HSBC Finance Corporation 2012 Form 10-K - Part 1

Organization and Basis of Reporting  HSBC Finance Corporation and subsidiaries is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. ("HSBC North America") which is a wholly owned subsidiary of HSBC Holdings plc ("HSBC"). HSBC Finance Corporation may also be referred to in Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") as "we", "us", or "our".

Historically we have offered a variety of lending products including real estate secured, personal non-credit card, and auto finance receivables as well as credit card and private label credit cards, all of which we no longer originate.  We have also historically offered tax refund anticipation loans and related products.  Upon completion of the pending sale of our Insurance business as discussed below, substantially all of our remaining operations will be in run-off.

We generate cash to fund our businesses primarily by collecting receivable balances and borrowing from HSBC affiliates. We also receive capital contributions as necessary from HSBC which serve as an additional source of funding. We use the cash generated by these funding sources to fund our operations, service our debt obligations and pay dividends to our preferred stockholders.

The following discussion of our financial condition and results of operations excludes the results of our discontinued operations unless otherwise noted. See Note 3, "Discontinued Operations" in the accompanying consolidated financial statements for further discussion of these operations.

Compliance  In 2012, we experienced increasing levels of compliance risk as regulators and other agencies pursued investigations into historical activities and we continued to work with them in relation to existing issues. These included an appearance by HSBC and HSBC Bank USA before the U.S. Senate Permanent Subcommittee on Investigations and the deferred prosecution agreement between U.S. authorities and HSBC and HSBC Bank USA in relation to investigations regarding inadequate compliance with anti-money laundering and sanctions law. With a new senior leadership team and a new strategy in place since 2011, HSBC has already taken significant steps to address these issues including making changes to strengthen compliance, risk management and culture. These steps, which should also serve over time to enhance our compliance risk management capabilities, include the following:

•       the creation of a new global structure which will make HSBC easier to manage and control;

•       simplifying HSBC's businesses through the ongoing implementation of an organizational effectiveness program and a five economic filters strategy;

•       developing a sixth global risk filter which should help to standardize our approach to doing business in higher risk countries;

•       substantially increasing resources, doubling global expenditure and significantly strengthening Compliance as a control (and not only as an advisory) function;

•       continuing to roll out cultural and values programs that define the way everyone in the HSBC Group should act;

•       appointing a new Chief Legal Officer and Head of Group Financial Crime Compliance with particular expertise and experience in U.S. law and regulation;

•       appointing a new Global Head of Regulatory Compliance and restructuring the Global Compliance function accordingly;

•       designing and implementing new global standards by which HSBC entities conduct their businesses; and

•       enforcing a consistent global sanctions policy.

It is clear from both our own and wider industry experience that the level of activity among regulators and law enforcement agencies in investigating possible breaches of regulations has increased, and that the direct and indirect costs of such breaches can be significant. Coupled with a substantial increase in the volume of new regulation, we believe that the level of inherent compliance risk that we face will continue to remain high for the foreseeable future.

Current Environment  The U.S. economy continued its gradual recovery in 2012 with GDP continuing to grow well below the economy's potential growth rate. A decline in business investment spending continues to restrain economic growth. Businesses continue to be cautious about the underlying strength of demand and are hesitant about ramping up hiring activity. Although consumer confidence climbed to a new post-recession high in November, consumer confidence retreated once again in December as many households remained uncertain about the future as domestic fiscal uncertainties continued to play a role in diminishing sentiment and influencing interest rates and spreads. Serious threats to economic growth remain, including high energy costs, continued pressure on housing prices and elevated unemployment levels.  In September, Federal Reserve policy makers initiated a new round of quantitative easing designed to stimulate economic activity and in December, announced that policy makers did not expect to increase short-term rates until the unemployment rate falls below 6.5 percent which means, according to the Federal Reserve's economic projections, that the Federal funds rate will be kept near zero into 2015. While the housing markets in general began to rebound in the second half of the year with overall home prices beginning to move higher as demand increased while the supply of homes for sale declined, housing prices will continue to remain under pressure in many markets as servicers resume foreclosure activities and the underlying properties are listed for sale.

Mortgage lending industry trends continued to be affected by the following in 2012:

While the economy continued to add jobs in 2012, the pace of new job creation continued to be slower than needed to meaningfully reduce unemployment. As a result, uncertainty remains as to how pronounced the economic recovery will be and whether it can be sustained. Although U.S. unemployment rates, which have been a major factor in the deterioration of credit quality in the U.S., fell from 8.5 percent at the beginning of the year to 7.8 percent in December 2012, unemployment remained high based on historical standards. 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, fiscal policy, the ability of the legislature to work collaboratively to address fiscal issues in the U.S., volatility in energy prices, credit market volatility, including the ability to permanently resolve the European sovereign debt crisis 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. These conditions in combination with the impact of recent regulatory changes, including the on-going implementation of the "Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010" ("Dodd-Frank"), will continue to impact our results in 2013 and beyond. 

Due to the significant slow-down in foreclosure processing which began in the second half of 2008, and in some instances the prior cessation of all foreclosure processing by numerous loan servicers in late 2010, there has been a reduction in the number of properties being marketed following foreclosure. This reduction has contributed to an increase in demand for properties currently on the market resulting in a general improvement in home prices in recent months but has also resulted in a larger number of vacant properties still pending foreclosure in certain communities. As servicers begin to increase foreclosure activities and market properties in large numbers, an over-supply of housing inventory could occur creating downward pressure on property values and tempering any future home price improvement.

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.

Growing government indebtedness and a large budget deficit resulted in a downgrade in the U.S. sovereign debt rating by one major rating agency in 2011 while two other major rating agencies have U.S. sovereign debt on a negative watch. There is an underlying risk that lower growth, fiscal challenges including debate over government spending and a general lack of political consensus will result in continued scrutiny of the U.S. credit standing resulting in further action by the rating agencies. While the potential effects of rating agency actions 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.

