Fair Value Measurements

9 Months Ended

Sep. 30, 2011

Fair Value Option and Fair Value Measurements [Abstract]

Fair Value Measurements

14.   Fair Value Measurements

Accounting principles related to fair value measurements provide a framework for measuring fair value and focus on an exit price in the principal (or alternatively, the most advantageous) market accessible in an orderly transaction between willing market participants (the “Fair Value Framework”). The Fair Value Framework establishes a three-tiered fair value hierarchy with Level 1 representing quoted prices (unadjusted) in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs are inputs that are observable for the identical asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are inactive, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. 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. Transfers between leveling categories are recognized at the end of each reporting period.

Fair Value of Financial Instruments The fair value estimates, methods and assumptions set forth below for our financial instruments, including those financial instruments carried at cost, are made solely to comply with disclosures required by generally accepted accounting principles in the United States and should be read in conjunction with the financial statements and notes included in this quarterly report. The following table summarizes the carrying amounts and estimated fair value of our financial instruments at September 30, 2011 and December 31, 2010.

	September 30, 2011				December 31, 2010
	Carrying		Estimated		Carrying		Estimated
	Value		Fair Value		Value		Fair Value
	(in millions)
Financial assets:
Cash	$	227	$	227	$	175	$	175
Interest bearing deposits with banks		12		12		1,016		1,016
Securities purchased under agreements to resell		2,875		2,875		4,311		4,311
Securities		3,658		3,658		3,371		3,371
Consumer receivables(1):
Mortgage Services:
First lien		11,039		7,584		12,687		8,810
Second lien		1,519		468		1,832		492
Total Mortgage Services		12,558		8,052		14,519		9,302
Consumer Lending:
First lien		25,356		18,031		28,796		20,589
Second lien		2,542		719		3,000		691
Total Consumer Lending real estate secured receivables		27,898		18,750		31,796		21,280
Non-real estate secured receivables		4,671		3,477		6,004		4,409
Total Consumer Lending		32,569		22,227		37,800		25,689
Total consumer receivables		45,127		30,279		52,319		34,991
Receivables held for sale		-		-		4		4
Due from affiliates		202		202		126		126
Derivative financial assets		3		3		75		75
Financial liabilities:
Commercial paper		4,303		4,303		3,156		3,156
Due to affiliates carried at fair value		425		425		436		436
Due to affiliates		8,316		7,988		7,819		7,518
Long-term debt carried at fair value		16,025		16,025		20,844		20,844
Long-term debt not carried at fair value		27,154		26,093		33,772		32,924
Insurance policy and claim reserves		989		1,274		982		1,184
Derivative financial liabilities		275		275		2		2

⁽¹⁾ The carrying amount of consumer receivables presented in the table above reflects the unamortized cost of the receivable, including any accrued interest, less credit loss reserves.

Receivable values presented in the table above were determined using the Fair Value Framework for measuring fair value, which is based on our best estimate of the amount within a range of values we believe would be received in a sale as of the balance sheet date (i.e. exit price). The secondary market demand and estimated value for our receivables has been heavily influenced by the challenging economic conditions during the past few years, including house price depreciation, rising unemployment, changes in consumer behavior, changes in discount rates and the lack of financing options available to support the purchase of receivables. Many investors are non-bank financial institutions or hedge funds with high equity levels and a high cost of debt. For certain consumer receivables, investors incorporate numerous assumptions in predicting cash flows, such as higher charge-off levels and/or slower voluntary prepayment speeds than we, as the servicer of these receivables, believe will ultimately be the case. The investor discount rates reflect this difference in overall cost of capital as well as the potential volatility in the underlying cash flow assumptions, the combination of which may yield a significant pricing discount from our intrinsic value. The estimated fair values at September 30, 2011 and December 31, 2010 reflect these market conditions.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis The following table presents information about our assets and liabilities measured at fair value on a recurring basis as of September 30, 2011 and December 31, 2010, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value.

