HSBC USA Q3 2005 10Q

HSBC Holdings PLC 14 November 2005 CONFORMED ================================================================================ 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, 2005 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| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X| At October 31, 2005, all voting stock (706 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 ......................... 21 Forward-Looking Statements .................................. 23 Executive Overview .......................................... 23 Basis of Reporting .......................................... 29 Results of Operations ....................................... 34 Business Segments ........................................... 46 Credit Quality .............................................. 54 Derivative Instruments and Hedging Activities ............... 58 Off-Balance Sheet Arrangements .............................. 60 Variable Interest Entities (VIEs) ........................... 61 Capital ..................................................... 63 Risk Management ............................................. 63 Item 3. Quantitative and Qualitative Disclosures About Market Risk ....... 68 Item 4. Controls and Procedures .......................................... 68 Part II OTHER INFORMATION -------------------------------------------------------------------------------- Item 6. Exhibits ......................................................... 69 Signature ................................................................. 70 2 Part I FINANCIAL INFORMATION Item 1. Consolidated Financial Statements -------------------------------------------------------------------------------- HSBC USA Inc. -------------------------------------------------------------------------------- C O N S O L I D A T E D S T A T E M E N T O F I N C O M E Three months ended September 30, Nine months ended September 30, 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------------------ (in millions) Interest income: Loans ................................................ $ 1,192 $ 779 $ 3,377 $ 2,060 Securities ........................................... 225 220 650 651 Trading assets ....................................... 73 43 193 114 Short-term investments ............................... 83 27 202 63 Other ................................................ 9 5 23 13 ------- ------- ------- ------- Total interest income .................................... 1,582 1,074 4,445 2,901 ------- ------- ------- ------- Interest expense: Deposits ............................................. 476 226 1,199 544 Short-term borrowings ................................ 87 49 205 100 Long-term debt ....................................... 258 101 720 216 ------- ------- ------- ------- Total interest expense ................................... 821 376 2,124 860 ------- ------- ------- ------- Net interest income ...................................... 761 698 2,321 2,041 Provision for credit losses .............................. 199 27 476 7 ------- ------- ------- ------- Net interest income after provision for credit losses .... 562 671 1,845 2,034 ------- ------- ------- ------- Other revenues: Trust income ......................................... 21 23 65 71 Service charges ...................................... 52 54 158 158 Other fees and commissions ........................... 192 110 481 341 Securitization revenue ............................... 30 -- 99 -- Other income ......................................... 25 200 180 283 Residential mortgage banking revenue (expense) ....... 31 (64) 41 (105) Trading revenues ..................................... 137 21 268 188 Security gains, net .................................. 17 18 105 59 ------- ------- ------- ------- Total other revenues ..................................... 505 362 1,397 995 ------- ------- ------- ------- Operating expenses: Salaries and employee benefits ....................... 257 219 778 714 Occupancy expense, net ............................... 49 42 134 124 Support services from HSBC affiliates ................ 213 99 649 291 Other expenses ....................................... 154 120 451 360 ------- ------- ------- ------- Total operating expenses ................................. 673 480 2,012 1,489 ------- ------- ------- ------- Income before income tax expense ......................... 394 553 1,230 1,540 Income tax expense ....................................... 142 214 450 551 ------- ------- ------- ------- Net income ............................................... $ 252 $ 339 $ 780 $ 989 ======= ======= ======= ======= The accompanying notes are an integral part of the consolidated financial statements. 3 HSBC USA Inc. -------------------------------------------------------------------------------- C O N S O L I D A T E D B A L A N C E S H E E T September 30, December 31, 2005 2004 ------------------------------------------------------------------------------------------------------- (in millions) Assets Cash and due from banks ............................................... $ 4,524 $ 2,682 Interest bearing deposits with banks .................................. 2,132 2,776 Federal funds sold and securities purchased under resale agreements ... 4,311 3,126 Trading assets ........................................................ 20,320 19,815 Securities available for sale ......................................... 15,917 14,655 Securities held to maturity (fair value $3,392 and $4,042) ............ 3,261 3,881 Loans ................................................................. 89,409 84,947 Less - allowance for credit losses .................................... 852 788 -------- -------- Loans, net ...................................................... 88,557 84,159 Properties and equipment, net ......................................... 531 594 Intangible assets, net ................................................ 394 352 Goodwill .............................................................. 2,694 2,697 Other assets .......................................................... 6,248 6,313 -------- -------- Total assets .......................................................... $148,889 $141,050 ======== ======== Liabilities Deposits in domestic offices: Noninterest bearing ................................................. $ 8,557 $ 7,639 Interest bearing .................................................... 56,155 50,069 Deposits in foreign offices: Noninterest bearing ................................................. 341 248 Interest bearing .................................................... 22,064 22,025 -------- -------- Total deposits .................................................. 87,117 79,981 -------- -------- Trading account liabilities ........................................... 11,202 12,120 Short-term borrowings ................................................. 9,324 9,874 Interest, taxes and other liabilities ................................. 4,610 4,370 Long-term debt ........................................................ 24,800 23,839 -------- -------- Total liabilities ..................................................... 137,053 130,184 -------- -------- Shareholders' equity Preferred stock ....................................................... 1,017 500 Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 706 shares issued) ............................ -- -- Capital surplus ..................................................... 8,136 8,418 Retained earnings ................................................... 2,668 1,917 Accumulated other comprehensive income .............................. 15 31 Total common shareholder's equity ............................... 10,819 10,366 -------- -------- Total shareholders' equity ............................................ 11,836 10,866 -------- -------- Total liabilities and shareholders' equity ............................ $148,889 $141,050 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 4 HSBC USA Inc. -------------------------------------------------------------------------------- C O N S O L I D A T E D S T A T E M E N T O F C H A N G E S I N S H A R E H O L D E R S' E Q U I T Y Nine months ended September 30, 2005 2004 --------------------------------------------------------------------------------------------------------------------- (in millions) Preferred stock Balance, January 1, ...................................................................... $ 500 $ 500 Preferred stock issuance ................................................................. 517 -- -------- -------- Balance, September 30, ................................................................... 1,017 500 -------- -------- Common stock Balance, January 1 and September 30, ..................................................... -- -- -------- -------- Capital surplus Balance, January 1, ...................................................................... 8,418 6,027 Capital contribution from parent ......................................................... 10 408 Preferred stock issuance costs ........................................................... (13) -- Employee benefit plans, including transfers and other .................................... (279) (21) -------- -------- Balance, September 30, ................................................................... 8,136 6,414 -------- -------- Retained earnings Balance, January 1, ...................................................................... 1,917 807 Net income ............................................................................... 780 989 Cash dividends declared: Preferred stock ...................................................................... (29) (17) Common stock ......................................................................... -- (125) -------- -------- Balance, September 30, ................................................................... 2,668 1,654 -------- -------- Accumulated other comprehensive income (loss) Balance, January 1, ...................................................................... 31 128 Net change in unrealized gains (losses) on securities .................................... (110) (45) Net change in unrealized gains (losses) on derivatives classified as cash flow hedges .... 93 (95) Net change in unrealized gains on interest only strip receivables ........................ 5 -- Foreign currency translation adjustments ................................................. (4) (3) -------- -------- Other comprehensive loss, net of tax ..................................................... (16) (143) -------- -------- Balance, September 30, ................................................................... 15 (15) -------- -------- Total shareholders' equity, September 30, ................................................ $ 11,836 $ 8,553 ======== ======== Comprehensive income Net income ............................................................................... $ 780 $ 989 Other comprehensive loss ................................................................. (16) (143) -------- -------- Comprehensive income ..................................................................... $ 764 $ 846 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 5 HSBC USA Inc. -------------------------------------------------------------------------------- C O N S O L I D A T E D S T A T E M E N T O F C A S H F L O W S Nine months ended September 30, 2005 2004 ------------------------------------------------------------------------------------------------------------------------ (in millions) Cash flows from operating activities Net income ...................................................................... $ 780 $ 989 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation, amortization and deferred taxes .............................. 570 314 Provision (credit) for credit losses ....................................... 476 7 Net change in other accrual accounts ....................................... 977 43 Net change in loans held for sale .......................................... (1,844) 1 Net change in trading assets and liabilities ............................... (1,454) (534) Other, net ................................................................. (595) (366) -------- -------- Net cash provided by (used in) operating activities ................... (1,090) 454 -------- -------- Cash flows from investing activities Net change in interest bearing deposits with banks .............................. 638 (1,330) Net change in short-term investments ............................................ (1,184) (3,848) Net change in securities available for sale: Purchases of securities available for sale ................................. (7,790) (8,971) Proceeds from sales of securities available for sale ....................... 3,299 4,195 Proceeds from maturities of securities available for sale .................. 3,074 4,568 Net change in securities held to maturity: Purchases of securities held to maturity ................................... (533) (821) Proceeds from maturities of securities held to maturity .................... 1,159 1,437 Net change in loans: Net change in credit card receivables ...................................... 11,918 (69) Net change in other short-term loans ....................................... (293) (743) Net originations and maturities of long-term loans ......................... (361) (15,716) Loans purchased from HSBC Finance Corporation .............................. (14,804) (3,068) Sales of loans and other ................................................... 51 132 Net change in tax refund anticipation loans program: Originations of loans ...................................................... (24,300) -- Sales of loans to HSBC Finance Corporation, including premium .............. 24,319 -- Net cash provided by (used for) sales (acquisitions) of properties and equipment ................................................... 41 (18) Net cash provided by (used for) acquisitions (disposals) of branches and subsidiaries ............................................................... (90) 196 Other, net ...................................................................... (546) (735) -------- -------- Net cash used in investing activities ................................. (5,402) (24,791) -------- -------- Cash flows from financing activities Net change in deposits .......................................................... 7,202 12,275 Net change in short-term borrowings ............................................. (550) 4,926 Net change in long-term debt: Issuance of long-term debt ................................................. 1,696 8,542 Repayment of long-term debt ................................................ (505) (720) Preferred stock issuance ........................................................ 517 -- Capital contribution from parent ................................................ 10 400 Other reductions of capital surplus ............................................. (13) (21) Dividends paid .................................................................. (23) (142) -------- -------- Net cash provided by financing activities ............................. 8,334 25,260 -------- -------- Net change in cash and due from banks ............................................... 1,842 923 Cash and due from banks at beginning of period ...................................... 2,682 2,534 -------- -------- Cash and due from banks at end of period ............................................ $ 4,524 $ 3,457 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 6 Notes to Consolidated Financial Statements Note 1. Organization and Basis of Presentation -------------------------------------------------------------------------------- HSBC USA Inc. is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. (HNAH), which is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC). HNAH's other principal indirect subsidiaries include: o HSBC Finance Corporation, a consumer finance company; o HSBC Markets (USA) Inc. (HSBC Markets), a holding company for investment banking and markets subsidiaries; o HSBC Technology & Services (USA) Inc. (HTSU), a provider of information technology services for HSBC affiliates; and o HSBC Bank Canada (HBCA), a Canadian banking subsidiary. The accompanying unaudited consolidated financial statements of HSBC USA Inc. and its subsidiaries (collectively, HUSI), including its principal subsidiary, HSBC Bank USA, National Association (HBUS), have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim financial information, 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 normal and recurring adjustments, considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. These unaudited interim financial statements should be read in conjunction with HUSI's Annual Report on Form 10-K for the year ended December 31, 2004 (the 2004 Form 10-K). Certain reclassifications have been made to prior period amounts to conform to the current period presentations. The accounting and reporting policies of HUSI are consistent, in all material respects, with those used to prepare the 2004 Form 10-K. 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 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. 7 Note 2. Securities -------------------------------------------------------------------------------- At September 30, 2005 and December 31, 2004, HUSI held no securities of any single issuer (excluding the U.S. Treasury, U.S. Government agencies, or U.S. Government sponsored enterprises) 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, 2005 Cost Gains Losses Value --------------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury ........................................... $ 451 $ -- $ (6) $ 445 U.S. Government sponsored enterprises(1) ................ 8,973 12 (183) 8,802 U.S. Government agency issued or guaranteed ............. 3,929 13 (48) 3,894 Obligations of U.S. states and political subdivisions ... 488 -- (6) 482 Asset backed securities ................................. 1,330 3 (3) 1,330 Other domestic debt securities .......................... 237 5 (1) 241 Foreign debt securities ................................. 662 8 (2) 668 Equity securities ....................................... 49 6 -- 55 -------- -------- -------- -------- $ 16,119 $ 47 $ (249) $ 15,917 ======== ======== ======== ======== Securities held to maturity: U.S. Treasury ........................................... $ 87 $ -- $ -- $ 87 U.S. Government sponsored enterprises(1) ................ 1,859 72 (6) 1,925 U.S. Government agency issued or guaranteed ............. 714 37 (2) 749 Obligations of U.S. states and political subdivisions ... 384 28 -- 412 Other domestic debt securities .......................... 166 3 (1) 168 Foreign debt securities ................................. 51 -- -- 51 -------- -------- -------- -------- $ 3,261 $ 140 $ (9) $ 3,392 ======== ======== ======== ======== --------------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair December 31, 2004 Cost Gains Losses Value --------------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury ........................................... $ 203 $ -- $ (3) $ 200 U.S. Government sponsored enterprises(1) ................ 8,136 47 (90) 8,093 U.S. Government agency issued or guaranteed ............. 3,029 32 (29) 3,032 Asset backed securities ................................. 1,122 3 (1) 1,124 Other domestic debt securities .......................... 990 6 (2) 994 Foreign debt securities ................................. 1,090 15 (2) 1,103 Equity securities ....................................... 64 49 (4) 109 -------- -------- -------- -------- $ 14,634 $ 152 $ (131) $ 14,655 ======== ======== ======== ======== Securities held to maturity: U.S. Treasury ........................................... $ 122 $ -- $ -- $ 122 U.S. Government sponsored enterprises(1) ................ 2,202 92 (11) 2,283 U.S. Government agency issued or guaranteed ............. 716 40 (2) 754 Obligations of U.S. states and political subdivisions ... 465 37 -- 502 Other domestic debt securities .......................... 231 6 (1) 236 Foreign debt securities ................................. 145 -- -- 145 -------- -------- -------- -------- $ 3,881 $ 175 $ (14) $ 4,042 ======== ======== ======== ======== (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). 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, 2005 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Government sponsored enterprises(1) ............ 312 $ (111) $ 5,882 49 $ (72) $ 1,782 U.S. Government agency issued or guaranteed ...... 294 (28) 2,498 75 (20) 467 All other securities ........ 105 (17) 1,576 25 (1) 85 ------- ------- ------- ------- ------- ------- 711 $ (156) $ 9,956 149 $ (93) $ 2,334 ======= ======= ======= ======= ======= ======= Securities held to maturity: U.S. Government sponsored enterprises(1) ............ 15 $ (3) $ 261 3 $ (3) $ 51 U.S. Government agency issued or guaranteed ...... 131 (2) 74 -- -- -- All other securities ........ -- -- -- 10 (1) 4 ------- ------- ------- ------- ------- ------- 146 $ (5) $ 335 13 $ (4) $ 55 ======= ======= ======= ======= ======= ======= ------------------------------------------------------------------------------------------------------------------------ Less Than One Year Greater Than One Year ------------------------------------------ ------------------------------------------ Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value December 31, 2004 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Government sponsored enterprises(1) ............ 78 $ (36) $ 3,118 51 $ (54) $ 1,344 U.S. Government agency issued or guaranteed ...... 62 (11) 646 115 (18) 532 All other securities ........ 32 (9) 687 21 (3) 103 ------- ------- ------- ------- ------- ------- 172 $ (56) $ 4,451 187 $ (75) $ 1,979 ======= ======= ======= ======= ======= ======= Securities held to maturity: U.S. Government sponsored enterprises(1) ............ 8 $ (2) $ 163 12 $ (9) $ 247 U.S. Government agency issued or guaranteed ...... 4 (1) 27 3 (1) 34 All other securities ........ 7 (1) 5 -- -- -- ------- ------- ------- ------- ------- ------- 19 $ (4) $ 195 15 $ (10) $ 281 ======= ======= ======= ======= ======= ======= (1) Includes primarily mortgage-backed securities issued by FNMA and FHLMC. Gross unrealized losses on securities available for sale increased during the nine months ended September 30, 2005 due to rising short-term and medium-term interest rates. Since substantially all of these securities are high credit grade (i.e., AAA or AA), and HUSI has the ability and intent to hold these securities until maturity or a market price recovery, these securities are not considered to be other than temporarily impaired. 9 Note 3. Loans -------------------------------------------------------------------------------- The following table shows the composition of the loan portfolio. -------------------------------------------------------------------------------------------------------- September 30, 2005 December 31, 2004 --------------------- --------------------- Held Held Total for Sale Total for Sale -------------------------------------------------------------------------------------------------------- (in millions) Commercial: Construction and other real estate ... $ 8,994 $ -- $ 8,281 $ -- Other commercial ..................... 16,136 -- 14,691 -- Consumer: Residential mortgages ................ 46,793 3,140 46,775 1,352 Credit card receivables .............. 14,285 -- 12,078 -- Other consumer loans ................. 3,201 402 3,122 393 ------- ------- ------- ------- Total loans ................................. $89,409 $ 3,542 $84,947 $ 1,745 ======= ======= ======= ======= In June 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties, with the intent of selling the loans to HSBC Markets. The increase in held for sale loans from December 31, 2004 to September 30, 2005 primarily resulted from this new activity. Note 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 ------------------ ------------------ 2005 2004 2005 2004 -------------------------------------------------------------------------------------------------------------- (in millions) Beginning balance .......................................... $ 790 $ 347 $ 788 $ 399 Allowance related to acquisitions and (dispositions), net .. -- (11) -- (20) Charge offs ................................................ 202 43 607 107 Recoveries ................................................. 65 20 195 61 ----- ----- ----- ----- Net charge offs ...................................... 137 23 412 46 ----- ----- ----- ----- Provision charged to income ................................ 199 27 476 7 ----- ----- ----- ----- Ending balance ............................................. $ 852 $ 340 $ 852 $ 340 ===== ===== ===== ===== The 2005 provision for credit losses and levels of allowance for credit losses reflect the impact of the acquisition of domestic private label receivables from HSBC Finance Corporation in December 2004 as well as the impact of loans and receivables growth during 2005. Additionally, the provision for the third quarter of 2005 and overall allowance levels at September 30, 2005 include an incremental provision of $26 million relating to Hurricane Katrina. Further analysis of the allowance for credit losses and credit quality begins on page 54 of this Form 10-Q. Note 5. Intangible Assets, Net -------------------------------------------------------------------------------- The following table summarizes the composition of intangible assets. ------------------------------------------------------------------------------------------------------------------ September 30, December 31, 2005 2004 ------------------------------------------------------------------------------------------------------------------ (in millions) Mortgage servicing rights, net of accumulated amortization and valuation allowance ... $346 $309 Other ................................................................................ 48 43 ---- ---- Intangible assets, net ............................................................... $394 $352 ==== ==== 10 Mortgage Servicing Rights (MSRs) The following table summarizes activity for MSRs and the related valuation allowance. Three Months Nine Months Ended September 30 Ended September 30 ------------------ ------------------ 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------- (in millions) MSRs, net of accumulated amortization: Beginning balance ............................... $ 394 $ 437 $ 416 $ 526 Additions related to loan sales ................. 30 14 62 49 Net MSRs acquisitions (sales) ................... -- -- -- (53) Permanent impairment charges .................... (4) (8) (21) (15) Amortization .................................... (18) (19) (55) (83) ----- ----- ----- ----- Ending balance .................................. 402 424 402 424 ----- ----- ----- ----- Valuation allowance for MSRs: Beginning balance ............................... (109) -- (107) (23) Temporary impairment recovery (provision) ....... 49 (95) 30 (82) Permanent impairment charges .................... 4 8 21 15 Release of allowance related to MSRs sold ....... -- -- -- 3 ----- ----- ----- ----- Ending balance .................................. (56) (87) (56) (87) ----- ----- ----- ----- MSRs, net of accumulated amortization and valuation allowance ........................................... $ 346 $ 337 $ 346 $ 337 ===== ===== ===== ===== Normal amortization for the current MSRs portfolios is expected to be approximately $72 million for the year ending December 31, 2005, declining gradually to approximately $36 million for the year ending December 31, 2009. 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. Note 6. Goodwill -------------------------------------------------------------------------------- During the second quarter of 2005, HUSI 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. During the first nine months of 2005, there were no significant events or transactions which warranted specific consideration for their impact on recorded book values assigned to goodwill. Note 7. Income Taxes -------------------------------------------------------------------------------- The following table presents the effective tax rate for the three months and nine months ended September 30, 2005 and 2004 respectively. -------------------------------------------------------------------------------- Three Months Nine Months Ended September 30 Ended September 30 -------------------- -------------------- 2005 2004 2005 2004 -------------------------------------------------------------------------------- Effective tax rate ...... 36.0% 38.6% 36.6% 35.8% In the first quarter of 2005, HUSI finalized certain prior year state and local tax returns and recorded a $20 million reduction of income tax expense, which represents the difference between its previous estimate of tax liability and the liability per the tax returns. In addition, during the third quarter of 2005, HUSI revised its estimate of certain tax credits and recorded the effect of certain audit adjustments that resulted in a $9 million reduction in income tax expense. Excluding the impact of these adjustments, the effective tax rate for the third quarter and the first nine months of 2005 would have been 38.4% and 39.0% respectively. 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. 