2012 Events

•       Due to the impact of the marketplace conditions described above on the performance of our receivable portfolios, we have incurred significant losses in 2012, 2011 and 2010. If our forecasts hold true, we expect to continue to generate losses from continuing operations for the foreseeable future. We believe that aspects of our 2013 funding strategy, including balance sheet attrition, cash generated from operations and other actions, including the sale of receivables currently classified as held for sale, will be sufficient to meet our funding requirements and maintain capital at levels we believe are prudent for the foreseeable future. However, long-term we will continue to remain dependent on capital infusions from HSBC and funding from HSBC and its affiliates as necessary to fully meet our longer-term funding requirements and maintain capital at levels we believe are prudent. HSBC has indicated it is fully committed and has the capacity to continue to provide such support.  We did not receive any capital contributions in 2012.  In 2011 and 2010, HSBC Investments (North America) Inc. ("HINO") made capital contributions to us totaling $690 million and $200 million, respectively.

•       During the second quarter of 2012, we decided to exit the manufacturing of all insurance products through the sale of our interest in substantially all of our insurance subsidiaries as this business did not fit with HSBC's core strategy in the United States and Canada. Insurance products will continue to be offered to HSBC customers through non-affiliate providers. As a result, our Insurance operations are part of a disposal group held for sale and we began reporting this business as discontinued operations in the second quarter of 2012.  In September 2012, we announced we entered into an agreement to sell our Insurance operations to Enstar Group Ltd ("Enstar") for $181 million in cash, to be adjusted to reflect the actuarial value and capital of these operations at the date of closing, which is anticipated to be by the end of the first quarter of 2013, subject to regulatory approval. Since the carrying value of the disposal group was greater than its estimated fair value less costs to sell, during 2012 we recorded a pre-tax lower of amortized cost or fair value less cost to sell of $119 million ($90 million after-tax) which takes into consideration foreign currency translation adjustments and unrealized gains on available-for-sale securities associated with the disposal group that are reflected in accumulated other comprehensive income. At December 31, 2012, disposal group assets consisted primarily of available-for-sale securities totaling $1.4 billion and disposal group liabilities consisted primarily of insurance policy and claim reserves totaling $988 million. 

•       On May 1, 2012, HSBC, through its wholly-owned subsidiaries HSBC Finance Corporation, HSBC USA Inc. and other wholly-owned affiliates, sold its Card and Retail Services business to Capital One Financial Corporation ("Capital One") for a premium of 8.75 percent of receivables. 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. Under the terms of the agreement, interests in facilities in Chesapeake, Virginia; Las Vegas, Nevada; Mettawa, Illinois; Volo, Illinois; Hanover, Maryland; Salinas, California; Sioux Falls, South Dakota and Tigard, 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 cash consideration was $11.8 billion which resulted in a pre-tax gain of $2.2 billion ($1.4 billion after-tax) being recorded during the second quarter of 2012. The majority of the employees in our Card and Retail Services business 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.

The sale of our Card and Retail Services business did not have a material impact on the recognition of our deferred tax assets. We are part of a consolidated group for filing federal and state income taxes. This consolidated group includes other U.S. affiliates which are profitable. Taxable profits from the disposal were incorporated into the ongoing analysis of recoverability of our deferred tax assets and considered with all other relevant factors, including on-going tax planning strategies. While the profit on disposal did have a positive effect in providing support for the recognition of deferred tax assets, currently the recognition of deferred tax assets relies more heavily on future taxable profits generated as a result of tax planning strategies implemented in relation to capital support from HSBC and these strategies remained unaffected by the sale.

As a result of the sale of our Card and Retail Services business, our credit card banking subsidiary, HSBC Bank Nevada, N.A., no longer has any ongoing business operations and we intend to surrender its national bank charter to the OCC as soon as practicable. We currently anticipate this will occur during 2013.

•       As discussed in prior filings, we have been engaged in an on-going evaluation of the optimal size of our balance sheet taking into consideration our liquidity, capital and funding requirements as well as capital requirements of HSBC. As part of this on-going evaluation, we identified a pool of real estate secured receivables for which we no longer had the intent to hold for the foreseeable future and, as a result, transferred this pool of real estate secured receivables to receivables held for sale during the second quarter of 2012.  The receivable pool identified comprised first lien partially charged-off accounts as of June 30, 2012, with an unpaid principal balance of approximately $8.1 billion.  The net realizable value of these receivables after considering the fair value of the property less cost to sell was approximately $4.6 billion prior to transfer.  Reducing these types of assets is expected to be capital accretive and will reduce funding requirements, accelerate portfolio wind-down and also alleviate some operational burden given that these receivables are servicing intense and subject to foreclosure delays.  Receivables greater than 180 days past due require substantial amounts of regulatory capital under the U.K. Financial Services Authority's requirements and the extension of the foreclosure timeline in the U.S. has increased the capital requirements for this run-off book of business.  This factor, combined with the increase in the market's appetite for this asset class, led us to the decision that the sale of certain of these assets would be the best financial decision based on certain facts and circumstances. 