											Total of
	Quoted Prices in										Assets
	Active Markets for		Significant Other			Significant					(Liabilities)
	Identical Assets		Observable Inputs			Unobservable Inputs					Measured at
	(Level 1)		(Level 2)			(Level 3)		Netting(1)			Fair Value
	(in millions)
September 30, 2011:
Derivative financial assets:
Interest rate swaps	$	-	$	1,144		$	-	$	-		$	1,144
Currency swaps		-		1,737			-		-			1,737
Foreign exchange forward		-		-			-		-			-
Derivative netting		-		-			-		(2,878	)		(2,878	)
Total derivative financial assets		-		2,881			-		(2,878	)		3
Available-for-sale securities:
U.S. Treasury		376		-			-		-			376
U.S. government sponsored enterprises		-		427			-		-			427
U.S. government agency issued or guaranteed		-		6			-		-			6
Obligations of U.S. states and political subdivisions		-		1			-		-			1
Asset-backed securities		-		27			17		-			44
U.S. corporate debt securities		-		1,635			28		-			1,663
Foreign debt securities:
Government		20		93			-		-			113
Corporate		-		433			-		-			433
Equity securities		10		-			-		-			10
Money market funds		558		-			-		-			558
Accrued interest		1		25			1		-			27
Total available-for-sale securities		965		2,647			46		-			3,658
Total assets	$	965	$	5,528		$	46	$	(2,878	)	$	3,661
Due to affiliates carried at fair value	$	-	$	(425	)	$	-	$	-		$	(425	)
Long-term debt carried at fair value		-		(16,025	)		-		-			(16,025	)
Derivative related liabilities:
Interest rate swaps		-		(1,715	)		-		-			(1,715	)
Currency swaps		-		(116	)		-		-			(116	)
Foreign Exchange Forward		-		(3	)		-		-			(3	)
Derivative netting		-		-			-		1,559			1,559
Total derivative related liabilities				(1,834	)		-		1,559			(275	)
Total liabilities	$	-	$	(18,284	)	$	-	$	1,559		$	(16,725	)
December 31, 2010:
Derivative financial assets:
Interest rate swaps	$	-	$	1,220		$	-	$	-		$	1,220
Currency swaps		-		2,067			-		-			2,067
Derivative netting		-		-			-		(3,212	)		(3,212	)
Total derivative financial assets		-		3,287			-		(3,212	)		75
Available-for-sale securities:
U.S. Treasury		349		-			-		-			349
U.S. government sponsored enterprises		-		284			1		-			285
U.S. government agency issued or guaranteed		-		11			-		-			11
Obligations of U.S. states and political subdivisions		-		30			-		-			30
Asset-backed securities		-		40			20		-			60
U.S. corporate debt securities		-		1,799			3		-			1,802
Foreign debt securities:
Government		14		84			-		-			98
Corporate		-		344			-		-			344
Equity securities		9		-			-		-			9
Money market funds		353		-			-		-			353
Accrued interest		1		29			-		-			30
Total available-for-sale securities		726		2,621			24		-			3,371
Total assets	$	726	$	5,908		$	24	$	(3,212	)	$	3,446
Due to affiliates carried at fair value	$	-	$	(436	)	$	-	$	-		$	(436	)
Long-term debt carried at fair value		-		(20,844	)		-		-			(20,844	)
Derivative related liabilities:
Interest rate swaps		-		(611	)		-		-			(611	)
Currency swaps		-		(151	)		-		-			(151	)
Foreign Exchange Forward		-		(3	)		-		-			(3	)
Derivative netting		-		-			-		763			763
Total derivative related liabilities		-		(765	)		-		763			(2	)
Total liabilities	$	-	$	(22,045	)	$	-	$	763		$	(21,282	)

⁽¹⁾ Represents counterparty and swap collateral netting which allow the offsetting of amounts relating to certain contracts when certain conditions are met.

The following table provides additional detail regarding the rating of our U.S. corporate debt securities at September 30, 2011 and December 31, 2010:

	Level 2		Level 3		Total
	(in millions)
September 30, 2011:
AAA to AA-(1)	$	425	$	-	$	425
A+ to A-(1)		1,083		14		1,097
BBB+ to Unrated(1)		127		14		141
December 31, 2010:
AAA to AA-(1)	$	381	$	-	$	381
A+ to A-(1)		1,280		-		1,280
BBB+ to Unrated(1)		138		3		141

⁽¹⁾ We obtain ratings on our U.S. corporate debt securities from Moody’s Investor Services, Fitch and Standard and Poor’s Corporation. In the event the ratings we obtain from these agencies differ, we utilize the lower of the three ratings.

Significant Transfers Between Level 1 and Level 2 There were no transfers between Level 1 and Level 2 during the three or nine months ended September 30, 2011 or 2010.

