Fair Value Measurements

3 Months Ended

Mar. 31, 2012

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 that would be received to sell an asset or paid to transfer a liability in the principal market (or in the absence of the principal market, the most advantageous market) accessible in an orderly transaction between willing market participants (the “Fair Value Framework”). Where required by the applicable accounting standards, assets and liabilities are measured at fair value using the “highest and best use” valuation premise. Fair value measurement guidance effective in 2012 clarifies that financial instruments do not have alternative use and, as such, the fair value of financial instruments should be determined using an “in-exchange” valuation premise. However, the fair value measurement literature provides a valuation exception and permits an entity to measure the fair value of a group of financial assets and financial liabilities with offsetting credit risk and/or market risks based on the exit price it would receive or pay to transfer the net risk exposure of a group of assets or liabilities if certain conditions are met. We have not elected to make fair value adjustments to a group of derivative instruments with offsetting credit and market risks.

Fair Value Adjustments The best evidence of fair value is quoted market price in an actively traded market, where available. In the event listed price or market quotes are not available, valuation techniques that incorporate relevant transaction data and market parameters reflecting the attributes of the asset or liability under consideration are applied. Where applicable, fair value adjustments are made to ensure the financial instruments are appropriately recorded at fair value. The fair value adjustments reflect the risks associated with the products, contractual terms of the transactions, and the liquidity of the markets in which the transactions occur. The fair value adjustments are broadly categorized by the following types:

Credit risk adjustment – The credit risk adjustment is an adjustment to a group of financial assets and financial liabilities, predominantly derivative assets and derivative liabilities, to reflect the credit quality of the parties to the transaction in arriving at fair value. A credit valuation adjustment to a financial asset is required to reflect the default risk of the counterparty. A debit valuation adjustment to a financial liability is recorded to reflect our default risk. Where applicable, we take into consideration the credit risk mitigating arrangements including collateral agreements and master netting arrangements in estimating the credit risk adjustments.

Liquidity risk adjustment– The liquidity risk adjustment reflects, among other things, (a) the cost that would be incurred to close out the market risks by hedging, disposing or unwinding the actual position (i.e., a bid-offer adjustment), and (b) the illiquid nature, other than the size of the risk position, of a financial instrument.

Input valuation adjustment – Where fair value measurements are determined using internal valuation model based on unobservable inputs, certain valuation inputs may be less readily determinable. There may be a range of possible valuation input that market participants may assume in determining the fair value measurement. The resultant fair value measurement has inherent measurement risk if one or more significant parameters are unobservable and must be estimated. An input valuation adjustment is necessary to reflect the likelihood that market participants may use different input parameters, and to mitigate the possibility of measurement error.

Valuation Control Framework  A control framework has been established which is designed to ensure that fair values are either determined or validated by a function independent of the risk-taker. To that end, the ultimate responsibility for the determination of fair values rests with the HSBC Finance Valuation Committee. The HSBC Finance Valuation Committee establishes policies and procedures to ensure appropriate valuations. Fair values for debt securities and long-term debt for which we have elected fair value option are determined by a third-party valuation source (pricing service) by reference to external quotations on the identical or similar instruments. Once fair values have been obtained from the third-party valuation source, an independent price validation process is performed and reviewed by the HSBC Finance Valuation Committee. For price validation purposes, we obtain quotations from at least one other independent pricing source for each financial instrument, where possible.

We consider the following factors in determining fair values:

• similarities between the asset or the liability under consideration and the asset or liability for which quotation is received;

• whether the security is traded in an active or inactive market;

• consistency among different pricing sources;

• the valuation approach and the methodologies used by the independent pricing sources in determining fair value;

• the elapsed time between the date to which the market data relates and the measurement date; and

• the manner in which the fair value information is sourced.

Greater weight is given to quotations of instruments with recent market transactions, pricing quotes from dealers who stand ready to transact, quotations provided by market-makers who originally underwrote such instruments, and market consensus pricing based on inputs from a large number of participants. Any significant discrepancies among the external quotations are reviewed by management and adjustments to fair values are recorded where appropriate.

Fair values for derivatives are determined by management using valuation techniques, valuation models and inputs that are developed, reviewed, validated and approved by the Quantitative Risk and Valuation Group of an HSBC affiliate. These valuation models utilize discounted cash flows or an option pricing model adjusted for counterparty credit risk and market liquidity. The models used apply appropriate control processes and procedures to ensure that the derived inputs are used to value only those instruments that share similar risk to the relevant benchmark indexes and therefore demonstrate a similar response to market factors. In addition, a validation process is followed which includes participation in peer group consensus pricing surveys, to ensure that valuation inputs incorporate market participants’ risk expectations and risk premium.