11 Note 8. Long-Term Debt -------------------------------------------------------------------------------- The following table presents a summary of long-term debt. -------------------------------------------------------------------------------- September 30, December 31, 2005 2004 -------------------------------------------------------------------------------- (in millions) Senior debt .................................. $19,062 $18,831 Subordinated debt ............................ 5,719 4,988 All other .................................... 19 20 ------- ------- Total long-term debt ......................... $24,800 $23,839 ======= ======= For a discussion of the components of long-term debt refer to Note 14, beginning on page 93 of HUSI's 2004 Form 10-K. In August 2005, HBUS issued $750 million of subordinated debt from its $20 billion Global Bank Note Program. The newly issued debt matures in August 2035 and pays interest at 5.625% per annum. Note 9. Preferred Stock -------------------------------------------------------------------------------- In April 2005, HUSI issued 20,700,000 shares of Series F, Floating Rate Non-Cumulative Perpetual Preferred stock with a stated value of $25 per share. Dividends are payable quarterly, beginning July 1, 2005 at .75% above three-month LIBOR, but not less than 3.50% per annum. The shares may be redeemed at the option of HUSI on or after April 7, 2010 at $25 per share, plus accrued dividends. Related issuance costs of $13 million have been recorded as a reduction of capital surplus. In October 2005, HUSI issued 373,750 shares of Floating Rate Non-Cumulative Perpetual Preferred Stock, represented by 14,950,000 depositary shares. Total proceeds, net of issuance costs, were approximately $365 million. 12 Note 10. Related Party Transactions -------------------------------------------------------------------------------- In the normal course of business, HUSI conducts transactions with HSBC and its subsidiaries (HSBC affiliates). These transactions occur at prevailing market rates and terms. All extensions of credit by HUSI to other HSBC affiliates are legally required to be secured by eligible collateral. The following table presents related party balances and the income and expense generated by related party transactions. --------------------------------------------------------------------------------------------------------------- September 30, December 31, 2005 2004 --------------------------------------------------------------------------------------------------------------- (in millions) Assets: Cash and due from banks ................................................ $ 119 $ 182 Interest bearing deposits with banks ................................... 77 283 Federal funds sold and securities purchased under resale agreements .... 147 47 Trading assets ......................................................... 5,490 3,167 Loans .................................................................. 1,158 1,378 Other .................................................................. 129 126 -------- -------- Total assets ........................................................... $ 7,120 $ 5,183 ======== ======== Liabilities: Deposits ............................................................... $ 9,036 $ 9,764 Trading account liabilities ............................................ 4,433 5,749 Short-term borrowings .................................................. 1,596 1,089 Long-term debt ......................................................... (31) (31) Other .................................................................. 98 58 -------- -------- Total liabilities ...................................................... $ 15,132 $ 16,629 ======== ======== ------------------------------------------------------------------------------------------------------------------------ Three Months Nine Months Ended September 30 Ended September 30 ----------------------- ----------------------- 2005 2004 2005 2004 ----------------------------------------------------------------------------------------------------------------------- (in millions) Interest income .......................................... $ 9 $ 6 $ 29 $ 13 Interest expense ......................................... 73 26 207 65 Trading losses ........................................... (285) (956) (2,039) (1,037) Other revenues ........................................... 19 118 79 141 Support services from HSBC affiliates: Fees paid to HTSU for technology services .......... 48 42 148 124 Fees paid to HSBC Finance Corporation .............. 102 8 307 19 Other fees, primarily treasury and traded markets services . 63 49 194 148 The following business transactions were conducted with HSBC Finance Corporation during 2005. o In December of 2004, approximately $12 billion of private label receivables and other loans were purchased from HSBC Finance Corporation. Retained interests in securitized private label credit card receivable pools of approximately $3 billion were also acquired. HSBC Finance Corporation retained the customer relationships and continues to service the loans. By agreement, HUSI is purchasing additional receivables generated under current and future private label accounts at fair value on a daily basis. During the first nine months of 2005, underlying customer balances included within the private label portfolio have revolved, and new relationships have been added, bringing the total private label portfolio balance to approximately $14 billion at September 30, 2005. Private label receivables were acquired from HSBC Finance Corporation at a total premium of $312 million during the first nine months of the year. 13 o During the first nine months of 2005, HUSI purchased approximately $1.5 billion of residential mortgage loans from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs. Total premiums paid to correspondents totaled $33 million, which is being amortized to interest income over the estimated life of the loans purchased. Purchases of residential mortgage loans from HSBC Finance Corporation correspondents were discontinued effective September 1, 2005 due to HUSI's increasing ability to originate similar products. o In July of 2004, in order to centralize the servicing of credit card receivables within a common HSBC affiliate in the United States, certain consumer MasterCard(1)/Visa(2) credit card customer relationships of HUSI were sold to HSBC Finance Corporation. A gain on this transaction was reported in other revenues in the third quarter of 2004. Receivable balances associated with these relationships were not sold as part of the transaction. New receivable balances generated by these relationships are purchased at fair value from HSBC Finance Corporation on a daily basis. During the first nine months of 2005, approximately $1.5 million of receivables associated with these relationships were purchased from HSBC Finance Corporation at a premium of approximately $25 million, which is being amortized to interest income over the estimated life of the receivables purchased. Servicing for these relationships was also transferred to HSBC Finance Corporation. o Support services from HSBC affiliates includes charges by HSBC Finance Corporation under various service level agreements for loan origination and servicing as well as other operational and administrative support. o Effective October 1, 2004, HBUS is the originating lender for loans initiated for HSBC Finance Corporation's Taxpayer Financial Services business for clients of various third party tax preparers. By agreement, HBUS processes applications, funds and subsequently sells these loans to HSBC Finance Corporation. Approximately $24 billion of loans were originated by HBUS and immediately sold to HSBC Finance Corporation during the first nine months of 2005, primarily during the first two quarters, resulting in gains of approximately $19 million and fees paid to HSBC Finance Corporation of $4 million. o At September 30, 2005, HUSI had a $2 billion line of credit from HSBC Finance Corporation, of which $1 billion was outstanding and included in short-term borrowings. The interest rate is comparable to third party rates for a line of credit with similar terms. o Trading losses primarily represent the mark to market of the intercompany components of interest rate and foreign currency derivative swap transactions entered into with HSBC Finance Corporation, which are substantially offset by the mark to market of related contracts entered into with third parties that are not reflected in the table on the preceding page. Specifically, HSBC Finance Corporation enters into these swap contracts with HUSI in order to hedge its interest rate positions. HUSI, within its Corporate, Investment Banking and Markets business, accounts for these transactions on a mark to market basis. HTSU charges HUSI for technology services pursuant to a master service level agreement. These charges are included in other expenses as HSBC affiliate charges. The following business transactions were conducted with HSBC Markets during 2005. o HUSI utilizes HSBC Markets for debt underwriting, customer referrals and for other treasury and traded markets related services, pursuant to service level agreements. Debt underwriting fees charged by HSBC Markets are deferred as a reduction of long-term debt and amortized to interest expense over the life of the related debt. Customer referral fees paid to HSBC Markets are netted against customer fee income, which is included in other fees and commissions. All other fees charged by HSBC Markets are included in support services from HSBC affiliates. ---------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated. (2) Visa is a registered trademark of Visa USA, Inc. 14 o In June 2005, HUSI began acquiring residential mortgage loans, excluding servicing, from unaffiliated third parties and subsequently selling these acquired loans to HSBC Markets. HUSI maintains no ownership interest in the residential mortgage loans after sale, and maintains no beneficial interest in the securitization vehicle. Since inception of this program, HUSI has acquired approximately $2 billion of residential mortgage loans, which it subsequently sold to HSBC Markets for total gains on sale of approximately $2 million. At September 30, 2005, HUSI had an unused line of credit from HSBC of $1,500 million. The interest rate is comparable to third party rates for a line of credit with similar terms. HUSI has extended loans and lines of credit to various other HSBC affiliates of $1,295 million, of which $288 million was outstanding at September 30, 2005. Interest rates are comparable to third party rates for lines of credit with similar terms. At September 30, 2005 and December 31, 2004, the aggregate notional amounts of all derivative contracts with other HSBC affiliates were approximately $479 billion and $302 billion respectively. The net credit risk exposure related to these contracts was approximately $4 billion at September 30, 2005 and $2 billion at December 31, 2004. Employees of HUSI participate in one or more stock compensation plans sponsored by HSBC. HUSI's share of the expense of the plans for the first nine months of 2005 and 2004 was $31 million and $46 million respectively. HUSI's share of expense has been reduced during 2005, resulting from a change in the amortization period utilized for share-based compensation in the CIBM business segment. A description of these plans begins on page 99 of HUSI's 2004 Form 10-K. Note 11. Pledged Assets -------------------------------------------------------------------------------- The following table presents pledged assets included in the consolidated balance sheet. -------------------------------------------------------------------------------- September 30, December 31, 2005 2004 -------------------------------------------------------------------------------- (in millions) Interest bearing deposits with banks ............. $ 1,062 $ 767 Trading assets ................................... 1,255 305 Securities available for sale .................... 5,648 6,096 Securities held to maturity ...................... 399 655 Loans ............................................ 6,034 5,971 ------- ------- Total ............................................ $14,398 $13,794 ======= ======= Securities available for sale are primarily pledged against various short-term borrowings. Loans are primarily residential mortgage loans pledged against long-term borrowings from the Federal Home Loan Bank. Note 12. Pensions and Other Postretirement Benefits -------------------------------------------------------------------------------- Through December 31, 2004, HUSI maintained noncontributory defined benefit pension plans covering substantially all of their employees hired prior to January 1, 1997 and those employees who joined HUSI through acquisitions and were participating in a defined benefit plan at the time of acquisition. Certain other HSBC affiliates participate in these plans. In addition, through December 31, 2004, HUSI also maintained unfunded noncontributory health and life insurance coverage for all employees who retired from HUSI and were eligible for immediate pension benefits from HUSI'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 HUSI's share of retiree medical cost. In November 2004, sponsorship of the U.S. defined benefit pension plans and the health and life insurance plan of HUSI and HSBC Finance Corporation were transferred to HNAH. Effective January 1, 2005, the separate U.S. defined benefit pension plans were merged into a single defined benefit pension plan which facilitates the development of a unified employee benefit policy and unified employee benefit plan administration for HSBC 15 affiliates operating in the U.S. As a result, HUSI's prepaid pension asset of $482 million, and a related deferred tax liability of $203 million, were transferred to HNAH. The net transfer amount of $279 million is reflected as a reduction of capital surplus on the consolidated statement of changes in shareholders' equity. The following table presents the components of net periodic benefit cost as allocated to HUSI from HNAH. --------------------------------------------------------------------------------------- Other Postretirement Pension Benefits Benefits ---------------- --------------- 2005 2004 2005 2004 --------------------------------------------------------------------------------------- (in millions) Three months ended September 30: Net periodic benefit cost: Service cost ...................... $ 7 $ 7 $ -- $ -- Interest cost ..................... 16 17 2 1 Expected return on plan assets .... (22) (24) -- -- Prior service cost amortization ... -- -- -- -- Actuarial loss .................... 1 7 -- -- Transition amount amortization .... -- -- 1 -- ---- ---- ---- ---- Net periodic benefit cost ......... $ 2 $ 7 $ 3 $ 1 ==== ==== ==== ==== Nine months ended September 30: Net periodic benefit cost: Service cost ...................... $ 20 $ 23 $ 1 $ 1 Interest cost ..................... 