Information on Level 3 Assets and Liabilities Securities are transferred into Level 3 classifications when an individual non-U.S. government issued asset-backed security is downgraded below a AAA credit rating or the individual security fails the quarterly pricing comparison test with a variance greater than 5 percent. Securities are transferred into Level 2 classifications when they no longer meet one or both of the above conditions. The table below reconciles the beginning and ending balances for assets recorded at fair value using significant unobservable inputs (Level 3) during the three and nine months ended September 30, 2011 or 2010.

			Total Gains and
			(Losses)
			Included in
					Other									Transfers		Transfers					Current Period
	July 1				Comp.									Into		Out of			Sept. 30,		Unrealized
	2011		Income		Income			Purchases		Issuances		Settlement		Level 3		Level 3			2011		Gains (Losses)
	(in millions)
Assets:
Securities available-for-sale:
U.S. Government sponsored enterprises	$	-	$	-	$	-		$	-	$	-	$	-	$	-	$	-		$	-	$	-
Asset-backed securities		19		-		(2	)		-		-		-		-		-			17		(1	)
U.S. corporate debt securities		14		-		-			-		-		-		26		(12	)		28		1
Total assets	$	33	$	-	$	(2	)	$	-	$	-	$	-	$	26	$	(12	)	$	45	$	-

			Total Gains and
			(Losses)
			Included in
					Other									Transfers		Transfers				Current Period
	July 1				Comp.									Into		Out of		Sept. 30,		Unrealized
	2010		Income		Income			Purchases		Issuances		Settlement		Level 3		Level 3		2010		Gains (Losses)
	(in millions)
Assets:
Securities available-for-sale:
U.S. Government sponsored enterprises	$	2	$	-	$	-		$	-	$	-	$	-	$	-	$	-	$	2	$	-
Asset-backed securities		24		-		(3	)		-		-		-		-		-		21		1
U.S. corporate debt securities		3		-		-			-		-		-		-		-		3		-
Total assets	$	29	$	-	$	(3	)	$	-	$	-	$	-	$	-	$	-	$	26	$	1

			Total Gains and
			(Losses)
			Included in
					Other										Transfers		Transfers					Current Period
	Jan. 1,				Comp.										Into		Out of			Sept. 30,		Unrealized
	2011		Income		Income			Purchases		Issuances		Settlement			Level 3		Level 3			2011		Gains (Losses)
	(in millions)
Assets:
Securities available-for-sale:
U.S. Government sponsored enterprises	$	1	$	-	$	-		$	-	$	-	$	-		$	-	$	(1	)	$	-	$	-
Asset-backed securities		20		-		(5	)		-		-		(1	)		3		-			17		(2	)
U.S. corporate debt securities		3		-		(1	)		-		-		-			38		(12	)		28		2
Total assets	$	24	$	-	$	(6	)	$	-	$	-	$	(1	)	$	41	$	(13	)	$	45	$	-

			Total Gains and
			(Losses)
			Included in
					Other										Transfers		Transfers					Current Period
	Jan. 1,				Comp.										Into		Out of			Sept. 30,		Unrealized
	2010		Income		Income			Purchases		Issuances		Settlement			Level 3		Level 3			2010		Gains (Losses)
	(in millions)
Assets:
Securities available-for-sale:
U.S. Government sponsored enterprises	$	2	$	-	$	-		$	-	$	-	$	-		$	2	$	(2	)	$	2	$	1
Obligations of U.S. states and political subdivision		1		-		-			-		-		(1	)		-		-			-		-
Asset-backed securities		26		-		(7	)		-		-		-			2		-			21		3
U.S. corporate debt securities		20		-		-			-		-		-			8		(25	)		3		-
Total assets	$	49	$	-	$	(7	)	$	-	$	-	$	(1	)	$	12	$	(27	)	$	26	$	4

Assets and Liabilities Recorded at Fair Value on a Non-recurring Basis The following table presents information about our assets and liabilities measured at fair value on a non-recurring basis as of September 30, 2011 and 2010, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value.

