsequent to 2005, net income is expected to increase due to decreases in premium amortization. Net interest income, other operating revenue, service fee expense, the provision and allowance for credit losses will all be impacted by the transaction in future periods. The Company and Household will consider potential transfers of MasterCard and Visa receivables in the future based upon continuing evaluations of capital and liquidity at each entity. At September 30, 2004 and December 31, 2003, the aggregate notional amounts of all derivative contracts with other HSBC affiliates were approximately $210 billion and $168 billion respectively. The net credit risk exposure related to these contracts was approximately $2 billion at September 30, 2004 and December 31, 2003. Employees of the Company participate in one or more stock compensation plans sponsored by HSBC. The Company's share of the expense of the plans for the first nine months of 2004 and 2003 was $46 million and $38 million respectively. A description of these plans is included on pages 91 and 92 of the Company's 2003 Form 10-K. On July 31, 2004, the Company transferred most of its Panamanian branch operations to a related HSBC group entity at fair value. Total assets and deposits transferred were approximately $1.0 billion and $.9 billion, respectively. The sale resulted in a loss of approximately $11 million which has been reported as a reduction of capital surplus. For the seven months ended July 31, 2004, the transferred operations contributed approximately $19 million of the Company's income before taxes. On September 30, 2004, the Company received a capital contribution of $400 million from its direct parent company, HSBC North America Inc., in exchange for one share of common stock. Also on September 30, 2004, the Company contributed $400 million to the Bank in exchange for one share of common stock. 10. Pledged Assets The following table presents pledged assets included in the consolidated balance sheet. -------------------------------------------------------------------------------- September 30, December 31, 2004 2003 -------------------------------------------------------------------------------- (in millions) Interest bearing deposits with banks ............ $ 315 $ 140 Interest bearing deposits with nonbanks ......... 365 500 Trading assets .................................. 343 647 Securities available for sale ................... 6,034 4,171 Securities held to maturity ..................... 644 956 Loans ........................................... 4,293 360 --------- --------- Total ........................................... $ 11,994 $ 6,774 ========= ========= The 2004 increase in pledged assets resulted primarily from collateral requirements associated with increased short-term borrowings and with increased derivatives activity. 15 11. Pensions and Other Postretirement Benefits The Company, the Bank and certain other subsidiaries maintain noncontributory defined benefit pension plans covering substantially all of their employees hired prior to January 1, 1997 and those employees who joined the Company through acquisitions and were participating in a defined benefit plan at the time of acquisition. Certain other HSBC subsidiaries participate in these plans. The Company also maintains unfunded noncontributory health and life insurance coverage for all employees who retired from the Company and were eligible for immediate pension benefits from the Company's retirement plan. Employees retiring after 1992 will absorb a portion of the cost of these benefits. Employees hired after that same date are not eligible for these benefits. A premium cap has been established for the Company's share of retiree medical cost. The following tables present the components of net periodic benefit cost. ---------------------------------------------------------------------------------------------- Pension Benefits Other Postretirement Benefits ---------------------- ----------------------------- 2004 2003 2004 2003 ---------------------------------------------------------------------------------------------- (in millions) Three Months Ended September 30 Net periodic benefit cost Service cost ....................... $ 7 $ 7 $ --(1) $ 1 Interest cost ...................... 17 16 1 2 Expected return on plan assets ..... (24) (21) -- -- Prior service cost amortization .... --(1) --(1) -- -- Actuarial loss ..................... 7 8 -- -- Transition amount amortization ..... -- -- --(1) 1 ------ ------ ------ ------ Net periodic benefit cost .......... $ 7 $ 10 $ 1 $ 4 ====== ====== ====== ====== Nine Months Ended September 30 Net periodic benefit cost Service cost ....................... $ 23 $ 22 $ 1 $ 2 Interest cost ...................... 51 48 5 5 Expected return on plan assets ..... (72) (65) -- -- Prior service cost amortization .... 1 1 -- -- Actuarial loss ..................... 20 24 -- -- Transition amount amortization ..... -- -- 2 2 ------ ------ ------ ------ Net periodic benefit cost .......... $ 23 $ 30 $ 8 $ 9 ====== ====== ====== ====== (1) Less than $500 thousand. The Company expects to make no contribution for pension benefits and contribute approximately $9 million for other postretirement benefits during fiscal year 2004. On November 9, 2004, sponsorship of the defined benefit pension plan for employees of the Bank was transferred to HNAH. 12. New Accounting Pronouncements In December 2003, the American Institute of Certified Public Accountants (AICPA) released Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences are attributable to credit quality. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004. Adoption is not expected to have a material impact on the Company's financial position or results of operations. In December 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 132 (revised), Employers' Disclosures about Pensions and Other Postretirement Benefits (SFAS 132 (revised)). SFAS 132 (revised) revises employers' disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans. SFAS 132 (revised) revises certain 16 disclosure requirements contained in the original SFAS 132. It also requires additional disclosures about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other postretirement benefit plans. The annual disclosure requirements for SFAS 132 (revised) were adopted in the 2003 Form 10-K and the interim period disclosure requirements were adopted in the Form 10-Q beginning with the quarter ended March 31, 2004. In January 2004, the FASB issued FASB Staff Position 106-1, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (FSP 106-1). FSP 106-1 was issued in response to a new Medicare bill that provides prescription drug coverage to Medicare-eligible retirees and was signed into law in December 2003. FSP 106-1 allowed plan sponsors the option of accounting for the effects of this new law in financial statements for periods that cover the date of enactment or making a one-time election to defer the accounting for the effects of the new law. The Company elected to defer the accounting for the effects of the new law. In May 2004, the FASB issued FASB Staff Position FAS 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (FSP 106-2), which superceded FSP 106-1. FSP 106-2 is effective for the first interim period beginning after June 15, 2004. For companies that elected deferral under FSP 106-1, and for which enactment is deemed to be a "significant event", FSP 106-2 provides two methods of transition - retroactive application or prospective application from the date of adoption. The effects of the new law were not deemed to be a "significant event" by the Company. Accordingly, the effects of the new law will be incorporated into the next measurement date following the effective date. Adoption of FSP 106-2 is not expected to have a material impact on the accumulated postretirement benefit obligation or the net periodic benefit cost. In March 2004, the FASB reached a consensus on EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03-1). EITF 03-1 provides guidance for determining when an investment is impaired and whether the impairment is other than temporary. EITF 03-1 also incorporates into its consensus the required disclosures about unrealized losses on investments announced by the EITF in late 2003 and adds new disclosure requirements relating to cost-method investments. The impairment accounting guidance is effective for reporting periods beginning after June 15, 2004 and the new disclosure requirements for annual reporting periods ending after June 15, 2004. The adoption of the impairment guidance contained in EITF 03-1 is not expected to have a material impact on the financial position or results of operations of the Company. In September 2004, the FASB issued FASB Staff Position EITF 03-1-1, Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments", (FSP 03-1-1). FSP 03-1-1 delays the effective date for the measurement and recognition guidance contained in paragraphs 10-20 of EITF 03-1, previously defined as annual reporting periods ending after June 15, 2004. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature, nor the disclosure guidance effective for annual reporting periods ending after June 15, 2004. The disclosure requirements for FSP 03-1-1 were adopted for the quarter ended September 30, 2004. In December 2003, the FASB issued Interpretation No. 46 Revised, Consolidation of Variable Interest Entities (FIN 46R). The Company has adopted all of the provisions of FIN 46R. All required disclosures are included in the MD&A section of this Form 10-Q or in the Company's 2003 Form 10-K under "Special Purpose and Variable Interest Entities". In March 2004, the SEC released Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (SAB 105) which provides guidance regarding commitments related to loans to be held for sale, and accounted for as derivative instruments. The guidance indicates that, for commitments issued after March 31, 2004, expected future cash flows from servicing may not be considered in valuing the derivatives and may only be recorded upon sale of the related loans. The Company previously recorded those cash flows as assets and income upon the issuance of the commitment. Commentary regarding the impact of SAB 105 on residential mortgage banking revenue is presented on page 33 of this Form 10-Q. 17 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations HSBC USA Inc. ------------------------------------------------------------------------------------------------------------------------ CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES (Taxable Equivalent Basis) Three Months Ended September 30, ------------------------------------------------------------------------- 2004 2003 ----------------------------------- ----------------------------------- Balance Interest Rate * Balance Interest Rate * ------------------------------------------------------------------------------------------------------------------------ in millions Assets Interest bearing deposits with banks ......... $ 2,642 $ 11 1.60% $ 1,910 $ 7 1.38% Federal funds sold and securities purchased under resale agreements ......... 4,132 16 1.56 4,088 11 1.09 Trading assets ................................ 14,778 43 1.16 11,892 30 1.01 Securities .................................... 18,566 224 4.80 19,448 222 4.53 Loans Domestic Commercial ................................ 16,376 196 4.77 16,647 204 4.85 Consumer Residential mortgages ................ 41,118 494 4.81 20,441 276 5.40 Other consumer ....................... 3,561 67 7.45 3,076 62 8.01 --------- -------- ------- --------- -------- ------- Total domestic .......................... 61,055 757 4.93 40,164 542 5.35 International ............................... 3,473 22 2.44 3,408 32 3.75 --------- -------- ------- --------- -------- ------- Total loans ............................. 