47 51 5 5 Expected return on plan assets .... (68) (72) -- -- Prior service cost amortization ... 1 1 -- -- Actuarial loss .................... 4 20 -- -- Transition amount amortization .... -- -- 2 2 ---- ---- ---- ---- Net periodic benefit cost ......... $ 4 $ 23 $ 8 $ 8 ==== ==== ==== ==== HUSI expects to make no contribution for pension benefits and to contribute approximately $12 million for other postretirement benefits during fiscal year 2005. Note 13. Business Segments -------------------------------------------------------------------------------- HUSI has five distinct segments that it utilizes for management reporting and analysis purposes, which are consistent with the line of business groupings used by HSBC. The segments are based upon customer groupings, as well as products and services offered. The segments are described in the following paragraphs. The Personal Financial Services (PFS) Segment This segment provides a broad range of financial products and services including installment and revolving term loans, deposits, branch services, mutual funds, investments and insurance. These products are marketed to individuals primarily through the branch banking network. Residential mortgage lending provides loan financing through direct retail and wholesale origination channels. Mortgage loans are originated through a network of brokers, wholesale agents and retail origination offices. Servicing is performed for the individual mortgage holder or on a contractual basis for mortgages owned by third parties. The PFS segment continues to include MasterCard/Visa credit card receivables acquired on a daily basis, related to account relationships which HUSI sold to HSBC Finance Corporation in 2004. The Consumer Finance (CF) Segment Effective for the first quarter of 2005, HUSI formed a new business segment, Consumer Finance (CF), which was reported as a component of PFS in prior periods. The CF segment includes point of sale and other lending activities primarily to meet the financial needs of individuals. Specifically, operating activity within the CF segment relates to various consumer loans, private label credit card receivables, and retained interests in securitized receivable trusts purchased from HSBC Finance Corporation, as well as consumer loans purchased from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs. 16 The Commercial Banking (CMB) Segment This segment provides loan and deposit products to small businesses and middle-market corporations including specialized products such as real estate financing. Various credit and trade related products are also offered such as standby facilities, performance guarantees and acceptances. These products and services are offered through multiple delivery systems, including the branch banking network. The Corporate, Investment Banking and Markets (CIBM) Segment This segment is comprised of Corporate/Institutional Banking (CIB) and Investment Banking and Markets (IBM). CIB provides deposit and lending functionality to large and multi-national corporations and banks. U.S. dollar clearing services are offered for domestic and international wire transfer transactions. Credit and trade related products such as standby facilities, performance guarantees and acceptances are also provided by CIB to large corporate entities. The IBM component includes treasury and traded markets. The treasury function maintains overall responsibility for the investment and borrowing of funds to ensure liquidity, manage interest rate risk and capital at risk. Traded markets encompasses the trading and sale of foreign exchange, banknotes, derivatives, precious metals, securities and emerging markets instruments, both domestically and internationally. The Private Banking (PB) Segment This segment offers a full range of services for high net worth domestic and foreign individuals including deposit, lending, trading, trust, branch services, mutual funds, insurance and investment management. Other Segment This segment includes equity investments in Wells Fargo HSBC Trade Bank N.A. and HSBC Republic Bank (Suisse) S.A. 17 The following table summarizes the results for each segment. The net interest income component in the table reflects actual interest earned, net of cost of funds as determined by corporate transfer pricing methodology. Effective January 2005, HUSI enhanced its funds transfer pricing methodology to better approximate current external market pricing and valuation, resulting in additional internal charges to the residential mortgage banking business, included in PFS, from CIBM. For comparability purposes, 2004 segment results were also restated, increasing CIBM revenues by $57 million for the third quarter and by $143 million for the first nine months of 2004, with the offsetting decrease to PFS revenues. Analysis of operating results for each segment begins on page 47 of this Form 10-Q. ----------------------------------------------------------------------------------------------------------------------- PFS CF CMB CIBM PB Other Total ----------------------------------------------------------------------------------------------------------------------- (in millions) Three months ended September 30: 2005 Net interest income(1) .. $ 300 $ 140 $ 172 $ 107 $ 45 $ (3) $ 761 Other revenues .......... 124 102 52 176 45 6 505 -------- -------- -------- -------- -------- -------- -------- Total revenues .......... 424 242 224 283 90 3 1,266 Operating expenses(2) ... 257 101 93 153 69 -- 673 -------- -------- -------- -------- -------- -------- -------- Working contribution .... 167 141 131 130 21 3 593 Provision for credit losses(3) ............. 23 176 7 (8) 1 -- 199 -------- -------- -------- -------- -------- -------- -------- Income (loss) before income tax expense .... $ 144 $ (35) $ 124 $ 138 $ 20 $ 3 $ 394 ======== ======== ======== ======== ======== ======== ======== Average assets .......... $ 48,655 $ 19,764 $ 16,200 $ 58,736 $ 4,999 $ 330 $148,684 Average liabilities/ equity(4) ............. 42,081 343 18,302 78,290 9,674 (6) 148,684 Goodwill at September 30 (5). 1,164 -- 471 631 428 -- 2,694 2004 Net interest income(1) .. $ 274 $ 49 $ 145 $ 200 $ 33 $ (3) $ 698 Other revenues .......... 168 -- 41 104 44 5 362 -------- -------- -------- -------- -------- -------- -------- Total revenues .......... 442 49 186 304 77 2 1,060 Operating expenses(2) ... 239 4 75 106 56 -- 480 -------- -------- -------- -------- -------- -------- -------- Working contribution .... 203 45 111 198 21 2 580 Provision for credit losses(3) ............. 20 3 (5) 7 2 -- 27 -------- -------- -------- -------- -------- -------- -------- Income before income tax expense ........... $ 183 $ 42 $ 116 $ 191 $ 19 $ 2 $ 553 ======== ======== ======== ======== ======== ======== ======== Average assets .......... $ 44,731 $ 4,777 $ 13,783 $ 47,342 $ 4,265 $ 300 $115,198 Average liabilities/ equity(4) ............. 34,072 (5) 14,180 58,229 8,722 -- 115,198 Goodwill at September 30 (5). 1,167 -- 473 631 428 -- 2,699 (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, 2004 to September 30, 2005 resulted from the sale of branches during 2004. 18 ----------------------------------------------------------------------------------------------------------------------- PFS CF CMB CIBM PB Other Total ----------------------------------------------------------------------------------------------------------------------- (in millions) Nine months ended September 30: 2005 Net interest income(1) ... $ 902 $ 436 $ 481 $ 384 $ 127 $ (9) $ 2,321 Other revenues ........... 339 249 139 441 206 23 1,397 -------- -------- -------- -------- -------- -------- -------- Total revenues .......... 1,241 685 620 825 333 14 3,718 Operating expenses(2) ... 757 318 281 459 197 -- 2,012 -------- -------- -------- -------- -------- -------- -------- Working contribution .... 484 367 339 366 136 14 1,706 Provision for credit losses(3) ............. 67 437 6 (33) (1) -- 476 -------- -------- -------- -------- -------- -------- -------- Income (loss) before income tax expense .... $ 417 $ (70) $ 333 $ 399 $ 137 $ 14 $ 1,230 ======== ======== ======== ======== ======== ======== ======== Average assets .......... $ 49,824 $ 18,890 $ 15,614 $ 55,777 $ 4,956 $ 318 $145,379 Average liabilities/ equity(4) ............. 43,465 506 17,226 74,652 9,528 2 145,379 2004 Net interest income(1) .. $ 803 $ 135 $ 434 $ 582 $ 95 $ (8) $ 2,041 Other revenues .......... 308 -- 126 387 157 17 995 -------- -------- -------- -------- -------- -------- -------- Total revenues .......... 1,111 135 560 969 252 9 3,036 Operating expenses(2) ... 709 10 249 345 176 -- 1,489 -------- -------- -------- -------- -------- -------- -------- Working contribution .... 402 125 311 624 76 9 1,547 Provision for credit losses(3) ............. 63 6 (8) (54) -- -- 7 -------- -------- -------- -------- -------- -------- -------- Income before income tax expense ........... $ 339 $ 119 $ 319 $ 678 $ 76 $ 9 $ 1,540 ======== ======== ======== ======== ======== ======== ======== Average assets .......... $ 38,877 $ 3,928 $ 13,504 $ 46,510 $ 3,899 $ 298 $107,016 Average liabilities/ equity(4) ............. 33,063 (3) 14,131 50,806 9,019 -- 107,016 (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. 19 Note 14. New Accounting Pronouncements -------------------------------------------------------------------------------- In December 2004, FASB issued Statement of Financial Accounting Standards No. 123 (Revised), Share-Based Payment (SFAS 123R). SFAS 123R requires public entities to measure the cost of stock-based compensation based on the grant date fair value of the award, as well as other disclosure requirements. On March 28, 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin 107 which amended the compliance date to allow public companies to comply with the provisions of SFAS 123R at the beginning of their next fiscal year that begins after June 15, 2005, instead of the next reporting period as originally required by SFAS 123R. HUSI was substantially in compliance with SFAS 123R as of December 31, 2004, and will be entirely compliant by the required adoption date. The adoption of SFAS 123R therefore will not have a significant effect on operating results or cash flows. In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections: a replacement of APB Opinion No. 20 and FASB Statement 3 (SFAS No. 154) which requires companies to apply voluntary changes in accounting principles retrospectively whenever it is practicable. The retrospective application requirement replaces APB 20's requirement to recognize most voluntary changes in accounting principle by including the cumulative effect of the change in net income during the period the change occurs. Retrospective application will be the required transition method for new accounting pronouncements in the event that a newly-issued pronouncement does not specify transition guidance. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. In November 2005, the Financial Accounting Standards Board (FASB) issued Staff Position Nos. FAS 115-1 and FAS 124-1 (FSP 115-1 and FSP 124-1), The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, in response to Emerging Issues Task Force 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03-1). FSP 115-1 and FSP 124-1 provide guidance regarding the determination as to when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. FSP 115-1 and FSP 124-1 also include accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than temporary-impairments. These requirements are effective for annual reporting periods beginning after December 15, 2004. Adoption of the impairment guidance contained in FSP 115-1 and FSP 124-1 is not expected to have a material impact on HUSI's financial position or results of operations. 20 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) -------------------------------------------------------------------------------- HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES The following table shows the quarterly average balances of the principal components of assets, liabilities and shareholders' equity, together with their respective interest amounts and rates earned or paid, presented on a taxable equivalent basis. Three Months Ended September 30, -------------------------------------------------------------- 2005 2004 ----------------------------- ---------------------------- Balance Interest Rate* Balance Interest Rate* ----------------------------------------------------------------------------------------------------------------------- Assets (in millions) Interest bearing deposits with banks ................ $ 2,912 $ 25 3.42% $ 2,642 $ 11 1.60% Federal funds sold and securities purchased under resale agreements ................................... 6,375 58 3.61 4,132 16 1.56 Trading assets ...................................... 19,846 73 1.48 14,778 43 1.16 Securities .......................................... 19,309 230 4.73 18,566 224 4.80 Loans Commercial ...................................... 24,333 328 5.35 19,849 218 4.36 Consumer: Residential mortgages ...................... 47,250 580 4.91 41,250 504 4.89 Credit cards ............................... 14,020 216 6.11 1,129 23 7.99 Other consumer ............................. 3,416 68 7.87 2,300 34 5.92 --------- ------ ---- --------- ------ ---- Total consumer ................................ 64,686 864 5.30 44,679 561 4.99 --------- ------ ---- --------- ------ ---- Total loans ................................... 89,019 1,192 5.31 64,528 779 4.80 --------- ------ ---- --------- ------ ---- Other ............................................... 644 9 5.18 546 5 3.60 --------- ------ ---- --------- ------ ---- Total earning assets ................................ 138,105 $1,587 4.56% 105,192 $1,078 4.07% --------- ------ ---- --------- ------ ---- Allowance for credit losses ......................... (892) (339) Cash and due from banks ............................. 3,516 3,290 Other assets ........................................ 7,955 7,055 --------- --------- Total assets ........................................ $ 148,684 $ 115,198 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits .................................. $ 29,082 $ 91 1.24% $ 27,350 $ 44 0.64% Other time deposits ............................... 26,168 226 3.43 17,935 111 2.47 Deposits in foreign offices ......................... 22,218 159 2.84 22,197 71 1.27 --------- ------ ---- --------- ------ ---- Total interest bearing deposits ..................... 77,468 476 2.44 67,482 226 1.33 --------- ------ ---- --------- ------ ---- Short-term borrowings ............................... 12,520 87 2.74 10,019 49 1.92 Long-term debt ...................................... 24,307 258 4.21 10,454 101 3.85 --------- ------ ---- --------- ------ ---- Total interest bearing liabilities .................. 