HSBC FINANCE CORP – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Forward-Looking Statements
Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this report and with our Annual Report on Form 10-K for the year endedDecember 31, 2011 (the "2011 Form 10-K"). 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. In addition, we may make or approve certain statements in future filings with theSEC , in press releases, or oral or written presentations by representatives of HSBC Finance Corporation that are not statements of historical fact and may also constitute forward-looking statements. Words such as "may," "will," "should," "would," "could," "appears," "believe," "intends," "expects," "estimates," "targeted," "plans," "anticipates," "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. These matters or statements will relate to our future financial condition, economic forecast, results of operations, plans, objectives, performance or business developments and will involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from that which were expressed or implied by such forward-looking statements. Forward-looking statements are based on our current views and assumptions and speak only as of the date they are made. HSBC Finance Corporation undertakes no obligation to update any forward-looking statement to reflect subsequent circumstances or events. Executive Overview HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC Holdings plc ("HSBC"). HSBC Finance Corporation may also be referred to in MD&A as "we", "us", or "our". The following discussion of our financial condition and results of operations excludes the results of our discontinued operations from all periods presented unless otherwise noted. See Note 2, "Discontinued Operations," in the accompanying consolidated financial statements for further discussion of these operations. Current Environment After beginning to show signs of improvement once again in late 2011, economic conditions inthe United States continued to improve during the first three months of 2012 as job growth continued and consumer spending trends remained positive. Improving consensus forecasts of GDP growth in 2012 since late last year have resulted from a steady stream of better than expected reports on U.S. economic activity that has led to a strong rebound in U.S. equity prices, lifting household wealth. In addition, conditions improved in financial markets around the world, includingthe United States , although concerns regarding government spending and the budget deficit continued to impact interest rates and spreads. Despite these improving conditions, serious threats to economic growth remain, including rising gasoline prices, continued pressure and uncertainty in the housing market and elevated unemployment levels. Federal Reserve policy makers currently anticipate that economic conditions are likely to warrant exceptionally low levels for the Federal funds rate at least through late 2014. In addition, housing prices continue to remain under pressure in many markets due to elevated foreclosure levels. Although the pace of new foreclosures has fallen from its peak, in part due to industry-wide compliance issues, further declines may be necessary before substantial progress in reducing the inventory of homes occurs.
Mortgage lending industry trends continued to be affected by the following in 2012:
> Overall levels of delinquencies remain elevated;
> While we ceased originating mortgage loans in early 2009, mortgage loan
originations from 2006 through 2008 continue to perform worse than originations from prior periods; 58
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Table of Contents HSBC Finance Corporation > Significant delays in foreclosure proceedings as a result of the broad
horizontal review of industry foreclosure practices by the Federal Reserve
Board ("Federal Reserve") and the
("OCC") that culminated in the issuance of consent orders to many servicers;
> Real estate markets in a large portion ofthe United States continue to be
affected by stagnation or declines in property values experienced over the
last few years; > Levels of foreclosed properties and properties in the process of being
foreclosed remain elevated, which has contributed to a continued general
decline in home prices during the first quarter of 2012;
> Lower secondary market demand for subprime loans resulting in reduced
liquidity for subprime mortgages; and
> Tighter lending standards by mortgage lenders, which impacts the ability of
borrowers to refinance existing mortgage loans.
While the economy continued to add jobs in the first quarter of 2012, the pace of new job creation continues to be slower than needed to meaningfully reduce unemployment. As a result, there continues to be uncertainty as to how pronounced the economic recovery will be and whether it can be sustained. Although consumer spending has improved, there is a fear that rising gas prices will begin to constrain consumer spending once again. In addition, while consumer confidence is on the rebound, it continues to be low based on historical standards. U.S. unemployment rates, which have been a major factor in the deterioration of credit quality in the U.S., remained high at 8.2 percent inMarch 2012 . Also, a significant number of U.S. residents are no longer looking for work and, therefore, are not reflected in the U.S. unemployment rates. Unemployment has continued to have an impact on the provision for credit losses in our loan portfolio and in loan portfolios across the industry. Concerns about the future of the U.S. economy, including the pace and magnitude of recovery from the recent economic recession, consumer confidence, volatility in energy prices, credit market volatility, and trends in corporate earnings will continue to influence the U.S. economic recovery and the capital markets. In particular, continued improvement in unemployment rates, a sustained recovery of the housing markets and stabilization in energy prices remain critical components of a broader U.S. economic recovery. Further weakening in any of these components as well as in consumer confidence may result in additional deterioration in consumer payment patterns and credit quality. Weak consumer fundamentals including declines in wage income and a difficult job market continue to influence consumer confidence. Additionally, there is continued uncertainty as to the future course of monetary policy and as to the impact on the economy and consumer confidence as the actions previously taken by the government to restore faith in the capital markets and stimulate consumer spending end. These conditions in combination with the impact of recent regulatory changes, including the continued implementation of the "Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010" ("Dodd-Frank"), will continue to impact our results in 2012 and beyond, the degree of which is largely dependent upon the pace and extent of the economic recovery. Due to the significant slow-down in foreclosure processing, and in some instances the prior cessation of all foreclosure processing by numerous loan servicers, there has been a reduction in the number of properties being marketed following foreclosure. This reduction may increase demand for properties currently on the market resulting in a stabilization of home prices but may also result in a larger number of vacant properties still pending foreclosure in certain communities creating downward pressure on general property values. Moreover, as servicers begin to increase foreclosure activities and market properties in large numbers, a significant over-supply of housing inventory is likely to occur. This could lead to an increase in loss severity, which would adversely impact our provision for credit losses in future periods.
In addition, certain courts and state legislatures have issued new rules or statutes relating to foreclosures. Scrutiny of foreclosure documentation has increased in some courts. Also, in some areas, officials are requiring additional verification of information filed prior to the foreclosure proceeding. The combination of these factors
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Table of Contents HSBC Finance Corporation
has led to a significant backlog of foreclosures which will take time to resolve. If these trends continue, there could be additional delays in the processing of foreclosures, which could have an adverse impact upon housing prices that is likely to result in higher loss severities while foreclosures are delayed.
Growing government indebtedness and a large budget deficit have resulted in a downgrade in the U.S. sovereign debt rating by one major rating agency and two major rating agencies having U.S. sovereign debt on a negative watch. There is an underlying risk that lower growth, fiscal challenges and a general lack of political consensus will result in continued scrutiny of the U.S. credit standing over the longer term. While the potential effects of the U.S. downgrade are broad and impossible to accurately predict, they could over time include a widening of sovereign and corporate credit spreads, devaluation of the U.S. dollar and a general market move away from riskier assets. Business Focus InAugust 2011 , HSBC, through its wholly-owned subsidiaries HSBC Finance Corporation, HSBC USA Inc and other wholly-owned affiliates, agreed to sell its Card and Retail Services business to Capital One Financial Corporation ("Capital One") for a premium of 8.75 percent of receivables. This transaction was completed onMay 1, 2012 . In addition to receivables, the sale included real estate and certain other assets and liabilities which were sold at book value or, in the case of real estate, appraised value at the date of closing. Under the terms of the agreement, facilities inChesapeake, Virginia ;Las Vegas, Nevada ;Mettawa, Illinois ;Volo, Illinois ;Hanover, Maryland ;Salinas, California ;Sioux Falls, South Dakota andTigard, Oregon were sold or transferred to Capital One, although we have entered into site-sharing arrangements for certain of these locations for a period of time. The total final cash consideration expected to be allocated to us based onApril 30, 2012 balances is approximately$11.8 billion , resulting in an after-tax gain of approximately$1.4 billion which will be recorded in the second quarter of 2012. The majority of the employees in our Card and Retail Services business were transferred to Capital One. As such, no significant one-time closure or severance costs were incurred as a result of this transaction. Our Card and Retail Services business is reported in discontinued operations. Our real estate secured and personal non-credit card receivable portfolios, which totaled$46.0 billion atMarch 31, 2012 , are currently running off. The timeframe in which these portfolios will liquidate is dependent upon the rate at which receivables pay off or charge-off prior to their maturity, which fluctuates for a variety of reasons such as interest rates, availability of refinancing, home values and individual borrowers' credit profile, all of which are outside our control. In light of the current economic conditions and mortgage industry trends described above, our loan prepayment rates have slowed when compared to historical experience even though interest rates remain low. Additionally, our loan modification programs, which are primarily designed to improve cash collections and avoid foreclosure as determined to be appropriate, are contributing to the slower loan prepayment rates. While difficult to project both loan prepayment rates and default rates, based on current experience we expect our run-off real estate secured receivable portfolio to decline to between 40 percent and 50 percent over the next four to five years. Attrition will not be linear during this period. Run-off is beginning to slow as charge-offs decline and the remaining real estate secured receivables stay on the balance sheet longer due to the impact of modifications and/or the lack of re-financing alternatives as well as the impact of our temporary suspension of foreclosure activities. We continue to evaluate our operations as we seek to optimize our risk profile and cost efficiencies as well as our liquidity, capital and funding requirements. This could result in further strategic actions that may include changes to our legal structure, asset levels, or cost structure in support of HSBC's strategic priorities. We also continue to focus on cost optimization efforts to ensure realization of cost efficiencies. In an effort to create a more sustainable cost structure, a formal review was initiated in 2011 to identify areas where we may be able to streamline or redesign operations within certain functions to reduce or eliminate costs. To date, we have identified various opportunities to reduce costs through organizational structure redesign, vendor spending, discretionary spending and other general efficiency initiatives which have resulted in workforce reductions. These workforce reductions have been largely offset by increased staffing related to processing foreclosures as 60
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Table of Contents HSBC Finance Corporation well as for compliance matters. Workforce reductions are also occurring in certain non-compliance shared services functions, which we expect will result in additional reductions to future allocated costs for these functions. The review is continuing and, as a result, we may incur restructuring charges in future periods, the amount of which will depend upon the actions that ultimately are implemented. As part of the ongoing review of our Insurance business, we previously decided to cease issuing new term life insurance inthe United States effectiveJanuary 2012 . As the review of our Insurance business continues, other actions may be taken. HSBC plans to continue to provide insurance products to its customers. During the first quarter of 2012, we made a decision to wind-down our commercial paper program during the remainder of 2012. Any required funding will be integrated into the overallHSBC North America funding plans, sourced primarily through HSBC USA Inc., or through direct support from HSBC and its affiliates.
Performance, Developments and Trends We reported a net loss of
Loss from continuing operations was$507 million during the three months endedMarch 31, 2012 compared to losses from continuing operations of$220 million during the year-ago quarter. We reported a loss from continuing operations before tax of$784 million during the three months endedMarch 31, 2012 compared to losses from continuing operations before tax of$523 million during the year-ago quarter. Our results in both periods were impacted by the change in the fair value of debt and related derivatives for which we have elected fair value option. In order to better understand the underlying performance trends of our business, the following table summarizes the impact of this item on our loss from continuing operations before tax for all periods presented. Three Months Ended March 31, 2012 2011 (in millions)
Loss from continuing operations before income tax, as reported
$ (784 )
$ (523 ) Change in value of fair value option debt and related derivatives
396
29
Loss from continuing operations before income tax, excluding above items(1) $ (388 ) $ (494 ) (1) Represents a non-U.S. GAAP financial measure. Excluding the impact of the change in the fair value of debt and related derivatives for which we have elected fair value option in the above table, our results for the three months endedMarch 31, 2012 improved$106 million compared to the prior year quarter reflecting higher other revenues and lower operating expenses, partially offset by lower net interest income and a higher provision for credit losses. The higher other revenues in the first quarter of 2012 was driven by higher derivative related income reflecting the impact of rising long-term interest rates during the quarter on the mark-to-market on derivatives in our non-qualifying economic hedge portfolio. The impact of interest rates on our non-qualifying economic hedge portfolio resulted in gains of$239 million during the three months endedMarch 31, 2012 compared to$63 million during the prior year quarter. While these positions act as economic hedges by lowering our overall interest rate risk through more closely matching both the structure and duration of our liabilities to the structure and duration of our assets, they did not qualify as effective hedges under hedge accounting principles. Net interest income decreased during the first quarter of 2012 reflecting lower average receivables as a result of receivable liquidation and a lower overall receivable yield. The lower overall receivable yield reflects lower yields in our real estate secured receivable portfolio, partially offset by higher yields in our personal non-credit card receivable portfolio. While overall receivable yields were lower during the first quarter of 2012, the overall yield on all interest earning assets during the current quarter was positively impacted by a shift in the mix of all interest earning assets to include a lower percentage of non-insurance investments, which have significantly lower yields than our receivable portfolios. The decrease in net interest income was partially offset by lower 61
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Table of Contents HSBC Finance Corporation interest expense due to lower average borrowings and lower average rates. Net interest margin was 3.00 percent for the three months endedMarch 31, 2012 compared to 2.68 percent during the prior year quarter. The increase in net interest margin during the first quarter of 2012 was driven by a lower cost of funds as a percentage of interest earning assets and a higher overall yield on all interest earning assets as discussed above. See "Results of Operations" in this MD&A for additional discussion regarding net interest income and net interest margin.
Our provision for credit losses increased during the three months ended
• The provision for credit losses for real estate secured loans increased
during the first quarter of 2012 as compared to the prior year quarter
reflecting the impact of higher reserve requirements on TDR Loans during
the first quarter of 2012 as a result of adopting the new Accounting
Standards Update as discussed below. This increase was partially offset by
the impact of lower receivable balances and lower loss estimates as compared to the prior year quarter. • The provision for credit losses for our personal non-credit card receivables was flat as compared to the prior year as the impact of a
higher loss provision on TDR Loans driven by the adoption of the new Accounting Standards Update as discussed below was offset by lower
receivable levels and improved credit quality, including lower delinquency
levels and lower loss estimates as compared to the prior year quarter.
As discussed in our 2011 Form 10-K, during the third quarter of 2011, we adopted an Accounting Standards Update which provided additional guidance to determine whether a restructuring of a receivable meets the criteria to be considered a troubled debt restructuring for purposes of the identification and disclosure of TDR Loans as well as for recording impairment. This new accounting guidance continues to impact our provision for credit loss in periods post-adoption, as loans that otherwise would not have qualified for such reporting in the past are now meeting the criteria under the new accounting guidance to be reported and reserved for as TDR Loans which will continue in future periods. Therefore, the provision for credit losses for the three months endedMarch 31, 2012 is not comparable to the provision for credit losses for the three months endedMarch 31, 2011 .
See "Results of Operations" for a more detailed discussion of our provision for credit losses.
During the first quarter of 2012, we decreased our credit loss reserves as the provision for credit losses was$87 million less than net charge-offs. Lower credit loss reserve levels reflect lower receivable levels, improved economic and credit conditions, including lower delinquency levels, and an increase in the amount and percentage of real estate secured receivables which are carried at the lower of amortized cost or fair value less cost to sell. The decrease in overall credit loss reserves was partially offset by higher credit loss reserve levels on TDR Loans due to higher outstanding balances. See "Credit Quality" for further discussion of credit loss reserves. 62
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Table of Contents HSBC Finance Corporation A significant portion of our receivable portfolio is considered to be TDR Loans which are reserved for based on the present value of expected future cash flows discounted at the loans' original effective interest rate which generally results in a higher reserve requirement for these loans. Additionally, a significant portion of real estate secured receivables in our portfolio is carried at the lower of amortized cost or fair value less cost to sell. The following table summarizes these receivables in comparison to our entire receivable portfolio: March 31, December 31, 2012 2011 (in millions) Total receivable portfolio $ 46,041 $ 47,936 Real estate secured receivables carried at the lower of amortized cost or fair value less cost to sell $ 6,204 $ 5,937 TDR Loans: Real estate secured(1) 12,107 11,717 Personal non-credit card 1,339 1,341 TDR Loans 13,446 13,058
Receivables carried at either the lower of amortized cost or fair value less cost to sell or reserved for using a discounted cash flow methodology
$ 19,650
$ 18,995
Real estate secured receivables carried at the lower of amortized cost or fair value less cost to sell or reserved for using a discounted cash flow methodology as a percentage of real estate secured receivables
44.40 %
41.33 %
Receivables carried at either the lower of amortized cost or fair value less cost to sell or reserved for using a discounted cash flow methodology as a percentage of total receivables
42.68 % 39.63 %
(1) Excludes TDR Loans which are carried at the lower of amortized cost or fair
value less cost to sell.