We have various controls over our valuation process and procedures for receivables held for sale. As these fair values are generally determined using modeling techniques, the controls may include independent development or validation of the logic within the valuation models, the inputs to those models, and adjustments required to outside valuation models. The inputs and adjustments to valuation models are reviewed with management and reconciled to inputs and assumptions used in other internal valuation processes. In addition, from time to time, certain portfolios are valued by independent third parties, primarily for related party transactions, which are used to validate our internal models.

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 Form 10-Q. The following table summarizes the carrying values and estimated fair value of our financial instruments at March 31, 2012 and December 31, 2011.

	March 31, 2012										December 31, 2011
	Carrying Value		Fair Value		Level 1		Level 2		Level 3		Carrying Value		Fair Value
Financial assets:
Cash	$	219	$	219	$	219	$	-	$	-	$	222	$	222
Interest bearing deposits with banks		1,307		1,307		-		1,307		-		1,143		1,143
Securities purchased under agreement to resell		2,745		2,745		-		2,745		-		920		920
Securities		1,977		1,977		150		1,811		16		2,039		2,039
Consumer receivables:
Real estate secured:
First lien		33,628		24,657		-		-		24,657		34,960		24,438
Second lien		3,619		1,154		-		-		1,154		3,828		1,110
Total real estate secured		37,247		25,811		-		-		25,811		38,788		25,548
Personal non-credit card		4,057		3,561		-		-		3,561		4,308		3,180
Total consumer receivables		41,304		29,372		-		-		29,372		43,096		28,728
Due from affiliates		144		144		-		144		-		124		124
Derivative financial assets		2		2		-		2		-		-		-
Financial liabilities:
Commercial paper	$	3,862	$	3,862	$	-	$	3,862	$	-	$	4,026	$	4,026
Due to affiliates carried at fair value		461		461		-		461		-		447		447
Due to affiliates		8,315		8,122		-		8,122		-		7,815		7,514
Long-term debt carried at fair value		14,110		14,110		-		14,110		-		13,664		13,664
Long-term debt not carried at fair value		25,134		24,798		-		22,010		2,788		26,126		25,090
Insurance policy and claims reserves		957		1,206		-		-		1,206		973		1,291
Derivative financial liabilities		43		43		-		43		-		26		26

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, elevated 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 March 31, 2012 and December 31, 2011 reflect these market conditions. During the first quarter of 2012, increased demand for personal non-credit card loans led to increased pricing for these loans in the marketplace.

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 March 31, 2012 and December 31, 2011, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value.

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Netting(1)			Total of Assets (Liabilities) Measured at Fair Value
	(in millions)
March 31, 2012:
Derivative financial assets:
Interest rate swaps	$	-	$	845		$	-	$	-		$	845
Currency swaps		-		1,488			-		-			1,488
Foreign exchange forward		-		2			-		-			2
Derivative netting		-		-			-		(2,333	)		(2,333	)
Total derivative financial assets		-		2,335			-		(2,333	)		2
Available-for-sale securities:
U.S. Treasury		12		-			-		-			12
U.S. government sponsored enterprises		-		35			-		-			35
Asset-backed securities		-		21			2		-			23
U.S. corporate debt securities		-		1,240			14		-			1,254
Foreign debt securities:
Government		5		135			-		-			140
Corporate		-		359			-		-			359
Equity securities		10		-			-		-			10
Money market funds		123		-			-		-			123
Accrued interest		-		21			-		-			21
Total available-for-sale securities		150		1,811			16		-			1,977
Total assets	$	150	$	4,146		$	16	$	(2,333	)	$	1,979
Due to affiliates carried at fair value	$	-	$	(461	)	$	-	$	-		$	(461	)
Long-term debt carried at fair value		-		(14,110	)		-		-			(14,110	)
Derivative related liabilities:
Interest rate swaps		-		(1,386	)		-		-			(1,386	)
Currency swaps		-		(100	)		-		-			(100	)
Derivative netting		-		-			-		1,443			1,443
Total derivative related liabilities		-		(1,486	)		-		1,443			(43	)
Total liabilities	$	-	$	(16,057	)	$	-	$	1,443		$	(14,614	)
December 31, 2011:
Derivative financial assets:
Interest rate swaps	$	-	$	973		$	-	$	-		$	973
Currency swaps		-		1,503			-		-			1,503
Derivative netting		-		-			-		(2,476	)		(2,476	)
Total derivative financial assets		-		2,476			-		(2,476	)		-
Available-for-sale securities:
U.S. Treasury		92		-			-		-			92
U.S. government sponsored enterprises		-		38			-		-			38
U.S. government agency issued or guaranteed		-		2			-		-			2
Asset-backed securities		-		25			2		-			27
U.S. corporate debt securities		-		1,297			11		-			1,308
Foreign debt securities:
Government		5		119			-		-			124
Corporate		-		320			5		-			325
Equity securities		10		-			-		-			10
Money market funds		93		-			-		-			93
Accrued interest		-		20			-					20
Total available-for-sale securities		200		1,821			18		-			2,039
Total assets	$	200	$	4,297		$	18	$	(2,476	)	$	2,039
Due to affiliates carried at fair value	$	-	$	(447	)	$	-	$	-		$	(447	)
Long-term debt carried at fair value		-		(13,664	)		-		-			(13,664	)
Derivative related liabilities:
Interest rate swaps		-		(1,762	)		-		-			(1,762	)
Currency swaps		-		(163	)		-		-			(163	)
Foreign Exchange Forward		-		(3	)		-		-			(3	)
Derivative netting		-		-					1,902			1,902
Total derivative related liabilities		-		(1,928	)		-		1,902			(26	)
Total liabilities	$	-	$	(16,039	)	$	-	$	1,902		$	(14,137	)