114,295 821 2.85 87,955 376 1.70 --------- ------ ---- --------- ------ ---- Net interest income / Interest rate spread .......... $ 766 1.71% $ 702 2.37% ------ ---- ------ ---- Noninterest bearing deposits ........................ 8,833 7,584 Other liabilities ................................... 13,779 11,646 Total shareholders' equity .......................... 11,777 8,013 --------- --------- Total liabilities and shareholders' equity .......... $ 148,684 $ 115,198 ========= ========= Net yield on average earning assets ................. 2.20% 2.65% ---- ---- Net yield on average total assets ................... 2.04 2.42 ==== ==== * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest for the third quarter of 2005 and 2004 included fees of $14 million and $21 million respectively. 21 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES The following table shows the year to date average balances of the principal components of assets, liabilities and shareholders' equity, together with their respective interest amounts and rates earned or paid, presented on a taxable equivalent basis. Nine Months Ended September 30, -------------------------------------------------------------- 2005 2004 ----------------------------- ---------------------------- Balance Interest Rate* Balance Interest Rate* ----------------------------------------------------------------------------------------------------------------------- Assets (in millions) Interest bearing deposits with banks ................ $ 3,555 $ 79 2.96% $ 2,230 $ 25 1.46% Federal funds sold and securities purchased under resale agreements ................................... 5,110 123 3.22 3,940 38 1.30 Trading assets ...................................... 19,028 193 1.35 15,011 114 1.01 Securities .......................................... 18,932 662 4.68 18,106 664 4.89 Loans Commercial ...................................... 23,302 867 4.97 19,298 598 4.14 Consumer: Residential mortgages ...................... 47,418 1,740 4.89 34,510 1,284 4.96 Credit cards ............................... 12,965 574 5.92 1,126 78 9.30 Other consumer ............................. 3,592 196 7.29 2,151 100 6.20 --------- ------ ---- --------- ------ ---- Total consumer ................................ 63,975 2,510 5.25 37,787 1,462 5.17 --------- ------ ---- --------- ------ ---- Total loans ................................... 87,277 3,377 5.17 57,085 2,060 4.82 --------- ------ ---- --------- ------ ---- Other ............................................... 614 23 4.98 526 13 3.39 --------- ------ ---- --------- ------ ---- Total earning assets ................................ 134,516 $4,457 4.43% 96,898 $2,914 4.02% --------- ------ ---- --------- ------ ---- Allowance for credit losses ......................... (890) (360) Cash and due from banks ............................. 3,657 3,197 Other assets ........................................ 8,096 7,281 --------- --------- Total assets ........................................ $ 145,379 $ 107,016 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits .................................. $ 28,398 $ 211 0.99% $ 27,250 $ 134 0.66% Other time deposits ............................... 24,214 551 3.04 14,837 228 2.05 Deposits in foreign offices ......................... 22,776 437 2.57 21,837 182 1.11 --------- ------ ---- --------- ------ ---- Total interest bearing deposits ..................... 75,388 1,199 2.13 63,924 544 1.14 --------- ------ ---- --------- ------ ---- Short-term borrowings ............................... 11,544 205 2.38 9,344 100 1.43 Long-term debt ...................................... 24,023 720 4.00 6,636 216 4.33 --------- ------ ---- --------- ------ ---- Total interest bearing liabilities .................. 110,955 2,124 2.56 79,904 860 1.44 --------- ------ ---- --------- ------ ---- Net interest income / Interest rate spread .......... $2,333 1.87% $2,054 2.58% ====== ==== ====== ==== Noninterest bearing deposits ........................ 9,077 7,470 Other liabilities ................................... 13,944 11,831 Total shareholders' equity .......................... 11,403 7,811 --------- --------- Total liabilities and shareholders' equity .......... $ 145,379 $ 107,016 ========= ========= Net yield on average earning assets ................. 2.32% 2.83% ---- ---- Net yield on average total assets ................... 2.15 2.56 ==== ==== * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest for the first nine months of 2005 and 2004 included fees of $33 million and $56 million respectively. 22 FORWARD-LOOKING STATEMENTS -------------------------------------------------------------------------------- The MD&A should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this Form 10-Q and with HUSI's 2004 Form 10-K. The MD&A may contain certain statements that may be forward-looking in nature within the meaning of the Private Securities Litigation Reform Act of 1995. HUSI's results may differ materially from those noted in the forward-looking statements. Words such as "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 may be made. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements which involve inherent risks and uncertainties and are based on current views and assumptions. A number of factors could cause actual results to differ materially from those contained in any forward-looking statements, such as the impact of natural disasters on the collectibility of receivables in the affected areas. For a list of important factors that may affect HUSI's actual results, see Cautionary Statement on Forward-Looking Statements in Part I, Item 1 of HUSI's 2004 Form 10-K. EXECUTIVE OVERVIEW -------------------------------------------------------------------------------- Net income decreased $87 million in the third quarter of 2005 and decreased $209 million in the first nine months of 2005 as compared with the same 2004 periods, primarily due to: o losses before taxes from the private label receivable portfolio acquired from HSBC Finance Corporation in December 2004, and from additional private label receivables acquired in 2005, caused by amortization of premiums paid, as reflected within the Consumer Finance (CF) segment. Amortization of these premiums were $180 million and $538 million for the third quarter and the first nine months of 2005 respectively; o an incremental third quarter provision for credit losses of $26 million within the CF segment related to Hurricane Katrina; o reduced income before taxes in the Corporate, Investment Banking and Markets (CIBM) segment resulting from the flattening yield curve and increased expenses associated with investment in business expansion initiatives; and o excluding the impact of Hurricane Katrina and the private label receivable portfolio acquired in December 2004, credit loss provisions increased modestly in the first nine months of 2005. Excluding the impact of the items noted above, 2005 has been highlighted by increases in year to date income before taxes in the Personal Financial Services (PFS), Commercial Banking (CMB) and Private Banking (PB) segments, due to: o successful rollout during 2005 of an enhanced deposit growth strategy; o significant expansion of residential mortgage, other consumer and commercial loan portfolios in 2004 and 2005 which, net of associated funding costs, have had a positive impact on 2005 earnings; o improvement in residential mortgage banking revenue, driven by increased values of mortgage servicing rights; and o gains realized on sales of certain assets during 2005. Further analysis of business segments begins on page 46 of this Form 10-Q. Private Label Loan Portfolio Purchases In December of 2004, HUSI acquired approximately $12 billion of private label receivables and other loans from HSBC Finance Corporation at fair value, without recourse. By agreement, HUSI is purchasing additional receivables generated under current and future private label credit card accounts at fair value on a daily basis. During 2005, underlying customer balances included within the private label portfolio have revolved, and new relationships have been added, bringing the total private label portfolio balance to $14 billion at September 30, 2005. Losses before income tax expense of $47 million and $175 million were realized from this portfolio for the three months and nine months ended September 30, 2005 respectively. Results have been negatively impacted by 23 significant amortization of the premium paid for these receivables. Further analysis regarding this acquired portfolio is included in the analysis of the CF segment, beginning on page 49 of this Form 10-Q. Hurricane Katrina In August 2005, Hurricane Katrina (Katrina) caused destruction and loss to individuals, businesses and public infrastructure. As of September 30, 2005, HUSI had $292 million (.3% of total loans) of credit card receivables and other loans outstanding with customers living in the Federal Emergency Management Agency (FEMA) designated Individual Assistance disaster areas(1) with approximately $99 million of these receivables secured by real estate. Assessment of the impact of Katrina on the collectibility of these receivables is continuing, but is complicated by the number of customers that have been displaced from their primary residence. Preliminary estimates of the potential impact to HUSI's businesses take into account a number of factors on which information is still being gathered such as: o how the current and long-term financial impact of the disaster on customers will affect future payment patterns; o the condition and value of any collateral supporting the amounts outstanding; and o the availability of insurance to cover losses on the underlying collateral. Based on the information currently available, HUSI has recorded an incremental provision for credit losses of $26 million at September 30, 2005, representing the best estimate of Katrina's impact on HUSI's loan portfolio. As these estimates are influenced by factors outside of HUSI's control, there is uncertainty inherent in these estimates, making it reasonably probable that they will change. As more information becomes available relating to the financial condition of HUSI's affected customers, the physical condition of the collateral for loans which are secured by real estate and the resultant impact on customer payment patterns, the estimate of credit loss exposure relating to Katrina will continue to be reviewed and any adjustments will be reported in earnings when they become known. In an effort to assist customers affected by the disaster, various programs have been initiated including extended payment arrangements and interest and fee waivers for up to 60 days for certain products depending upon customer circumstances. These interest and fee waivers totaled $4 million during the quarter. Additional interest and fee waivers of approximately $3 million are anticipated for the fourth quarter of 2005. Deposit Strategy and Growth Beginning in 2004, the deposit strategy for HUSI's retail network included a shifting emphasis toward building a deposit engine capable of generating significant balance growth over a three to five year period, across multiple markets and segments, utilizing multiple delivery systems. Specifically, the following were initiated: o full deployment of new personal and business checking and savings products; o emphasis on more competitive pricing with the introduction of high yielding products beginning in 2004; o retail branch expansion into new geographic markets; o improving delivery systems, including use of internet capabilities; o refining targeting of the affluent consumer population; o maintaining strong customer relationships; and o increasing deposits from, and improving retention of, existing customers. HUSI has experienced a successful rollout of its deposit strategy during 2005. Total deposits in domestic offices have increased $2.4 billion (7%) in the first nine months of the year across HUSI's retail network. ---------- (1) Customers in the Individual Assistance Counties, as defined by FEMA on the list last updated and published on September 9, 2005. 24 Balance Sheet Review Asset growth was managed to a more normalized level (less than 6%) during the first nine months of 2005, as compared with calendar year 2004. Total deposit growth of $7 billion during 2005 was the primary funding source for increased loans and short-term investments balances. Total loan growth of $4.5 billion during the first nine months of 2005 was highlighted by: o targeted growth in small business, middle market and real estate commercial lending portfolios; and o growth in private label credit card receivables, due partially to the addition of new private label relationships to the portfolio, and partially to declining balances required to be maintained in off-balance sheet securitized receivable trusts. HUSI utilizes borrowings from various sources to fund balance sheet growth, to meet cash and capital needs, and to fund investments in subsidiaries. Total long-term debt increased approximately $1 billion during the first nine months of 2005 to $25 billion at September 30, 2005. In August 2005, HBUS issued $750 million of subordinated debt from its $20 billion Global Bank Note Program. Total short-term borrowings decreased by less than $1 billion to $9 billion at September 30, 2005. Total deposits and borrowings from HSBC affiliates were $11 billion at September 30, 2005 and December 31, 2004. In April 2005, HUSI issued 20,700,000 shares of Series F, Floating Rate Non-Cumulative Perpetual Preferred stock with a stated value of $25 per share. In October 2005, HUSI issued 373,750 shares of Floating Rate Non-Cumulative Perpetual Preferred stock, represented by 14,950,000 depositary shares. Average earning assets and interest bearing liabilities increased significantly during the first nine months of 2005, as compared with the same 2004 period, primarily due to: o increased average residential mortgage loan balances from held portfolio growth in 2004; increased average credit card and other loan balances resulting from the private label receivable portfolio acquired in December 2004; o increased average commercial loan and deposit balances resulting from targeted growth in small business and middle-market commercial customers; and o increased average deposits, long-term debt and short-term borrowings balances, which were the primary funding sources for asset growth during 2004. Income Statement Review Increased net interest income in the first nine months of 2005 was primarily due to significantly increased average loan balances, the impact of which was partially offset by increased average deposits and long-term debt balances, and by amortization of premiums paid for acquiring private label receivables in 2004 and 2005. In addition, a flattening yield curve has resulted in tightening interest rate spreads associated with certain businesses, particularly within the CIBM