64,528 779 4.80 43,572 574 5.22 --------- -------- ------- --------- -------- ------- Other ......................................... 546 5 3.60 485 4 3.20 --------- -------- ------- --------- -------- ------- Total earning assets .......................... 105,192 $ 1,078 4.07% 81,395 $ 848 4.13% --------- -------- ------- --------- -------- ------- Allowance for credit losses ................... (339) (474) Cash and due from banks ....................... 3,290 2,648 Other assets .................................. 7,055 8,260 --------- --------- Total assets ..................................$ 115,198 $ 91,829 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits ..........................$ 27,350 $ 44 0.64% $ 25,602 $ 44 0.69% Other time deposits ....................... 17,935 111 2.47 9,665 50 2.06 Deposits in foreign offices ................... 22,197 71 1.27 19,374 56 1.14 --------- -------- ------- --------- -------- ------- Total interest bearing deposits ............... 67,482 226 1.33 54,641 150 1.09 --------- -------- ------- --------- -------- ------- Short-term borrowings ......................... 12,568 59 1.85 8,149 13 0.62 Long-term debt ................................ 7,905 91 4.58 3,725 50 5.28 --------- -------- ------- --------- -------- ------- Total interest bearing liabilities ............ 87,955 376 1.70% 66,515 213 1.27% --------- -------- ------- --------- -------- ------- Net interest income / Interest rate spread .... $ 702 2.37% $ 635 2.86% -------- ------- -------- ------- Noninterest bearing deposits .................. 7,584 6,628 Other liabilities ............................. 11,646 11,116 Total shareholders' equity .................... 8,013 7,570 --------- --------- Total liabilities and shareholders' equity ....$ 115,198 $ 91,829 ========= ========= * Rates are calculated on unrounded numbers 18 HSBC USA Inc. ------------------------------------------------------------------------------------------------------------------------ CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES (Taxable Equivalent Basis) Nine Months Ended September 30, ------------------------------------------------------------------------ 2004 2003 ---------------------------------- ---------------------------------- Balance Interest Rate * Balance Interest Rate * ------------------------------------------------------------------------------------------------------------------------ in millions Assets Interest bearing deposits with banks .......... $ 2,230 $ 24 1.46% $ 1,668 $ 19 1.55% Federal funds sold and securities purchased under resale agreements ......... 3,940 38 1.30 4,359 42 1.27 Trading assets ................................ 15,011 114 1.01 12,445 104 1.12 Securities .................................... 18,106 664 4.89 19,091 685 4.80 Loans Domestic Commercial ................................ 15,646 520 4.44 16,563 613 4.95 Consumer Residential mortgages ................ 34,391 1,258 4.88 20,667 874 5.64 Other consumer ....................... 3,396 205 8.04 3,011 188 8.34 --------- -------- ------- --------- -------- ------- Total domestic .......................... 53,433 1,983 4.96 40,241 1,675 5.56 International ............................... 3,652 78 2.86 3,198 95 3.97 --------- -------- ------- --------- -------- ------- Total loans ............................. 57,085 2,061 4.82 43,439 1,770 5.45 --------- -------- ------- --------- -------- ------- Other ......................................... 526 13 3.39 482 18 4.87 --------- -------- ------- --------- -------- ------- Total earning assets .......................... 96,898 $ 2,914 4.02% 81,484 $ 2,638 4.33% --------- -------- ------- --------- -------- ------- Allowance for credit losses ................... (360) (493) Cash and due from banks ....................... 3,197 2,452 Other assets .................................. 7,281 7,423 --------- --------- Total assets .................................. $ 107,016 $ 90,866 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits .......................... $ 27,250 $ 134 0.66% $ 24,414 $ 144 0.79% Other time deposits ....................... 14,837 228 2.05 10,553 172 2.17 Deposits in foreign offices ................... 21,837 182 1.11 19,208 195 1.36 --------- -------- ------- --------- -------- ------- Total interest bearing deposits ............... 63,924 544 1.14 54,175 511 1.26 --------- -------- ------- --------- -------- ------- Short-term borrowings ......................... 10,305 112 1.44 9,207 72 1.04 Long-term debt ................................ 5,675 204 4.80 3,714 155 5.59 --------- -------- ------- --------- -------- ------- Total interest bearing liabilities ............ 79,904 860 1.44% 67,096 738 1.47% --------- -------- ------- --------- -------- ------- Net interest income / Interest rate spread .... $ 2,054 2.58% $ 1,900 2.86% -------- ------- -------- ------- Noninterest bearing deposits .................. 7,470 6,261 Other liabilities ............................. 11,831 10,035 Total shareholders' equity .................... 7,811 7,474 --------- --------- Total liabilities and shareholders' equity .... $ 107,016 $ 90,866 ========= ========= * Rates are calculated on unrounded numbers 19 FORWARD-LOOKING STATEMENTS This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company's results may differ materially from those noted in the forward-looking statements. Words such as "believe", "expects", "estimates", "targeted", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements are made. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements and involve inherent risks and uncertainties and are based on current views and assumptions. A number of important factors could cause actual results to differ materially from those contained in any forward-looking statements. Such factors include, but are not limited to: sharp and/or rapid changes in interest rates; significant changes in the economic conditions which could materially change anticipated credit quality trends and the ability to generate loans; technology changes and challenges; significant changes in accounting, tax or regulatory requirements; consumer behavior; marketplace perceptions of the Company's reputation and competition in the geographic and business areas in which the Company conducts its operations. For a list of important factors that may affect the Company's actual results, see Forward-Looking Statements in Part I, Item 7 of the Company's 2003 Form 10-K. EXECUTIVE OVERVIEW Net income increased $141 million in the third quarter of 2004, and increased $264 million in the first nine months of 2004, as compared with the same 2003 periods. Third quarter and year-to-date 2004 operating performance has been highlighted by a significant increase in net interest income, primarily from residential mortgage loans, and by non-recurring transaction gains and other income amounts recorded as other revenues. Despite a third quarter 2004 increase, the provision for credit losses has also decreased significantly in the first nine months of 2004. During 2002 and 2003, certain equipment finance, commercial finance, and U.S. factoring business lines were exited or restructured, resulting in office closings and sales of customer relationships. Certain receivables associated with these businesses were retained, and have been decreasing throughout 2003 and 2004 as balances have run off. As a result of these transactions, average loan balances associated with these business lines have been steadily decreasing, and reported 2003 year-to-date amounts for net interest income, provision for credit losses, and operating expenses exceeded 2004 year-to-date amounts by approximately $49 million, $20 million and $28 million, respectively. During the first nine months of 2004, the Company sold or transferred certain foreign and domestic subsidiaries, at fair value, to affiliated HSBC group entities. As a result of these transactions, the Company reported 2003 year-to-date amounts for net interest income, other revenues and operating expenses that exceeded 2004 year-to-date amounts by approximately $8 million, $20 million and $24 million, respectively. Further discussion of these related party transactions is presented in Note 9 to the consolidated financial statements on pages 13 through 15 of this Form 10-Q. Balance Sheet Review Balance sheet growth during the third quarter and first nine months of 2004 was highlighted by significant growth in residential mortgage loans, and moderate growth in other consumer and commercial loans. Loan growth was primarily funded by relatively low cost interest bearing deposits and by long-term debt. Short-term investments, such as deposits placed with other banks and securities purchased under resale agreements, have also increased during the third quarter and the first nine months of 2004. In anticipation of the private label credit card portfolio transfer (see Note 9 to the consolidated financial statements on pages 13 through 15 of this Form 10-Q), the Bank has been raising funds through long-term debt issuances and through short-term borrowings. These accumulated funds are invested in the short-term assets noted above. Balance sheet funding needs and sources are further addressed under Liquidity Management in the Risk Management section on page 47 of this Form 10-Q. 20 Income Statement Review Net interest income increased $69 million in the third quarter of 2004, and increased $158 million in the first nine months of 2004, as compared with the same 2003 periods. For both reporting periods, a significant increase in total interest income was primarily due to volume growth in various consumer loan portfolios, especially residential mortgage loans. Smaller increases in total interest expense were due to general increases in deposits, short-term borrowings, and long-term debt balances. Net interest rate spreads for the third quarter and the first nine months of 2004 have been negatively impacted by a continuing trend of lower interest rates earned from loans, primarily residential mortgage loans. Higher average rates paid on the growing short-term borrowing balances also contributed to tightening interest spreads. Further analysis of net interest income is presented on pages 26 through 29 of this Form 10-Q. The provision for credit losses has decreased $79 million during the first nine months of 2004, as compared with the same 2003 periods. The Company has experienced a continuing trend of improved credit quality within the commercial lending portfolios, as evidenced by decreased charge offs of commercial loan balances, and by increased recoveries of commercial loan balances previously charged off. Changes in the allowance for credit losses are summarized in Note 4 to the consolidated financial statements on page 10 of this Form 10-Q. An analysis of credit quality is presented on pages 42 and 43 of this Form 10-Q. Other revenues increased $157 million in the third quarter of 2004 and increased $122 million in the first nine months of 2004, as compared with the same 2003 periods. During the third quarter of 2004, the Company recorded the following significant non-recurring transactions: - Sale of credit card account relationships to a related HSBC entity for a gain of approximately $99 million. This transaction is further described in Note 9 of the financial statements on pages 13 through 15 of this Form 10-Q. - Sale of an investment in NYCE Corporation for a gain of approximately $45 million. This transaction is further described in the "Other Revenues" section on pages 29 through 31 of this Form 10-Q. - Refund of interest previously paid to the Internal Revenue Service of approximately $17 million. This transaction is further described in the "Other Revenues" section on pages 29 through 31 of this Form 10-Q. The net 2004 comparative increases in other revenues also reflect activity from non-interest residential mortgage banking performance, non-interest trading revenues and