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

Assets recorded at fair value using significant unobservable inputs (Level 3) at March 31, 2012 primarily consisted of U.S. corporate debt securities. The primary significant unobservable input used in the valuation of these U.S. corporate debt securities was the credit spreads associated with these securities, the impact of which on our overall valuation as of March 31, 2012 was not significant.

The following table provides additional detail regarding the rating of our U.S. corporate debt securities at March 31, 2012 and December 31, 2011:

	Level 2		Level 3		Total
	(in millions)
March 31, 2012:
AAA to AA (1)	$	256	$	6	$	262
A+ to A- (1)		864		6		870
BBB+ to Unrated (1)		120		2		122
December 31, 2011:
AAA to AA (1)	$	270	$	-	$	270
A+ to A- (1)		872		9		881
BBB+ to Unrated (1)		155		2		157

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

Transfers Between Level 1 and Level 2 There were no transfers between Level 1 and Level 2 during the three months ended March 31, 2012 or 2011.

Information on Level 3 Assets and Liabilities The table below reconciles the beginning and ending balances for assets recorded at fair value using significant unobservable inputs (Level 3) during the three months ended March 31, 2012 or 2011.

			Total Gains and (Losses) Included in												Transfers Into Level 3		Transfers Out of Level 3
	Jan. 1, 2012		Income		Other Comp. Income			Purchases		Issuances		Settlement								Mar. 31, 2012		Current Period Unrealized Gains (Losses)
	(in millions)
Assets:
Securities available-for-sale:
Asset-backed securities	$	2	$	-	$	-		$	-	$	-	$	-		$	-	$	-		$	2	$	-
U.S. corporate debt securities		11		-		-			-		-		-			12		(9	)		14		-
Foreign corporate debt securities		5		-		-			-		-		-			-		(5	)		-		-
Total assets	$	18	$	-	$	-		$	-	$	-	$	-		$	12	$	(14	)	$	16	$	-
			Total Gains and (Losses) Included in												Transfers Into Level 3		Transfers Out of Level 3
	Jan. 1, 2011		Income		Other Comp. Income			Purchases		Issuances		Settlement								Mar. 31, 2011		Current Period Unrealized Gains (Losses)
	(in millions)
Assets:
Securities available-for-sale:
U.S. Government sponsored enterprises	$	1	$	-	$	-		$	-	$	-	$	-		$	-	$	-		$	1	$	-
Asset-backed securities		20		-		-			-		-		(1	)		2		-			21		-
U.S. corporate debt securities		3		-		(1	)		-		-		-			-		-			2		-
Total assets	$	24	$	-	$	(1	)	$	-	$	-	$	(1	)	$	2	$	-		$	24	$	-

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 March 31, 2012 and 2011, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value.

	Non-Recurring Fair Value Measurements as of March 31, 2012								Total Gains (Losses) for the Three Months  Ended March 31, 2012
	Level 1		Level 2		Level 3		Total
	(in millions)
Real estate owned (1)	$	-	$	290	$	-	$	290	$	(26	)
Total assets at fair value on a non-recurring basis	$	-	$	290	$	-	$	290	$	(26	)

	Non-Recurring Fair Value Measurements as of March 31, 2011								Total Gains (Losses) for the Three Months  Ended March 31, 2011
	Level 1		Level 2		Level 3		Total
	(in millions)
Real estate secured receivables held for sale at fair value	$	-	$	-	$	5	$	5	$	1
Real estate owned (1)		-		924		-		924		(75	)
Total assets at fair value on a non-recurring basis	$	-	$	924	$	5	$	929	$	(74	)

⁽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 analytical reviews of fair value changes on a quarterly basis and periodically validate our valuation methodologies and assumptions based on the results of actual sales of such receivables. In addition, from time to time, we may 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.