Total operating expenses decreased$80 million , or 22 percent, during the three months endedMarch 31, 2012 driven by lower real estate owned ("REO") expenses, partially offset by increased expenses for consulting services and other expenses related to compliance matters. See "Results of Operations" for a more detailed discussion of operating expenses. Our effective income tax rate for continuing operations was (35.3) percent during the three months endedMarch 31, 2012 compared to (57.9) percent for the prior year quarter. The effective tax rate for the three months endedMarch 31, 2012 was impacted by the effect of a change in state tax rates used to value deferred taxes and purchase accounting adjustments on leveraged leases that matured inJanuary 2012 . The effective tax rate for the three months endedMarch 31, 2011 was significantly impacted by a release of valuation allowance previously established on foreign tax credits. The effective tax rate for both the three months endedMarch 31, 2012 and 2011 was also impacted by state taxes, including states where we file combined unitary state tax returns with other HSBC affiliates. See Note 8, "Income Taxes," in the accompanying consolidated financial statements for further discussion. 63
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Table of Contents HSBC Finance Corporation
The financial information set forth below summarizes selected financial highlights of HSBC Finance Corporation for the three month periods ended
Three Months Ended March 31, 2012 2011 (dollars are in millions) Loss from continuing operations $ 507 $ 220 Return on average assets ("ROA") (3.76 )% (1.34 )% Return on average common shareholder's equity ("ROE") (43.41 ) (15.64 ) Net interest margin 3.00 2.68 Consumer net charge-off ratio, annualized 7.49 9.27 Efficiency ratio(1) 97.32 64.08 March 31, December 31, 2012 2011 (dollars are in millions) Receivables: Real estate secured $ 41,243 $ 42,713 Personal non-credit card 4,794 5,196 Commercial and other 4 27 Total $ 46,041 $ 47,936 Two-month-and-over contractual delinquency ratio 17.58 % 17.93 % (1) Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits. Performance Ratios Our efficiency ratio from continuing operations was 97.32 percent during the three months endedMarch 31, 2012 as compared to 64.08 percent in the prior year quarter. Our efficiency ratio in both periods was impacted by the change in the fair value of debt for which we have elected fair value option accounting. Excluding this item from both periods, our efficiency ratio was significantly lower during the first quarter of 2012 primarily due to higher other revenues driven by derivative-related income as well as lower operating expenses driven by lower REO expenses, partially offset by lower net interest income as a result of receivable portfolio liquidation. ROE was (43.41) percent for the three months endedMarch 31, 2012 compared to (15.64) percent in the prior year quarter. ROA was (3.76) percent for the three months endedMarch 31, 2012 compared to (1.34) percent in the year-ago quarter. ROE and ROA in both periods were impacted by the change in the fair value of debt for which we have elected fair value option accounting. Excluding this item from both periods, both ROE and ROA deteriorated during the first quarter of 2012 as compared to the year-ago quarter due to a higher net loss during the current period as the net loss in the prior year was positively impacted by a higher effective tax benefit as discussed above. ROE and ROA were also negatively impacted by the impact of lower average common shareholder's equity and lower average assets, respectively. Receivables Receivables were$46.0 billion atMarch 31, 2012 and$47.9 billion atDecember 31, 2011 . The decrease reflects the continued liquidation of our real estate secured and personal non-credit card receivable portfolios, which will continue going forward, as well as improvements in collection activities during the first quarter of the year as some customers use their tax refunds to make payments. As it relates to our real estate secured receivable portfolio, liquidation rates continue to be impacted by low loan prepayments as few refinancing opportunities for our customers exist and the previously discussed trends impacting the mortgage lending industry. See "Receivables Review" for a more detailed discussion of the decreases in receivable balances. Credit Quality Dollars of two-month-and-over contractual delinquency for continuing operations decreased for both real estate secured and personal non-credit card receivables as compared toDecember 31, 2011 . In our real estate secured receivable portfolio, dollars of delinquency decreased as compared toDecember 31, 2011 due to a 64
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Table of Contents HSBC Finance Corporation significant decrease in dollars of delinquency on accounts less than 180 days contractually delinquent due to lower receivable levels, the impact of improvements in economic conditions and seasonal improvements in collection activities during the first quarter of the year as some customers use their tax refunds to make payments, partially offset by an increase in late stage delinquency driven by our earlier decision to temporarily suspended foreclosure activities. Dollars of delinquency decreased in our personal non-credit card receivable portfolio reflecting the impact of lower receivable levels, improved credit quality and seasonal improvements in collection activities during the first quarter of the year as discussed above. Dollars of two-months-and-over contractual delinquency as a percentage of receivables ("delinquency ratio") decreased as compared toDecember 31, 2011 driven by the factors discussed above as dollars of delinquency declined at a faster pace than receivable levels. See "Credit Quality-Delinquency" for a more detailed discussion of our delinquency ratio. Overall dollars of net charge-offs decreased during the first quarter of 2012 as compared to both the prior quarter and prior year quarter as all receivable portfolios were positively impacted by lower receivable levels and lower delinquency levels as discussed above. The decrease also reflects the impact of lower levels of personal bankruptcy filings and improvements in economic conditions. Net charge-off of consumer receivables as a percentage of average consumer receivables (the "net charge-off ratio") for the first quarter of 2012 increased as compared to the prior quarter as the decrease in receivable levels during the first quarter as previously discussed outpaced the decrease in dollars of net charge-offs. As compared to the prior year quarter, the net charge-off ratio decreased as the decrease in net charge-off dollars as discussed above outpaced the decrease in receivable levels.See "Credit Quality-Net Charge-offs of Consumer Receivables" for a more detailed discussion of our net charge-off ratio.
Performance of our Discontinued Card and Retail Services Business The financial information set forth below summarizes selected financial highlights of our discontinued Card and Retail Services business for the three months ended
Three Months Ended March 31 2012 2011 (dollars are in millions)
Finance and other interest income $ 438 $ 502 Interest expense 21 26 Net interest income 417 476 Provision for credit losses(2) - 74 Net interest income after provision for credit losses 417 402 Fee income and enhancement services revenue 193 145 Gain on receivable sales with affiliates 79 113 Servicing and other fees from HSBC affiliates 158 151 Gain on sale of account relationships to HSBC Bank USA 79 - Other income (1 ) 6 Total other revenues 508 415 Salaries and employee benefits 68 82 Other marketing expenses 46 85 Other servicing and administrative expenses 51 90 Support services from affiliates 212 215 Amortization of intangibles - 34 Total operating expenses 377 506 Income from discontinued operations before income tax $ 548 $ 311 Net interest margin 18.78 %
19.72 %
Consumer net charge-off ratio, annualized(2) -
11.92 Efficiency ratio(1) 40.76 56.79 65
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Table of Contents HSBC Finance Corporation March 31, 2012 December 31, 2011 (dollars are in millions) Credit card receivables $ 8,521 $ 9,001 Two-month-and-over contractual delinquency ratio 4.67 % 5.34 % (1) Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits.
(2) For periods following the transfer of the receivables to held for sale, the
receivables are included as part of the disposal group held for sale to
Capital One which is carried at the lower of amortized cost or fair value
and we no longer record provisions for credit losses, including charge-offs,
for these receivables.
In our credit card business we saw continued declines in our credit card receivable balances due to seasonal run-off in the first quarter of 2012, partially offset by new purchase volume. In addition, the receivables continued to run-off due to our decision in prior periods to reduce marketing expense. Credit quality continued to improve during the first quarter of 2012 as delinquency levels continued to decline due in part to seasonal improvements in our collection activities as some customers use their tax refunds to make payments. As discussed more fully above, onMay 1, 2012 we completed the sale of our Card and Retail Services business to Capital One. Income from our discontinued Card and Retail Services business improved during the three months endedMarch 31, 2012 as compared to the prior year quarter primarily due to lower operating expenses, lower provision for credit losses and higher other revenues, partially offset by lower net interest income. Lower net interest income during the first quarter of 2012 reflects the impact of lower average receivables as discussed more fully below and a lower yield on credit card receivables, partially offset by lower interest expense. The lower yields on our credit card receivables reflect improved credit quality due to lower delinquency levels as compared to the prior year quarter. Net interest margin for our Card and Retail Services business decreased during the first quarter of 2012 as a result of lower receivable yields as discussed above, partially offset by a lower cost of funds. We did not record any provision for credit losses for our credit card receivable portfolio during the first quarter of 2012 as these receivables were included as part of the disposal group held for sale, which was carried at the lower of amortized cost or fair value and we ceased recording provisions for credit losses on these receivables following the transfer to held for sale during the third quarter of 2011. Other revenues for our discontinued Card and Retail Services business increased during the first quarter of 2012 driven by a gain of$79 million on the sale of account relationships to HSBC USA Inc. and its subsidiaries inMarch 2012 . The account relationships sold were account relationships we had purchased from HSBC BankUSA inJuly 2004 which were not part of the transaction with Capital One. The increase in other revenues during the first quarter of 2012 also reflects higher late fees resulting primarily from minimum payment changes. Operating expenses decreased during the first quarter of 2012 due to lower third party collection costs as credit card loan balances have decreased and credit quality has improved, lower salaries and employee benefits due to the impact of entity-wide initiatives to reduce costs, lower marketing expenses and the elimination of intangible amortization as amortization ceased following the transfer to held for sale during the third quarter of 2011. Receivables Credit card receivables totaled$8.5 billion atMarch 31, 2012 compared to$9.0 billion atDecember 31, 2011 . The decrease reflects seasonal improvements in our collection activities during the first quarter of the year as some customers use their tax refunds to make payments and run-off in the segments of our credit card receivable portfolio where we no longer originate new accounts, partially offset by new purchase volume. 66
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Table of Contents HSBC Finance Corporation Credit Quality Dollars of delinquency for our discontinued credit card receivable portfolio atMarch 31, 2012 decreased as compared toDecember 31, 2011 due to lower receivable levels and seasonal improvements in our collection activities as discussed above. The delinquency ratio decreased as compared toDecember 31, 2011 as dollars of delinquency decreased at a faster pace than receivable levels due to improvements in credit quality as discussed above. During the first quarter of 2012, we did not record any charge-offs for our credit card receivable portfolio as we stopped recording charge-offs after it became part of the disposal group held for sale to Capital One inAugust 2011 and the receivables are now carried at the lower of amortized cost or fair value. Funding and Capital During the first quarter of 2012, we did not receive any capital contributions from HSBC Investments (North America ) Inc. ("HINO"). However, as we continue to liquidate our real estate secured and personal non-credit card receivable portfolios, HSBC's continued support will be required to properly manage our business operations and maintain appropriate levels of capital. HSBC has historically provided significant capital in support of our operations and has indicated that it is fully committed and has the capacity and willingness to continue that support. In the current market environment, market pricing continues to value the cash flows associated with our real estate secured and personal non-credit card portfolios at amounts which are lower than what we believe will ultimately be realized. Therefore, we have determined that we have the positive intent and ability to hold these receivables for the foreseeable future and, as such, have classified our real estate secured and personal non-credit card receivable portfolios as held for investment purposes. However, should market pricing improve in the future or ifHSBC North America calls upon us to execute certain strategies in order to address capital considerations, it could result in the reclassification of a portion of these portfolios into receivables held for sale. The tangible common equity to tangible assets ratio was 7.44 percent and 7.12 percent atMarch 31, 2012 andDecember 31, 2011 , respectively. This ratio represents a non-U.S. GAAP financial ratio that is used by HSBC Finance Corporation management, certain rating agencies and our credit-providing banks to evaluate capital adequacy and may be different from similarly named measures presented by other companies. See "Basis of Reporting" and "Reconciliations of Non-U.S. GAAP Financial Measures to U.S. GAAP Financial Measures" for additional discussion and quantitative reconciliation to the equivalent U.S. GAAP basis financial measure. As discussed in previous filings,HSBC North America is required to implement Basel II provisions in accordance with current regulatory timelines. While we will not report separately under the new rules, the composition of our balance sheet will impact the overallHSBC North America regulatory capital requirement. Adoption of Basel II requires the approval of U.S. regulators and encompasses enhancements to a number of risk policies, processes and systems to alignHSBC North America with the Basel II final rule requirements. It is uncertain whenHSBC North America will receive approval to adopt Basel II from theFederal Reserve Board , its primary regulator.HSBC North America has integrated Basel II metrics into its management reporting and decision making processes. As a result of Dodd-Frank, a banking organization that has formally implemented Basel II must calculate its capital requirements under Basel I and Basel II, compare the two results, and then use the lower of such ratios for purposes of determining compliance with its minimum Tier 1 capital and total risk-based capital requirements. 67
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Table of Contents HSBC Finance Corporation Income (Loss) Before Income Tax Expense from Continuing Operations - Significant Trends Loss from continuing operations before income tax expense, and various trends and activity affecting operations, are summarized in the following table: Three Months EndedMarch 31, 2012
2011
(in
millions)
Loss from continuing operations before income tax from prior year
$ (523 ) $ (1,310 ) Increase (decrease) in income from continuing operations before income tax expense attributable to: Net interest income (38 ) (117 ) Provision for credit losses (83 )
956
Mark-to-market on derivatives which do not qualify as effective hedges
176
101
Gain (loss) on debt designated at fair value and related derivatives
(367 ) (162 ) Servicing and other fees from HSBC affiliates 1 (11 ) Salaries and employee benefits (3 ) 29 REO expenses 77 (67 ) All other activity(1) (24 ) 58 (261 ) 787 Loss from continuing operations before income tax for current period $ (784 ) $ (523 )
(1) Reflects other activity for other revenues and operating expenses.
For additional discussion regarding changes in the components of income and expense, see "Results of Operations."
Basis of Reporting
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted inthe United States ("U.S. GAAP"). Unless noted, the discussion of our financial condition and results of operations included in MD&A are presented on a continuing operations basis of reporting. Certain reclassifications have been made to prior year amounts to conform to the current year presentation.