gains on the sale of available for sale securities. Quarterly and year-to-date results for these areas are presented on pages 31 through 35 of this Form 10-Q. Operating expenses decreased $43 million in the third quarter of 2004 and decreased $11 million in the first nine months of 2004, as compared with the same 2003 periods. The expense decreases were primarily attributable to sales or transfers of various subsidiaries and commercial lending lines of business in 2003 and 2004, which were partially offset by increased technology-related fees and increases in other fees charged by affiliated HSBC entities. An analysis of operating expenses is presented on pages 35 through 37 of this Form 10-Q. Income tax expense increased $100 million in the third quarter of 2004, and increased $106 million during the first nine months of 2004, as compared with the same 2003 periods. In June 2004, approximately $51 million of income tax liability related to the anticipated completion of an outstanding audit was released. Excluding the impact of this adjustment, increased income tax expense for the third quarter and the first nine months of 2004 was a direct result of increased taxable income, which is taxed at the full corporate rate. An analysis of the Company's effective tax rate is presented in Note 8 to the financial statements on page 13 of this Form 10-Q. 21 The following table presents a five quarter summary of selected financial information. ----------------------------------------------------------------------------------------------------------------------- September 30 June 30 March 31 December 31 September 30 Three months ended 2004 2004 2004 2003 2003 ----------------------------------------------------------------------------------------------------------------------- (in millions) Income statement data: Net interest income ........................... $ 698 $ 689 $ 655 $ 627 $ 629 Provision for credit losses ................... 27 6 (25) 27 (1) Other revenues ................................ 362 298 334 280 205 Operating expenses ............................ 480 520 489 539 523 Income tax expense ............................ 214 130 207 125 114 Net income .................................... 339 331 318 216 198 Balance sheet data (period end balances): Cash and short-term investments ............... $ 11,821 $ 8,490 $ 7,111 $ 5,823 $ 8,406 Loans, net .................................... 66,700 61,719 52,075 48,075 44,473 Total assets .................................. 120,939 112,791 102,502 95,562 92,718 Total deposits ................................ 74,803 74,534 67,994 63,955 62,098 Short-term borrowings ......................... 11,467 9,499 5,906 6,782 6,466 Long-term debt ................................ 12,118 6,135 4,871 3,814 3,740 Total shareholders' equity .................... 8,553 7,815 7,839 7,462 7,736 Total tangible common shareholder's equity .... 5,336 4,673 4,341 4,022 4,196 Financial performance: Net yield on average earning assets ........... 2.65% 2.91% 2.96% 2.95% 3.09% Net yield on average total assets ............. 2.42 2.63 2.66 2.65 2.74 BASIS OF REPORTING HSBC reports results in accordance with accounting principles generally accepted in the United Kingdom (U.K. GAAP). Therefore, management separately monitors net income and earnings excluding goodwill amortization under U.K. GAAP (non-GAAP financial measures). The following table reconciles net income of the Company on a U.S. GAAP basis to net income on a U.K. GAAP basis. ------------------------------------------------------------------------------------------------------------------- Three Months Nine Months Ended September 30 Ended September 30 --------------------- --------------------- 2004 2003 2004 2003 ------------------------------------------------------------------------------------------------------------------- (in millions) Net income - U.S. GAAP basis .................................. $ 339 $ 198 $ 989 $ 725 Deferred loan origination fees and costs ...................... (1) -- (18) -- Derivative financial instruments .............................. 6 3 -- 3 Deferred taxation ............................................. (26) 4 (12) 22 Depreciation .................................................. 4 4 12 12 Software amortization ......................................... 2 (1) 7 (2) Other ......................................................... -- (1) -- (2) ------- ------- ------- ------- Earnings excluding goodwill amortization - U.K. GAAP basis .... 324 207 978 758 Goodwill amortization ......................................... (34) (54) (105) (135) ------- ------- ------- ------- Net income - U.K. GAAP basis .................................. $ 290 $ 153 $ 873 $ 623 ======= ======= ======= ======= Differences between U.S. and U.K. GAAP are as follows: Deferred loan origination fees and costs U.K. GAAP - Fee and commission income is accounted for in the period when receivable, except when it is charged to cover the costs of a continuing service to, or risk borne for, the customer, or is interest in nature. In these cases, it is recognized on an appropriate basis over the relevant period. 22 - Loan origination costs are generally expensed as incurred. As permitted by U.K. GAAP, HSBC applies a restricted definition of the incremental, directly attributable origination expenses that are deferred and subsequently amortized over the life of the loans. U.S. GAAP - In accordance with Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (SFAS 91), certain loan fee income and direct loan origination costs are amortized to the profit and loss account over the life of the loan as an adjustment to interest income. Derivative financial instruments U.K. GAAP - Non-trading derivatives are those which are held for hedging purposes as part of our risk management strategy against cash flows, assets, liabilities, or positions measured on an accruals basis. Non-trading transactions include qualifying hedges and positions that synthetically alter the characteristics of specified financial instruments. - Non-trading derivatives are accounted for on an equivalent basis to the underlying assets, liabilities or net positions. Any profit or loss arising is recognized on the same basis as that arising from the related assets, liabilities or positions. - To qualify as a hedge, a derivative must effectively reduce the price, foreign exchange or interest rate risk of the asset, liability or anticipated transaction to which it is linked and be designated as a hedge at inception of the derivative contract. Accordingly, changes in the market value of the derivative must be highly correlated with changes in the market value of the underlying hedged item at inception of the hedge and over the life of the hedge contract. If these criteria are met, the derivative is accounted for on the same basis as the underlying hedged item. Derivatives used for hedging purposes include swaps, forwards and futures. - Interest rate swaps are also used to alter synthetically the interest rate characteristics of financial instruments. In order to qualify for synthetic alteration, a derivative instrument must be linked to specific individual, or pools of similar, assets or liabilities by the notional principal and interest rate risk of the associated instruments, and must achieve a result that is consistent with defined risk management objectives. If these criteria are met, accrual based accounting is applied, i.e. income or expense is recognized and accrued to the next settlement date in accordance with the contractual terms of the agreement. - Any gain or loss arising on the termination of a qualifying derivative is deferred and amortized to earnings over the original life of the terminated contract. Where the underlying asset, liability or position is sold or terminated, the qualifying derivative is immediately marked-to-market through the profit and loss account. - Derivatives that do not qualify as hedges or synthetic alterations at inception are marked-to-market through the profit and loss account, with gains and losses included within "other income". U.S. GAAP - All derivatives must be recognized as either assets or liabilities in the balance sheet and be measured at fair value, in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). - The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation as described below: o For a derivative designated as hedging exposure to changes in the fair value of a recognized asset or liability or a firm commitment, the gain or loss is recognized in earnings in the period of change together with the associated loss or gain on the hedged item attributable to the risk being hedged. Any resulting net gain or loss represents the ineffective portion of the hedge. o For a derivative designated as hedging exposure to variable cash flows of a recognized asset or liability, or of a forecast transaction, the derivative's gain or loss associated with the effective portion of the hedge is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecast transaction affects earnings. The ineffective portion is reported in earnings immediately. 23 o For net investment hedges in which derivatives hedge the foreign currency exposure of a net investment in a foreign operation, the change in fair value of the derivative associated with the effective portion of the hedge is included as a component of other comprehensive income, together with the associated loss or gain on the hedged item. The ineffective portion is reported in earnings immediately. o In order to apply hedge accounting it is necessary to comply with documentation requirements and to demonstrate the effectiveness of the hedge on an ongoing basis. o For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change in fair value. Deferred taxation U.K. GAAP - Deferred tax is generally recognized for all timing differences subject to exceptions in FRS 19, Deferred Tax, and the assessment of the recoverability of deferred tax assets. - Fair value adjustments on acquisition are treated as if they were timing differences arising in the acquired entity's own accounts. Deferred tax is recognized on fair value adjustments where they give rise to deferral or acceleration of taxable cash flows. U.S. GAAP - In accordance with Statement of Financial Accounting Standards No. 109, Accounting For Income Taxes (SFAS 109), deferred tax liabilities and assets are recognized for all temporary differences. A valuation allowance is raised against any deferred tax asset where it is more likely than not that the asset, or a part thereof, will not be realized (SFAS 109 'Accounting for Income Taxes'). - The deferred taxation impact of all temporary differences arising from fair value adjustments on acquisition is recognized as part of the purchase accounting adjustment. Depreciation U.K. GAAP - HSBC revalues its properties on an annual basis. HSBC depreciates non-investment properties based on their cost or revalued amounts. No depreciation is charged on investment properties, other than leaseholds, with useful lives of 20 years or less. U.S. GAAP - U.S. GAAP does not permit revaluation of property, although it requires recognition of asset impairment. Depreciation is recognized on all properties, based on cost, over the useful lives of the assets. Software amortization U.K. GAAP - HSBC generally expenses costs of software developed for internal use. If it can be shown that conditions for capitalization are met under FRS 10, Goodwill and Intangible Assets, or FRS 15, Tangible Fixed Assets, the software is capitalized and amortized over its useful life. Website design and content development costs are capitalized only to the extent that they lead to the creation of an enduring asset delivering benefits at least as great as the amount capitalized. U.S. GAAP - The American Institute of Certified Public Accountants' (AICPA) Statement of Position 98-1, Accounting For the Costs of Computer Software Developed or Obtained For Internal Use, requires that all costs incurred in the preliminary project and post implementation stages of internal software development be expensed. Costs incurred in the application development stage must be capitalized and amortized over their estimated useful life. Website design costs are capitalized and website content development costs are expensed as they are incurred. 