segment. Further analysis of the components of net interest income begins on page 34 of this Form 10-Q. The provision for credit losses increased during the first nine months of 2005, as compared with the same 2004 period, due mainly to an additional provision associated with the private label receivable portfolios acquired in 2004 and 2005. During the third quarter of 2005, an incremental provision for credit losses related to Hurricane Katrina was also recorded. New bankruptcy legislation became effective in October 2005. As a result of changes in bankruptcy legislation, consumers nationwide filed bankruptcies in record numbers in recent months. HUSI's provision for the third quarter and allowance for credit losses at September 30, 2005 have not been materially impacted by the changed legislation. Further analysis of credit quality and the allowance for credit losses begins on page 54 of this Form 10-Q. 25 Other revenues increased in the first nine months of 2005, as compared with 2004, primarily due to: o new fee income and new securitization revenue associated with the acquired private label receivable portfolio; o increased residential mortgage banking revenue; o increased trading revenues; and o increased gains on sales of securities. Further analysis of other revenues begins on page 37 of this Form 10-Q. Operating expenses increased in the first nine months of 2005, as compared with 2004, primarily due to new fees charged by HSBC Finance Corporation for loan origination and servicing related to the private label receivable portfolio and other loans acquired from HSBC Finance Corporation in 2004 and 2005. Fees charged by HSBC affiliates for technology services, for broker-dealer services, and for other operational and administrative support functions have also increased. Increased expenses have also resulted from investment in expansion initiatives in various business segments, particularly CIBM. Further commentary regarding support services from HSBC affiliates is provided in Note 10 of the consolidated financial statements beginning on page 13 of this Form 10-Q. Further analysis of operating expenses begins on page 44 of this Form 10-Q. For the first nine months of 2005, income tax expense was reduced by the following items: o a $20 million reduction of expense recorded in the first quarter resulting from the difference between the previous estimate of tax liability for the prior year and the liability per the final tax returns; o a $9 million reduction of expense resulting from revised estimates of certain tax credits and the effect of certain audit adjustments; and o a reduction of taxable income for 2005. 26 The following tables present a summary of selected financial information for 2005 and 2004. ---------------------------------------------------------------------------------------------------------------------- Increase (Decrease) ----------------------- Three months ended September 30: 2005 2004 Amount % ---------------------------------------------------------------------------------------------------------------------- (in millions) Net interest income ......................................... $ 761 $ 698 $ 63 9 --------- --------- --------- --------- Trading revenues ............................................ 137 21 116 552 Residential mortgage banking revenue (expense) .............. 31 (64) 95 148 Securities gains, net ....................................... 17 18 (1) (6) Other income ................................................ 320 387 (67) (17) --------- --------- --------- --------- Total other revenues ........................................ 505 362 143 40 --------- --------- --------- --------- Operating expenses .......................................... 673 480 193 40 Provision (credit) for credit losses ........................ 199 27 172 637 --------- --------- --------- --------- Income before income tax expense ............................ 394 553 (159) (29) Income tax expense .......................................... 142 214 (72) (34) --------- --------- --------- --------- Net income .................................................. $ 252 $ 339 $ (87) (26) ========= ========= ========= ========= Balances at period end: Loans: Commercial loans ...................................... $ 25,130 $ 20,869 $ 4,261 20 Residential mortgages ................................. 46,793 42,958 3,835 9 Credit card receivables ............................... 14,285 1,127 13,158 1,168 Other consumer loans .................................. 3,201 2,086 1,115 53 --------- --------- --------- --------- Total loans ........................................... 89,409 67,040 22,369 33 Allowance for credit losses ........................... (852) (340) (512) (151) --------- --------- --------- --------- Loans, net of allowance ............................... 88,557 66,700 21,857 33 Total assets ................................................ 148,889 120,939 27,950 23 Total tangible assets ....................................... 146,146 118,195 27,951 24 Total deposits .............................................. 87,117 74,803 12,314 16 Short-term borrowings ....................................... 9,324 7,967 1,357 17 Long-term debt .............................................. 24,800 15,618 9,182 59 Common shareholder's equity ................................. 10,819 8,053 2,766 34 Tangible common shareholder's equity ........................ 8,074 5,336 2,738 51 Total shareholders' equity .................................. 11,836 8,553 3,283 38 Selected financial ratios: Total shareholders' equity to total assets, at period end ... 7.95% 7.07% Tangible common shareholder's equity to total tangible assets, at period end ............................. 5.52 4.51 Rate of return on average(1): Total assets .......................................... .67 1.17 Total common shareholder's equity ..................... 8.83 17.68 Net interest margin to average(1): Earning assets ........................................ 2.20 2.65 Total assets .......................................... 2.04 2.42 Average total shareholders' equity to average total assets(1) .................................................. 7.92 6.96 Cost:income ratio(1) ........................................ 53.15 45.28 (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 60 of the 2004 Form 10-K. 27 ---------------------------------------------------------------------------------------------------------------------- Increase (Decrease) ----------------------- Nine months ended September 30: 2005 2004 Amount % ---------------------------------------------------------------------------------------------------------------------- (in millions) Net interest income ......................................... $ 2,321 $ 2,041 $ 280 14 --------- --------- --------- --------- Trading revenues ............................................ 268 188 80 43 Residential mortgage banking revenue (expense) .............. 41 (105) 146 139 Securities gains, net ....................................... 105 59 46 78 Other income ................................................ 983 853 130 15 --------- --------- --------- --------- Total other revenues ........................................ 1,397 995 402 40 --------- --------- --------- --------- Operating expenses .......................................... 2,012 1,489 523 35 Provision (credit) for credit losses ........................ 476 7 469 6,700 --------- --------- --------- --------- Income before income tax expense ............................ 1,230 1,540 (310) (20) Income tax expense .......................................... 450 551 (101) (18) --------- --------- --------- --------- Net income .................................................. $ 780 $ 989 $ (209) (21) ========= ========= ========= ========= Balances at period end: Loans: Commercial loans ...................................... $ 25,130 $ 20,869 $ 4,261 20 Residential mortgages ................................. 46,793 42,958 3,835 9 Credit card receivables ............................... 14,285 1,127 13,158 1,168 Other consumer loans .................................. 3,201 2,086 1,115 53 --------- --------- --------- --------- Total loans ........................................... 89,409 67,040 22,369 33 Allowance for credit losses ........................... (852) (340) (512) (151) --------- --------- --------- --------- Loans, net of allowance ............................... 88,557 66,700 21,857 33 Total assets ................................................ 148,889 120,939 27,950 23 Total tangible assets ....................................... 146,146 118,195 27,951 24 Total deposits .............................................. 87,117 74,803 12,314 16 Short-term borrowings ....................................... 9,324 7,967 1,357 17 Long-term debt .............................................. 24,800 15,618 9,182 59 Common shareholder's equity ................................. 10,819 8,053 2,766 34 Tangible common shareholder's equity ........................ 8,074 5,336 2,738 51 Total shareholders' equity .................................. 11,836 8,553 3,283 38 Selected financial ratios: Total shareholders' equity to total assets, at period end ... 7.95% 7.07% Tangible common shareholder's equity to total tangible assets, at period end ............................. 5.52 4.51 Rate of return on average(1): Total assets .......................................... .72 1.23 Total common shareholder's equity ..................... 9.50 17.76 Net interest margin to average(1): Earning assets ........................................ 2.32 2.83 Total assets .......................................... 2.15 2.56 Average total shareholders' equity to average total assets(1) .................................................. 7.84 7.30 Cost:income ratio(1) ........................................ 54.10 49.04 (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 60 of the 2004 Form 10-K. The annualized rate of return and net interest margin ratios in the table above reflect high amortization of premiums associated with private label receivables acquired from HSBC Finance Corporation in December 2004. The initial premium paid for these receivables is heavily front loaded into 2005. Commentary regarding the private label receivable portfolio acquired, and the related premiums, is provided on pages 23-24 of this Form 10-Q. 28 BASIS OF REPORTING -------------------------------------------------------------------------------- HUSI's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP). International Financial Reporting Standards (IFRS) Because HSBC reports results in accordance with IFRS and IFRS results are used in measuring and rewarding performance of employees, HUSI management also separately monitors net income under IFRS (a non-U.S. GAAP financial measure). The following table reconciles HUSI's net income on a U.S. GAAP basis to net income on an IFRS basis: ----------------------------------------------------------------------------------------------------------------------- Three Months Ended Nine Months Ended September 30, 2005 September 30, 2005 ----------------------------------------------------------------------------------------------------------------------- (in millions) Net income - U.S. GAAP basis ............................................... $ 252 $ 780 Adjustments, net of tax: Securitizations .................................................... (1) 5 Derivatives and hedge accounting (including fair value adjustments) ... 5 15 Loan origination ...................................................... (5) (15) Loan impairment ....................................................... (2) (11) Stock-based compensation .............................................. (3) (11) Property .............................................................. (4) (15) Pension costs ......................................................... 2 3 Designation of financial assets through profit and loss ............... 1 2 ----- ----- Net income - IFRS basis ....................................................... $ 245 $ 753 ===== ===== Differences between U.S. GAAP and IFRS are as follows: Securitizations IFRS o The recognition of securitized assets is governed by a three-step process. The process may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows have been transferred to a third party, those securitized assets should be derecognized. - If the rights to the cash flows are retained but there is a contractual obligation to pay the cash flows to another party, the securitized assets should be derecognized if certain conditions are met, for example, where there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If it is determined that some significant risks and rewards of ownership have been transferred, but some significant risks and rewards have also been retained, it must be determined whether or not control has been retained. If it has not been retained, the asset should be derecognized. If control has been retained, an entity shall continue to recognize the asset to the extent of its continuing involvement. U.S. GAAP o SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over those securitized assets. o Control has been surrendered over transferred assets if and only if all of the following conditions are met: - The transferred assets have been put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. 29 - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. o Where HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the special purpose entity, HSBC recognizes this interest at fair value on sale of the assets. Derivatives and hedge accounting IFRS o Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values are obtained from quoted market prices in active markets, or by using valuation techniques, including recent market transactions, where an active market does not exist. Valuation techniques include discounted cash flow models and option pricing models as appropriate. All derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. o In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (i.e. the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (i.e. without modification or repackaging) or based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading profit or loss on inception of the derivative. If observable market data are not available, the initial increase in fair value indicated by the valuation model, but based on unobservable inputs, is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis, or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out. o Certain derivatives embedded in other financial instruments, such as the conversion option in a convertible bond, are treated as separate derivatives when their economic characteristics and risks are not clearly and closely related to those of the host contract, the terms of the embedded derivative are the same as those of a stand-alone derivative, and the combined contract is not designated at fair value through profit and loss. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. o Derivative assets and liabilities on different transactions are only netted if the transactions are with the same counterparty, a legal right of set-off exists, and the cash flows are intended to be settled on a net basis. o The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument, and if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. Where derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. Hedge Accounting: o It is HSBC's policy to document, at the inception of a hedging relationship, the relationship between the hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking the hedge. Such policies also require documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. Interest on designated qualifying hedges is included in "Net interest income". Fair value hedge: o Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair value of the asset or liability or group thereof that are attributable to the hedged risk. 30 o If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item for which the effective interest method is used is amortized to the income statement over the residual period to maturity. Cash flow hedge: - The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement. - Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect profit or loss. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability. - When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. Net investment hedge: - Hedges of net investments in foreign operations are accounted for similarly to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation. Hedge effectiveness testing: - To qualify for hedge accounting, IAS 39 requires that at the inception of the hedge and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness). Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis. - The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. The method an HSBC entity adopts for assessing hedge effectiveness will depend on its risk management strategy. - For fair value hedge relationships, HSBC entities utilize the cumulative dollar offset method or regression analysis as effectiveness testing methodologies. For cash flow hedge relationships, HSBC entities utilize the change in variable cash flow method or the cumulative dollar offset method using the hypothetical derivative approach. - For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For actual effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective. Derivatives that do not qualify for hedge accounting: - All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement. These gains and losses are reported in "Trading income", except where derivatives are managed in conjunction with financial instruments designated at fair value, in which case gains and losses are reported in "Net income from financial instruments designated at fair value". U.S. GAAP o The accounting under SFAS 133 "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39 as described above (from January 1, 2005). However, see below for discussion of the designation of financial assets and liabilities at fair value. o SFAS 133 permits the "shortcut method" of hedge effectiveness testing for certain transactions. Under this method, it may be assumed, at inception of the hedge, there is no ineffectiveness in the hedging of interest rate risk with an interest rate swap provided specific criteria are met. 31 Loan origination IFRS o Certain loan fee income and incremental directly attributable loan origination costs are amortized to the profit and loss account over the life of the loan as part of the effective interest calculation under IAS 39. U.S. GAAP o Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the profit and loss account over the life of the loan as an adjustment to interest income (SFAS 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) Loan impairment IFRS o Where there is evidence of impairment, based on statistical models using historic loss rates adjusted for economic conditions, portfolios of loans are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate and includes reasonably estimable recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. U.S. GAAP o Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery of these amounts, the loans are written off in full, or to recoverable value where collateral exists. The delinquency status, for example, the number of days payment is overdue, where write-off occurs is applied consistently across similar loan products as described in HSBC's credit guidelines. Where local regulators mandate the delinquency status at which write-off must occur for different retail products and these reasonably reflect estimable recoveries on individual loans, this basis of measuring impairment is reflected in U.S. GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. Stock-based compensation IFRS o IFRS 2 "Share-based Payment" requires that where annual bonuses are paid in restricted shares, whereby the employee must remain with HSBC for a fixed period in order to receive the shares, the award is expensed over that period. U.S. GAAP o In its U.S. GAAP reporting, under SFAS 123 "Accounting for Stock Based Compensation", HSBC has interpreted the service period as being the period to which the bonus relates. o For 2005 bonuses, awarded in early 2006, HSBC will follow SFAS 123 (revised 2004) "Share-Based Payment" ("SFAS 123R"). SFAS 123R is consistent with IFRS 2, requiring restricted bonuses be expensed over the period the employee must remain with HSBC. However, SFAS 123R only applies to awards made after the date of adoption, which HSBC has elected as July 1, 2005. Property IFRS o Under the transition rules of IFRS 1, HSBC has elected to freeze the value of its properties at their January 1, 2004 valuations. These are the "deemed cost" of properties under IFRSs and will not be revalued in the future. Properties held at historical or deemed cost are depreciated except for freehold land and leasehold leases greater than 500 years. Investment properties are not depreciated. o Investment properties are recognized at current market value with gains or losses recognized in net income for the period. 32 U.S. GAAP o U.S. GAAP does not permit revaluations of property, including investment property, although it requires recognition of asset impairment. Any realized surplus or deficit is, therefore, reflected in income on disposal of the property. Depreciation is charged on all properties based on cost. Pension costs IFRS o IAS 19, "Employee Benefits" requires pension liabilities to be assessed based on current actuarial assumptions and methods and pension assets to be measured at fair value. The net pension surplus or deficit, representing the difference between plan assets and liabilities, is recognized on the balance sheet. o As permitted by IAS 19 (revised 2004), HSBC elects to record all actuarial gains and losses on the pension surplus or deficit in the year they occur within the Statement of Recognized Income and Expense. U.S. GAAP o SFAS 87 "Employers' Accounting for Pensions" prescribes a similar method of actuarial valuation for pension liabilities and measurement of plan assets at fair value as IAS 39. o Where the accumulated benefit obligation (the value of benefits accrued based on employee service up to the balance sheet date) exceeds the value of plan assets, HSBC recognizes an additional minimum pension liability equal to this excess, as long as the excess is greater than any accrual already established for unfunded pension costs. o SFAS 87 does not permit recognition of all actuarial gains and losses in a performance statement other than the primary income statement. Under U.S. GAAP, HSBC elects to use the "corridor method", whereby actuarial gains and losses outside a certain range are recognized in the income statement, in equal amounts over the remaining service lives of current employees. That range is equal to 10% of the greater of plan assets and plan liabilities. The remaining additional minimum pension liability is recognized directly in other comprehensive income. Designation of financial assets and liabilities at fair value through profit and loss IFRS o Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to key management personnel; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. o Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it is made. Financial assets and financial liabilities are recognized using trade date accounting. o Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends, within "Net income from financial instruments designated at fair value". U.S. GAAP o There are no provisions to make such an election in U.S. GAAP similar to that in IAS 39. - Generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement under U.S. GAAP, they must meet the definition of trading securities in SFAS 115 "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities are generally reported at amortized cost under U.S. GAAP. 33 RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Net Interest Income The following table presents a summary of net interest income. -------------------------------------------------------------------------------- Increase (Decrease) ------------------- 2005 2004 Amount % -------------------------------------------------------------------------------- (in millions) Three months ended September 30: Interest income: Loans ....................... $ 1,192 $ 779 $ 413 53 Securities .................. 225 220 5 2 Trading assets .............. 73 43 30 70 Short-term investments ...... 83 27 56 207 Other ....................... 9 5 4 80 ------- ------- ------- ------- Total interest income ... 1,582 1,074 508 47 ------- ------- ------- ------- Interest expense: Deposits .................... 476 226 250 111 Short-term borrowings ....... 87 49 38 78 Long-term debt .............. 258 101 157 155 ------- ------- ------- ------- Total interest expense .. 821 376 445 118 ------- ------- ------- ------- Net interest income ............... $ 761 $ 698 $ 63 9 ======= ======= ======= ======= Nine months ended September 30: Interest income: Loans ....................... $ 3,377 $ 2,060 $ 1,317 64 Securities .................. 650 651 (1) -- Trading assets .............. 193 114 79 69 Short-term investments ...... 202 63 139 221 Other ....................... 23 13 10 77 ------- ------- ------- ------- Total interest income ... 4,445 2,901 1,544 53 ------- ------- ------- ------- Interest expense: Deposits .................... 1,199 544 655 120 Short-term borrowings ....... 205 100 105 105 Long-term debt .............. 720 216 504 233 ------- ------- ------- ------- Total interest expense .. 2,124 860 1,264 147 ------- ------- ------- ------- Net interest income ............... $ 2,321 $ 2,041 $ 280 14 ======= ======= ======= ======= 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 21-22 of this Form 10-Q. All increases and decreases referenced on the following pages for the third quarter and nine months of 2005 represent comparisons with the same 2004 periods. Interest Income - Loans Total interest income on loans increased $413 million (53%) in the third quarter of 2005 and increased $1,317 million (64%) in the first nine months of 2005. Average total loan balances increased 38% for the third quarter and 53% for the first nine months of 2005, resulting from significant increases in various consumer and commercial loan portfolios during 2004. In addition to significant organic residential mortgage loan growth during 2004, loans and receivables acquired directly from HSBC Finance Corporation, from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs, and from unrelated third parties have had a significant impact on interest income during 2005. Increases in average loan balances, and the resulting increases in interest income, were offset by significant amortization of premiums paid for the specific portfolios, most notably private label receivables acquired 34 from HSBC Finance Corporation in December 2004. Purchases of residential mortgage loans from HSBC Finance Corporation correspondents were discontinued effective September 1, 2005 due to HUSI's increasing ability to originate similar products. Credit Card Receivables Interest earned from credit card receivables increased $193 million (839%) in the third quarter of 2005, and increased $496 million (636%) in the first nine months of 2005. Average credit card receivable balances were $12 billion higher for the first nine months of 2005. In December 2004, HUSI acquired $12 billion of private label receivables and other loans from HSBC Finance Corporation. Total premiums paid for these receivables, which are being amortized against interest income over the estimated life of the related receivables, totaled $639 million. During the first nine months of 2005, underlying customer balances included within the private label portfolio have revolved, and new relationships have been added, bringing the total private label portfolio balance to $14 billion at September 30, 2005. By agreement, new receivables generated from these private label relationships are being acquired from HSBC Finance Corporation on a daily basis. Total premiums paid, which are being amortized against interest income over the estimated life of the related receivables, totaled $312 million for the first nine months of the year. HUSI continues to purchase additional private label credit card receivables on a daily basis from HSBC Finance Corporation, which continues to own the private label customer relationships noted above. During 2004, HUSI sold certain MasterCard/Visa credit card relationships to HSBC Finance Corporation. HUSI purchases receivables associated with these MasterCard/Visa relationships from HSBC Finance Corporation on a daily basis. Total premiums paid for these new receivables, which are being amortized against interest income over the estimated life of the related receivables, totaled $25 million. The average yields for credit card receivables and total loans were reduced in 2005 as a result of amortization of premiums paid for various credit card portfolios, as follows: ------------------------------------------------------------------------------------------------------ Three Months Ended Nine Months Ended September 30, 2005 September 30, 2005 ------------------ ------------------ Amount Rate Amount Rate ------------------------------------------------------------------------------------------------------ (in millions) Credit card receivables: Interest income, before premium amortization ......... $ 396 11.58% $ 1,112 11.94% Premium amortization ................................. (180) (5.47) (538) (6.02) ------- ----- ------- ----- Interest income, adjusted for premium amortization ... $ 216 6.11% $ 574 5.92% ======= ===== ======= ===== Total loans: Interest income, before premium amortization ......... $ 1,372 6.15% $ 3,915 6.03% Premium amortization ................................. (180) (.84) (538) (.86) ------- ----- ------- ----- Interest income, adjusted for premium amortization ... $ 1,192 5.31% $ 3,377 5.17% ======= ===== ======= ===== Residential Mortgage Loans Interest income earned from residential mortgage loans increased $76 million (15%) in the third quarter of 2005, and increased $456 million (36%) in the first nine months of 2005. HUSI significantly expanded the volume of adjustable rate residential mortgage loans originated during 2004, which were retained on the balance sheet. As a result, average residential mortgage loans held increased by approximately 37% for the first nine months of 2005. 