We anticipate the receivables will be sold in multiple transactions generally over the next two years or, if the foreclosure process is completed prior to sale, the underlying properties acquired in satisfaction of the receivables will be classified as real estate owned ("REO") and sold. As we continue to work with borrowers, we may also agree to a short sale whereby the property is sold by the borrower at a price which has been pre-negotiated with us and the borrower is released from further obligation. This pool of receivables includes a substantial majority of our real estate receivables which had been written down to the lower of amortized cost or fair value of the collateral less cost to sell as of June 30, 2012 in accordance with our existing charge-off policies as we considered the collateral as the sole source for repayment. However, as we now plan to sell these receivables, fair value represents the price we believe a third party investor would pay to acquire the receivable portfolios. A third party investor of receivables would incorporate a number of assumptions in predicting future cash flows, such as differences in overall cost of capital assumptions which results in a lower estimate of fair value for the cash flows associated with the receivables. At December 31, 2012, the fair value of the real estate secured receivables held for sale totaled $3.0 billion. We recorded a lower of amortized cost or fair value adjustment of $1.4 billion, net of reversals, during 2012 for these real estate secured receivables. See Note 7, "Receivables Held for Sale," in the accompanying consolidated financial statements for additional information.

Based on the projected timing of loan sales and the anticipated flow of foreclosure volume into REO over the next two years, a portion of the real estate secured receivables classified as held for sale during the second quarter of 2012 will ultimately become REO. Upon classification of the underlying properties acquired in satisfaction of these loans as REO, the properties will be recorded at the fair value of the collateral less cost to sell which we expect will represent a higher value than the price a third party investor would have paid to acquire the receivables as explained above. As a result, a portion of the fair value adjustment on receivables held for sale will be recorded in earnings over time, which could be in the region of 20 percent of the fair value adjustment. This estimate is highly dependent upon the timing and size of future receivable sales as well as the volume and timelines associated with foreclosure activity. During the second half of 2012, we transferred a portion of our real estate secured receivable portfolio held for sale with a carrying value of $168 million to REO after obtaining title to the underlying collateral and reversed a portion of the lower of amortized cost or fair value adjustment previously recorded totaling $50 million.  Additionally, during the second half of 2012, we completed short sales on real estate secured receivables with a carrying value of $96 million. As a result of these short sales, we reversed a portion of the lower of amortized cost or fair value adjustment previously recorded totaling $20 million as the settlement price was higher than the carrying value. See Note 7, "Receivables Held for Sale," in the accompanying consolidated financial statements for additional information.

•       In addition to the real estate secured receivables discussed above, we also determined that, given current market conditions for the personal non-credit card receivable portfolio, a sale of our remaining personal non-credit card receivables is expected to reduce a significant amount of risk-weighted assets which would provide net capital relief, reduce funding requirements and allow us to exit an entire product line, reducing both the related cost infrastructure and operational risk.  As such, during the second quarter of 2012, we made the decision to pursue a sale of the personal non-credit card receivable portfolio. The personal non-credit card receivable portfolio was previously held for investment purposes and was transferred to held for sale during the second quarter of 2012 as we no longer had the intention to hold our portfolio of personal non-credit card receivables for the foreseeable future and anticipate these receivables will be sold in the near term. As a result, our personal non-credit card receivable portfolio was transferred to held for sale during the second quarter of 2012. At December 31, 2012, the fair value of our personal non-credit card receivable portfolio totaled $3.2 billion. We recorded a lower of amortized cost or fair value adjustment of $289 million during 2012. See Note 7, "Receivables Held for Sale," in the accompanying consolidated financial statements for additional information.

•       During the fourth quarter, we sold the recovery rights to certain personal non-credit card receivables with an unpaid principal balance of $979 million which had previously been fully charged-off. The cash proceeds from this transaction of $81 million were recorded during the fourth quarter of 2012 as a recovery of charge-offs.

•       During the first quarter of 2012, we made a decision to wind-down our commercial paper program. During the second quarter of 2012, we ceased new commercial paper issuances and at December 31, 2012 no longer have any commercial paper balances outstanding.  Commercial paper balances totaled $4.0 billion at December 31, 2011.  Any required funding has been integrated into the overall HSBC North America funding plans and will be sourced through HSBC USA Inc., or through direct support from HSBC or its affiliates.

•       We historically have estimated probable losses for real estate secured receivables collectively evaluated for impairment which do not qualify as a troubled debt restructure using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency and ultimately charge-off.  This has historically resulted in the identification of a loss emergence period for these real estate secured receivables collectively evaluated for impairment using a roll rate migration analysis which results in approximately 7 months of losses in our credit loss reserves. A loss coverage of 12 months using a roll rate migration analysis would be more aligned with U.S. bank industry practice. As previously disclosed in the third quarter of 2012, our regulators indicated they would like us to more closely align our loss coverage period implicit within the roll rate methodology with U.S. bank industry practice. During the fourth quarter of 2012, we extended our loss emergence period to 12 months for U.S. GAAP.  As a result, during the fourth quarter of 2012, we increased credit loss reserves by approximately $350 million for these loans. We will perform an annual review of our portfolio going forward to assess the period of time utilized in our roll rate migration period.  See "Credit Quality" in this MD&A and Note 6, "Credit Loss Reserves," in the accompanying consolidated financial statements for additional discussion.

•       As disclosed previously, during the third quarter of 2012 we began evaluating recently issued regulatory guidance requiring receivables discharged under Chapter 7 bankruptcy and not re-affirmed to be classified as TDR Loan balances.  During the fourth quarter of 2012, we completed our analysis and now classify these receivables as TDR Loans which resulted in an increase in TDR Loans of $1.0 billion at December 31, 2012, of which 37 percent had been carried at the lower of amortized cost or fair value of the collateral less cost to sell.  Excluding the receivables carried at the lower of amortized cost or fair value of the collateral less cost to sell, these receivables are now reserved for using a discounted cash flow analysis which resulted in an increase in credit loss reserves during the fourth quarter of 2012 of approximately $40 million.  See Note 5, "Receivables," in the accompanying consolidated financial statements for additional information about TDR Loans.