24 Goodwill amortization U.K. GAAP - Goodwill arising on acquisitions of subsidiary undertakings, associates or joint ventures prior to 1998 was charged against reserves in the year of acquisition. - For acquisitions made on or after January 1, 1998, goodwill is included in the balance sheet and amortized over its estimated useful life on a straight-line basis. U.K. GAAP allows goodwill previously eliminated against reserves to be reinstated, but does not require it. - Goodwill included in the balance sheet is tested for impairment when necessary by comparing the recoverable amount of an entity with the carrying value of its net assets, including attributable goodwill. The recoverable amount of an entity is the higher of its value in use, generally the present value of the expected future cash flows from the entity, and its net realizable value. - At the date of disposal of subsidiaries, associates or joint ventures, any unamortized goodwill or goodwill charged directly against reserves is included in the share of the undertakings' total net assets in the calculation of the gain or loss on disposal. - Where quoted securities are issued as part of the purchase consideration in an acquisition, the fair value of those securities for the purpose of determining the cost of acquisition is the market price at the date of completion. U.S. GAAP - Goodwill acquired up to June 30, 2001 was capitalized and amortized over its useful life but not more than 25 years. The amortization of previously acquired goodwill ceased from December 31, 2001. - Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142) requires that goodwill should not be amortized but should be tested for impairment annually at the reporting unit level by applying a fair-value-based test. - The goodwill of a reporting unit should be tested for impairment between annual tests in response to events or changes in circumstance which could result in an impairment. - Where quoted securities are issued as part of the purchase consideration in an acquisition, the fair value of those securities for the purpose of determining the cost of acquisition is the average market price of the securities for a reasonable period before and after the date that the terms of the acquisition are agreed and announced. Other - Includes various immaterial items. 25 RESULTS OF OPERATIONS Net Interest Income The following table presents a five quarter summary of net interest income for the Company. ------------------------------------------------------------------------------------------------------- September 30 June 30 March 31 December 31 September 30 Three months ended 2004 2004 2004 2003 2003 ------------------------------------------------------------------------------------------------------- (in millions) Interest income: Loans ......................... $ 779 $ 669 $ 613 $ 580 $ 573 Securities .................... 220 215 215 218 217 Trading assets ................ 43 38 33 32 30 Short-term investments ........ 27 18 18 19 18 Other ......................... 5 4 4 3 4 -------- -------- -------- -------- -------- Total interest income ...... 1,074 944 883 852 842 -------- -------- -------- -------- -------- Interest expense: Deposits ...................... 226 158 160 155 150 Short-term borrowings ......... 59 35 17 20 13 Long-term debt ................ 91 62 51 50 50 -------- -------- -------- -------- -------- Total interest expense ..... 376 255 228 225 213 -------- -------- -------- -------- -------- Net interest income ............. $ 698 $ 689 $ 655 $ 627 $ 629 ======== ======== ======== ======== ======== In the discussion that follows, interest income and rates are presented and analyzed on a taxable equivalent basis to permit comparisons of yields on tax-exempt and taxable assets. An analysis of consolidated average balances and interest rates on a taxable equivalent basis is presented on pages 18-19 of this Form 10-Q. All increases and decreases referred to below for the third quarter and for the first nine months of 2004 represent comparisons with the same 2003 periods. Interest Income - Loans Total interest income on loans increased $205 million (36%) in the third quarter of 2004 and increased $291 million (16%) in the first nine months of 2004. Increased interest income from residential mortgage and other consumer loans were partially offset by decreased interest income from commercial and international loans. Residential Mortgage Loans Interest income earned from residential mortgage loans increased $218 million (79%) in the third quarter of 2004, and increased $384 million (44%) in the first nine months of 2004. The Company has significantly expanded the volume of adjustable rate residential mortgage loans originated during 2003 and 2004. As a result, average residential mortgage loans held increased $21 billion (101%) in the third quarter of 2004, and increased $14 billion (66%) in the first nine months of 2004. On December 31, 2003, approximately $2.8 billion of domestic residential mortgage loan assets were purchased from Household at fair value. On March 31, 2004, approximately $900 million of additional mortgages were purchased from Household. During 2004, approximately $2.2 billion of residential mortgages have been purchased from originating lenders pursuant to a Household correspondent loan program. Originations of other residential mortgage loans during the first nine months of 2004 continued to be strong, due to competitive pricing, an expanded sales force, development of a correspondent network, and increased marketing efforts. The increased loan balances, and their positive effect on earnings, were partially offset by continued decreases in the average yield earned on residential mortgages during the third quarter and first nine months of 2004, as consumers continued to take advantage of lower coupon adjustable rate products. Competitive pricing in a contracting national mortgage originations market contributed to a general trend toward declining mortgage rates in 2004, as compared with 2003. The lower level of refinancings in 2004, and a reduction in loans originated for sale, also resulted in lower interest income on mortgages held for sale. 26 Residential mortgage growth is expected to continue at a moderate level through the remainder of 2004 by continuing to increase loans originated for various product offerings, including, jumbo (mortgages greater than Government Sponsored Enterprise limits), other prime (adjustable rate mortgages not sold to Government Sponsored Enterprises) and limited documentation products. Loan originations from the relationship with Household are also expected to provide some level of growth. Other Consumer Loans Interest earned from various other consumer lending programs increased $5 million (8%) in the third quarter of 2004, and $17 million (9%) in the first nine months of 2004. These increases resulted directly from growth in average loan balances, especially in automobile and other installment lending programs. Moderate expansion of these programs is expected to continue for the remainder of 2004, driven mainly by increased consumer loan originations arising from the relationship with Household. These average balance increases were partially offset by a decrease in the average yield earned on consumer loans, as new loans are being originated with lower interest rates than loans that are maturing. Subject to regulatory approval, certain private label credit card receivables are expected to be purchased from Household by year end. Residual interests in certain securitized private label credit card receivable pools will also be acquired. The timing of regulatory approval, and therefore the timing of the asset transfers, cannot be predicted with any degree of certainty. Commercial Loans Interest income earned from commercial loans decreased $8 million (4%) in the third quarter of 2004, and decreased $93 million (15%) in the first nine months of 2004. The decreases are due to slightly lower average loan balances and to lower average yields earned on the commercial lending portfolios, resulting from an increasingly competitive rate environment. Average commercial loan balances decreased $.3 billion (2%) in the third quarter of 2004 and decreased $1 billion (6%) in the first nine months of 2004. Loan decreases resulting from decisions made to exit or restructure certain business lines during 2003, including equipment finance, commercial finance and domestic receivables factoring businesses, and from significant pay downs of certain nonaccruing and charged off loans, were partially offset by general growth in the remaining commercial loan portfolios during 2004. Operating and financial performance continue to stabilize and improve for large corporate clients, leading to a generally improving credit profile within most industry sectors. Demand for ongoing credit support for these customers during the first nine months of 2004 was comparable to the same 2003 period. This stability is expected to continue for the remainder of 2004. The Company will continue to improve its commercial loan mix as well as grow certain commercial banking businesses. Additional resources are being allocated to commercial middle market, real estate and small business lending, particularly in the New York City, California and Florida markets. Overall commercial loan growth will continue to be limited, however, due to the 2003 sale of the U.S. factoring business, and planned run-off of equipment financing and commercial finance portfolios. The supply of credit in the overall commercial lending market is increasing. The increased credit supply is partially offset, however, by marginal credit supply restrictions stemming from ongoing bank industry consolidation. The overall increase in credit supply is placing downward competitive pressure on pricing and fees. This trend may continue throughout the balance of the year, absent a material change in economic conditions. 