In addition to the U.S. GAAP financial results reported in our consolidated financial statements, MD&A includes reference to the following information which is presented on a non-U.S. GAAP basis:
Equity Ratios Tangible common equity to tangible assets is a non-U.S. GAAP financial measure that is used by HSBC Finance Corporation management, certain rating agencies and our credit-providing banks to evaluate capital adequacy. This ratio excludes from equity the impact of unrealized gains (losses) on cash flow hedging instruments, postretirement benefit plan adjustments, unrealized gains (losses) on investments, intangible assets as well as subsequent changes in fair value recognized in earnings associated with debt for which we elected the fair value option and the related derivatives. This ratio may differ from similarly named measures presented by other companies. The most directly comparable U.S. GAAP financial measure is the common and preferred equity to total assets ratio. For a quantitative reconciliation of these non-U.S. GAAP financial measures to our common and preferred equity to total assets ratio, see "Reconciliations of Non-U.S. GAAP Financial Measures to U.S. GAAP Financial Measures." 68
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Table of Contents HSBC Finance Corporation International Financial Reporting Standards Because HSBC reports results in accordance with International Financial Reporting Standards ("IFRSs") and IFRSs results are used in measuring and rewarding performance of employees, our management also separately monitors net income under IFRSs (a non-U.S. GAAP financial measure). All purchase accounting fair value adjustments relating to our acquisition by HSBC have been "pushed down" to HSBC Finance Corporation for both U.S. GAAP and IFRSs. The following table reconciles our net loss on a U.S. GAAP basis to net loss on an IFRSs basis Three Months Ended March 31, 2012 2011 (in millions) Net loss - U.S. GAAP basis $ (155 ) $ (21 ) Adjustments, net of tax: Derivatives and hedge accounting (including fair value adjustments) (2 ) (2 ) Intangible assets -
8
Loan origination cost deferrals 3 (6 ) Loan impairment 29 (281 ) Loans previously held for sale -
(7 ) Credit card receivables transferred to held for sale and include in discontinued operations for U.S. GAAP
(58 ) - Interest recognition (1 ) (3 ) Securities - 6 Present value of long term insurance contracts 5
6
Pension and other postretirement benefit costs 7
5
Release of tax valuation allowance - 18 Other 11 4 Net loss - IFRSs basis (161 ) (273 ) Tax benefit - IFRSs basis 94 362 Loss before tax - IFRSs basis $ (255 ) $ (635 )
A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are presented below:
Derivatives and hedge accounting (including fair value adjustments) - The historical use of the "shortcut" and "long haul" hedge accounting methods for U.S. GAAP resulted in different cumulative adjustments to the hedged item for both fair value and cash flow hedges. These differences are recognized in earnings over the remaining term of the hedged items. All of the hedged relationships which previously qualified under the shortcut method provisions of derivative accounting principles have been redesignated and are now either hedges under the long-haul method of hedge accounting or included in the fair value option election. Intangible assets - Intangible assets under IFRSs are significantly lower than those under U.S. GAAP as the intangibles created as a result of our acquisition by HSBC were reflected in goodwill for IFRSs. As a result, amortization of intangible assets is lower under IFRSs. Loan origination cost deferrals - Under IFRSs, loan origination cost deferrals are more stringent and generally result in lower costs being deferred than permitted under U.S. GAAP. In addition, all deferred loan origination fees, costs and loan premiums must be recognized based on the expected life of the receivables under IFRSs as part of the effective interest calculation while under U.S. GAAP they may be recognized on either a contractual or expected life basis. As a result, in years with lower levels of receivable originations, net income is lower under U.S. GAAP as the higher costs deferred in prior periods are amortized into income without the benefit of similar levels of cost deferrals for current period originations. 69
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Table of Contents HSBC Finance Corporation Loan impairment - IFRSs requires a discounted cash flow methodology for estimating impairment on pools of homogeneous customer loans which requires the discounting of cash flows including recovery estimates at the original effective interest rate of the pool of customer loans. The amount of impairment relating to the discounting of future cash flows unwinds with the passage of time, and is recognized in interest income. Also under IFRSs, if the recognition of a write-down to fair value on secured loans decreases because collateral values have improved and the improvement can be related objectively to an event occurring after recognition of the write-down, such write-down can be reversed, which is not permitted under U.S. GAAP. Additionally under IFRSs, future recoveries on charged-off loans or loans written down to fair value less cost to obtain title and sell the collateral are accrued for on a discounted basis and a recovery asset is recorded. Subsequent recoveries are recorded to earnings under U.S. GAAP, but are adjusted against the recovery asset under IFRSs. Under IFRSs, interest on impaired loans is recorded at the effective interest rate on the customer loan balance net of impairment allowances, and therefore reflects the collectibility of the loans. In the third quarter of 2011 we adopted new guidance under U.S. GAAP for determining whether a restructuring of a receivable meets the criteria to be considered a TDR Loan. Credit loss reserves on TDR Loans are established based on the present value of expected future cash flows discounted at the loans' original effective interest rate. Under IFRSs, impairment on the residential mortgage loans where we have granted the borrower a concession as a result of financial difficulty is measured based on the cash flows attributable to the credit loss events which occurred before the reporting date. HSBC's accounting policy under IFRSs is to remove such loans from the category of impaired loans after a defined period of re-performance, although such loans remain segregated from loans that were not impaired in the past for the purposes of collective impairment assessment to reflect their credit risk. Under U.S. GAAP, when a loan is impaired the impairment is measured based on all expected cash flows over the remaining expected life of the loan. Such loans generally remain impaired for the remainder of their lives under U.S. GAAP. Loans previously held for sale - IFRSs requires loans designated as held for sale at the time of origination to be treated as trading assets and recorded at their fair value. Under U.S. GAAP, loans designated as held for sale are reflected as loans and recorded at the lower of amortized cost or fair value. Under U.S. GAAP, the income and expenses related to receivables held for sale are reported similarly to loans held for investment. Under IFRSs, the income and expenses related to receivables held for sale are reported in other operating income. Certain receivables that were previously classified as held for sale under U.S. GAAP were transferred to held for investment during 2009 as at that time we intended to hold these receivables for the foreseeable future. Under U.S. GAAP, these receivables were subject to lower of amortized cost or fair value ("LOCOM") adjustments while classified as held for sale and were transferred to held for investment at LOCOM. Since these receivables were not classified as held for sale under IFRSs during 2008, these receivables were always reported within loans and the measurement criteria did not change. As a result, loan impairment charges were recorded under IFRSs which were essentially included as a component of the lower of amortized cost or fair value adjustments under U.S. GAAP. Credit card receivables transferred to held for sale and included in discontinued operations for U.S. GAAP - For receivables transferred to held for sale subsequent to origination, IFRSs requires these receivables to be reported separately on the balance sheet but does not change the recognition and measurement criteria. Accordingly for IFRSs purposes, such loans continue to be accounted for in accordance with IAS 39, "Financial Instruments: Recognition and Measurement" ("IAS 39"), with any gain or loss recorded at the time of sale. U.S. GAAP requires loans that meet the held for sale classification requirements be transferred to a held for sale category at the lower of amortized cost or fair value. Interest recognition - The calculation of effective interest rates under IAS 39 requires an estimate of changes in estimated contractual cash flows, including fees and points paid or recovered between parties to the contract that 70
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Table of Contents HSBC Finance Corporation are an integral part of the effective interest rate be included. U.S. GAAP generally prohibits recognition of interest income to the extent the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. Also under U.S. GAAP, prepayment penalties are generally recognized as received. Other-than-temporary impairment on available-for-sale securities - Under U.S. GAAP, the credit loss component of an other-than-temporary impairment of a debt security is recognized in earnings while the remaining portion of the impairment loss is recognized in other comprehensive income provided a company concludes it neither intends to sell the security nor concludes that it is more-likely-than-not that it will have to sell the security prior to recovery. Under IFRSs, there is no bifurcation of other-than-temporary impairment and the entire decline in fair value is recognized in earnings. Securities - Under IFRSs, securities include HSBC shares held for stock plans at fair value. These shares are recorded at fair value through other comprehensive income and subsequently recognized in profit and loss as the shares vest. If it is determined these shares have become impaired, the fair value loss is recognized in profit and loss and any fair value loss recorded in other comprehensive income is reversed. There is no similar requirement under U.S. GAAP. During the second quarter of 2009, under IFRSs we recorded income for the value of additional shares attributed to HSBC shares held for stock plans as a result of HSBC's rights offering earlier in 2009. During 2012 and 2011, under IFRSs we recorded additional gains as these shares vest. The additional shares are not recorded under U.S. GAAP. Present value of long-term insurance contracts - Under IFRSs, the present value of an in-force ("PVIF") long-term insurance contract is determined by discounting future cash flows expected to emerge from business currently in force using appropriate assumptions plus a margin in assessing factors such as future mortality, lapse rates and levels of expenses, and a discount rate that reflects the risk free rate plus a margin for operational risk. Movements in the PVIF of long-term insurance contracts are included in other operating income. Under U.S. GAAP, revenue is recognized over the life insurance policy term. Pension and other postretirement benefit costs - Net income under U.S. GAAP is lower than under IFRSs as a result of the amortization of the amount by which actuarial losses exceeded the higher of 10 percent of the projected benefit obligation or fair value of plan assets (the "corridor.")
Other - There are other differences between IFRSs and U.S. GAAP including purchase accounting, other miscellaneous items and, in 2011, mortgage servicing related matters.
Quantitative Reconciliations of Non-U.S. GAAP Financial Measures to U.S. GAAP Financial Measures For quantitative reconciliations of non-U.S. GAAP financial measures presented herein to the equivalent GAAP basis financial measures, see "Reconciliations of Non-U.S. GAAP Financial Measures to U.S. GAAP Financial Measures." 71
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Table of Contents HSBC Finance Corporation Receivables Review
The following table summarizes receivables at
Increases (Decreases) From March 31, December 31, 2011 2012 $ % (dollars are in millions) Receivables: Real estate secured: First lien $ 37,021 $ (1,214 ) (3.2 )% Second lien 4,222 (256 ) (5.7 )
Total real estate secured(1) 41,243 (1,470 ) (3.4 )
Personal non-credit card 4,794 (402 ) (7.7 ) Commercial and other 4 (23 ) (85.2 ) Total receivables $ 46,041 $ (1,895 ) (4.0 )%
(1) At
includes
are carried at the lower of amortized cost or fair value less cost to sell
in accordance with our existing charge-off policy.
Real estate secured receivables The decrease in real estate secured receivable balances sinceDecember 31, 2011 reflects the continuing liquidation of these portfolios, which will continue going forward, as well as seasonal improvements in our collection activities during the first quarter of the year as some customers use their tax refunds to make payments. The liquidation rates in our real estate secured receivable portfolios also continue to be impacted by low loan prepayments as few refinancing opportunities for our customers exist and by the trends impacting the mortgage lending industry as discussed above. Real estate markets in a large portion ofthe United States have been affected by stagnation or declines in property values. As such, the loan-to-value ("LTV") ratios for our real estate secured receivable portfolios have generally deteriorated since origination. Receivables that have an LTV greater than 100 percent have historically had a greater likelihood of becoming delinquent, resulting in higher loss severities which could adversely impact our provision for credit losses. Refreshed loan-to-value ratios for our real estate secured receivable portfolios are presented in the table below as ofMarch 31, 2012 andDecember 31, 2011 . Refreshed LTVs(1)(2) March 31, 2012(3) December 31, 2011(3) First Second First Second Lien Lien Lien Lien LTV<80% 40 % 13 % 38 % 13 % 80%100%(4) 27 60 29 61 Average LTV for portfolio 87 107 88 108 72
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Table of Contents HSBC Finance Corporation
(1) Refreshed LTVs for first liens are calculated using the receivable balance
as of the reporting date (including any charge-offs recorded to reduce
receivables to the lower of amortized cost or fair value less cost to sell
in accordance with our existing charge-off policies). Refreshed LTVs for
second liens are calculated using the receivable balance as of the reporting
date (including any charge-offs recorded to reduce receivables to the lower
of amortized cost or fair value less cost to sell in accordance with our
existing charge-off policies) plus the senior lien amount at origination.
For purposes of this disclosure, current estimated property values are
derived from the property's appraised value at the time of receivable
origination updated by the change in the
(formerly known as the
pricing index ("HPI") at either a Core Based Statistical Area ("CBSA") or
state level. The estimated value of the homes could vary from actual fair
values due to changes in condition of the underlying property, variations in
housing price changes within metropolitan statistical areas and other
factors. As a result, actual property values associated with loans that end
in foreclosure may be significantly lower than the estimated values used for
purposes of this disclosure.
(2) For purposes of this disclosure, current estimated property values are
calculated using the most current HPI's available and applied on an
individual loan basis, which results in an approximately three month delay
in the production of reportable statistics for the current period.
Therefore, the
above reflects current estimated property values using HPIs as of
declines in property values in certain markets, the refreshed LTVs of our portfolio may, in fact, be higher than reflected in the table. (3) Excludes purchased receivable portfolios which totaled$1.0 billion and$1.1 billion atMarch 31, 2012 andDecember 31, 2011 , respectively. (4) The following reflects the average Refreshed LTVs for loans with an LTV ratio greater than or equal to 100 percent: RefreshedLTVs March31, 2012 December31, 2011 First Second First Second Lien Lien Lien Lien AverageLTV for LTV>100% 119% 124% 119% 125% Personal non-credit card receivables The decrease in personal non-credit card receivable balances sinceDecember 31, 2011 reflects the continuing liquidation of these portfolios, which will continue going forward, and seasonal improvements in our collection activities during the first quarter of the year as some customers use their tax refunds to make payments.
Real Estate Owned
We obtain real estate by taking possession of the collateral pledged as security for real estate secured receivables. Prior to taking possession of the pledged collateral, receivable carrying amounts in excess of fair value less cost to sell are generally charged-off at or before the time foreclosure is completed or settlement is reached with the borrower but, in any event, generally no later than the end of the month in which the account becomes six months contractually delinquent. If foreclosure is not pursued (which frequently occurs on loans in the second lien position) and there is no reasonable expectation for recovery (insurance claim, title claim, pre-discharge bankrupt account), the account is generally charged-off no later than the end of the month in which the account becomes six months contractually delinquent. Values are determined based upon broker price opinions or appraisals which are updated every 180 days. During the quarterly period between updates, real estate price trends are reviewed on a geographic basis and additional downward adjustments are recorded as necessary. Collateral acquired in satisfaction of a loan is initially recognized at the lower of amortized cost or its fair value less estimated costs to sell and reported as real estate owned ("REO"). Fair values of foreclosed properties at the time of acquisition are initially determined based upon broker price opinions. Subsequent to acquisition, a more detailed property valuation is performed, reflecting information obtained from a walk-through of the property in the form of a listing agent broker price opinion as well as an independent broker price opinion or appraisal. A valuation is determined from this information within 90 days and any additional write-downs required are recorded through charge-off at that time. This value, which includes the impact on fair value from the conditions inside the property, becomes the "Initial REO Carrying Amount." 73
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Table of Contents HSBC Finance Corporation In determining the appropriate amounts to charge-off when a property is acquired in exchange for a loan, we do not consider losses on sales of foreclosed properties resulting from deterioration in value during the period the collateral is held because these losses result from future loss events which cannot be considered in determining the fair value of the collateral at the acquisition date in accordance with generally accepted accounting principles. Once a property is classified as real estate owned, we do not consider the losses on past sales of foreclosed properties when determining the fair value of any collateral during the period it is held in REO. Rather, a valuation allowance is created to recognize any subsequent declines in fair value less cost to sell as they become known after the Initial REO Carrying Amount is determined with a corresponding amount reflected in operating expense. Property values are periodically reviewed for impairment until the property is sold and any impairment identified is immediately recognized through the valuation allowance. Recoveries in value are also recognized against the valuation allowance but not in excess of cumulative losses previously recognized subsequent to the date of repossession. Adjustments to the valuation allowance, costs of holding REO and any gain or loss on disposition are credited or charged to operating expense. The following table provides quarterly information regarding our REO properties: Three Months Ended Mar. 31, Dec. 31, Sept. 30, June 30, Mar. 30, 2012 2011 2011 2011 2011 Number of REO properties at end of period 3,066 3,446 4,250 6,854 10,016 Number of properties added to REO inventory in the period 1,907 1,676 1,378 2,495 5,408 Average loss on sale of REO properties(1) 8.3 % 10.2 % 8.9 % 7.0 % 7.9 % Average total loss on foreclosed properties(2) 56.5 % 57.6 % 56.4 % 54.9 % 54.6 % Average time to sell REO properties (in days) 192 206 196 169 167
(1) Property acquired through foreclosure is initially recognized at the lower
of amortized cost or its fair value less estimated costs to sell ("Initial
REO Carrying Amount"). The average loss on sale of REO properties is
calculated as cash proceeds less the Initial REO Carrying Amount divided by
the unpaid loan principal balance prior to write-down (excluding any accrued
finance income) plus certain other ancillary disbursements that, by law, are
reimbursable from the cash proceeds (e.g., real estate tax advances) and
were incurred prior to our taking title to the property. This ratio represents the portion of our total loss on foreclosed properties that occurred after we took title to the property.
(2) The average total loss on foreclosed properties sold each quarter includes
both the loss on sale of the REO property as discussed above and the
cumulative write-downs recognized on the loans up to the time we took title
to the property. This calculation of the average total loss on foreclosed
properties uses the unpaid loan principal balance prior to write-down
(excluding any accrued finance income) plus certain other ancillary
disbursements that, by law, are reimbursable from the cash proceeds (e.g.,
real estate tax advances) and were incurred prior to our taking title to the
property.