•       As previously reported, in April 2011, HSBC Finance Corporation and our indirect parent, HSBC North America Holdings Inc. ("HSBC North America"), entered into a consent cease and desist order with the Federal Reserve (the "Federal Reserve Consent Order") and our affiliate HSBC Bank USA, entered into a similar consent order with the Office of the Comptroller of the Currency (the "OCC") (together with the Federal Reserve Servicing Consent order, the "Servicing Consent Orders") following completion of a  broad horizontal review of industry foreclosure practices.  The Federal Reserve Servicing Consent Order requires us to take prescribed actions to address deficiencies noted in the joint examination and described in the consent order.  We continue to work with our regulators to align our process with the requirements of the Servicing Consent Orders and are implementing operational changes as required.  The Servicing Consent Orders required an independent review of foreclosures ("the Independent Foreclosure Review") pending or completed between January 2009 and December 2010 to determine if any borrower was financially injured as a result of an error in the foreclosure process. We previously retained an independent consultant to conduct the Independent Foreclosure Review.  

On February 28, 2013, HSBC Finance Corporation and our indirect parent, HSBC North America, entered into an agreement with the Federal Reserve, and our affiliate, HSBC Bank USA, entered into an agreement with the OCC, pursuant to which the Independent Foreclosure Review will cease and HSBC North America will make a cash payment of $96 million into a fund that will be used to make payments to borrowers that were in active foreclosure during 2009 and 2010 and, in addition, will provide other assistance (e.g., loan modifications) to help eligible borrowers. As a result, during 2012, we recorded expenses of $85 million which reflects the portion of HSBC North America's total expense of $104 million that we believe is allocable to us.  While we believe compliance related costs have permanently increased to higher levels due to the remediation requirements of the regulatory consent agreements, this settlement will positively impact compliance expenses in future periods as the significant resources working on the Independent Foreclosure Review will no longer be required.  See Note 23, "Litigation and Regulatory Matters" in the accompanying consolidated financial statements for further information.

•       On July 21, 2010, the "Dodd-Frank Wall Street Reform and Consumer Protection Act" was signed into law and is a sweeping overhaul of the financial regulatory system. The legislation will have a significant impact on the operations of many financial institutions in the U.S. As the legislation calls for extensive regulations to be promulgated to interpret and implement the legislation, it is not possible to precisely determine the impact to operations and financial results at this time. For a more complete description of the law and implications to our business, see the "Regulation - Financial Regulatory Reform" section under the "Regulation and Competition" section in Item 1. Business.

Business Focus  Excluding receivables held for sale as discussed above, our real estate secured receivable portfolio, which totaled $32.9 billion at December 31, 2012, is currently running off. The timeframe in which this portfolio 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 (excluding receivables held for sale) 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 expected to be 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. The workforce reductions have been largely offset, however, by increased staffing related to processing foreclosures as 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.

Performance, Developments and Trends  We reported a net loss of $845 million during 2012 compared to a net loss of $1.4 billion and $1.9 billion during 2011 and 2010, respectively. 

Loss from continuing operations was $2.4 billion during 2012 compared to losses from continuing operations of $2.3 billion and $2.5 billion during 2011 and 2010, respectively. We reported a loss from continuing operations before taxes of $3.8 billion during 2012 compared to losses from continuing operations before tax of $3.8 billion and $4.0 billion during 2011 and 2010, respectively. Our results in all periods were impacted by the change in the fair value of debt and related derivatives for which we have elected the fair value option.  During 2012 our results were significantly impacted by the initial lower of amortized cost or fair value adjustment, including the credit component recorded in the provision for credit losses, recorded on the receivables transferred to held for sale during the second quarter of 2012 as discussed above as well as the impact to our provision for credit losses from the changes made to the loss emergence period used in our roll rate migration analysis as discussed above.  Additionally, our results during 2011 were impacted by the adoption of new accounting guidance related to troubled debt restructurings ("TDR Loans") as discussed more fully below.  In order to better understand the underlying performance trends of our business, the following table summarizes the impact of these items on our loss from continuing operations for all periods presented.

⁽¹⁾        Represents a non-U.S. GAAP financial measure.

⁽²⁾        During the second half of 2012, we reversed $18 million of the initial lower of amortized cost or fair value adjustments on receivables held for sale of  which is not reflected in the table above.

Excluding the collective impact of the items in the table above, our loss from continuing operations before tax for 2012 improved $2.6 billion compared to 2011. The increase reflects lower provisions for credit losses, higher other revenues due to improved derivative income (expense) and lower operating expenses, partially offset by lower net interest income. The improvement in derivative income (expense) reflects the impact of a general decline in long-term interest rates on the mark-to-market on derivatives in our non-qualifying hedge portfolio during both 2012 and 2011 which was more pronounced in 2011. 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. See "Results of Operations" for a more detailed discussion of our derivative income (expense).

Net interest income decreased during 2012 as compared to 2011 reflecting lower average receivables as a result of receivable liquidation, partially offset by higher overall receivable yields and lower interest expense due to lower average borrowings and lower average rates. Overall receivable yields increased during 2012 as receivable yields were positively impacted by the transfer of our entire personal non-credit card portfolio and certain real estate secured receivables to held for sale in the second quarter of 2012 as these receivables are now carried at the lower of amortized cost or fair value which reduces average receivable balances while interest income otherwise remains the same. Excluding the impact of the transfer of these receivables to held for sale from the calculation of average receivable balances, overall receivable yields were essentially flat during 2012 as slightly higher real estate secured receivable yields and higher personal non-credit card receivable yields were largely offset by the impact of 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. Net interest income in 2011 also benefited from an increase in our estimate of interest receivable relating to income tax receivables of $117 million due to the resolution of an issue with the Internal Revenue Service Appeals' Office during the second quarter of 2011 which was recorded as a component of finance and other interest income. Net interest margin was 3.37 percent in 2012 compared to 2.90 percent in 2011. Net interest margin in 2012 was positively impacted by the transfer of our entire personal non-credit card portfolio and certain real estate secured receivables to held for sale in the second quarter of 2012 as discussed above. Net interest margin in 2011 was impacted by the tax-related interest income as discussed above. Excluding the impact of these items from the periods presented, net interest margin remained higher in 2012 driven by a lower cost of funds as a percentage of average interest earning assets as overall receivable yields were essentially flat 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 was lower in 2012 as compared to the prior year as discussed below:

Ÿ      The provision for credit losses for real estate secured loans decreased significantly during 2012 reflecting the impact of lower loss estimates due to lower receivable levels, lower dollars of delinquency on accounts less than 180 days contractually delinquent, improved credit quality and lower volumes of new TDR Loans during 2012.  The decrease also reflects, in part, the transfer of certain real estate secured receivables to held for sale during the second quarter of 2012.  Subsequent to the transfer to held for sale no further provision for credit losses are recorded on these receivables as receivables held for sale are carried at the lower of amortized cost or fair value. The decrease in the provision for credit losses during 2012 was partially offset by the change in the loss emergence period used in our roll rate migration analysis as previously discussed, which increased the provision for credit losses during the fourth quarter of 2012 by approximately $350 million. The decrease in the provision for credit losses for 2012 also reflects the impact of lower reserve requirements on TDR Loans as a greater percentage of TDR Loans are carried at the lower of amortized cost or fair value of the collateral less cost to sale, partially offset by updates in prepayment speeds and yield assumptions used in the discounted cash flow methodology as well as the classification during the fourth quarter of 2012 of certain bankrupt accounts as TDR Loans as previously discussed.

Ÿ      The provision for credit losses for our personal non-credit card receivables decreased significantly during 2012.  As discussed above, at June 30, 2012 we transferred our entire personal non-credit card receivable portfolio to receivables held for sale which resulted in a cumulative lower of cost or fair value adjustment of which $112 million related to credit and was recorded as a component of provision for credit losses during 2012.  Subsequent to the transfer to held for sale, no further provision for credit losses are recorded on these receivables.  The provision for credit losses during the second half of 2012 also reflects recoveries received from borrowers on fully charged-off personal non-credit card receivables that were not transferred to held for sale as well as $81 million of cash proceeds received from the bulk sale of recovery rights of certain previously charged-off personal non-credit card receivables as previously discussed. The decrease also reflects lower receivable levels and improved credit quality including lower delinquency levels and lower loss estimates prior to reclassification to held for sale.

See "Results of Operations" for a more detailed discussion of our provision for credit losses.

Credit loss reserves at December 31, 2012 are not comparable to December 31, 2011 as a result of the transfer to receivables held for sale of our entire personal non-credit card receivable portfolio and a substantial majority of real estate secured receivables which had been written down to the lower of amortized cost or fair value of the collateral less cost to sell as of June 30, 2012 in accordance with our existing charge-off policies. As a result, credit loss reserves at June 30, 2012 and forward are only associated with real estate secured receivables held for investment. Excluding the impact of the transfers of receivables to held for sale, credit loss reserves decreased as compared to December 31, 2011 due to lower receivable levels, improved credit quality, including lower levels of two-months-and-over contractual delinquency on accounts less than 180 days contractually delinquent and lower reserve requirements for TDR Loans, partially offset by the impact of changes to the loss emergence period used in our roll rate migration analysis as discussed previously.  Reserve requirements on TDR Loans were lower at December 31, 2012 due to a greater percentage of TDR Loans being carried at the lower of amortized cost or fair value of the collateral less cost to sale, partially offset by updates in prepayment speeds and yield assumptions used in the discounted cash flow methodology as well as the classification during the fourth quarter of 2012 of certain bankrupt accounts as TDR Loans as previously discussed.

See "Credit Quality" for further discussion of credit loss reserves.

A significant portion of our real estate secured receivable portfolio held for investment 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 portion of real estate secured receivables in our portfolio are carried at the lower of amortized cost or fair value of the collateral less cost to sell. The following table summarizes these receivables in comparison to the real estate secured receivable portfolio held for investment:

⁽¹⁾       Excludes TDR Loans which are recorded at the lower of amortized cost or fair value of the collateral less cost to sell and included separately in the table.

Total operating expenses during 2012 and 2011 were impacted by expenses related to mortgage servicing related matters of $85 million and $157 million, respectively, as well as during 2011 an increase in legal reserves of $150 million related to increased exposure estimates on certain litigation matters. Excluding these items from the periods presented, total operating expenses increased $81 million, or 9 percent, during 2012 reflecting increased expenses for consulting services and other compliance related matters, partially offset by lower REO expenses. See "Results of Operations" for a more detailed discussion of operating expenses.

Our effective income tax rate was (36.9) percent during 2012 compared to (38.1) percent during 2011. The effective tax rate in 2012 was impacted by correcting prior year deferred tax errors in the current year, an increase in valuation allowance on states with net operating loss carryforward periods of 15 to 20 years, a decrease in tax reserves relating to the conclusion of state audits and expiration of state statutes of limitations, and corrections to the current tax liability account.  The effective tax rate in 2012 was also impacted by state taxes, including states where we file combined unitary state tax returns with other HSBC affiliates. See Note 13, "Income Taxes," in the accompanying consolidated financial statements for further discussion.