27 Interest Income - Trading Assets Interest income from trading assets increased $13 million (43%) in the third quarter of 2004 and increased $10 million (10%) in the first nine months of 2004. During the third quarter of 2004, the Company increased average trading asset balances, and experienced an increase in the average yield earned on these balances. For the first nine months of 2004, increased average balances were offset by a decrease in the average yield earned. Increased balances are primarily due to planned growth initiatives related to derivative structured products, and temporary growth in anticipation of the planned purchase of credit card receivables from Household. Interest Income - Short-Term Investments Short-term investments include interest bearing deposits with banks, federal funds sold and securities purchased under resale agreements. Interest income from short-term investments increased $9 million (50%) in the third quarter of 2004 and increased $1 million (2%) in the first nine months of 2004. Short-term investment balances have grown significantly during 2004, as funds generated from borrowings have been invested in short-term, liquid assets in anticipation of the planned credit card portfolio purchase from Household (see Interest Income - Other Consumer Loans). Average rates earned on these balances have also increased during 2004, primarily due to increases in the federal funds rate. Interest Expense - Deposits Total interest expense on deposits increased $76 million (51%) in the third quarter of 2004, and increased $33 million (6%) in the first nine months of 2004. Interest expense increases were noted from both domestic and foreign deposits. Deposits in Domestic Offices Interest expense on interest bearing deposits in domestic offices increased $61 million (65%) in the third quarter of 2004, and increased $46 million (15%) in the first nine months of 2004. General increases in average deposit balances and increased expense associated with interest rate swaps used to hedge deposit liabilities were the primary drivers of the overall interest expense increase. Decreases in average interest rates paid to customers during 2004 partially offset overall expense increases. Total average interest bearing deposits in domestic offices increased $10 billion (28%) in the third quarter of 2004, and increased $7 billion (20%) in the first nine months of 2004. General increases were noted for commercial and personal interest bearing deposit balances. Increased marketing efforts have also resulted in increased noninterest bearing demand deposit balances. Interest rates paid on deposits generally decreased in the third quarter and the first nine months of 2004. The low interest rate environment, combined with continued uncertainty of the equity markets, continues to cause many personal and commercial customers to show preference for highly liquid but low yielding demand and savings deposits as opposed to longer term time deposits and mutual funds. This accounts for the significant increase in deposit balances, and also effectively continues to reduce the overall rate paid on liabilities. Balance sheet growth will continue to be partially funded by domestic deposit growth for the remainder of 2004, as marketing of deposit products will continue. Deposits in Foreign Offices Interest expense on deposits in foreign offices increased $15 million (27%) in the third quarter of 2004, due to a combination of increased average balances outstanding and an increase in the average interest rate paid. Interest expense decreased $13 million (7%) in the first nine months of 2004, as a decrease in the average interest rate paid was partially offset by increased average balances outstanding. 28 Interest Expense - Short-Term Borrowings Interest expense on short-term borrowings increased $46 million (354%) in the third quarter of 2004 and $40 million (56%) in the first nine months of 2004. Average short-term borrowings balances increased in the third quarter and in the first nine months of 2004, due to Bank funding activity in anticipation of the purchase of private label credit card receivables from Household, and to increased expense associated with interest rate swaps used to hedge short-term liabilities. The average interest rate paid on short-term borrowings increased during the third quarter and the first nine months of 2004, due primarily to increases in the federal funds rate. Interest Expense - Long-Term Debt Interest expense on long-term debt increased $41 million (82%) in the third quarter of 2004 and $49 million (32%) in the first nine months of 2004, due mainly to new debt issued during 2004, which was partially offset by a decrease in the average interest rate paid on long-term debt. Long-term debt will continue to be a primary funding source for balance sheet growth for the remainder of 2004, and into 2005. For further details regarding long-term debt, refer to Note 7 of the financial statements on pages 12 through 13 of this Form 10-Q. Other Revenues The following tables present the components of other revenues for the three months and nine months ended September 30, 2004 and 2003. -------------------------------------------------------------------------------------------------------- Increase (Decrease) Three months ended September 30 2004 2003 Amount % -------------------------------------------------------------------------------------------------------- (in millions) Trust income ...................................... $ 23 $ 24 $ (1) (4.2) Service charges ................................... 54 54 -- -- Other fees and commissions: Letter of credit fees ........................... 18 18 -- -- Credit card fees ................................ 20 19 1 5.3 Investment product fees ......................... -- 18 (18) (100.0) Wealth and tax advisory services ................ 10 9 1 11.1 Other fee-based income .......................... 50 43 7 16.3 HSBC group income ............................... 12 3 9 300.0 ------- ------- ------- ------- Total other fees and commissions ................ 110 110 -- -- ------- ------- ------- ------- Other income: Insurance ....................................... 16 17 (1) (5.9) Other ........................................... 167 20 147 735.0 Interest on tax settlement ...................... 17 -- 17 -- ------- ------- ------- ------- Total other income .............................. 200 37 163 440.5 ------- ------- ------- ------- Residential mortgage banking revenue (expense) .... (64) (74) 10 13.5 Trading revenues .................................. 21 52 (31) (59.6) Securities gains, net ............................. 18 2 16 800.0 ------- ------- ------- ------- Total other revenues .............................. $ 362 $ 205 $ 157 76.6 ======= ======= ======= ======= 29 -------------------------------------------------------------------------------------------------------- Increase (Decrease) Nine months ended September 30 2004 2003 Amount % -------------------------------------------------------------------------------------------------------- (in millions) Trust income ...................................... $ 71 $ 70 $ 1 1.4 Service charges ................................... 158 157 1 .6 Other fees and commissions: Letter of credit fees ........................... 53 53 -- -- Credit card fees ................................ 61 58 3 5.2 Investment product fees ......................... 36 58 (22) (37.9) Wealth and tax advisory services ................ 34 31 3 9.7 Other fee-based income .......................... 137 127 10 7.9 HSBC group income ............................... 20 7 13 185.7 ------- ------- ------- ------- Total other fees and commissions ................ 341 334 7 2.1 ------- ------- ------- ------- Other income: Insurance ....................................... 48 50 (2) (4.0) Other ........................................... 218 58 160 275.9 Interest on tax settlement ...................... 17 21 (4) (19.0) ------- ------- ------- ------- Total other income .............................. 283 129 154 119.4 ------- ------- ------- ------- Residential mortgage banking revenue (expense) .... (105) (80) (25) (31.3) Trading revenues .................................. 188 212 (24) (11.3) Securities gains, net ............................. 59 51 8 15.7 ------- ------- ------- ------- Total other revenues .............................. $ 995 $ 873 $ 122 14.0 ======= ======= ======= ======= Other Fees and Commissions The 2004 increase in other fee-based income, and the partially offsetting decrease in investment product fees, are attributable to the June 1, 2004 transfer of a brokerage subsidiary of the Company to a related HSBC group entity. As a result of the transfer, income received directly from customers and recorded as investment product fees prior to June 1, 2004, has been partially replaced by fees received from an affiliated HSBC group entity, and recorded as HSBC group income. Refer to Note 9 of the financial statements on pages 13 through 15 of this Form 10-Q for further discussion. Ongoing efforts to maximize the "cross-sell" potential of the existing customer base and of the relationship with Household will continue to be a key business development theme for the remainder of 2004. Further growth in fees and commissions income is expected to continue from these efforts. Other Income Other income for 2004 includes the following items: - During the first quarter of 2004, equity investment revenue increased approximately $13 million, as compared with the same 2003 period, due to higher than expected earnings from a foreign investment. - In July 2004, certain consumer credit card relationships were sold to Household at a gain of approximately $99 million. This transaction is further described in Note 9 to the financial statements on pages 13 through 15 of this Form 10-Q. - In July 2004, the Company sold an investment in NYCE Corporation for a gain of approximately $45 million. The Company had held its non-marketable minority investment since 1985, at a recorded cost of approximately $2 million. The Company was obliged to sell its investment by the majority shareholder in accordance with the terms of the shareholder agreement. - In July 2004, the Company recorded a $17 million refund of interest previously paid to the Internal Revenue Service related to a prior year tax audit. The settlement included a $14 million refund of interest previously paid, plus accrued interest on the refunded amount. 30 Other income for 2003 included $21 million of interest on an income tax refund. Excluding the effect of these items, other income for the first nine months of 2004, as compared with the same 2003 period, remained relatively constant. Subject to regulatory approval, certain private label credit card receivables are expected to be purchased from Household by year end. Residual interests in certain securitized private label credit card receivable pools will also be acquired. The timing of regulatory approval, and therefore the timing of the asset transfers, cannot be predicted with any degree of certainty. Residential Mortgage Banking Revenue The following tables present the components of residential mortgage banking revenue for the three months and nine months ended September 30, 2004 and 2003. The tables include net interest income earned on assets and liabilities of the mortgage banking business as well as an allocation of the funding benefit or cost associated with these balances. The net interest income component is included in net interest income in the consolidated statement of income. ----------------------------------------------------------------------------------------------------------------------- Increase (Decrease) Three months ended September 30 2004 2003 Amount % ----------------------------------------------------------------------------------------------------------------------- (in millions) Net interest income ............................................... $ 179 $ 104 $ 75 72.1 ------- ------- ------- ------- Servicing related income (expense): Servicing fee income ............................................ 20 15 5 33.3 MSRs amortization ............................................... (19) (44) 25 56.8 MSRs temporary impairment (provision) recovery .................. (95) 7 (102) (1,457.1) Trading - Derivative instruments used to offset changes in value of MSRs ................................................. 33 (98) 131 133.7 Gains on sales of available for sale securities ................. -- 7 (7) (100.0) ------- ------- ------- ------- Total net servicing related expense .......................... (61) (113) 52 46.0 ------- ------- ------- ------- Originations and sales related income (expense): (Losses) gains on sales of mortgages ............................ 1 (18) 19 105.6 Trading - Forward loan sale commitments ........................ (4) 55 (59) (107.3) - Interest rate lock commitments ....................... (3) (2) (1) (50.0) Fair value hedge activity (1) ................................... (1) 1 (2) (200.0) ------- ------- ------- ------- Total net originations and sales related income (expense) .... (7) 36 (43) (119.4) ------- ------- ------- ------- Other mortgage income ............................................. 4 3 1 33.3 ------- ------- ------- ------- Total residential mortgage banking expense included in other revenues ................................................... (64) (74) 10 13.5 ------- ------- ------- ------- Total residential mortgage banking related revenue ................ $ 115 $ 30 $ 85 283.3 ======= ======= ======= ======= (1) Includes SFAS 133 qualifying fair value adjustments related to residential mortgage banking warehouse fair value hedging activity. 31 ----------------------------------------------------------------------------------------------------------------------- Increase (Decrease) Nine months ended September 30 2004 2003 Amount % ----------------------------------------------------------------------------------------------------------------------- (in millions) Net interest income ............................................... $ 485 $ 320 $ 165 51.6 ------- ------- ------- ------- Servicing related income (expense): Servicing fee income ............................................ 60 50 10 20.0 MSRs amortization ............................................... (82) (129) 47 36.4 MSRs temporary impairment (provision) recovery .................. (82) (51) (31) (60.8) Trading - Derivative instruments used to offset changes in value of MSRs ................................................. 9 (83) 92 110.8 Gains on sales of available for sale securities ................. 8 22 (14) (63.6) ------- ------- ------- ------- Total net servicing related expense .......................... (87) (191) 104 54.5 ------- ------- ------- ------- Originations and sales related income (expense): (Losses) gains on sales of mortgages ............................ (7) 93 (100) (107.5) Trading - Forward loan sale commitments ........................ (1) 33 (34) (103.0) - Interest rate lock commitments ....................... (13) (24) 11 45.8 Fair value hedge activity (1) ................................... (2) -- (2) -- ------- ------- ------- ------- Total net originations and sales related income (expense) .... (23) 102 (125) (122.5) ------- ------- ------- ------- Other mortgage income ............................................. 5 9 (4) (44.4) ------- ------- ------- ------- Total residential mortgage banking expense included in other revenues ................................................... (105) (80) (25) (31.3) ------- ------- ------- ------- Total residential mortgage banking related revenue ................ $ 380 $ 240 $ 140 58.3 ======= ======= ======= ======= (1) Includes SFAS 133 qualifying fair value adjustments related to residential mortgage banking warehouse fair value hedging activity. Overview Increased residential mortgage banking related revenue for the third quarter and for the first nine months of 2004 was primarily due to increased net interest income and decreased net servicing related expense, which were partially offset by decreased net originations and sales related income. All increases and decreases referred to below for the third quarter and the first nine months of 2004 represent comparisons with the same 2003 periods. Net Interest Income Increased net interest income for the third quarter and for the first nine months of 2004 resulted from the mortgage loans acquired from Household and from originating lenders pursuant to a Household correspondent loan program, and from increased origination volumes in the held loan portfolio. Other mortgage portfolio increases were partially offset by lower interest rate spreads on originated mortgages and lower income on loans held for sale due to reduced levels of loans originated for sale. Refer to "Originations and Sales Related Income (Expense)" for further discussion of market factors. Commentary regarding residential mortgage interest income is presented on pages 26 through 27 of this Form 10-Q. Servicing Related Income (Expense) Decreased net servicing related expense for the third quarter and for the first nine months of 2004 resulted from increased servicing fee income, decreased MSRs amortization expense and increased income associated with derivative instruments used to offset changes in the economic value of MSRs. These were partially offset by increases in temporary impairment reserves. Normal amortization of MSRs decreased $25 million for the third quarter and decreased $47 million for the first nine months of 2004. 32 The recorded net book value of MSRs, as well as related MSRs amortization expense, are directly impacted by levels of residential mortgage prepayments. Higher levels of prepayments generally increase amortization expense and decrease the net book value of MSRs. Conversely, lower levels of prepayments generally decrease amortization expense and increase the net book value of MSRs. During 2004, prepayments of residential mortgages, mostly in the form of loan refinancings, have decreased in comparison with 2003 levels. Mortgage rates generally rose in the second quarter of 2004 from the historically low rates experienced in 2003, but declined in the third quarter of 2004. Loan refinance activity represented 52% of total originations through the first nine months of 2004, as compared with 78% in the first nine months of 2003. The reduction in amortization is also partially due to lower MSRs balances in 2004, as compared with 2003. The positive impacts on amortization and trading revenue for 2004 were offset by increases in the temporary impairment valuation allowance, which resulted from a combination of lower interest rates and changes resulting from the Company's ongoing review of assumptions used in its MSRs valuation model. The net servicing related expense amounts in the tables do not reflect approximately $6 million of unrealized losses, recorded as other comprehensive income, on available for sale securities used to offset changes in the economic value of MSRs as well as net interest income of $16 million on these securities. Additional commentary regarding risk management associated with the MSRs hedging program is presented on pages 51 through 52 of this Form 10-Q. Originations and Sales Related Income (Expense) The overall decrease in originations and sales related income in the first nine months of 2004 reflects decreased gains realized on sales of mortgages due mainly to significantly lower volume of loans originated with the intention to sell as well as lower gains recorded on each sale transaction. During the first nine months of 2004, residential mortgages originated with the intention to sell declined 66% from the same 2003 period, as a direct result of lower mortgage refinancings and a larger proportion of adjustable rate mortgage originations in 2004, which are generally held on the Bank's balance sheet. In the low interest rate environment that existed prior to 2004, customers tended to refinance with fixed rate loans, which are generally sold. As interest rates have risen during 2004, and refinancing activity has decreased, origination of fixed rate loans originated for sale also has decreased. General market conditions and industry factors have affected the ability of lenders to recognize the same level of gains in 2004 when compared to 2003. During 2003, the market demand for residential mortgages far outweighed the supply of such mortgages originated by lenders, which drove up pricing and associated gains recorded on the sales. During 2004, due to lower mortgage refinancings and a contracting national mortgage originations market, the demand has weakened relative to supply, which in turn has returned pricing to more normalized levels and net gains associated with sales of mortgages. Secondary market gains on sales now reflect a more normalized environment when compared with unusually high levels of 2003. The adoption of Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 105, Applications of Accounting Principles to Loan Commitments (SAB 105), effective April 1, 2004, also decreased originations and sales related income by approximately $22 million in the first nine months of 2004. This income is expected to be realized in future reporting periods. Trading Revenues Trading revenues are generated by the Company's participation in the foreign exchange, credit derivative and precious metals markets; from trading derivative contracts, including interest rate swaps and options; and from trading securities. Trading revenues related to the mortgage banking business are included in residential mortgage banking revenue. See analysis of residential mortgage banking revenue for details. The following tables present trading related revenues by business for the three months and nine months ended September 30, 2004 and 2003. The data in the table includes interest income earned on trading instruments, net of allocated funding cost associated with the trading positions. The net interest income component is included in net interest income on the consolidated statement of income. 33 -------------------------------------------------------------------------------- Increase (Decrease) Three months ended September 30 2004 2003 Amount % ------------------------------------------------------------------------------- (in millions) Trading revenues ............... $ 21 $ 52 $ (31) (59.6) Net interest income ............ 24 18 6 33.3 ------- ------- ------- ------- Trading related revenues ....... $ 45 $ 70 $ (25) (35.7) ======= ======= ======= ======= Business: Derivatives and treasury ..... $ 2 $ 23 $ (21) (91.3) Foreign exchange ............. 27 32 (5) (15.6) Precious metals .............. 11 13 (2) (15.3) Other trading ................ 5 2 3 150.0 ------- ------- ------- ------- Trading related revenues ....... $ 45 $ 70 $ (25) (35.7) ======= ======= ======= ======= -------------------------------------------------------------------------------- Increase (Decrease) Nine months ended September 30 2004 2003 Amount % ------------------------------------------------------------------------------- (in millions) Trading revenues ............... $ 188 $ 212 $ (24) (11.3) Net interest income ............ 61 64 (3) (4.7) ------- ------- ------- ------- Trading related revenues ....... $ 249 $ 276 $ (27) (9.8) ======= ======= ======= ======= Business: Derivatives and treasury ..... $ 103 $ 138 $ (35) (25.4) Foreign exchange ............. 90 70 20 28.6 Precious metals .............. 39 52 (13) (25.0) Other trading ................ 17 16 1 6.3 ------- ------- ------- ------- Trading related revenues ....... $ 249 $ 276 $ (27) (9.8) ======= ======= ======= ======= All increases and decreases referred to below for the third quarter and the first nine months of 2004 represent comparisons with the same 2003 periods. Derivatives and Treasury Derivatives trading revenue decreased significantly in the third quarter and in the first nine months of 2004. Derivatives business lines were negatively impacted by decreased customer activity due primarily to a lower interest rate environment. Foreign Exchange Although revenue decreased slightly in the third quarter of 2004, the first nine months of 2004 was highlighted by improved foreign currency and banknotes trading results. 2003 trading activity was negatively impacted by the SARS scare and by the war in Iraq. 2004 activity reflects increased levels of customer activity and improved proprietary results. Precious Metals Decreased precious metals trading revenue in the third quarter and the first nine months of 2004 was primarily due to a significant default by a customer in Australia. Partially offsetting the loss in Australia were improved results in other domestic and foreign locations, driven by higher customer activity resulting from enhanced marketing efforts, and by higher proprietary revenue. 