									Total Gains			Total Gains
	Non-Recurring Fair Value Measurements as of								(Losses) for the			(Losses) for the
	September 30, 2011								Three Months Ended			Nine Months Ended
	Level 1		Level 2		Level 3		Total		September 30, 2011			September 30, 2011
	(in millions)
Real estate owned(1)	$	-	$	403	$	-	$	403	$	(41	)	$	(155	)

									Total Gains			Total Gains
	Non-Recurring Fair Value Measurements as of								(Losses) for the			(Losses) for the
	September 30, 2010								Three Months Ended			Nine Months Ended
	Level 1		Level 2		Level 3		Total		September 30, 2010			September 30, 2010
	(in millions)
Real estate secured receivables held for sale at fair value	$	-	$	-	$	4	$	4	$	-		$	2
Real estate owned(1)		-		994		-		994		(58	)		(139	)
Total assets at fair value on a non-recurring basis	$	-	$	994	$	4	$	998	$	(58	)	$	(137	)

⁽¹⁾ Real estate owned is required to be reported on the balance sheet net of transactions costs. The real estate owned amounts in the table above reflect the fair value of the underlying asset unadjusted for transaction costs.

Valuation Techniques The following summarizes the valuation methodologies used for assets and liabilities recorded at fair value and for estimating fair value for financial instruments not recorded at fair value but for which fair value disclosures are required.

Cash: Carrying amount approximates fair value due to cash’s liquid nature.

Interest bearing deposits with banks: Carrying amount approximates fair value due to the asset’s liquid nature.

Securities purchased under agreements to resell: The fair value of securities purchased under agreements to resell approximates carrying amount due to the short-term maturity of the agreements.

Securities: Fair value for our available-for-sale securities is generally determined by a third party valuation source. The pricing services generally source fair value measurements from quoted market prices and if not available, the security is valued based on quotes from similar securities using broker quotes and other information obtained from dealers and market participants. For securities which do not trade in active markets, such as fixed income securities, the pricing services generally utilize various pricing applications, including models, to measure fair value. The pricing applications are based on market convention and use inputs that are derived principally from or corroborated by observable market data by correlation or other means. The following summarizes the valuation methodology used for our major security types:

•  U.S. Treasury, U.S. government agency issued or guaranteed and Obligations of U.S. States and political subdivisions – As these securities transact in an active market, the pricing services source fair value measurements from quoted prices for the identical security or quoted prices for similar securities with adjustments as necessary made using observable inputs which are market corroborated.

•  U.S. government sponsored enterprises – For certain government sponsored mortgage-backed securities which transact in an active market, the pricing services source fair value measurements from quoted prices for the identical security or quoted prices for similar securities with adjustments as necessary made using observable inputs which are market corroborated. For government sponsored mortgage-backed securities which do not transact in an active market, fair value is determined using discounted cash flow models and inputs related to interest rates, prepayment speeds, loss curves and market discount rates that would be required by investors in the current market given the specific characteristics and inherent credit risk of the underlying collateral.

•  Asset-backed securities – Fair value is determined using discounted cash flow models and inputs related to interest rates, prepayment speeds, loss curves and market discount rates that would be required by investors in the current market given the specific characteristics and inherent credit risk of the underlying collateral.

•  U.S. corporate and foreign debt securities – For non-callable corporate securities, a credit spread scale is created for each issuer. These spreads are then added to the equivalent maturity U.S. Treasury yield to determine current pricing. Credit spreads are obtained from the new issue market, secondary trading levels and dealer quotes. For securities with early redemption features, an option adjusted spread (“OAS”) model is incorporated to adjust the spreads determined above. Additionally, the pricing services will survey the broker/dealer community to obtain relevant trade data including benchmark quotes and updated spreads.

•  Preferred equity securities – In general, for perpetual preferred securities, fair value is calculated using an appropriate spread over a comparable U.S. Treasury security for each issue. These spreads represent the additional yield required to account for risk including credit, refunding and liquidity. The inputs are derived principally from or corroborated by observable market data.

•  Money market funds – Carrying amount approximates fair value due to the asset’s liquid nature.

Significant inputs used in the valuation of our investment securities include selection of an appropriate risk-free rate, forward yield curve and credit spread which establish the ultimate discount rate used to determine the net present value of estimated cash flows. For asset-backed securities, selection of appropriate prepayment rates, default rates and loss severities also serve as significant inputs in determining fair value. We perform validations of the fair values sourced from the independent pricing services at least quarterly. Such validation principally includes sourcing security prices from other independent pricing services or broker quotes. The validation process provides us with information as to whether the volume and level of activity for a security has significantly decreased and assists in identifying transactions that are not orderly. Depending on the results of the validation, additional information may be gathered from other market participants to support the fair value measurements. A determination will be made as to whether adjustments to the observable inputs are necessary as a result of investigations and inquiries about the reasonableness of the inputs used and the methodologies employed by the independent pricing services.