Our methodology for determining the fair values of the underlying collateral as described above is continuously validated by comparing our net investment in the loan subsequent to charging the loan down to the lower of amortized cost or fair value less cost to sell, or our net investment in the property upon completing the foreclosure process, to the updated broker's price opinion and once the collateral has been obtained, any adjustments that have been made to lower the expected selling price, which may be lower than the broker's price opinion. Adjustments in our expectation of the ultimate proceeds that will be collected are recognized as they occur based on market information at that time and consultation with our listing agents for the properties. As previously reported, beginning in late 2010 we temporarily suspended all new foreclosure proceedings and in early 2011 temporarily suspended foreclosures in process where judgment had not yet been entered while we enhanced foreclosure documentation and processes for foreclosures and re-filed affidavits where necessary. During the first quarter of 2012, we added 1,907 properties to REO inventory which primarily reflects loans for which we accepted the deed to the property in lieu of payment ("deed-in-lieu"). We expect the number of REO properties added to inventory will begin to increase during 2012 although the number of new REO properties added to inventory will continue to be impacted by our ongoing refinements to our foreclosure processes as well as the extended foreclosure timelines in all states as discussed below. 74
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Table of Contents HSBC Finance Corporation The number of REO properties atMarch 31, 2012 decreased as compared toDecember 31, 2011 as the volume of properties added to REO inventory continues to be slow as a result of the backlog in foreclosure activities driven by the temporary suspension of foreclosures as discussed above, as well as continuing sales of REO properties during the first quarter of 2012. We have resumed processing suspended foreclosure activities where judgment had not yet been entered in all states except one. We have also begun initiating new foreclosure activities in all states except one, although we are currently focusing our new foreclosure activities only in certain states. It will take time to work through the backlog of loans in each state that have not yet been referred to foreclosure. In addition, certain courts and state legislatures have issued new rules or statutes relating to foreclosures. Scrutiny of foreclosure documentation has increased in some courts. Also, in some areas, officials are requiring additional verification of information filed prior to the foreclosure proceeding. The combination of these factors has led to a significant backlog of foreclosures which will take time to resolve. If these trends continue, there could be additional delays in the processing of foreclosures, which could have an adverse impact upon housing prices which is likely to result in higher loss severities while foreclosures are delayed. The average loss on sale of REO properties and the average total loss on foreclosed properties for the first quarter of 2012 decreased as compared to the prior quarter as a greater mix of the REO properties sold during the quarter were properties for which we had accepted a deed-in-lieu. Total losses on a deed-in-lieu are typically lower than expected total losses from REO properties acquired through the standard foreclosure process and provide resolution to the delinquent receivable over a shorter period of time. The decrease was partially offset by the impact of continued declines in home prices during the first quarter of 2012 due, in part, to the continued elevated levels of foreclosed properties. During the first quarter of 2012, we saw a slight decrease in the average number of days to sell REO properties due to a greater mix of REO properties sold during the quarter being properties for which we had accepted a deed-in-lieu. Historically, properties acquired through deed-in-lieu result in shorter time to sell. Results of Operations Net interest income In the following table which summarizes net interest income, interest expense includes$21 million and$26 million for the three months endedMarch 31, 2012 and 2011, respectively, that has been allocated to our discontinued operations in accordance with our existing internal transfer pricing policies as external interest expense is unaffected by the transfer of businesses to discontinued operations. Increase 2012 2011 (Decrease) Three Months Ended March 31, $ %(1) $
%(1) Amount %
(dollars are in millions) Finance and other interest income $ 906 7.04 % $ 1,092 6.99 % $ (186 ) (17.0 )% Interest expense 520 4.04 673 4.31 (153 ) (22.7 ) Net interest income $ 386 3.00 % $ 419 2.68 % $ (33 ) (7.9 )%
(1) % Columns: comparison to average owned interest-earning assets.
Net interest income decreased during the three months endedMarch 31, 2012 as compared to the prior year quarter. The decrease reflects lower average receivables as a result of receivable liquidation and a lower overall receivable yield as discussed below. While receivable yields were lower during the first quarter of 2012, the overall yield on all interest earning assets during the current quarter was positively impacted by a shift in the mix of all interest earning assets to include a lower percentage of non-insurance investments, which have significantly lower yields than our receivable portfolios. This decrease in non-insurance investments resulted from changes made in our overall investment strategy beginning in the fourth quarter of 2011. The decrease in net interest income was partially offset by lower interest expense due to lower average borrowings and lower average rates. 75
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Table of Contents HSBC Finance Corporation Overall receivable yield decreased during the first quarter of 2012 as receivable yields continue to be negatively impacted by a shift in receivable mix to higher levels of lower yielding first lien real estate secured receivables as higher yielding second lien real estate secured receivables and personal non-credit card receivables have run-off at a faster pace than first lien real estate secured receivables. While the overall receivable yield in our receivable portfolio decreased during the first quarter of 2012, receivable yields vary between receivable products. Yields in our real estate secured receivable portfolio decreased reflecting the impact of a higher percentage of nonaccrual real estate secured receivables as compared to the prior year quarter due to the temporary suspension of foreclosure activities. Yields in our personal non-credit card receivable portfolio increased during the first quarter of 2012 reflecting the impact of a lower percentage of nonaccrual personal non-credit card receivables as compared to the prior year quarter. Net interest margin was 3.00 percent for the three months endedMarch 31, 2012 compared to 2.68 percent for the prior year quarter. The increase in net interest margin for the first quarter of 2012 was driven by a lower cost of funds as a percentage of average interest earning assets and a higher overall yield on all interest earning assets driven by the shift in the mix of all interest earning assets to include a lower percentage of non-insurance investments, which have significantly lower yields than our receivable portfolios as discussed above, partially offset by lower overall receivable yields as discussed above.
Significant trends affecting the comparability of net interest income and net interest margin are summarized below:
Three Months EndedMarch 31, 2012 (dollars are
in millions) Net interest income/net interest margin from prior year quarter
$ 419
2.68 %
Impact to net interest income resulting from: Lower asset levels (192 ) Asset mix 35 Receivable yields: Receivable pricing (11 ) Receivable product mix (29 ) Impact of nonaccrual receivables (11 ) Impact of receivable modifications 7 Interest receivable related to income tax receivables 4 Non-insurance investment income (rate) (3 ) Cost of funds (rate and volume) 153 Other 14 Net interest income/net interest margin for current quarter $ 386 3.00 % The varying maturities and repricing frequencies of both our assets and liabilities expose us to interest rate risk. When the various risks inherent in both the asset and the debt do not meet our desired risk profile, we use derivative financial instruments to manage these risks to acceptable interest rate risk levels. See "Risk Management" for additional information regarding interest rate risk and derivative financial instruments. 76
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Table of Contents HSBC Finance Corporation Provision for credit losses The following table summarizes provision for credit losses by product: Increase (Decrease) Three Months Ended March 31, 2012 2011 Amount % (dollars are in millions) Provision for credit losses: Real estate secured $ 773 $ 690 $ 83 12.0 % Personal non-credit card 18 18 - - $ 791 $ 708 $ 83 11.7 %
Our provision for credit losses increased during the three months ended
• The provision for credit losses for real estate secured loans increased
during the first quarter of 2012 as compared to the prior year quarter
reflecting the impact of higher reserve requirements on TDR Loans during
the first quarter of 2012 as a result of adopting the new Accounting
Standards Update as discussed below. This increase was partially offset by
the impact of lower receivable balances and lower loss estimates as compared to the prior year quarter. • The provision for credit losses for our personal non-credit card receivables was flat as compared to the prior year as the impact of a
higher loss provision on TDR Loans driven by the adoption of the new Accounting Standards Update as discussed below was offset by lower
receivable levels and improved credit quality including lower delinquency
levels and lower loss estimates as compared to the prior year quarter.
As discussed in our 2011 Form 10-K, during the third quarter of 2011, we adopted an Accounting Standards Update which provided additional guidance to determine whether a restructuring of a receivable meets the criteria to be considered a troubled debt restructuring for purposes of the identification and disclosure of TDR Loans as well as for recording impairment. This new accounting guidance continues to impact our provision for credit loss in periods post-adoption, as loans that otherwise would not have qualified for such reporting in the past are now meeting the criteria under the new accounting guidance to be reported and reserved for as TDR Loans which will continue in future periods. Therefore, the provision for credit losses for the three months endedMarch 31, 2012 is not comparable to the provision for credit losses for the three months endedMarch 31, 2011 . Net charge-off dollars totaled$878 million and$1.3 billion during the three months endedMarch 31, 2012 and 2011, respectively. The decrease reflects the impact of lower receivable levels and lower delinquency levels as well as lower levels of personal bankruptcy filings and improvements in economic conditions. See "Credit Quality" for further discussion of our net charge-offs. Credit loss reserves atMarch 31, 2012 decreased as compared toDecember 31, 2011 as we recorded provision for credit losses less than net charge-offs of$87 million during the current quarter. Lower credit loss reserve levels reflect lower receivable levels, improved economic and credit conditions, including lower delinquency levels, and an increase in the amount and percentage of real estate secured receivables which are carried at the lower of amortized cost or fair value less cost to sell. The decrease in overall credit loss reserves was partially offset by higher credit loss reserve levels on TDR Loans due to higher outstanding balances. See "Credit Quality" for further discussion of credit loss reserves. 77
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Table of Contents HSBC Finance Corporation
Other revenues The following table summarizes other revenues:
Increase (Decrease) Three Months Ended March 31, 2012 2011 Amount % (dollars are in millions) Insurance revenue $ 58 $ 60 $ (2 ) (3.3 )% Investment income 20 25 (5 ) (20.0 ) Derivative related income (expense) 205 34 171 100+ Gain (loss) on debt designated at fair value and related derivatives (396 ) (29 ) (367 ) (100+ ) Servicing and other fees from HSBC affiliates 8 7 1 14.3 Other income (4 ) 14 (18 ) (100+ ) Total other revenues $ (109 ) $ 111 $ (220 ) (100+ )% Insurance revenue decreased during the first quarter of 2012 as a result of the decision to cease issuing new term life insurance inthe United States effectiveJanuary 2012 as well as a decrease in the number of credit insurance policies in force sinceMarch 31, 2011 primarily due to the run-off of our Consumer Lending portfolio. Investment income includes interest income on available-for-sale securities in our insurance investment portfolio as well as realized gains and losses from the sale of all investment securities. Investment income decreased during the three months endedMarch 31, 2012 due to lower average balances and lower yields. Derivative related income (expense) includes realized and unrealized gains and losses on derivatives which do not qualify as effective hedges under hedge accounting principles as well as the ineffectiveness on derivatives which are qualifying hedges. Designation of swaps as effective hedges reduces the volatility that would otherwise result from mark-to-market accounting. All derivatives are economic hedges of the underlying debt instruments regardless of the accounting treatment. Derivative related income (expense) is summarized in the table below: Three Months Ended March 31, 2012 2011 (in millions) Net realized losses $ (31 ) $ (20 ) Mark-to-market on derivatives which do not qualify as effective hedges 239 63 Ineffectiveness (3 ) (9 ) Total $ 205 $ 34 Derivative related income (expense) increased during the first quarter of 2012. As previously discussed, our real estate secured receivables are remaining on the balance sheet longer due to lower prepayment rates. AtMarch 31, 2012 , we had$9.0 billion of interest rate swaps outstanding for the purpose of offsetting the increase in the duration of these receivables and the corresponding increase in interest rate risk as measured by the present value of a basis point ("PVBP"). While these positions acted as economic hedges by lowering our overall interest rate risk and more closely matching both the structure and duration of our liabilities to the structure and duration of our assets, they did not qualify as effective hedges under hedge accounting principles. As a result, these positions are carried at fair value and are marked-to-market through income while the item being hedged is not carried at fair value and, therefore, no offsetting fair value adjustment is recorded. Of these non-qualifying hedges,$6.4 billion were longer-dated pay fixed/receive variable interest rate swaps with an average life of 12.8 years and$2.6 billion were shorter-dated receive fixed/pay variable interest rate swaps with an average life of 3.2 years. Market value movements for the longer-dated pay fixed/receive variable interest rate swaps may be volatile during periods in which long-term interest rates fluctuate, but they effectively lock in fixed interest rates for a set period of time which results in funding that is better aligned with longer term assets. Market value movements on the shorter-dated receive fixed/pay variable interest rate swaps may offset a portion of this volatility. 78
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Table of Contents HSBC Finance Corporation Rising long-term interest rates during both the three months endedMarch 31, 2012 and 2011 had a positive impact on the mark-to-market for this portfolio of swaps in both periods; however, the impact was more pronounced during the first quarter of 2012. Net realized losses were higher during the three months endedMarch 31, 2012 as a result of terminations of non-qualifying hedges during the period. Ineffectiveness during both the three months endedMarch 31, 2012 and 2011 was not significant. Net income volatility, whether based on changes in interest rates for swaps which do not qualify for hedge accounting or ineffectiveness recorded on our qualifying hedges under the long haul method of accounting, impacts the comparability of our reported results between periods. Accordingly, derivative related income (expense) for the three months endedMarch 31, 2012 or any prior periods should not be considered indicative of the results for any future periods. Gain (loss) on debt designated at fair value and related derivatives reflects fair value changes on our fixed rate debt accounted for under FVO as well as the fair value changes and realized gains (losses) on the related derivatives associated with debt designated at fair value. The loss on debt designated at fair value and related derivatives during both the three months endedMarch 31, 2012 and 2011 reflects the impact of rising long-term interest rates, although the impact was more pronounced during the three months endedMarch 31, 2011 . The loss on debt designated at fair value and related derivatives during both the three months endedMarch 31, 2012 and 2011 was also impacted by a tightening of our credit spreads, although the impact of tightening credit spreads was more pronounced during the current quarter. See Note 7, "Fair Value Option," in the accompanying consolidated financial statements for additional information, including a break out of the components of the gain (loss) on debt designated at fair value and related derivatives. Servicing and other fees from HSBC affiliates represents revenue received under service level agreements under which we service real estate secured and private label receivables as well as rental revenue fromHSBC Technology & Services (USA) Inc. ("HTSU") for certain office and administrative costs. During the first quarter of 2012, servicing and other fees from HSBC affiliates were essentially flat. Other income decreased in the three months endedMarch 31, 2012 due to the reversal of income previously recorded on lender-placed hazard insurance for real estate secured receivable customers which we estimate will be refunded, partially offset by higher gains on sales of miscellaneous commercial assets. Operating expenses The following table summarizes total costs and expenses: Increase (Decrease) Three Months Ended March 31, 2012 2011 Amount % (dollars are in millions) Salaries and employee benefits $ 51 $ 48 $ 3 6.3 % Occupancy and equipment expenses 11 16 (5
) (31.3 )
Real estate owned expenses 29 106 (77
) (72.6 )
Other servicing and administrative expenses 90 84 6 7.1 Support services from HSBC affiliates 73 76 (3 ) (3.9 ) Policyholders' benefits 37 41 (4 ) (9.8 ) Total costs and expenses $ 291 $ 371 $ (80 ) (21.6 )% Compliance costs were a growing component of our operating expenses in the first quarter of 2012, increasing by$30 million in the first quarter of 2012, primarily within other servicing and administrative expenses. We anticipate compliance remediation costs will continue to increase in future periods as we continue to address the requirements of the regulatory consent order relating to foreclosure activities. 79
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Table of Contents HSBC Finance Corporation Salaries and employee benefits increased slightly during the first quarter of 2012 as a result of increased staffing related to processing foreclosures as well as compliance matters, partially offset by the impact of the continuing reduced scope of our business operations and the impact of entity-wide initiatives to reduce costs.
Occupancy and equipment expenses decreased in the first quarter of 2012 primarily due to lower depreciation expense, repair costs and property taxes reflecting the impact of the continuing reduced scope of our business operations.