34 Security Gains, Net The following tables present realized security gains and losses included in the income statement for the three months and nine months ended September 30, 2004 and 2003. -------------------------------------------------------------------------------------------------------------- 2004 2003 ---------------------------------- ---------------------------------- Gross Gross Net Gross Gross Net Realized Realized Realized Realized Realized Realized Gains (Losses) Gains Gains (Losses) Gains -------------------------------------------------------------------------------------------------------------- (in millions) Three months ended September 30 Net security gains included in: Residential mortgage banking related revenue ................. $ -- $ -- $ -- $ 7 $ -- $ 7 Security gains, net .............. 19 (1) 18 2 -- 2 ------ ------ ------ ------ ------ ------ $ 19 $ (1) $ 18 $ 9 $ -- $ 9 ====== ====== ====== ====== ====== ====== Nine months ended September 30 Net security gains included in: Residential mortgage banking related revenue ................. $ 8 $ -- $ 8 $ 22 $ -- $ 22 Security gains, net .............. 66 (7) 59 57 (6) 51 ------ ------ ------ ------ ------ ------ $ 74 $ (7) $ 67 $ 79 $ (6) $ 73 ====== ====== ====== ====== ====== ====== Net realized gains on sales of available for sale securities increased $9 million in the third quarter and decreased $6 million in the first nine months of 2004, as compared to the same 2003 periods. Third quarter 2004 activity was highlighted by gains from sale of various debt, equity and asset backed securities, in anticipation of a downturn in long term interest rates. Proceeds of these sales were generally reinvested in U.S. Government agency sponsored securities. In the first nine months of 2004, security sales volume was significantly lower than the same 2003 period, due to the rising interest rate environment. Operating Expenses The following table presents the components of operating expenses for the three and nine months ended September 30, 2004 and 2003. For presentation purposes, amounts paid to HSBC group entities have been excluded from functional expense categories as included within the consolidated statement of income, and are presented as "HSBC group charges" in the table below. ------------------------------------------------------------------------------------------- Increase (Decrease) -------------------- Three months ended September 30 2004 2003 Amount % ------------------------------------------------------------------------------------------- (in millions) Salaries and employee benefits ............. $ 219 $ 291 $ (72) (24.7) Occupancy expense, net ..................... 43 42 1 2.4 Other expenses: Equipment and software ................... 26 38 (12) (31.6) Marketing ................................ 13 10 3 30.0 Outside services ......................... 24 30 (6) (20.0) Professional fees ........................ 14 18 (4) (22.2) Telecommunications ....................... 4 11 (7) (63.6) Postage, printing and office supplies .... 6 7 (1) (14.3) Insurance business ....................... 6 9 (3) (33.3) HSBC group charges ....................... 99 42 57 135.7 Other .................................... 26 25 1 4.0 ------- ------- ------- ------- Total other expenses ..................... 218 190 28 14.7 ------- ------- ------- ------- Total operating expenses ................... $ 480 $ 523 $ (43) (8.2) ======= ======= ======= ======= Personnel - average number ................. 11,108 13,466 (2,358) (17.5) 35 -------------------------------------------------------------------------------------------- Increase (Decrease) --------------------- Nine months ended September 30 2004 2003 Amount % -------------------------------------------------------------------------------------------- (in millions) Salaries and employee benefits ............. $ 714 $ 851 $ (137) (16.1) Occupancy expense, net ..................... 124 121 3 2.5 Other expenses: Equipment and software ................... 83 106 (23) (21.7) Marketing ................................ 34 30 4 13.3 Outside services ......................... 74 81 (7) (8.6) Professional fees ........................ 35 41 (6) (14.6) Telecommunications ....................... 13 30 (17) (56.7) Postage, printing and office supplies .... 18 22 (4) (18.2) Insurance business ....................... 17 25 (8) (32.0) HSBC group charges ....................... 291 103 188 182.5 Other .................................... 86 90 (4) (4.4) ------- ------- ------- ------- Total other expenses ..................... 651 528 123 23.3 ------- ------- ------- ------- Total operating expenses ................... $ 1,489 $ 1,500 $ (11) (.7) ======= ======= ======= ======= Personnel - average number ................. 11,634 13,513 (1,879) (13.9) All increases and decreases referred to below for the third quarter and the first nine months of 2004 represent comparisons with the same 2003 periods. Overview Total operating expenses decreased $43 million (8%) in the third quarter and decreased $11 million (1%) in the first nine months of 2004. Increases in various HSBC group charges were offset by a decrease in salaries and employee benefits, and by general decreases in several other expense categories. During 2003, certain equipment finance, commercial finance and U.S. factoring businesses were sold. In addition, during 2004, certain domestic and foreign operations were sold or transferred to affiliated HSBC group entities at fair value. These transactions effectively decreased operating expenses by approximately $36 million and $52 million in the third quarter and the first nine months of 2004, respectively. HSBC group charges include amounts paid to various HSBC group entities for information technology, loan origination and servicing, administrative and other operational support. During 2003 and into 2004, HSBC instituted certain organizational changes that resulted in employees and other aspects of operations being transferred to other HSBC group entities in North America. These other HSBC group entities in turn charge for services in accordance with service level agreements. These organizational changes have impacted the amounts recorded in various functional expense categories included in operating expenses on the consolidated statement of income. Direct expenses previously recorded in "salaries and employee benefits" and "occupancy expense, net" on the consolidated statement of income for 2003 are now recorded in "other expenses" for 2004. As a result, in the preceding table, the increase in HSBC group charges, as well as the decreases for salaries and employee benefits, equipment and software, and telecommunications expenses, primarily resulted from these organizational changes. Additional details regarding HSBC group charges are presented in Note 9 of the consolidated financial statements on pages 13 through 15 of this Form 10-Q. Total other expenses have increased in the first nine months of 2004 primarily due to increased charges by affiliated HSBC group entities for technology related, debt underwriting, broker-dealer, loan origination and servicing and other administrative services. During the remainder of 2004, the Company plans to maintain a relatively flat operating expense base while supporting new business initiatives and developing information systems conversions/upgrades. Continued benefit is expected from expense reduction initiatives, begun in 2003, including Household related synergies and global resourcing. 36 Ongoing business initiatives for the remainder of 2004 include: - hiring relationship managers and staff and opening new offices to support commercial middle market, small business and commercial real estate expansion - growing the emerging markets derivatives business - supporting planned expansion of our corporate investment banking business - opening new retail branches in selected growth markets Increased costs for independent audit fees and costs for implementing a Sarbanes-Oxley Section 404 compliance environment have been recorded in the first nine months of 2004 and are expected to continue through year end. Salaries and Employee Benefits The decrease in salaries and employee benefits in the third quarter and in the first nine months of 2004 was primarily due to the transfer of employees to affiliated HSBC group entities, to sales of various commercial lending business units in 2003, and to the sales or transfers of various subsidiaries to affiliated HSBC entities during 2004, as previously described. Additional decreases in salaries have resulted from ongoing efforts to integrate and centralize operations of various departments with those of Household. As a result of the organizational changes and other efforts, the average number of personnel employed directly by the Company has decreased during 2004, as compared with 2003. HSBC Group Charges Fees are charged by various related HSBC group entities for technology services, for underwriting and broker-dealer services, for loan origination and servicing, and for other operational and administrative support functions. As noted above, a significant number of employees were transferred to these entities during 2004. Fees charged by these entities in accordance with various service level agreements either began on January 1, 2004, or have increased during the year due to expansion of the services they provide. Technology related expenses have increased during 2004 as the Company has continued to upgrade its automated technology environment. Debt underwriting expenses have increased in 2004 due to a significant increase in debt issuances from the Company's new Global Bank Note Program. Origination and servicing expenses have increased due to increased services provided by Household related to residential mortgages and other consumer loans. Subject to regulatory approval, certain private label credit card receivables are expected to be purchased from Household by year end. Residual interests in certain securitized private label credit card receivable pools will also be acquired. Household will maintain the related customer relationships for the receivables purchased, and charge the Company for ongoing servicing of the accounts. The timing of regulatory approval, and therefore the timing of the asset transfers, cannot be predicted with any degree of certainty. 37 BUSINESS SEGMENTS Business segments are managed consistently with the line of business groupings used by HSBC. The segments are based upon customer groupings and products and services offered. These segments are described on page 30 of the 2003 Form 10-K. Prior period disclosures previously reported for 2003 have been conformed herein to the presentation of current segments, including methodology changes related to the transfer pricing of assets and liabilities. The following tables summarize the results for each segment for the three months and nine months ended September 30, 2004 and 2003. ------------------------------------------------------------------------------------------------------------------------ Corporate, Personal Investment Financial Commercial Banking and Private Services Banking Markets Banking Other Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Three months ended September 30 2004 Net interest income (1) ............... $ 379 $ 148 $ 140 $ 34 $ (3) $ 698 Other revenues ........................ 168 42 102 44 6 362 --------- --------- --------- --------- --------- --------- Total revenues ........................ 547 190 242 78 3 1,060 Operating expenses (2) ................ 240 79 106 55 -- 480 --------- --------- --------- --------- --------- --------- Working contribution .................. 307 111 136 23 3 580 Provision for credit losses (3) ....... 24 (13) 6 10 -- 27 --------- --------- --------- --------- --------- --------- Income before income tax expense ...... $ 283 $ 124 $ 130 $ 13 $ 3 $ 553 ========= ========= ========= ========= ========= ========= Average assets ........................ $ 49,490 $ 13,855 $ 47,294 $ 4,261 $ 298 $ 115,198 Average liabilities/equity (4) ........ 34,116 14,608 57,682 8,792 -- 115,198 Goodwill at September 30, 2004 (5) .... 1,155 485 631 428 -- 2,699 2003 Net interest income (1) ............... $ 296 $ 146 $ 162 $ 29 $ (4) $ 629 Other revenues ........................ 