2011 as compared to 2010  Our 2011 and 2010 results were significantly impacted by the change in the fair value of debt and related derivatives for which we have elected the fair value option. Additionally, our results in 2011 were impacted by the adoption of new accounting guidance related to TDR Loans as discussed below.  Excluding the collective impact of these items in both periods, our loss from continuing operations before tax improved to a loss of $4.0 billion in 2011 as compared to a loss of $4.7 billion in 2010 reflecting a lower provision for credit losses, partially offset by lower net interest income, lower other revenues, driven by lower derivative related income, and higher operating expenses.  The impact of interest rates on our non-qualifying hedge portfolio resulted in losses of $1.1 billion during 2011 as compared to losses of $188 million during 2010. 

Net interest income decreased during 2011 reflecting lower average receivables as a result of receivable liquidation and lower overall receivable yields driven 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. Lower overall receivable yields were partially offset by lower levels of nonaccrual receivables. These decreases were partially offset by an increase in our estimate of interest receivable relating to income tax receivables which totaled $117 million during 2011 as previously discussed as well as lower interest expense due to lower average borrowings and lower average rates.

Net interest margin was 2.90 percent in 2011 and 2.54 percent in 2010. Net interest margin was positively impacted in 2011 by the estimated interest receivable relating to income tax receivables as discussed above. Excluding the impact of this item, net interest margin remained higher during 2011 reflecting a lower cost of funds as a percentage of interest earning assets, partially offset by lower overall receivable yield as discussed above. See "Results of Operations" in this MD&A for additional discussion regarding net interest income and net interest margin.

During the third quarter of 2011, we adopted a new Accounting Standards Update which provided additional guidance to determine whether a restructuring of a receivable meets the criteria to be considered a TDR Loan.  Under this new guidance, we have determined that substantially all receivables modified as a result of a financial difficulty, regardless of whether the modification was permanent or temporary, including all modifications with trial periods, should be reported as TDR Loans. Additionally, we have determined that all re-ages, except first time early stage delinquency re-ages where the customer has not been granted a prior modification or re-age since the first quarter of 2007, should be considered TDR Loans. As required, the new guidance was applied retrospectively to restructurings occurring on or after January 1, 2011 and resulted in the reporting of an additional $4.1 billion of real estate secured receivables and an additional $717 million of personal non-credit card receivables as TDR Loans. As a result, our provision for credit losses during 2011 included approximately $766 million for real estate secured receivables and approximately $159 million for personal non-credit card receivables recorded in the third quarter of 2011 related to the adoption of new accounting guidance related to TDR Loans.  Therefore, the provision for credit losses during 2011 is not comparable to prior reporting periods. See Note 5, "Receivables," in the accompanying consolidated financial statements for further discussion of this new guidance and the related impacts. 

Also during the third quarter of 2011, we reviewed our existing models for determining credit loss reserves. As part of this process, we considered recent environmental activity including the impact of foreclosure delays, unique characteristics of our run-off portfolio and changes in how loans are ultimately running off. As a result, we made the following enhancements to our credit loss reserve estimation process during the third quarter of 2011. These changes in estimation were necessary because previous estimation techniques no longer represented the composition of the run-off portfolio or the current environment. The changes resulted in a net increase to our provision for credit losses of approximately $175 million.  Because these changes were inter-related and included re-segmentation of the portfolio, it is difficult to determine the precise amount of each item. However, we have used a reasonable method to approximate the impact of each change as described below: 

i)      Severity - Enhancements were made to the process for determining loss severity associated with real estate secured loans. These enhancements resulted in a net decrease to our provision for credit losses of approximately $75 million. The loss severity changes were comprised of two main components. The first component relates to adjustments we determined were required to be made to broker price opinions used to determine the fair value of the collateral less costs to sell when loans became 180 days contractually delinquent. In 2011, we began to see a pattern of lower estimates of collateral value after the more detailed property valuations were performed which include information obtained from a walk-through of the property after we obtained title and determined this difference should be considered in our estimate of loss severity. This component resulted in an increase to our credit loss reserves of approximately $350 million for loans which had been written down to the fair value of the collateral less costs to sell. The second component relates to loss severity estimates on real estate loans collectively evaluated for impairment   Historically, loss estimates on these accounts were based on a recent average total losses incurred at the time the loans were transferred to Real Estate Owned ("REO").  Due to the significant reduction in loans transferred to REO during 2011 as a result of foreclosure delays and concentrations in mix of loans transferred to REO in certain states, these most recent averages of total loss were no longer representative of the loss severity associated with our outstanding loan portfolio based on geographical mix. As a result, we determined that the best estimate of loss severity should be based on an average of recent broker price opinions received (as adjusted for information obtained from a walk-through of the property discussed above). We obtain broker price opinions on receivables that are greater than 180 days delinquent every six months.  These broker price opinions provide our best estimate of the value of the properties that are likely to transfer to REO.  Therefore, we utilized this information when estimating the loss severity on our loan portfolio.  This component resulted in approximately a $425 million reduction in our credit loss reserves for these loans.

ii)     Projected Cash Flows - We revised our estimate of projected cash flows for TDR Loans which resulted in an increase in credit loss reserves of approximately $260 million on our existing population of TDR Loans.  This impact was principally comprised of two factors which we have not attempted to quantify individually:

a.     First, prior to the third quarter of 2011, our projections included macroeconomic assumptions incorporating recent portfolio performance.  During the third quarter of 2011, we began to rely more heavily on portfolio performance as the macroeconomic forecast included home price appreciation. We concluded it was appropriate to follow a more conservative approach and eliminate the use of these forward looking macroeconomic factors in light of growing uncertainty of forecasting these factors in the current environment.   

b.     Second, the revised estimate of cash flows included a change in assumptions regarding both the amount of interest that would not be collected on existing TDR Loans and the timing of interest collections based on changes in the economic environment, including the elongated timeframes associated with completing foreclosure.  

iii)    Portfolio Re-segmentation - Changes were made to increase the segmentation of the portfolio affecting the weighting of severity rates used (as previously discussed) for these more granular portfolios, the historical roll rates for each of the more granular portfolios as well as the estimated loans that would ultimately go to foreclosure.  The revised segmentation considered specific characteristics of the portfolio such as year of origination, location of the property and underlying economic factors present where the property is located. Segmenting the portfolio based on these risk characteristics provides greater risk differentiation based on the underlying trends in our portfolio and will be more responsive to the changing portfolio characteristics in the future as the loan portfolio continues to run-off. We estimate these changes had a net impact of reducing credit loss reserves by approximately $10 million.