Real estate owned expenses decreased significantly during the first quarter of 2012 primarily due to lower holding costs for REO properties due to a decrease in the number of REO properties held as compared to the prior year quarter resulting from a significant decrease in the number of REO properties added to inventory subsequent toMarch 31, 2011 due to the temporary suspension of foreclosure activities and higher REO sales. The decrease in REO expense during the first quarter of 2012 also reflects lower losses on sales of REO properties due to fewer REO properties being sold during the first quarter of 2012 as fewer REO properties were available for sale as a result of the temporary suspension of foreclosure activities. Other servicing and administrative expenses increased during the first quarter of 2012 reflecting higher fees for consulting services and other expenses related to compliance matters, partially offset by the continuing reduction in the scope of our business operations and the impact of entity-wide initiatives to reduce costs, including lower third party collection costs as sales of charged-off accounts to third parties increased. Support services from HSBC affiliates decreased slightly during the first quarter of 2012 reflecting lower technology operational support costs and lower fees for servicing real estate secured receivables, partially offset by higher allocations for compliance, finance, tax and treasury costs. Policyholders' benefits decreased slightly during the first quarter of 2011 due to lower claims on credit insurance policies as there are fewer such policies in place primarily due to the run-off of our receivable portfolio. Efficiency ratio Our efficiency ratio from continuing operations was 97.32 percent during the three months endedMarch 31, 2012 as compared to 64.08 percent in the prior year quarter. Our efficiency ratio in both periods was impacted by the change in the fair value of debt for which we have elected fair value option accounting. Excluding this item from both periods, our efficiency ratio was significantly lower during the first quarter of 2012 primarily due to higher other revenues driven by derivative-related income as well as lower operating expenses driven by lower REO expenses, partially offset by lower net interest income driven by receivable portfolio liquidation.
Segment Results - IFRS Basis
We have one reportable segment: Consumer. Our Consumer segment consists of our run-off Consumer Lending and Mortgage Services businesses. The Consumer segment provided real estate secured and personal non-credit card loans with both revolving and closed-end terms and with fixed or variable interest rates. Loans were originated through branch locations and direct mail. Products were also offered and customers serviced through the Internet. Prior to the first quarter of 2007, we acquired loans from correspondent lenders and prior toSeptember 2007 we also originated loans sourced through mortgage brokers. While these businesses are operating in run-off mode, they have not been reported as discontinued operations because we continue to generate cash flow from the ongoing collections of the receivables, including interest and fees. 80
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Table of Contents HSBC Finance Corporation The All Other caption includes our Insurance and Commercial businesses. Each of these businesses falls below the quantitative threshold tests under segment reporting accounting principles for determining reportable segments. The "All Other" caption also includes our corporate and treasury activities, which includes the impact of FVO debt. Certain fair value adjustments related to purchase accounting resulting from our acquisition by HSBC and related amortization have been allocated to corporate, which is included in the "All Other" caption within our segment disclosure. We report results to our parent, HSBC, in accordance with its reporting basis, International Financial Reporting Standards ("IFRSs"). Our segment results are presented on an IFRSs legal entity basis ("IFRS Basis") (a non-U.S. GAAP financial measure) as operating results are monitored and reviewed and trends are evaluated on an IFRS Basis. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on a U.S. GAAP basis. There have been no significant changes in measurement or composition of our segment reporting as compared with the presentation in our 2011 Form 10-K.
A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are summarized in Note 12, "Business Segments," in the accompanying consolidated financial statements as well as under the caption "Basis of Reporting" in this MD&A.
Consumer Segment The following table summarizes the IFRS Basis results for our Consumer segment: Increase (Decrease) Three Months Ended March 31: 2012 2011 Amount % (dollars are in millions) Net interest income $ 597 $ 657 $ (60 ) (9.1 )% Other operating income (expense) (31 ) (32 ) 1 3.1 Total operating income 566 625 (59 ) (9.4 ) Loan impairment charges 855 1,277 (422 ) (33.1 ) (289 ) (652 ) 363 55.7 Operating expenses 183 234 (51 ) (21.8 ) Profit (loss) before tax $ (472 ) $ (886 ) $ 414 46.7 % Net interest margin, annualized 5.08 % 4.76 % - - Efficiency ratio 32.33 37.44 - - Return (after-tax) on average assets (2.61 ) (4.11 ) - - Balances at end of period: Customer loans $ 46,132 $ 54,156 $ (8,024 ) (14.8 )% Assets 44,175 53,011 (8,836 ) (16.7 )% Our Consumer segment reported a lower loss before tax during the three months endedMarch 31, 2012 due to lower loan impairment charges and lower operating expenses, partially offset by lower net interest income while other operating income remained flat.
Loan impairment charges decreased significantly during the first quarter of 2012 as discussed below.
• Loan impairment charges for the real estate secured loan portfolios
decreased during the first quarter of 2012. The decrease reflects lower
loan balances outstanding as the portfolios continue to liquidate as well
as lower loss estimates. Loan impairment charges in both periods were
impacted by the discounting of estimated future amounts to be received on
real estate loans which have been written down to fair value less cost to
obtain and sell the collateral, although the impact was higher in the prior
year period. Also contributing to the decrease was lower levels of
two-months-and-over contractual delinquency on accounts less than 180 days
contractually delinquent, partially offset by an increase in late stage delinquency, reflecting the continuing impact from foreclosure delays previously discussed. 81
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Table of Contents HSBC Finance Corporation
• Loan impairment charges for personal non-credit card loans increased during
the first quarter of 2012 as during the first quarter of 2011 we recorded a
significant decrease in reserve levels due to improved credit quality.
While we also decreased reserve levels during the first quarter of 2012,
the impact to loan impairment charges was not as pronounced as during the
prior year quarter.
During the three months endedMarch 31, 2012 , we decreased credit loss reserves to$5.7 billion as loan impairment charges were$111 million less than net charge-offs reflecting the lower overall delinquency levels during the first quarter of 2012 due to improvements in economic conditions as well as seasonal improvements in collection activities during the first quarter of the year as customers use their tax refunds to make payments. Net interest income decreased during the three months endedMarch 31, 2012 primarily due to lower average loan levels as a result of loan liquidation and lower overall loan yields, partially offset by lower interest expense. The lower overall yield in our loan portfolio reflects the impact of lower amortization associated with the discounting of future estimated cash flows associated with real estate secured loans due to the passage of time. Overall loan yields were negatively impacted by a shift in mix to higher levels of lower yielding first lien real estate secured loans as higher yielding second lien real estate secured and personal non-credit card loans have run-off at a faster pace than first lien real estate secured loans. As yields vary between loan products, yields in our real estate secured loan portfolio decreased due to higher levels of impaired real estate secured loans, partially offset by higher yields in our personal non-credit card loan portfolio due to lower levels of impaired personal non-credit card loans. Lower interest expense during the three months endedMarch 31, 2012 reflects lower average borrowings. Net interest margin increased during the first quarter of 2012 reflecting a lower cost of funds as a percentage of average interest earning assets, partially offset by lower loan yields as discussed above. Other operating income was essentially flat as lower losses on REO properties were offset by a reversal of income previously recorded on lender-placed hazard insurance for real estate secured receivable customers which we estimate will be refunded. Lower losses on REO properties during the current quarter reflects fewer REO properties sales during the first quarter of 2012 due to fewer REO properties available for sale as a result of the temporary suspension of foreclosure activities. Operating expenses decreased 22 percent during the three months endedMarch 31, 2012 primarily due to lower holding costs on REO properties, lower support services from affiliates and lower third party collection costs as sales of charged-off accounts to third parties increased, partially offset by higher fees for consulting services and other expenses relating to compliance matters. Lower holding costs on REO properties reflects a significant decrease in the number of new REO properties due to the temporary suspension of foreclosure activities previously discussed.
The efficiency ratio improved during the first quarter of 2012 due to lower operating expenses, partially offset by lower net interest income as discussed above as expenses declined at a faster pace than revenue.
ROA improved during the first quarter of 2012 primarily driven by lower loan impairment charges and lower operating expenses, partially offset by the impact of lower average assets. 82
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Table of Contents HSBC Finance Corporation Customer loans Customer loans for our Consumer segment can be analyzed as follows: March 31, Increases (Decreases) From 2012 December 31, 2011 $ % (dollars are in millions) Real estate secured $ 41,210 $ (1,491 ) (3.5 )%
Personal non-credit card 4,922 (398 )
(7.5 ) Total customer loans $ 46,132 $ (1,889 ) (3.9 )% Customer loans decreased 4 percent to$46.1 billion atMarch 31, 2012 reflecting the continued liquidation of these portfolios which will continue going forward. The decrease also reflects seasonal improvements in our collection activities during the first quarter of the year as some customers use their tax refunds to make payments. The liquidation rates in our real estate secured loan portfolio continues to be impacted by declines in loan prepayments as fewer refinancing opportunities for our customers exist and the trends impacting the mortgage lending industry as previously discussed.
See "Receivables Review" for a more detail discussion of the decreases in our receivable portfolios.
Credit Quality Credit Loss Reserves We maintain credit loss reserves to cover probable incurred losses of principal, interest and fees and, as it relates to loans which have been identified as troubled debt restructures, credit loss reserves are maintained based on the present value of expected future cash flows discounted at the loans' original effective interest rates. Credit loss reserves are based on a range of estimates and are intended to be adequate but not excessive. We estimate probable losses for consumer receivables which do not qualify as troubled debt restructurings using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge-off based upon recent historical performance experience of other loans in our portfolio. This analysis considers delinquency status, loss experience and severity and takes into account whether borrowers have filed for bankruptcy, or loans have been re-aged or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves take into consideration the expected loss severity based on the underlying collateral, if any, for the loan in the event of default based on recent trends. Delinquency status may be affected by customer account management policies and practices, such as the re-age of accounts, forbearance agreements, extended payment plans, modification arrangements, external debt management programs and deferments. When customer account management policies or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this will be reflected in our roll rate statistics. To the extent that re-aged or modified accounts have a greater propensity to roll to higher delinquency buckets, this will be captured in the roll rates. Since the loss reserve is computed based on the composite of all of these calculations, this increase in roll rate will be applied to receivables in all respective delinquency buckets, which will increase the overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors that may not be fully reflected in the statistical roll rate calculation or when historical trends are not reflective of current inherent losses in the portfolio. Portfolio risk factors considered in establishing loss reserves on consumer receivables include product mix, unemployment rates, bankruptcy trends, the credit performance of modified loans, geographic concentrations, loan product features such as adjustable rate loans, the credit performance of second lien loans where the first lien loan that we own or service is 90 or more days contractually delinquent, economic conditions, such as national and local trends in housing markets and interest rates, portfolio seasoning, account management policies and practices, current levels of charge-offs and delinquencies, changes in laws and regulations and other factors which can affect consumer payment patterns on outstanding receivables, such as natural disasters. 83
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Table of Contents HSBC Finance Corporation While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. We also consider key ratios, including reserves to nonaccrual receivables, loans, reserves as a percentage of net charge-offs and reserves as a percentage of two-months-and-over contractual delinquency. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. In establishing reserve levels, given the general decline in U.S. home prices that has occurred since 2007, we anticipate that losses in our real estate secured receivable portfolios will continue to be incurred with greater frequency and severity than experienced prior to 2007. There continues to be a significantly reduced level of secondary market liquidity for subprime mortgages. As a result of these conditions, lenders have significantly tightened underwriting standards, substantially limiting the availability of alternative and subprime mortgages. As fewer financing options currently exist in the marketplace for home buyers, properties in certain markets are remaining on the market for longer periods of time which contributes to home price depreciation. For many of our customers, the ability to refinance and access equity in their homes is no longer an option as home prices remain stagnant in many markets and have depreciated in others. These housing market trends were exacerbated by the recent economic downturn, including high levels of unemployment, and these industry trends continue to impact our portfolio. It is generally believed that a sustained recovery of the housing market, as well as unemployment conditions, is not expected in the near-term. We have considered these factors in establishing our credit loss reserve levels, as appropriate.
The following table sets forth credit loss reserves for our continuing operations for the periods indicated:
March 31, December 31, 2012 2011 (dollars are in millions) Credit loss reserves(1) $ 5,865 $ 5,952 Reserves as a percent of: Receivables(2)(4) 12.74 % 12.42 % Net charge-offs(3) 167.0 164.6 Two-months-and-over contractual delinquency(2)(4) 72.5 69.3 Nonaccrual receivables(2)(4) 86.6 86.6
(1) At
million and
carried at the lower of amortized cost or fair value less cost to sell
primarily reflecting an estimate of additional loss following an interior
appraisal of the property.
(2) These ratios are significantly impacted by changes in the level of real
estate secured receivables carried at the lower of amortized cost or fair
value less cost to sell. The following table shows these ratios excluding
the receivables carried at the lower of amortized cost or fair value less
cost to sell and any associated credit loss reserves.March 31 ,December 31, 2012 2011
Reserves as a percentage of:
Receivables 13.69 %
13.16 %
Two-months-and-over contractual delinquency 181.9 147.5 Nonaccrual receivables 300.0 251.9 (3) Reserves as a percent of net charge-offs for the quarter, annualized.
(4) While reserves associated with accrued finance charges are reported within
our total credit loss reserve balances noted above, accrued finance charges
for real estate secured receivables and certain personal non-credit card
receivables are not reported within receivables, nonaccrual receivables and
two-months-and-over contractual delinquency. 84
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Table of Contents HSBC Finance Corporation Credit loss reserves atMarch 31, 2012 decreased as compared toDecember 31, 2011 as we recorded provision for credit losses less than net charge-offs of$87 million during the three months endedMarch 31, 2012 . Credit loss reserves for our real estate secured and personal non-credit card receivable portfolios are discussed below.
• Credit loss reserves for real estate secured receivables increased modestly
due to higher reserve requirements for TDR Loans due to higher TDR Loan levels, largely offset by the impact of lower receivable levels and lower</pre>levels of two-months-and-over contractual delinquency, driven by accounts
less than 180 days contractually delinquent, which in our total reported
contractual delinquency for real estate secured receivables was partially
offset by an increase in late stage delinquency, reflecting the continuing
impact from foreclosure delays as previously discussed.• Credit loss reserve levels in our personal non-credit card portfolio
decreased due to lower receivable levels and improved credit quality.
AtMarch 31, 2012 andDecember 31, 2011 , 76 percent and 74 percent, respectively, of our credit loss reserves are associated with TDR Loans which are reserved for using a discounted cash flow analysis which, in addition to considering all expected future cash flows, also takes into consideration the time value of money and the difference between the current interest rate and the original effective interest rate on the loan. This methodology generally results in a higher reserve requirement for TDR Loans than the remainder of our receivable portfolio for which credit loss reserves are established using a roll rate migration analysis that only considers credit losses. This methodology is highly sensitive to changes in volumes of TDR Loans as well as changes in estimates of the timing and amount of cash flows for TDR Loans. As a result, credit loss reserves and provisions for credit losses for TDR Loans for the three months endedMarch 31, 2012 should not be considered indicative of the results for any future periods. Generally as TDR Loan levels increase, overall credit loss reserves also increase. AtMarch 31, 2012 , approximately$6.2 billion , or 15 percent of our real estate secured receivable portfolio, is carried at the lower of amortized cost or fair value less cost to sell. In addition, approximately$12.1 billion of real estate secured receivables which are not carried at the lower of amortized cost or fair value less cost to sell are considered TDR Loans and$1.3 billion of personal non-credit card receivables are considered TDR Loans, which are reserved for using a discounted cash flow analysis that generally results in a higher reserve requirement. As a result, atMarch 31, 2012 , 44 percent of our real estate secured receivable portfolio and 43 percent of our total receivable portfolio are carried at the lower of amortized cost or fair value less cost to sell or are reserved for using a discounted cash flow analysis as compared to 41 percent and 40 percent, respectively, atDecember 31, 2011 .Reserve ratios Following is a discussion of changes in the reserve ratios we consider in establishing reserve levels.