16 38 90 55 6 205 --------- --------- --------- --------- --------- --------- Total revenues ........................ 312 184 252 84 2 834 Operating expenses (2) ................ 234 117 109 63 -- 523 --------- --------- --------- --------- --------- --------- Working contribution .................. 78 67 143 21 2 311 Provision for credit losses (3) ....... 17 (2) (10) (6) -- (1) --------- --------- --------- --------- --------- --------- Income before income tax expense ...... $ 61 $ 69 $ 153 $ 27 $ 2 $ 312 ========= ========= ========= ========= ========= ========= Average assets ........................ $ 28,051 $ 14,403 $ 46,140 $ 2,954 $ 281 $ 91,829 Average liabilities/equity (4) ........ 31,376 13,483 38,690 8,280 -- 91,829 Goodwill at September 30, 2003 (5) .... 1,223 534 631 428 -- 2,816 (1) 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. (2) Expenses for the segments include fully apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. Credit loss reserves are established at a level sufficient to absorb the losses considered to be inherent in the portfolio. (4) Common shareholder's equity and earnings on common shareholder's equity are allocated back to the segments based on the percentage of capital assigned to the business. (5) The reduction in goodwill from September 30, 2003 to September 30, 2004 resulted from the sale or transfer of certain domestic and foreign operations during the fourth quarter of 2003 and the first nine months of 2004. 38 ------------------------------------------------------------------------------------------------------------------- Corporate, Personal Investment Financial Commercial Banking and Private Services Banking Markets Banking Other Total ------------------------------------------------------------------------------------------------------------------- (in millions) Nine months ended September 30 2004 Net interest income (1) ............. $ 1,081 $ 434 $ 439 $ 95 $ (8) $ 2,041 Other revenues ...................... 308 126 387 157 17 995 -------- -------- -------- -------- -------- -------- Total revenues ...................... 1,389 560 826 252 9 3,036 Operating expenses (2) .............. 718 249 346 176 -- 1,489 -------- -------- -------- -------- -------- -------- Working contribution ................ 671 311 480 76 9 1,547 Provision for credit losses (3) ..... 69 (8) (54) -- -- 7 -------- -------- -------- -------- -------- -------- Income before income tax expense .... $ 602 $ 319 $ 534 $ 76 $ 9 $ 1,540 ======== ======== ======== ======== ======== ======== Average assets ...................... $ 42,805 $ 13,500 $ 46,514 $ 3,899 $ 298 $107,016 Average liabilities/equity (4) ...... 33,060 14,128 50,809 9,019 -- 107,016 2003 Net interest income (1) ............. $ 892 $ 447 $ 467 $ 89 $ (12) $ 1,883 Other revenues ...................... 188 117 397 152 19 873 -------- -------- -------- -------- -------- -------- Total revenues ...................... 1,080 564 864 241 7 2,756 Operating expenses (2) .............. 692 316 311 181 -- 1,500 -------- -------- -------- -------- -------- -------- Working contribution ................ 388 248 553 60 7 1,256 Provision for credit losses (3) ..... 51 34 7 (6) -- 86 -------- -------- -------- -------- -------- -------- Income before income tax expense .... $ 337 $ 214 $ 546 $ 66 $ 7 $ 1,170 ======== ======== ======== ======== ======== ======== Average assets ...................... $ 27,950 $ 14,225 $ 45,538 $ 2,872 $ 281 $ 90,866 Average liabilities/equity (4) ...... 30,913 13,251 38,598 8,104 -- 90,866 (1) 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. (2) Expenses for the segments include fully apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. Credit loss reserves are established at a level sufficient to absorb the losses considered to be inherent in the portfolio. (4) Common shareholder's equity and earnings on common shareholder's equity are allocated back to the segments based on the percentage of capital assigned to the business. All increases and decreases referred to below for the third quarter and the first nine months of 2004 represent comparisons with the same 2003 periods. Personal Financial Services Income before income tax expense increased $222 million (364%) in the third quarter and increased $265 million (79%) in the first nine months of 2004. For both reporting periods, significant increases in net interest income and other revenues were partially offset by increases in operating expenses and provision for credit losses. Net interest income increased $83 million (28%) in the third quarter and increased $189 million (21%) in the first nine months of 2004, primarily due to increased residential mortgage and other consumer loan balances. Further analysis of increases in residential mortgage loans and other consumer loans is presented on pages 26-27 of this Form 10-Q. Other revenues increased $152 million (950%) in the third quarter and increased $120 million (64%) in the first nine months of 2004. Third quarter and nine month 2004 activity was highlighted by a $99 million gain on sale of certain credit card relationships to an affiliated HSBC entity, and a $45 million gain on sale of an equity investment. 39 Other revenues also include non-interest mortgage banking revenue, which increased by $10 million in the third quarter of 2004 and decreased by $25 million in the first nine months of 2004. Analysis of residential mortgage banking related revenue is presented on pages 31-33 of this Form 10-Q. Operating expenses increased $6 million (3%) in the third quarter and increased $26 million (4%) in the first nine months of 2004, primarily due to increased salary costs associated with the expansion of the residential mortgage business. The loan origination and servicing workforces have been increased during 2004 to accommodate business growth. Increased technology related costs also have contributed to overall expense increases. Decreases in expenses resulting from sales or transfers of certain subsidiaries to affiliated HSBC group entities during 2004 partially offset the overall expense increases. The provision for credit losses increased $7 million (41%) in the third quarter and increased $18 million (35%) in the first nine months of 2004, primarily due to increases in the allowance and provision for credit losses associated with the growing residential mortgage portfolio. Commercial Banking Income before income tax expense increased $55 million (80%) in the third quarter and increased $105 million (49%) in the first nine months of 2004. During 2002 and 2003, certain equipment finance, commercial finance and U.S. factoring business lines were exited or restructured resulting in office closings and sales of customer relationships. Certain receivables associated with these businesses were retained and have been decreasing throughout 2003 and 2004 as balances have run off. As a result of these transactions, reported amounts for the first nine months of 2003 for net interest income, operating expenses, and provision for credit losses all exceeded 2004 amounts. Net interest income increased $2 million in the third quarter and decreased $13 million in the first nine months of 2004. Excluding the effect of the commercial business sale transactions noted above, net interest income associated with the remaining commercial loan portfolios increased moderately in the third quarter and in the first nine months of 2004. 2004 has been highlighted by increases in commercial loan balances in remaining portfolios as well as increased commercial core deposit balances, especially in downstate New York. More favorable interest spreads associated with growing commercial loans and related core deposit balances also contributed to the overall increase in net interest income. Operating expenses decreased $38 million (32%) in the third quarter and decreased $67 million (21%) in the first nine months of 2004. Excluding the impact of the commercial business sale transactions noted above, operating expenses associated with remaining commercial lending operations decreased approximately $26 million in the third quarter and decreased approximately $39 million in the first nine months of 2004. The first nine months of 2004 has been highlighted by lower corporate cost allocations for employee benefits and restructuring expenses, and lower allocation of expenses from central units including credit and deposit services. The provision for credit losses decreased $11 million in the third quarter and decreased $42 million in the first nine months of 2004. Excluding the effect of the commercial business sale transactions noted above, the provision for credit losses associated with the remaining commercial loan portfolios decreased approximately $10 million in the third quarter and decreased approximately $22 million in the first nine months of 2004. The decrease in the provision for credit losses is due to general improvement in commercial credit quality, as evidenced by decreased nonaccruing loan balances, decreased criticized asset balances, decreased charge offs of commercial loan balances, and increased recoveries of commercial loans previously charged off. 40 Corporate, Investment Banking and Markets Income before income tax expense decreased $23 million (15%) in the third quarter and decreased $12 million (2%) in the first nine months of 2004. Net interest income decreased $22 million (14%) in the third quarter and decreased $28 million (6%) in the first nine months of 2004, primarily due to significantly increased interest paid on growing short-term borrowing and long-term debt balances for both reporting periods. Net interest rate spreads associated with earning assets and paying liabilities also tightened during the third quarter of 2004, contributing to the overall quarter and year-to-date decreases. Other revenues increased $12 million (13%) in the third quarter of 2004, as increased net gains on sales of available for sale investment securities, and increases in various credit-related and other fees, were partially offset by decreased non-interest trading revenues. Other revenues decreased $10 million (3%) in the first nine months of 2004. Decreased trading revenues were partially offset by increased gains on sales of securities, and increases in various credit-related and other fees. Operating expenses decreased $3 million (3%) in the third quarter and increased $35 million (11%) in the first nine months of 2004. Expense increases in the first nine months of 2004 reflect increased technology related costs, increased incentive compensation expenses and increased fees charged by affiliated HSBC group entities for brokerage and underwriting services. Third quarter expenses reflected lower technology expenses and incentive compensation expenses, as compared to previous 2004 quarters, as well as a decrease in the provision for off-balance sheet credit exposures, as compared with the same 2003 quarter. The provision for credit losses increased $16 million (160%) in the third quarter, but decreased $61 million (871%) in the first nine months of 2004. The year-to-date decrease in the provision reflects continuation of improvement in credit quality associated with commercial loan portfolios, as evidenced by decreased charge offs of loans and increased recoveries of loans previously charged off. Private Banking Income before income tax expense decreased $14 million (52%) in the third quarter, and increased $10 million (15%) in the first nine months of 2004. During the third quarter of 2003, a one time gain was recognized on the sale of private banking operations in a foreign subsidiary of the Bank. In addition, specific loan charge offs increased in the third quarter of 2004, leading to an increase in provision expense. 41 This information is provided by RNS The company news service from the London Stock Exchange

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