Excluding the impact of the adoption of the new Accounting Standards Update and the enhancements made to our credit loss reserve estimation process during the third quarter of 2011 discussed above, our overall provision for credit losses decreased significantly during 2011 as discussed below.

•       The provision for credit losses for real estate secured loans decreased $871 million during 2011. The decrease reflects lower balances outstanding as the portfolios continue to liquidate and lower charge-off levels. These decreases were partially offset by higher expected losses on TDR Loans. Also contributing to the decrease was lower levels of two-months-and-over contractual delinquency on accounts less than 180 days contractually delinquent, which in our total reported contractual delinquency for real estate secured receivables was largely offset by an increase in late stage delinquency, reflecting the continuing impact from foreclosure delays as discussed above.

•       The provision for credit losses for our personal non-credit card receivables decreased during 2011 reflecting lower receivable, delinquency and charge-off levels as well as improved credit quality.

See "Results of Operations" for a more detailed discussion of our provision for credit losses.

During 2011, we increased our credit loss reserves as the provision for credit losses was $440 million higher than net charge-offs. Excluding the impact of adopting new accounting guidance on TDR Loans and the enhancements made to our credit loss reserve estimation process as previously discussed, the provision for credit losses was $660 million lower than net charge-offs reflecting lower receivable levels, lower overall delinquency levels and improvements in economic conditions. See "Credit Quality" for further discussion of credit loss reserves.

Total operating expenses for continuing operations increased $79 million, or 7 percent, during 2011 driven by an expense accrual related to mortgage servicing matters of $157 million, an increase in legal reserves of $150 million reflecting increased exposure estimates on litigation and a $58 million increase in compliance related costs associated principally with our foreclosure remediation efforts, partially offset by lower salary and employee benefits and lower real estate owned ("REO") expenses. See "Results of Operations" for a more detailed discussion of operating expenses.

Our effective income tax rate for continuing operations was (38.1) percent in 2011 and (36.3) percent in 2010. The effective tax rate for 2011 was impacted by a release of valuation allowance previously established on foreign tax credits. HSBC North America implemented an additional tax planning strategy which is expected to generate sufficient taxable foreign source income to allow us to recognize and utilize foreign tax credits currently on our balance sheet before they expire. The effective tax rate for 2011 was also impacted by the non-deductible portion of the accrual related to mortgage servicing matters, deferred tax prior period adjustments, an increase in the valuation allowance on state deferred taxes, an increase in uncertain tax positions and state taxes, including states where we file combined unitary state tax returns with other HSBC affiliates. See Note 13, "Income Taxes," in the accompanying consolidated financial statements for further discussion.

Performance Ratios  Our efficiency ratio from continuing operations was (235.5) percent in 2012 compared to 65.5 percent in 2011 and 46.7 percent in 2010. Our efficiency ratio from continuing operations during all periods was impacted by the change in the fair value of debt and related derivatives for which we have elected fair value option accounting. Additionally, in 2012 the efficiency ratio was impacted by the initial lower of amortized cost or fair value adjustment recorded on receivables transferred to held for sale during June 2012 as discussed above. Excluding these items from the periods presented, our efficiency ratio remained elevated during 2012 due to lower net interest income, partially offset by improvements in derivative related income (expense) and lower operating expenses.  Excluding these items from the periods presented, our efficiency ratio deteriorated significantly in 2011 reflecting lower other revenues driven by lower derivative related income and lower net interest income driven by portfolio liquidation while operating expenses increased as discussed above.

Our return on average common shareholder's equity ("ROE") was (46.2) percent for 2012 compared to (39.1) percent for 2011 and (37.0) percent for 2010. Our return on average assets ("ROA") was (4.9) percent for 2012 compared to (3.9) percent for 2011 and (3.5) percent for 2010. ROE and ROA in all periods were significantly impacted by the change in the fair value of debt for which we have elected fair value option accounting. In 2012 ROE and ROA were also impacted by the initial lower of amortized cost or fair value adjustment recorded on receivables transferred to held for sale during June 2012 as discussed above.  Additionally, ROE and ROA during 2011 were also impacted by the adoption of new accounting guidance related to TDR Loans during the third quarter of 2011 as previously discussed. Excluding these items from the periods presented, both ROE and ROA improved for 2012 as compared to 2011 largely due to a lower net loss during 2012.  Excluding these items, ROE for 2011 improved as compared to 2010 reflecting a lower loss from continuing operations driven by lower provision for credit losses and ROA was essentially flat as the rate of improvement in loss from continuing operations as discussed above was at the same pace as the decrease in average assets.

Receivables  Receivables held for investment were $32.9 billion at December 31, 2012 compared to $47.9 billion at December 31, 2011. The significant decrease since December 31, 2011 reflects the transfer to receivables held for sale of our entire personal non-credit card receivable portfolio and a portion of our real estate secured receivables as discussed above with a combined fair value of $6.8 billion at the time of transfer during the second quarter of 2012 as well as the continued liquidation of the real estate secured receivable portfolios which will continue going forward.  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.