Reserves as a percentage of receivables were higher atMarch 31, 2012 as compared toDecember 31, 2011 as the decrease in receivables outpaced the decrease in reserves due to higher reserve requirements for TDR Loans due to higher TDR Loan levels atMarch 31, 2012 , partially offset by the impact of lower levels of two-months-and-over contractual delinquency driven by accounts less than 180 days contractually delinquent. The increase in this ratio was also partially offset by a shift in mix in our receivable portfolio to higher levels of first lien real estate secured receivables, which generally carry lower reserve requirements than second lien real estate secured and personal non-credit card receivables. Reserves as a percentage of net charge-offs atMarch 31, 2012 increased as compared toDecember 31, 2011 due to dollars of net charge-offs decreasing at a faster pace than reserves due to higher reserve requirements for TDR Loans as discussed above. 85--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation Reserves as a percentage of two-months-and-over contractual delinquency atMarch 31, 2012 increased as compared toDecember 31, 2011 . This ratio has been impacted by real estate secured receivables which are carried at the lower of amortized cost or fair value less cost to sell. Excluding receivables carried at the lower of amortized cost or fair value less cost to sell and any associated credit loss reserves from this ratio for both periods, reserves as a percentage of two-months-and-over contractual delinquency atMarch 31, 2012 increased significantly as compared toDecember 31, 2011 reflecting significantly lower levels of two-months-and-over contractual delinquency on accounts less than 180 days contractually delinquent as discussed below while overall reserve levels were negatively impacted by higher reserve requirements for TDR Loans as discussed above. Reserves as a percentage of nonaccrual receivables for bothMarch 31, 2012 andDecember 31, 2011 were impacted by nonaccrual real estate secured receivables carried at the lower of amortized cost or fair value less cost to sell. Excluding receivables carried at the lower of amortized cost or fair value less cost to sell and any associated credit loss reserves from this ratio in both periods, reserves as a percentage of nonaccrual receivables increased significantly atMarch 31, 2012 as compared toDecember 31, 2011 due to lower levels of nonaccrual receivables as discussed below while overall reserve levels were negatively impacted by higher reserve requirements for TDR Loans as discussed above. See Note 5, "Credit Loss Reserves," in the accompanying consolidated financial statements for a rollforward of credit loss reserves by product for the three months endedMarch 31, 2012 and 2011. Delinquency Our policies and practices for the collection of consumer receivables, including our customer account management policies and practices, permit us to modify the terms of loans, either temporarily or permanently (a "modification"), and/or to reset the contractual delinquency status of an account that is contractually delinquent to current (a "re-age"), based on indicia or criteria which, in our judgment, evidence continued payment probability. Such policies and practices vary by product and are designed to manage customer relationships, improve collection opportunities and avoid foreclosure or repossession as determined to be appropriate. If a re-aged account subsequently experiences payment defaults, it will again become contractually delinquent and be included in our delinquency ratios.The following table summarizes dollars of two-months-and-over contractual delinquency and two-months-and-over contractual delinquency as a percent of consumer receivables ("delinquency ratio"):
March 31, December 31, 2012 2011 (dollars are in millions) Dollars of contractual delinquency: Real estate secured: Receivables carried at the lower of amortized cost or fair value less cost to sell $ 5,095 $ 4,843 Remainder 2,638 3,262 Total real estate secured(1) 7,733 8,105 Personal non-credit card 360 486 Total $ 8,093 $ 8,591 Delinquency ratio: Real estate secured: Receivables carried at the lower of amortized cost or fair value less cost to sell 82.12 % 81.57 % Remainder 7.53 8.87 Total real estate secured(1) 18.75 18.98 Personal non-credit card 7.50 9.35 Total 17.58 % 17.93 %(1) The following reflects dollars of contractual delinquency and the
delinquency ratio for interest-only, stated income and second lien real
estate secured receivables: 86--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation March 31, December 31, 2012 2011 (dollars are in millions) Dollarsof contractual delinquency: Interest-only receivables $ 356 $ 370 Stated income receivables 562 590 Second lien receivables 391 500 Delinquencyratio: Interest-only receivables 39.47 %38.54 %
Stated income receivables 27.4327.35
Second lien receivables 9.2611.16
Dollars of delinquency decreased a total of$498 million sinceDecember 31, 2011 for real estate secured and personal non-credit card receivables. In our real estate secured receivable portfolio, dollars of delinquency decreased as compared toDecember 31, 2011 due to a significant decrease in dollars of delinquency on accounts less than 180 days contractually delinquent due to lower receivable levels, the impact of improvements in economic conditions and seasonal improvements in collection activities during the first quarter of the year as some customers use their tax refunds to make payments, partially offset by an increase in late stage delinquency driven by our earlier decision to temporarily suspended foreclosure activities. Dollars of delinquency decreased in our personal non-credit card receivable portfolio reflecting the impact of lower receivable levels, improved credit quality and seasonal improvements in collection activities during the first quarter of the year as discussed above. The delinquency ratio decreased as compared toDecember 31, 2011 driven by the factors discussed above as dollars of delinquency declined at a faster pace than receivable levels.See "Customer Account Management Policies and Practices" regarding the delinquency treatment of re-aged accounts and accounts subject to forbearance and other customer account management tools.
Net Charge-offs of Receivables The following table summarizes net charge-off of receivables both in dollars and as a percent of average receivables ("net charge-off ratio"). March 31, December 31, March 31, Three Months Ended(1) 2012 2011 2011 (dollars are in millions) Net charge-off dollars: Real estate secured $ 735 $ 757 $ 1,016 Personal non-credit card 143 147 260 Total $ 878 $ 904 $ 1,276 Net charge-off ratio: Real estate secured 7.01 % 6.97 % 8.43 % Personal non-credit card 11.54 10.92 15.26 Total 7.49 % 7.41 % 9.27 % Real estate secured net charge-offs and REO expense as a percent of average real estate secured receivables 7.29 % 7.27 % 9.31 %(1) The net charge-off ratio for all quarterly periods presented is net
charge-offs for the quarter, annualized, as a percentage of average receivables for the quarter. 87--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation Overall dollars of net charge-offs decreased as compared to both the prior quarter and prior year quarter as all receivable portfolios were positively impacted by lower receivable levels and lower delinquency levels as discussed above. The decrease also reflects the impact of lower levels of personal bankruptcy filings and improvements in economic conditions. The overall decrease in dollars of net charge-offs for real estate secured receivables also reflects the impact of fewer accounts migrating to charge-off due to lower receivables and the impact of our temporary suspension of foreclosure activities because once foreclosure is initiated a higher payment is required for an account to be re-aged. As a result, more accounts are receiving re-ages than otherwise would if the accounts were in the process of foreclosure. As we have commenced foreclosures in 49 of 50 states, once we initiate foreclosure proceedings, customers will be required to make higher payments in order to qualify for a re-age. See "Customer Account Management Policies and Practices" for more information regarding the delinquency treatment of re-aged accounts and other customer account management tools. The net charge-off ratio increased 8 basis points as compared to the prior quarter as the decrease in receivable levels due to improvements in seasonal collection activities during the first quarter as previously discussed outpaced the decrease in dollars of net charge-offs. The net charge-off ratio decreased 178 basis points as compared to the prior year quarter as the decrease in net charge-off dollars as discussed above outpaced the decrease in receivable levels. Real estate charge-offs and REO expenses as a percentage of average real estate secured receivables in the first quarter of 2012 were essentially flat as compared to the prior quarter. Real estate charge-offs and REO expenses as a percentage of average real estate secured receivables were significantly lower in the first quarter of 2012 as compared to the prior year quarter due to lower dollars of net charge-offs and REO expenses, partially offset by the impact of lower average receivable levels. See "Results of Operations" for further discussion of REO expenses. Nonperforming Assets Nonperforming assets are summarized in the following table: March 31, December 31, 2012 2011 (dollars are in millions) Nonaccrual receivable portfolios(1): Real estate secured: Receivables carried at the lower of amortized cost or fair value less cost to sell $ 4,958 $ 4,687 Remainder 1,571 1,857 Total real estate secured(2) 6,529 6,544 Personal non-credit card 247 330 Total nonaccrual receivables 6,776 6,874 Real estate owned 263 299 Total nonperforming assets $ 7,039 $ 7,173 Credit loss reserves as a percent of nonaccrual receivables 86.6 % 86.6 %(1) Nonaccrual receivables reflect all loans which are 90 or more days
contractually delinquent as well as second lien loans where the first lien
loan that we own or service is 90 or more days contractually delinquent.
Nonaccrual receivables do not include receivables which have made qualifying
payments and have been re-aged and the contractual delinquency status reset
to current as such activity, in our judgment, evidences continued payment
probability. If a re-aged loan subsequently experiences payment default and
becomes 90 or more days contractually delinquent, it will be reported as nonaccrual.(2) At
March 31, 2012 andDecember 31, 2011 , nonaccrual second lien real estatesecured receivables totaled
$297 million and$344 million , respectively.88--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation Total nonaccrual receivables decreased as compared toDecember 31, 2011 due to lower receivable levels and improvements in seasonal collection activities in the first quarter of the year as some customers use their tax refunds to make payments, partially offset by the impact of higher late stage delinquency for real estate secured receivables reflecting the continuing impact of our temporary suspension of foreclosure activities as discussed above. The following table summarizes TDR Loans, some of which are carried at the lower of amortized cost or fair value less cost to sell in accordance with our existing charge-off policies, that are shown as nonaccrual receivables in the table above: March 31, December 31, 2012 2011 (in millions) Real estate secured $ 3,288 $ 2,685 Personal non-credit card 160 174 Total $ 3,448 $ 2,859For additional information related to TDR Loans, see Note 4, "Receivables," to our accompanying consolidated financial statements.
Customer Account Management Policies and Practices Currently, we utilize the following account management actions:
• Modification - Management action that results in a change to the terms and
conditions of the loan either temporarily or permanently without changing
the delinquency status of the loan. Modifications may include changes to
one or more terms of the loan including, but not limited to, a change in
interest rate, extension of the amortization period, reduction in payment
amount and partial forgiveness or deferment of principal.• Collection Re-age - Management action that results in the resetting of the
contractual delinquency status of an account to current but does not
involve any changes to the original terms and conditions of the loan. If an
account which has been re-aged subsequently experiences a payment default,
it will again become contractually delinquent. We use collection re-aging
as an account and customer management tool in an effort to increase the
cash flow from our account relationships, and accordingly, the application
of this tool is subject to complexities, variations and changes from time
to time. • Modification Re-age - Management action that results in a change to theterms and conditions of the loan, either temporarily or permanently, and
also resets the contractual delinquency status of an account to current as
discussed above. If an account which has been re-aged subsequently experiences a payment default, it will again become contractually delinquent. Our policies and practices for the collection of consumer receivables, including our customer account management policies and practices, permit us to take action with respect to delinquent or troubled accounts based on criteria which, in our judgment, evidence continued payment probability, as well as, in the case of real estate secured receivables, a continuing desire for borrowers to stay in their homes. The policies and practices are designed to manage customer relationships, improve collection opportunities and avoid foreclosure as determined to be appropriate. From time to time we re-evaluate these policies and procedures and make changes as deemed appropriate. It is our practice to defer past due interest on re-aged real estate secured and personal non-credit card accounts to the end of the loan period. We do not accrue interest on these past due interest payments consistent with our 2002 settlement agreement with the State Attorneys General. Our policies and practices for managing accounts are 89
Table of Contents HSBC Finance Corporation continually reviewed and assessed to assure that they meet the goals outlined above, and accordingly, we make exceptions to these general policies and practices from time to time. In addition, exceptions to these policies and practices may be made in specific situations in response to legal agreements, regulatory agreements or orders. As a result of the expansion of our modification and re-age programs in response to the marketplace conditions previously described, modification and re-age volumes sinceJanuary 2007 for real estate secured receivables have increased. SinceJanuary 2007 , we have cumulatively modified and/or re-aged approximately 377,100 real estate secured loans with an aggregate outstanding principal balance of$43.7 billion at the time of modification and/or re-age under our foreclosure avoidance programs, which are described below, and a proactive adjustable rate mortgage ("ARM") reset modification program which ended during the fourth quarter of 2009. The following provides information about the subsequent performance of all real estate secured loans granted a modification and/or re-age sinceJanuary 2007 , some of which may have received multiple account management actions: Outstanding Receivable Balance at Number Time of Account Status as of March 31, 2012 of Loans Modification Action Current or less than 30-days delinquent 37 % 35 % 30- to 59-days delinquent 5 5 60-days or more delinquent 18 23 Paid-in-full 8 8 Charged-off, transferred to real estate owned or sold 32 29 100 % 100 % The following table shows the number of real estate secured accounts remaining in our portfolio as well as the outstanding receivable balance of these accounts as of the period indicated for loans that we have taken an account management action by the type of action taken: Outstanding Number of Receivable Accounts(1) Balance(1)(4) (accounts are in thousands, dollars are in millions)March 31, 2012 : Collection re-age only 118.4 $ 9,972 Modification only(2) 12.9 1,335 Modification re-age 109.0 12,309Total loans modified and/or re-aged(3) 240.3 $23,616December 31, 2011 : Collection re-age only 119.4 $ 10,129 Modification only(2) 13.6 1,439 Modification re-age 110.2 12,668Total loans modified and/or re-aged(3) 243.2 $24,236(1) See Note 6, "Receivables," in our 2011 Form 10-K for additional information
describing modified and/or re-aged loans which are accounted for as troubled
debt restructurings. (2) Includes loans that have been modified under a proactive ARM reset modification program which ended during the fourth quarter of 2009 as described in our 2010 Form 10-K.(3) The following table provides information regarding the delinquency status of
loans remaining in the portfolio that were granted modifications of loan terms and/or re-aged: 90--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation Outstanding Numberof Receivable Accounts Balance March31, 2012:Current or less than 30-days delinquent 64 %63 %
30- to 59-days delinquent 8 8 60-days or more delinquent 2829 100 % 100 % December31, 2011:Current or less than 30-days delinquent 61 %61 %
30- to 59-days delinquent 1010
60-days or more delinquent 2929 100 % 100 %(4) The outstanding receivable balance included in this table reflects the
principal amount outstanding on the loan net of any charge-off recorded in
accordance with our existing charge-off policies but excludes any basis
adjustments to the loan such as unearned income, unamortized deferred fees
and costs on originated loans, purchase accounting fair value adjustments
and premiums or discounts on purchased loans.