Receivables and receivables held for sale: The estimated fair value of our receivables was determined by developing an approximate range of value from a mix of various sources as appropriate for the respective pool of assets. These sources include, among other items, value estimates from an HSBC affiliate which reflect over-the-counter trading activity; forward looking discounted cash flow models using assumptions we believe are consistent with those which would be used by market participants in valuing such receivables; trading input from other market participants which includes observed primary and secondary trades; where appropriate, the impact of current estimated rating agency credit tranching levels with the associated benchmark credit spreads; and general discussions held directly with potential investors. For revolving products, the estimated fair value excludes future draws on the available credit line as well as other items and, therefore, does not include the fair value of the entire relationship.

Valuation inputs include estimates of future interest rates, prepayment speeds, default and loss curves, estimated collateral values and market discount rates reflecting management’s estimate of the rate of return that would be required by investors in the current market given the specific characteristics and inherent credit risk of the receivables. Some of these inputs are influenced by collateral value changes and unemployment rates. To the extent available, such inputs are derived principally from or corroborated by observable market data by correlation and other means. We perform periodic validations of our valuation methodologies and assumptions based on the results of actual sales of such receivables. In addition, from time to time, we will engage a third party valuation specialist to measure the fair value of a pool of receivables. Portfolio risk management personnel provide further validation through discussions with third party brokers. Since an active market for these receivables does not exist, the fair value measurement process uses unobservable significant inputs which are specific to the performance characteristics of the various receivable portfolios.

Real estate owned: Fair value is determined based on third party appraisals obtained at the time we take title to the property and, if less than the carrying amount of the loan, the carrying amount of the loan is adjusted to the fair value. The carrying amount of the property is further reduced, if necessary, at least every 45 days to reflect observable local market data, including local area sales data.

Due from affiliates: Carrying amount approximates fair value because the interest rates on these receivables adjust with changing market interest rates.

Commercial paper: The fair value of these instruments approximates existing carrying amount because interest rates on these instruments adjust with changes in market interest rates due to their short-term maturity or repricing characteristics.

Long-term debt and Due to affiliates: Fair value was primarily determined by a third party valuation source. The pricing services source fair value from quoted market prices and, if not available, expected cash flows are discounted using the appropriate interest rate for the applicable duration of the instrument adjusted for our own credit risk (spread). The credit spreads applied to these instruments were derived from the spreads recognized in the secondary market for similar debt as of the measurement date. Where available, relevant trade data is also considered as part of our validation process.

Insurance policy and claim reserves: The fair value of insurance reserves for periodic payment annuities was estimated by discounting future expected cash flows at estimated market interest rates.

Derivative financial assets and liabilities: Derivative values are defined as the amount we would receive or pay to extinguish the contract using a market participant as of the reporting date. The values are determined by management using a pricing system maintained by HSBC Bank USA. In determining these values, HSBC Bank USA uses quoted market prices, when available, principally for exchange-traded options. For non-exchange traded contracts, such as interest rate swaps, fair value is determined using discounted cash flow modeling techniques. Valuation models calculate the present value of expected future cash flows based on models that utilize independently-sourced market parameters, including interest rate yield curves, option volatilities, and currency rates. Valuations may be adjusted in order to ensure that those values represent appropriate estimates of fair value. These adjustments are generally required to reflect factors such as market liquidity and counterparty credit risk that can affect prices in arms-length transactions with unrelated third parties. Finally, other transaction specific factors such as the variety of valuation models available, the range of unobservable model inputs and other model assumptions can affect estimates of fair value. Imprecision in estimating these factors can impact the amount of revenue or loss recorded for a particular position.

Counterparty credit risk is considered in determining the fair value of a financial asset. The Fair Value Framework specifies that the fair value of a liability should reflect the entity’s non-performance risk and accordingly, the effect of our own credit risk (spread) has been factored into the determination of the fair value of our financial liabilities, including derivative instruments. In estimating the credit risk adjustment to the derivative assets and liabilities, we take into account the impact of netting and/or collateral arrangements that are designed to mitigate counterparty credit risk.