Receivables held for sale  Receivables held for sale were $6.2 billion at December 31, 2012.  Receivables held for sale include our entire personal non-credit card receivable portfolio as well as a pool of real estate secured receivables which includes the substantial majority of our real estate receivables which had been written down to the lower of amortized cost or fair value of the collateral less cost to sell as of June 30, 2012 in accordance with our existing charge-off policies.  There were no receivables held for sale at December 31, 2011. See Note 7, "Receivables Held for Sale," in the accompanying consolidated financial statements for additional information.

Credit Quality  Overall dollars of delinquency were $6.3 billion at December 31, 2012 compared to $8.6 billion at December 31, 2011. The overall delinquency ratio was 16.03 percent at December 31, 2012 compared to 17.93 percent at December 31, 2011.  Dollars of delinquency and the delinquency ratio have been impacted by the transfer during the second quarter of 2012 of our entire personal non-credit card receivable portfolio and a pool of certain real estate secured receivables to held for sale as previously discussed which has resulted in these receivables being carried at the lower of amortized cost or fair value.  As a result, dollars of delinquency and the delinquency ratios at December 31, 2012 are not comparable to the dollars of delinquency and the delinquency ratios at December 31, 2011.   See "Credit Quality-Delinquency" for a more detailed discussion of our delinquency ratio.

Overall dollars of net charge-offs for full year 2012 decreased as compared to full year 2011. The decrease reflects, in part, the impact of the transfer of our entire personal non-credit card receivable portfolio and certain real estate secured receivables to receivables held for sale at June 30, 2012 as these receivables are now carried at the lower of amortized cost or fair value and there are no longer any charge-offs associated with these receivables. Assuming these receivables had not been transferred to held for sale and we had continued to record charge-offs, overall dollars of net charge-off would have remained lower for the full year 2012 as all receivable portfolios were positively impacted by lower receivable levels and lower dollars of delinquency on accounts less than 180 days contractually delinquent than during the prior periods. The decrease also reflects the impact of lower levels of personal bankruptcy filings and improvements in credit quality. The net charge-off ratio for full year 2012 decreased as compared to full year 2011 as the decrease in net charge-off dollars as discussed above outpaced the decrease in average receivable levels.  See "Credit Quality-Net Charge-offs of Consumer Receivables" for a more detailed discussion of our net charge-off ratio.

Funding and Capital  During 2012, we did not receive any capital contributions from HINO as compared to 2011 when we received capital contributions from HINO totaling $690 million to support ongoing operations and to maintain capital above the minimum levels we believe are necessary to support our operations.  During 2012, we retired $11.4 billion of term debt as it matured or was redeemed. The maturing and redeemed debt cash requirements were met through proceeds from the sale of our Cards and Retail Services business, funding from HSBC affiliates and cash generated from operations including balance sheet attrition.  The balance sheet and credit dynamics described above continue to have an impact on our liquidity and risk management processes. Continued success in reducing the size of our receivable portfolios as discussed above will be the primary driver of our liquidity during 2013.  However, lower cash flow as a result of declining receivable balances will not provide sufficient cash to fully repay maturing debt over the next four to five years.  As we continue to liquidate our 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. Any required incremental funding has been integrated into the overall HSBC North America funding plans and will be sourced through HSBC USA Inc. or through direct support from HSBC or its affiliates.  HSBC has indicated it remains fully committed and has the capacity to continue to provide such support. 

As discussed above, on June 30, 2012, we transferred our entire personal non-credit card receivable portfolio and a portion of our real estate secured receivables to held for sale as we no longer have the intent to hold these receivables for the foreseeable future for capital or operational reasons. In the current market environment, market pricing continues to value the cash flows associated with the remainder of our real estate secured receivable portfolio at amounts which do not provide economic benefits. Therefore, we have determined that we have the positive intent and ability to hold these remaining real estate secured receivables for the foreseeable future and, as such, have classified these real estate secured receivables as held for investment purposes. However, should market pricing improve in the future or if HSBC calls upon us to execute certain strategies in order to address capital considerations, it could result in the reclassification of additional real estate secured receivables to held for sale.

The tangible common equity to tangible assets ratio was 9.87 percent and 7.11 percent at December 31, 2012 and 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.

We continue to be dependent on balance sheet attrition, capital contributions from our parent and affiliate funding to meet our funding requirements.  Numerous factors, both internal and external, may impact funding strategy. These factors may include our efforts to restructure the risk profile of our operations, our affiliate's debt ratings, overall economic conditions, overall capital markets volatility, the counterparty credit limits of investors to the HSBC Group and the effectiveness of our management of credit risks inherent in our customer base.

Our results are also impacted by general economic conditions, including unemployment, housing market conditions, property valuations, interest rates and legislative and regulatory changes, all of which are beyond our control. Because our businesses have historically lent to customers who have limited credit histories, modest incomes and high debt-to-income ratios or who have experienced prior credit problems, overall our customers are more susceptible to economic slowdowns than other consumers. When unemployment increases or changes in the rate of home value appreciation or depreciation occur, a higher percentage of our customers default on their loans and our charge-offs increase. Changes in interest rates generally affect both the rates that we charge to our customers on variable rate loans and the rates that we must pay on our borrowings. In 2012, the interest rates that we paid on our short-term debt decreased. Excluding the impact of the transfer of receivables to held for sale from the calculation of average receivable balances as previously discussed, overall receivable yields were essentially flat during 2012. See "Results of Operations" in this MD&A for additional discussion on receivable yields. The primary risks to our performance in 2013 are largely dependent upon macro-economic conditions which include a housing market which is slow to recover, high unemployment rates, the pace and extent of the economic recovery, the performance of modified loans and consumer confidence, all of which could impact delinquencies, charge-offs, net interest income and ultimately our results of operations.