Another account management technique that we employ in respect of delinquent accounts is forbearance which may also be considered a modification. Under a forbearance agreement, we may agree not to take certain collection or credit agency reporting actions with respect to missed payments, often in return for the borrower's agreement to pay an additional amount with future required payments. We typically use forbearance with individual borrowers in transitional situations, usually involving borrower hardship circumstances or temporary setbacks that are expected to affect the borrower's ability to pay the contractually specified amount for a period of time. Additionally, in the past we also used loan rewrites to assist our customers which involved an extension of a new loan. We currently no longer offer loan rewrites. The amount of receivables subject to forbearance or rewrites is not significant. In addition to the account management techniques discussed above, we have also increased the use of deed-in-lieu and short sales beginning in 2010 to assist our real estate secured receivable customers. In a deed-in-lieu, the borrower agrees to surrender the deed to the property without going through foreclosure proceedings and we release the borrower from further obligation. In a short sale, the property is offered for sale to potential buyers at a price which has been pre-negotiated between us and the borrower. This pre-negotiated price is based on updated property valuations and overall loss exposure given liquidation through foreclosure. Short sales also release the borrower from further obligation. From our perspective, total losses on deed-in-lieu and short sales are lower than expected total losses from foreclosed loans, or loans where we have previously decided not to pursue foreclosure, and provide resolution to the delinquent receivable over a shorter period of time. We currently anticipate the use of deed-in-lieu and short sales will continue to be elevated in future periods as we continue to work with our customers. Modification programs OurMortgage Services and Consumer Lending businesses actively use account modifications to reduce the rate and/or payment on a number of qualifying loans and generally re-age certain of these accounts upon receipt of two or more modified payments and other criteria being met. This account management practice is designed to assist borrowers who may have purchased a home with an expectation of continued real estate appreciation or whose income has subsequently declined. Additionally, our loan modification programs are designed to improve cash collections and avoid foreclosure as determined to be appropriate. Based on the economic environment and expected slow recovery of housing values, during 2008 we developed additional analytical review tools leveraging best practices to assist us in identifying customers who are willing to pay, but are expected to have longer term disruptions in their ability to pay. Using these analytical review tools, we expanded our foreclosure avoidance programs to assist customers who did not qualify for assistance under prior program requirements or who required greater assistance than available under the programs. The 91--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation expanded program required certain documentation as well as receipt of two qualifying payments before the account could be re-aged. Prior toJuly 2008 , for our Consumer Lending customers, receipt of one qualifying payment was required for a modified account before the account would be re-aged. We also increased the use of longer term modifications to provide assistance in accordance with the needs of our customers which may result in higher credit loss reserve requirements. For selected customer segments, this expanded program lowered the interest rate on fixed rate loans and for ARM loans the expanded program modified the loan to a lower interest rate than scheduled at the first interest rate reset date. The eligibility requirements for this expanded program allow more customers to qualify for payment relief and in certain cases can result in a lower interest rate than allowed under other existing programs. During the third quarter of 2009, in order to increase the long-term success rate of our modification programs we increased certain documentation requirements for participation in these programs. Late in the third quarter of 2011 the modification program was enhanced to improve underwriting and achieve a better balance between economics and customer-driven variables. The enhanced program offers a longer modification duration to select borrowers facing a temporary hardship and expands the treatment options to include term extension and principal forbearance. Beginning in late 2009 and continuing through 2011, the volume of loans that qualified for a new modification had fallen significantly. We expect the volume of new modifications to continue to decline as we believe a smaller percentage of our customers with unmodified loans will benefit from loan modification in a way that will not ultimately result in a repeat default on their loans. Additionally, volumes of new loan modifications are expected to decrease due to the impact of improvements in economic conditions over the long-term, the continued seasoning of a liquidating portfolio and, beginning in the second quarter of 2010, the requirement for real estate secured and personal noncredit card borrowers to make two qualifying payments in 60 days before an account will be modified. Modification volumes will also be lower going forward as we are no longer originating real estate secured and personal noncredit card receivables. We will continue to evaluate our consumer relief programs as well as all aspects of our account management practices to ensure our programs benefit our customers in accordance with their financial needs in ways that are economically viable for both our customers and our stakeholders. We have elected not to participate in the U.S. Treasury sponsored programs as we believe our long-standing home preservation programs provide more meaningful assistance to our customers. Loans modified under these programs are only included in the re-aging statistics table ("Re-age Table") that is included in our discussion of our re-age programs if the delinquency status of a loan was reset as a part of the modification or was re-aged in the past for other reasons. Not all loans modified under these programs have the delinquency status reset and, therefore, are not considered to have been re-aged.The following table summarizes loans modified during the three months ended
March 31, 2012 and 2011, some of which may also have been re-aged:Outstanding Number of Receivable Accounts Balance (accounts are in thousands, dollars are in billions) Foreclosure avoidance programs(1)(2): Three months ended March 31, 2012 5.2 $ .7 Three months ended March 31, 2011 10.2 1.4(1) Includes all loans modified during the three months ended
March 31, 2012 and2011 regardless of whether the loan was also re-aged.(2) If qualification criteria are met, loan modification may occur on more than
one occasion for the same account. For purposes of the table above, an
account is only included in the modification totals once in an annual period
and not for each separate modification in an annual period. 92--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation A primary tool used during account modification, involves modifying the monthly payment through lowering the rate on the loan on either a temporary or permanent basis. The following table summarizes the weighted-average contractual rate reductions and the average amount of payment relief provided to customers that entered an account modification for the first time during the quarter indicated. Quarter Ended Mar. 31, Dec. 31, Sept. 30, June 30, Mar. 31, 2012 2011 2011 2011 2011 Weighted-average contractual rate reduction in basis points on account modifications during the period(1)(2) 341 340 343 336 340 Average payment relief provided on account modifications as a percentage of total payment prior to modification(2) 26.8 % 26.2 % 27.1 % 27.1 % 27.2 % (1) The weighted-average rate reduction was determined based on the rate ineffect immediately prior to the modification, which for ARMs may be lower
than the rate on the loan at the time of origination.(2) Excludes any modifications on purchased receivable portfolios which totaled
$1.0 billion $1.1 billion ,$1.1 billion ,$1.1 billion and$1.1 billion as of
March 31, 2012 ,December 31, 2011 ,September 30, 2011 ,June 30, 2011 and
March 31, 2011 , respectively.Re-age programs Our policies and practices include various criteria for an account to qualify for re-aging, but do not, however, require us to re-age the account. The extent to which we re-age accounts that are eligible under our existing policies will vary depending upon our view of prevailing economic conditions and other factors which may change from period to period. In addition, exceptions to our policies and practices may be made in specific situations in response to legal or regulatory agreements or orders. It is our practice to defer past due interest on certain re-aged real estate secured and personal non-credit card accounts to the end of the loan period. We do not accrue interest on these past due interest payments consistent with our 2002 settlement agreement with the State Attorneys General. We continue to monitor and track information related to accounts that have been re-aged. AtMarch 31, 2012 , approximately 93 percent of all re-aged receivables are real estate secured products. First lien real estate secured products generally have less loss severity exposure than other products because of the underlying collateral. Credit loss reserves, including reserves on TDR Loans, take into account whether loans have been re-aged or are subject to forbearance, an external debt management plan, modification, extension or deferment. Our credit loss reserves, including reserves on TDR Loans, also take into consideration the expected loss severity based on the underlying collateral, if any, for the loan. TDR Loans are typically reserved for using a discounted cash flow methodology. We used certain assumptions and estimates to compile our re-aging statistics. The systemic counters used to compile the information presented below exclude from the reported statistics loans that have been reported as contractually delinquent but have been reset to a current status because we have determined that the loans should not have been considered delinquent (e.g., payment application processing errors). When comparing re-aging statistics from different periods, the fact that our re-age policies and practices will change over time, that exceptions are made to those policies and practices, and that our data capture methodologies have been enhanced, should be taken into account. 93--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation Re-age Table(1)(2)(3)(4) March 31, December 31, 2012 2011 Never re-aged 49.5 % 50.0 % Re-aged:Re-aged in the last 6 months 10.39.5
Re-aged in the last 7-12 months 9.312.1
Previously re-aged beyond 12 months 30.928.4 Total ever re-aged 50.5 50.0 Total 100.0 % 100.0 %Re-aged by Product(1)(2)(3)(4)
March 31, December 31, 2012 2011 (dollars are in millions) Real estate secured $ 21,553 52.3 % $ 22,080 51.7 % Personal non-credit card 1,709 35.6 1,874 36.1 Total $ 23,262 50.5 % $ 23,954 50.0 %(1) The tables above includes both Collection Re-ages and Modification Re-ages,
as discussed above. (2) The outstanding receivable balance included in this table reflects theprincipal amount outstanding on the loan net of unearned income, unamortized
deferred fees and costs on originated loans, purchase accounting fair value
adjustments and premiums or discounts on purchased loans as well as net of
any charge-off recorded in accordance with our existing charge-off policies.
(3) Excludes commercial and other.(4) The tables above exclude any accounts re-aged without receipt of a payment
which only occurs under special circumstances, such as re-ages associated
with disaster or in connection with a bankruptcy filing. At
March 31, 2012 and
December 31, 2011 , the unpaid principal balance of re-ages withoutreceipt of a payment totaled
$780 million and$783 million , respectively.The overall decrease in dollars of re-aged loans during the first quarter of 2012 reflects the lower receivable levels as discussed above. AtMarch 31, 2012 andDecember 31, 2011 ,$6.5 billion (28 percent of total re-aged loans in the Re-age Table) and$6.9 billion (29 percent of total re-aged loans in the Re-age Table), respectively, of re-aged accounts have subsequently experienced payment defaults and are included in our two-months-and-over contractual delinquency at the period indicated. We continue to work with advocacy groups in select markets to assist in encouraging our customers with financial needs to contact us. We have also implemented new training programs to ensure that our customer service representatives are focused on helping the customer through difficulties, are knowledgeable about the available re-aging and modification programs and are able to advise each customer of the best solutions for their individual circumstance.We also support a variety of national and local efforts in homeownership preservation and foreclosure avoidance.
Liquidity and Capital Resources
HSBC Related Funding In connection with our acquisition by HSBC, funding costs for the HSBC Finance Corporation businesses were expected to be lower as a result of the funding diversity provided by HSBC. We work with our affiliates under the oversight ofHSBC North America to maximize funding opportunities and efficiencies in HSBC's operations inthe United States . 94--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation Due to affiliates totaled$8.8 billion and$8.3 billion atMarch 31, 2012 andDecember 31, 2011 , respectively. AtMarch 31, 2012 andDecember 31, 2011 , funding from HSBC, including debt issuances to HSBC subsidiaries and clients, represented 20 percent and 18 percent of our total debt and preferred stock funding, respectively. AtMarch 31, 2012 andDecember 31, 2011 , we have committed back-up lines of credit totaling$2.0 billion with HSBC affiliates. There were no balances outstanding under these back-up lines of credit atMarch 31, 2012 orDecember 31, 2011 . Additionally, we have a$1.5 billion uncommitted secured credit facility and a$1.0 billion committed unsecured credit facility from HSBC BankUSA , and a$3.0 billion uncommitted credit facility from HSBC USA Inc. AtMarch 31, 2012 andDecember 31, 2011 , there were no balances outstanding under these facilities. We have derivative contracts with a notional value of$38.3 billion , or approximately 99 percent of total derivative contracts, outstanding with HSBC affiliates atMarch 31, 2012 and$40.4 billion , or approximately 99 percent atDecember 31, 2011 . Interest Bearing Deposits with Banks and Other Short-Term Investments Interest bearing deposits with banks totaled$1.3 billion and$1.1 billion atMarch 31, 2012 andDecember 31, 2011 , respectively. Securities purchased under agreements to resell totaled$2.7 billion and$920 million atMarch 31, 2012 andDecember 31, 2011 , respectively. Securities purchased under agreements to resell increased as compared toDecember 31, 2011 as a result of an increase in due to affiliates and an increase in collateral required from counterparties under our derivative agreements as well as the generation of additional liquidity as a result of the run-off of our liquidating receivable portfolios and the sale of REO properties, partially offset by debt maturities. Commercial paper totaled$3.9 billion and$4.0 billion atMarch 31, 2012 andDecember 31, 2011 , respectively. Included in this total was outstanding Euro commercial paper sold to customers of HSBC of$803 million and$365 million atMarch 31, 2012 andDecember 31, 2011 , respectively. Our funding strategies are structured such that committed bank credit facilities exceed 100 percent of outstanding commercial paper. We currently plan to wind-down our commercial paper program during 2012. We anticipate any required incremental funding will be integrated into the overallHSBC North America funding plans, sourced primarily through HSBC USA Inc., or through direct support from HSBC and its affiliates. AtMarch 31, 2012 andDecember 31, 2011 , we have third party back-up lines of credit totaling$4.0 billion of which$2.0 billion expired inApril 2012 and$2.0 billion will expire inApril 2014 . We did not renew the$2.0 billion credit facility which expired inApril 2012 . This reduction is consistent with our planned wind-down of our commercial paper program and thus we do not expect that it will have a significant impact on our availability of short term funding. AtMarch 31, 2012 andDecember 31, 2011 , we also have credit facilities totaling$2.0 billion with HSBC affiliates to support any ongoing issuance of commercial paper as discussed above. Long-term debt decreased to$39.2 billion atMarch 31, 2012 from$39.8 billion atDecember 31, 2011 . The following table summarizes issuances and repayments of long-term debt for continuing operations during the three months endedMarch 31, 2012 and 2011: Three Months Ended March 31, 2012 2011 (in millions) Long-term debt issued $ - $ 162 Long-term debt retired (1,040 ) (3,106 ) Net long-term debt retired $ (1,040 ) $ (2,944 ) Secured financings of$3.2 billion atMarch 31, 2012 were secured by$5.2 billion of closed-end real estate secured receivables. Secured financings previously issued under public trusts of$3.3 billion atDecember 31, 2011 are secured by$5.3 billion of closed-end real estate secured receivables. 95--------------------------------------------------------------------------------
Table of Contents HSBC Finance CorporationIn order to eliminate future foreign exchange risk, currency swaps were used at the time of issuance to fix in U.S. dollars substantially all foreign-denominated notes previously issued.
As it relates to our discontinued credit card operations, we had secured conduit credit facilities with commercial banks which provided for secured financings of credit card receivables on a revolving basis totaling$650 million at bothMarch 31, 2012 andDecember 31, 2011 . AtMarch 31, 2012 , secured financings with a balance of$195 million were secured by$355 million of credit card receivables. AtDecember 31, 2011 , secured financings with a balance of$195 million were secured by$355 million of credit card receivables. The secured financings were paid in full onApril 30, 2012 . Common Equity During the first quarter of 2012, we did not receive any capital contributions from HINO. However, as we continue to liquidate our real estate secured and personal non-credit card receivable portfolios, HSBC's continued support will be required to properly manage our business and maintain appropriate levels of capital. HSBC has historically provided significant capital in support of our operations and has indicated that they remain fully committed and have the capacity to continue that support. Selected capital ratios In managing capital, we develop a target for tangible common equity to tangible assets. This ratio target is based on discussions with HSBC and rating agencies, risks inherent in the portfolio and the projected operating environment and related risks. Additionally, we are required by our credit-providing banks to maintain a minimum tangible common equity to tangible assets ratio of 6.75 percent. Our targets may change from time to time to accommodate changes in the operating environment or other considerations such as those listed above.Selected capital ratios are summarized in the following table:
March 31 ,December 31, 2012 2011Tangible common equity to tangible assets(1) 7.44 %7.12 %
Common and preferred equity to total assets 10.7510.91(1) Tangible common equity to tangible assets represents a non-U.S. GAAP
financial ratio that is used by HSBC Finance Corporation management and
applicable rating agencies to evaluate capital adequacy and may differ from
similarly named measures presented by other companies. See "Basis of
Reporting" for additional discussion on the use of non-U.S. GAAP financial
measures and "Reconciliations of Non-U.S. GAAP Financial Measures to U.S.
GAAP Financial Measures" for quantitative reconciliations to the equivalent
U.S. GAAP basis financial measure.
Commitments We enter into commitments to meet the financing needs of our customers. In most cases, we have the ability to reduce or eliminate these open lines of credit. AtMarch 31, 2012 andDecember 31, 2011 we had$540 million and$535 million of open consumer lines of credit. 96--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation2012 Funding Strategy Our current range of estimates for funding needs and sources for 2011 are summarized in the table that follows.
Actual January 1 Estimated Estimated Full through March 31, April 1 through Year 2012 December 31, 2012 2012 (in billions) Funding needs: Net commercial paper maturities and paydowns $ - $ 4 - 4 $ 4 - 4 Term debt maturities 1 10 - 11 11 - 12 Secured financing maturities - 1 - 2 1 - 2 Litigation bond - 3 - 4 3 - 4 Total funding needs $ 1 $ 18 - 21 $ 19 - 22 Funding sources: Net asset attrition(1) $ 1 $ 2 - 2 $ 3 - 3 Liquidation of short-term investments (2 ) 2 - 3 0 - 1 Asset sales and transfers - 12 - 13 12 - 13 HSBC and HSBC subsidiaries, including capital infusions - 2 - 3 2 - 3 Other(2) 2 0 - 0 2 - 2 Total funding sources $ 1 $ 18 - 21 $ 19 - 22(1) Net of receivable charge-off.
(2) Primarily reflects cash provided by operating activities and sales of REO
properties.
For 2012, the sale of the Card and Retail Services business and continued portfolio attrition will be key sources of liquidity. The combination of the sale of our Card and Retail Services business, cash generated from operations, potential asset sales should market pricing for receivables improve and borrowings from HSBC or its subsidiaries is expected to generate the liquidity necessary to meet our maturing debt obligations in 2012.