35 Since the beginning of 2004, approximately $5.5 billion of residential mortgages have been purchased from HSBC Finance Corporation and from originating lenders pursuant to an HSBC Finance Corporation correspondent loan program. Purchases from these correspondents were discontinued effective September 1, 2005 due to HUSI's increasing ability to originate similar products. Originations of residential mortgage loans have decreased in 2005 as compared with 2004, due to the contracting national originations market. The increased average loan balances, and their positive effect on earnings, were partially offset by a year to date decrease in the average yield earned on residential mortgages during the first nine months of 2005. Despite rising interest rates, consumers continued to take advantage of lower coupon adjustable rate products, resulting in lower overall average yields. The residential mortgage loan portfolio is expected to remain relatively constant through the remainder of 2005. Loan originations of various adjustable rate products that previously would have been retained in the held loan portfolio are now being sold in the secondary market. Other Consumer Loans Interest earned from various other consumer lending programs increased $34 million (100%) in the third quarter of 2005, and increased $96 million (96%) in the first nine months of 2005. Average loan balances increased by 67% in the first nine months of 2005, primarily due to consumer loans purchased from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs. The average yield earned on consumer loans also increased due to the rising rate environment. Commercial Loans Interest income from commercial loans increased $110 million (50%) in the third quarter of 2005, and increased $269 million (45%) in the first nine months of 2005. Average commercial loan balances increased by 21% in the first nine months of 2005. The average yield earned on commercial loans also increased due to increases in HBUS's prime lending rate during 2005. Targeted growth in small business, middle market and real estate lending portfolios, which began in 2004, has continued to increase loan balances in 2005. HUSI plans to continue to build upon its status as the top small business lender in New York State. Interest Income - Trading Assets Interest income from trading assets increased $30 million (70%) in the third quarter of 2005, and increased $79 million (69%) in the first nine months of 2005. In the first nine months of 2005, average trading assets increased by 27% mainly as a result of various business expansion initiatives. Average yields earned on these balances also increased for the first nine months of 2005. Interest Income - Short-Term Investments Short-term investments include interest bearing deposits with banks and federal funds sold and securities purchased under resale agreements. Fluctuations in short-term investments directly result from the relationship between HUSI's excess liquidity position and its funding needs at any given point in time. Interest income from short-term investments increased $56 million (207%) in the third quarter of 2005, and increased $139 million (221%) in the first nine months of 2005. Average short-term investment balances grew by 40% the first nine months of 2005, while average rates earned also increased significantly, primarily due to increases in the federal funds rate. 36 Interest Expense - Deposits Total interest expense on interest bearing deposits increased $250 million (111%) in the third quarter of 2005, and increased $655 million (120%) in the first nine months of 2005. Interest expense increased for both domestic and foreign deposits. Average interest bearing deposits increased by 18% in the first nine months of 2005. Average interest rates paid to these customers also increased significantly, due to increases in short-term interest rates and to introduction of more competitively priced consumer and commercial products. An overview of deposit growth initiatives is provided on page 24 of this Form 10-Q. Interest Expense - Short-Term Borrowings Interest expense on short-term borrowings increased $38 million (78%) in the third quarter of 2005, and increased $105 million (105%) in the first nine months of 2005. Average short-term borrowings balances increased by 24% in the first nine months of 2005, while the average interest rate paid also increased significantly, due primarily to increases in the federal funds rate. Interest Expense - Long-Term Debt Interest expense on long-term debt increased $157 million (155%) in the third quarter of 2005, and increased $504 million (233%) in the first nine months of 2005. Average long-term debt balances increased by 262% in the first nine months of 2005, due primarily to new debt issued during the second half of 2004 to fund balance sheet growth. A decrease in the average interest rate paid on long-term debt in the first nine months of 2005, which resulted from new debt being issued at significantly lower rates than existing debt, partially offset the average balance increases. Other Revenues The following table presents the components of other revenues. ------------------------------------------------------------------------------------------------------------ Increase (Decrease) ---------------- 2005 2004 Amount % ------------------------------------------------------------------------------------------------------------ (in millions) Three months ended September 30: Trust income .............................................. $ 21 $ 23 $ (2) (9) Service charges: HSBC affiliate income ................................. 4 4 -- -- Other service charges ................................. 48 50 (2) (4) ----- ----- ----- ----- Total service charges ................................. 52 54 (2) (4) ----- ----- ----- ----- Other fees and commissions: Letter of credit fees ................................. 18 18 -- -- Credit card fees ...................................... 93 20 73 365 Wealth and tax advisory services ...................... 15 10 5 50 HSBC affiliate income ................................. 12 14 (2) (14) Other fee-based income, net of referral fees .......... 54 48 6 13 ----- ----- ----- ----- Total other fees and commissions ...................... 192 110 82 75 ----- ----- ----- ----- Securitization revenue .................................... 30 -- 30 -- Other income: Insurance ............................................. 6 16 (10) (63) HSBC affiliate income ................................. 3 100 (97) (97) Interest on tax settlement ............................ -- 17 (17) (100) Gains on sale of property and other financial assets .. 22 50 (28) (56) Other ................................................. (6) 17 (23) (135) ----- ----- ----- ----- Total other income .................................... 25 200 (175) (88) ----- ----- ----- ----- Residential mortgage banking revenue (expense) ............ 31 (64) 95 148 Trading revenues .......................................... 137 21 116 552 Securities gains, net ..................................... 17 18 (1) (6) ----- ----- ----- ----- Total other revenues ...................................... $ 505 $ 362 $ 143 40 ===== ===== ===== ===== 37 ------------------------------------------------------------------------------------------------------------ Increase (Decrease) ---------------- 2005 2004 Amount % ------------------------------------------------------------------------------------------------------------ (in millions) Nine months ended September 30: Trust income .............................................. $ 65 $ 71 $ (6) (8) Service charges: HSBC affiliate income ................................. 11 14 (3) (21) Other service charges ................................. 147 144 3 2 ------ ------ ------ ------ Total service charges ................................. 158 158 -- -- ------ ------ ------ ------ Other fees and commissions: Letter of credit fees ................................. 53 53 -- -- Credit card fees ...................................... 211 60 151 252 Wealth and tax advisory services ...................... 44 34 10 29 HSBC affiliate income ................................. 42 25 17 68 Other fee-based income, net of referral fees .......... 131 169 (38) (22) ------ ------ ------ ------ Total other fees and commissions ...................... 481 341 140 41 ------ ------ ------ ------ Securitization revenue .................................... 99 -- 99 -- Other income: Insurance ............................................. 37 47 (10) (21) HSBC affiliate income ................................. 26 102 (76) (75) Interest on tax settlement ............................ -- 17 (17) (100) Gains on sale of property and other financial assets .. 68 56 12 21 Other ................................................. 49 61 (12) (20) ------ ------ ------ ------ Total other income .................................... 180 283 (103) (36) ------ ------ ------ ------ Residential mortgage banking revenue (expense) ............ 41 (105) 146 139 Trading revenues .......................................... 268 188 80 43 Securities gains, net ..................................... 105 59 46 78 ------ ------ ------ ------ Total other revenues ...................................... $1,397 $ 995 $ 402 40 ====== ====== ====== ====== All increases and decreases referenced on the following pages for the third quarter and first nine months of 2005 represent comparisons with the same 2004 periods. Other Fees and Commissions Increased credit card fees in the third quarter and first nine months of 2005 primarily resulted from the private label receivables acquired from HSBC Finance Corporation in 2004 and 2005. Other fee-based income increased in the third quarter of 2005. New fees generated by a subsidiary transferred from HSBC in March 2005, which provides accounting and valuation services for hedge fund clients, were partially offset by referral fees paid to other HSBC affiliates under new referral arrangements in 2005, which are netted against related fee revenues received from customers. In June 2004, HUSI transferred an investment brokerage subsidiary to an HSBC affiliate. Fees received from brokerage customers prior to the transfer date are reported as other fee-based income in the preceding tables, while fees received pursuant to an ongoing arrangement with the HSBC affiliate since the transfer date are reported as HSBC affiliate income. Therefore, for the first nine months of 2005, HSBC affiliate income increased, while other fee-based income decreased. 38 Securitization Revenue Securitization revenue results directly from the purchase of residual interests in securitized private label credit card receivables from HSBC Finance Corporation in December 2004. Securitization revenue is comprised of the following activity: --------------------------------------------------------------------------------------------------------- Three Months Ended Nine Months Ended September 30, 2005 September 30, 2005 --------------------------------------------------------------------------------------------------------- (in millions) Net replenishment gains, net of provision for credit losses ..... $24 $66 Servicing revenue and excess spread ............................. 6 33 --- --- Total ........................................................... $30 $99 === === The securitized trusts require replenishments of receivables to support previously issued securities. Receivables will continue to be sold to these trusts until their revolving periods end, the last of which is expected to occur in 2008. The replenishment gains result from these receivable sales to the trusts. Third quarter servicing revenue and excess spread was comparable to the second quarter, but has decreased when compared with previous periods, due to declining receivable balances in the securitized trusts. There have been no new securitization transactions during 2005. Other Income HSBC affiliate income for the third quarter of 2004 included a gain of $99 million related to the sale of certain credit card relationships to HSBC Finance Corporation. HSBC affiliate income during the first nine months of 2005 was primarily attributable to HBUS's new role, effective October 2004, as originating lender for HSBC Finance Corporation's Taxpayer Financial Services business. This revenue is further described in Note 10 of the consolidated financial statements beginning on page 13 of this Form 10-Q. In July 2004, HUSI recorded a $17 million refund of interest previously paid to the Internal Revenue Service related to a prior year tax audit. Gains on sale of property and other financial assets primarily include the following significant activity and/or transactions for 2005 and 2004: 2005 o $17 million gain from the sale of property in July 2005; o $26 million gain from the sale of property in May 2005; o $16 million of gains from the sales of various branches and from the sale of a portion of HUSI's personal trust business during the first nine months of 2005; and o In June 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties and subsequently selling these loans to HSBC Markets. Since the inception of this program, HUSI has acquired approximately $2 billion of residential mortgage loans, which it subsequently sold to HSBC Markets for total gains of approximately $2 million. 2004 o $45 million gain on the sale of an investment in NYCE Corporation in July 2004. Other includes the following significant activity and/or transactions for 2005: o In June 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties and subsequently selling these acquired loans to HSBC Markets. At September 30, 2005, HUSI had approximately $1.5 billion of residential mortgage loans held for sale on its consolidated balance sheet, which are reported at the lower of cost or market value. A mark to market loss of $24 million was included in other income related to these loans; and 39 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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