Net income volatility arising from changes in either interest rate or credit components of the mark-to-market on debt designated at fair value and related derivatives affects the comparability of reported results between periods. Accordingly, gain on debt designated at fair value and related derivatives for the three months endedMarch 31, 2012 should not be considered indicative of the results for any future period. Fair Value Hierarchy Accounting principles related to fair value measurements establish a fair value hierarchy structure that prioritizes the inputs to valuation techniques used to determine the fair value of an asset or liability (the "Fair Value Framework"). The Fair Value Framework distinguishes between inputs that are based on observed market data and unobservable inputs that reflect market participants' assumptions. It emphasizes the use of valuation methodologies that maximize market inputs. For financial instruments carried at fair value, the best evidence of fair value is a quoted price in an actively traded market (Level 1). Where the market for a financial instrument is not active, valuation techniques are used. The majority of valuation techniques use market inputs that are either observable or indirectly derived from and corroborated by observable market data for substantially the full term of the financial instrument (Level 2). Because Level 1 and Level 2 instruments are determined by observable inputs, less judgment is applied in determining their fair values. In the absence of observable market inputs, the financial instrument is valued based on valuation techniques that feature one or more significant unobservable inputs (Level 3). The determination of the level of fair value hierarchy within which the fair value measurement of an asset or a liability is classified often requires judgment. We consider the following factors in developing the fair value hierarchy:• whether the pricing quotations vary substantially among independent pricing
services; 97--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation• whether the asset or liability is transacted in an active market with a
quoted market price that is readily available; • the size of transactions occurring in an active market; • the level of bid-ask spreads;• a lack of pricing transparency due to, among other things, the complexity
of the product structure and market liquidity;• whether only a few transactions are observed over a significant period of
time; • whether the inputs to the valuation techniques can be derived from orcorroborated with market data; and • whether significant adjustments are made to the observed pricing information or model output to determine the fair value. Level 1 inputs are unadjusted quoted prices in active markets that the reporting entity has the ability to access for the identical assets or liabilities. A financial instrument is classified as a Level 1 measurement if it is listed on an exchange or is an instrument actively traded in the OTC market where transactions occur with sufficient frequency and volume. We regard financial instruments that are listed on the primary exchanges of a country, such as equity securities and derivative contracts, to be actively traded. Non-exchange-traded instruments classified as Level 1 assets include securities issued by the U.S. Treasury. Level 2 inputs are inputs that are observable either directly or indirectly but do not qualify as Level 1 inputs. We generally classify derivative contracts, corporate debt including asset-backed securities as well as our own debt issuance for which we have elected fair value option which are not traded in active markets, as Level 2 measurements. Currently, substantially all such items qualify as Level 2 measurements. These valuations are typically obtained from a third party valuation source which, in the case of derivatives, includes valuations provided by an affiliate, HSBC BankUSA . Level 3 inputs are unobservable inputs for the asset or liability and include situations where there is little, if any, market activity for the asset or liability. Level 3 inputs incorporate market participants' assumptions about risk and the risk premium required by market participants in order to bear that risk. We develop Level 3 inputs based on the best information available in the circumstances. As ofMarch 31, 2012 andDecember 31, 2011 , our Level 3 instruments recorded at fair value on a recurring basis include$16 million and$18 million , respectively, primarily U.S. corporate debt securities, asset-backed securities and atDecember 31, 2011 , foreign corporate debt securities. As ofMarch 31, 2012 andDecember 31, 2011 , we had no Level 3 assets recorded at fair value on a non-recurring basis in continuing operations. Classification within the fair value hierarchy is based on whether the lowest level input that is significant to the fair value measurement is observable. As such, the classification within the fair value hierarchy is dynamic and can be transferred to other hierarchy levels in each reporting period. Transfers between leveling categories are assessed, determined and recognized at the end of each reporting period.Transfers between leveling categories are recognized at the end of each reporting period.
Transfers Between Level 1 and Level 2 Measurements There were no transfers between Level 1 and Level 2 during the three months ended
March 31, 2012 or 2011.Transfers Between Level 2 and Level 3 Measurements Assets recorded at fair value on a recurring basis atMarch 31, 2012 andDecember 31, 2011 which have been classified as using Level 3 measurements include 98--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation certain U.S. corporate debt securities, mortgage-backed securities and atDecember 31, 2011 , foreign corporate debt securities. Securities are classified as using Level 3 measurements when one or both of the following conditions are met: • An asset-backed security is downgraded below a AAA credit rating; or• An individual security fails the quarterly pricing comparison test with a
variance greater than 5 percent.
Transfers into or out of Level 3 classifications, net, represents changes in the mix of individual securities that meet one or both of the above conditions. During the three months endedMarch 31, 2012 , we transferred$14 million of U.S. Corporate debt securities and foreign corporate debt securities from Level 3 to Level 2 which no longer met one or both of the conditions described above, partially offset by the transfer of$12 million of U.S. corporate debt securities from Level 2 to Level 3 as they met one or both of the conditions described above. During the three months endedMarch 31, 2011 , we transferred$2 million of asset-back securities from Level 2 to Level 3 which met one or both of the conditions described above. We reported a total of$16 million and$18 million of available-for-sale securities, or approximately 1 percent of our securities portfolio as Level 3 at bothMarch 31, 2012 andDecember 31, 2011 , respectively. AtMarch 31, 2012 andDecember 31, 2011 , total Level 3 assets were 1 percent and 1 percent, respectively, of total assets measured at fair value on a recurring basis.See Note 14, "Fair Value Measurements" in the accompanying consolidated financial statements for further details including our valuation techniques as well as the classification hierarchy associated with assets and liabilities measured at fair value.
Risk Management Credit Risk Management Day-to-day management of retail credit risk is administered by theHSBC North America Chief Retail Credit Officer who reports to theHSBC North America Chief Risk Officer.The HSBC North America Chief Risk Officer reports to theHSBC North America Chief Executive Officer and to the Group Managing Director and Chief Risk Officer of HSBC. We have established detailed policies to address the credit risk that arises from our lending activities. Our credit and portfolio management procedures focus on sound underwriting, effective collections and customer account management efforts for each loan. Our lending guidelines, which delineate the credit risk we are willing to take and the related terms, are specific not only for each product, but also take into consideration various other factors including borrower characteristics, return on equity, capital deployment and our overall risk appetite. We also have specific policies to ensure the establishment of appropriate credit loss reserves on a timely basis to cover probable losses of principal, interest and fees. See the captions "Credit Quality" and "Risk Management" in our 2011 Form 10-K for a detailed description of our policies regarding the establishment of credit loss reserves, our delinquency and charge-off policies and practices and our customer account management policies and practices. Also see Note 2, "Summary of Significant Accounting Policies and New Accounting Pronouncements," in our 2011 Form 10-K for further discussion of our policies surrounding credit loss reserves. Our policies and procedures are consistent with HSBC standards and are regularly reviewed and updated both on an HSBC Finance Corporation and HSBC level. The credit risk function continues to refine "early warning" indicators and reporting, including stress testing scenarios on the basis of current experience. These risk management tools are embedded within our business planning process. Counterparty credit risk is our primary exposure on our interest rate swap portfolio. Counterparty credit risk is the risk that the counterparty to a transaction fails to perform according to the terms of the contract. Currently the majority of our existing derivative contracts are with HSBC subsidiaries, making them our primary counterparty in derivative transactions. Most swap agreements, both with unaffiliated and affiliated third parties, require that payments be made to, or received from, the counterparty when the fair value of the agreement reaches a certain level. Generally, non-affiliate swap counterparties provide collateral in the form of cash which is recorded in our balance sheet as derivative financial assets or derivative related liabilities. We provided third party swap counterparties with collateral totaling$12 million and$10 million atMarch 31, 2012 andDecember 31, 2011 , respectively. The fair value of our agreements with affiliate counterparties required the affiliate to provide cash 99--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporationcollateral of
$902 million and$584 million atMarch 31, 2012 andDecember 31, 2011 , respectively. These amounts are offset against the fair value amount recognized for derivative instruments that have been offset under the same master netting arrangement.There have been no significant changes in our approach to credit risk management since
December 31, 2011 .Liquidity Risk Management Continued success in reducing the size of our run-off real estate secured and personal non-credit card receivable portfolios coupled with the sale of our Card and Retail Services business during the second quarter of 2012 as previously discussed will be the primary driver of our liquidity management process going forward. However, lower cash flow, as a result of declining receivable balances as well as lower cash generated from balance sheet attrition due to increased charge-offs, will not provide sufficient cash to fully cover maturing debt over the next four to five years. During 2011, the shelf registration statement under which we have historically issued long-term debt expired and we chose not to renew it. We currently do not expect third-party long-term debt to be a source of funding for us in the future given the run-off nature of our business subsequent to the sale of our Card and Retail Services business as previously discussed. Further, we currently expect a significant shift in our short-term funding sources through a planned wind-down of our commercial paper program. We anticipate any required incremental funding will be integrated into the overallHSBC North America funding plans, sourced primarily through HSBC USA Inc., or through direct support from HSBC and its affiliates. HSBC has indicated it remains fully committed and has the capacity to continue to provide such support. Should market pricing for receivables improve or ifHSBC North America calls upon us to execute certain strategies in order to address capital considerations, our intent may change and a portion of this required funding could be generated through selected receivable portfolio sales in our run-off portfolios. Maintaining our credit ratings is an important part of maintaining our overall liquidity profile. As indicated by the major rating agencies, our credit ratings are directly dependent upon the continued support of HSBC. A credit rating downgrade would increase borrowing costs, and depending on its severity, substantially limit access to capital markets, require cash payments or collateral posting, require delivery of secured financing collateral documents, and permit termination of certain contracts material to us. The following summarizes our credit ratings atMarch 31, 2012 andDecember 31, 2011 : Standard Moody's Poor's Investor Fitch Corporation Service Ratings As ofMarch 31, 2012 : Senior debt A A3 AA- Senior subordinated debt A- Baa1 A+ Commercial paper A-1 P-1 F1+ Series B preferred stock BBB+ Baa2 - As ofDecember 31, 2011 : Senior debt A A3 AA- Senior subordinated debt A- Baa1 A+ Commercial paper A-1 P-1 F1+ Series B preferred stock BBB+ Baa2 - InDecember 2011 , Fitch finalized a revised global criteria for assessing the credit ratings of non-common equity securities which qualify for treatment as bank regulatory capital. InMarch 2012 , Fitch reaffirmed the rating for our Senior Debt and indicated that the reaffirmation of the rating reflects the strength and support of HSBC. Fitch also indicated that any changes in the rating of HSBC would similarly result in a change in our ratings. Separately, inMarch 2012 , Fitch placed the outlook for HSBC and related entities to negative. OnFebruary 15, 2012 , Moody's announced rating actions affecting 114 financial institutions in 16 European countries, including the ratings of HSBC. The rating action follows Moody's publications onJanuary 19, 2012 100--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation where Moody's announced that they expect to place a number of bank ratings under review for downgrade during the first quarter of 2012 in order to assess the overall negative impact of the adverse trends affecting banks in advanced countries and notably inEurope . OnFebruary 22, 2012 , Moody's put our long-term and short-term ratings on negative credit watch. We believe there is the potential for a multiple notch downgrade on our long-term rating. Any downgrade of the long-term rating would likely result in a minimum 1 notch downgrade of our short-term rating. InApril 2012 , Moody's released a time table for its review process indicating it expects to conclude the reviews by the end ofJune 2012 .As of
March 31, 2012 , there were no other pending actions in terms of changes to ratings for HSBC Finance Corporation from any of the rating agencies listed above.Other than the planned wind-down of our commercial paper program during 2012 and increased reliance on HSBC affiliates for funding, there have been no significant changes in our approach to liquidity risk management since
December 31, 2011 .Market Risk Management We maintain an overall risk management strategy that primarily uses standard interest rate and currency derivative financial instruments to mitigate our exposure to fluctuations caused by changes in interest rates and currency exchange rates. We managed our exposure to interest rate risk primarily through the use of interest rate swaps, but have used forwards, futures, options, and other risk management instruments. We do not use leveraged derivative financial instruments. We manage our exposure to foreign currency exchange risk primarily through the use of currency swaps, options and forwards. Our financial statements are affected by movements in exchange rates on our foreign currency denominated debt as well as by movements in exchange rates between the Canadian dollar and the U.S. dollar related to specialty insurance products offered inCanada .There has been no significant change in our approach to market risk management since
December 31, 2011 .Interest Rate Risk Management HSBC has certain limits and benchmarks that serve as additional guidelines in determining the appropriate levels of interest rate risk. One such limit is expressed in terms of the Present Value of aBasis Point , which reflects the change in value of the balance sheet for a one basis point movement in all interest rates without considering other correlation factors or assumptions. At bothMarch 31, 2012 andDecember 31, 2011 , our absolute PVBP limit was$5.50 million , which included the risk associated with the hedging instruments we employed. Thus, for a one basis point change in interest rates, the policy atMarch 31, 2012 andDecember 31, 2011 dictated that the value of the balance sheet could not increase or decrease by more than$5.50 million .The following table shows the components of our absolute PVBP position at
March 31, 2012 andDecember 31, 2011 broken down by currency risk:March 31, December 31, 2012 2011 (in millions) USD $ .624 $ 1.679 Other .057 .151 Absolute PVBP risk $ .681 $ 1.830The decrease since
December 31, 2011 reflects changes in cash flow projections relating to our real estate secured receivable portfolio.We also monitor the impact that an immediate hypothetical increase or decrease in interest rates of 25 basis points applied at the beginning of each quarter over a 12 month period would have on our net interest income assuming for 2012 and 2011 a declining balance sheet and the current interest rate risk profile. These estimates 101--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation include the impact on net interest income of debt and related derivatives carried at fair value and also assume we would not take any corrective actions in response to interest rate movements and, therefore, exceed what most likely would occur if rates were to change by the amount indicated. The estimates as ofMarch 31, 2012 andDecember 31, 2011 have been adjusted to reflect the impact of the Capital One transaction previously discussed with balances reduced at the sale date and the associated impact of that reduction is included in these estimates. The following table summarizes such estimated impact, excluding any impacts on our portfolio of non-qualifying hedges: March 31, December 31, 2012 2011 (in millions) Increase (decrease) in net interest income following a hypothetical 25 basis points rise in interest rates applied at the beginning of each quarter over the next 12 months $ (30 ) $ 27 Increase (decrease) in net interest income following a hypothetical 25 basis points fall in interest rates applied at the beginning of each quarter over the next 12 months 29 (20 ) The decrease in net interest income following a hypothetical rate rise and increase in net interest income following a hypothetical rate fall as compared toDecember 31, 2011 reflect regular adjustments of asset and liability behavior assumptions, updates of economic stress scenarios including housing price index assumptions, and model enhancements. A principal consideration supporting both of the PVBP and margin at risk analyses is the projected prepayment of loan balances for a given economic scenario. Individual loan underwriting standards in combination with housing valuations, loan modification program, changes to our foreclosure processes and macroeconomic factors related to available mortgage credit are the key assumptions driving these prepayment projections. While we have utilized a number of sources to refine these projections, we cannot currently project precise prepayment rates with a high degree of certainty in all economic environments given recent, significant changes in both subprime mortgage underwriting standards and property valuations across the country.There has been no significant change in our approach to interest rate risk management since
December 31, 2011 .Operational Risk Management There has been no significant change in our approach to operational risk management since
December 31, 2011 .Compliance Risk Management There has been no significant change in our approach to compliance risk management since
December 31, 2011 .Reputational Risk Management There has been no significant change in our approach to reputational risk management since
December 31, 2011 .Strategic Risk Management There has been no significant change in our approach to strategic risk management since
December 31, 2011 .102--------------------------------------------------------------------------------
Table of Contents HSBC Finance Corporation RECONCILIATIONS OF NON-U.S. GAAP FINANCIAL MEASURES TO U.S. GAAP FINANCIAL MEASURES March 31, 2012 December 31, 2011 (dollars are in millions) Tangible common equity: Common shareholder's equity $ 5,223 $ 5,351 Exclude: Fair value option adjustment (426 ) (755 ) Unrealized (gains) losses on cash flow hedging instruments 439 494 Postretirement benefit plan adjustments, net of tax 11 11 Unrealized (gains) losses on investments (93 ) (102 ) Intangible assets (485 ) (514 ) Tangible common equity $ 4,669 $ 4,485 Tangible shareholders' equity: Tangible common equity $ 4,669 $ 4,485 Preferred stock 1,575 1,575 Mandatorily redeemable preferred securities of Household Capital Trusts 1,000 1,000 Tangible shareholders' equity $ 7,244 $ 7,060 Tangible assets: Total assets $ 63,243 $ 63,469 Exclude: Intangible assets (485 ) (514 ) Derivative financial assets (2 ) - Tangible assets $ 62,756 $ 62,955 Equity ratios: Common and preferred equity to total assets 10.75 % 10.91 % Tangible common equity to tangible assets 7.44 7.12 Tangible shareholders' equity to tangible assets 11.54 11.21 103--------------------------------------------------------------------------------
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