Fair Value Measurements

6 Months Ended

Jun. 30, 2012

Fair Value Option and Fair Value Measurements [Abstract]

Fair Value Measurements

15.    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 June 30, 2012 and December 31, 2011.

	June 30, 2012										December 31, 2011
	Carrying Value		Fair Value		Level 1		Level 2		Level 3		Carrying Value		Fair Value
	(in millions)
Financial assets:
Cash	$	967	$	967	$	967	$	-	$	-	$	215	$	215
Interest bearing deposits with banks		2,830		2,830		-		2,830		-		1,140		1,140
Securities purchased under agreement to resell		1,697		1,697		-		1,697		-		920		920
Securities		151		151		39		112		-		188		188
Consumer receivables:
Real estate secured:
First lien		27,846		19,950		-		-		19,950		34,960		24,438
Second lien		3,427		1,094		-		-		1,094		3,828		1,110
Total real estate secured		31,273		21,044		-		-		21,044		38,788		25,548
Personal non-credit card		-		-		-		-		-		4,308		3,180
Total consumer receivables		31,273		21,044		-		-		21,044		43,096		28,728
Receivables held for sale		6,756		6,756		-		-		6,756		-		-
Due from affiliates		101		101		-		101		-		124		124
Derivative financial assets		183		183		-		183		-		-		-
Financial liabilities:
Commercial paper	$	302	$	302	$	-	$	302	$	-	$	4,026	$	4,026
Due to affiliates carried at fair value		466		466		-		466		-		447		447
Due to affiliates		7,564		7,444		-		7,444		-		7,815		7,514
Long-term debt carried at fair value		11,288		11,288		-		11,288		-		13,664		13,664
Long-term debt not carried at fair value		22,302		22,088		-		19,404		2,684		26,126		25,090
Derivative financial liabilities		-		-		-		-		-		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 June 30, 2012 and December 31, 2011 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 June 30, 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)
June 30, 2012:
Derivative financial assets:
Interest rate swaps	$	-	$	617		$	-	$	-		$	617
Currency swaps		-		1,185			-		-			1,185
Derivative netting		-		-			-		(1,619	)		(1,619	)
Total derivative financial assets		-		1,802			-		(1,619	)		183
Available-for-sale securities:
U.S. government sponsored enterprises		-		1			-		-			1
U.S. corporate debt securities		-		62			-		-			62
Foreign debt securities:
Government		-		3			-		-			3
Corporate		-		45			-		-			45
Equity securities		10		-			-		-			10
Money market funds		29		-			-		-			29
Accrued interest		-		1			-		-			1
Total available-for-sale securities		39		112			-		-			151
Total assets	$	39	$	1,914		$	-	$	(1,619	)	$	334
Due to affiliates carried at fair value	$	-	$	(466	)	$	-	$	-		$	(466	)
Long-term debt carried at fair value		-		(11,288	)		-		-			(11,288	)
Derivative related liabilities:
Interest rate swaps		-		(1,748	)		-		-			(1,748	)
Currency swaps		-		(221	)		-		-			(221	)
Derivative netting		-		-			-		1,969			1,969
Total derivative related liabilities		-		(1,969	)		-		1,969			-
Total liabilities	$	-	$	(13,723	)	$	-	$	1,969		$	(11,754	)

	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)
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		80		-			-		-			80
U.S. government sponsored enterprises		-		1			-		-			1
U.S. corporate debt securities		-		57			-		-			57
Foreign debt securities:
Corporate		-		26			-		-			26
Equity securities		10		-			-		-			10
Money market funds		13		-			-		-			13
Accrued interest		-		1			-					1
Total available-for-sale securities		103		85			-		-			188
Total assets	$	103	$	2,561		$	-	$	(2,476	)	$	188
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.

The following table provides additional detail regarding the rating of our U.S. corporate debt securities at June 30, 2012 and December 31, 2011:

	Level 2		Level 3		Total
			(in millions)
June 30, 2012:
AAA to AA (1)	$	17	$	-	$	17
A+ to A- (1)		41		-		41
BBB+ to Unrated (1)		4		-		4
December 31, 2011:
AAA to AA (1)	$	26	$	-	$	26
A+ to A- (1)		25		-		25
BBB+ to Unrated (1)		6		-		6

⁽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 or six months ended June 30, 2012 or 2011.

Information on Level 3 Assets and Liabilities  There were no assets recorded at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three or six months ended June 30, 2012. 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 six months ended June 30, 2011.

			Total Gains and (Losses) Included in
	Apr. 1, 2011		Income		Other Comp. Income			Purchases		Issuances		Settlement		Transfers Into Level 3		Transfers Out of Level 3		June 30, 2011		Current Period Unrealized Gains (Losses)
	(in millions)
Assets:
Securities available-for-sale:
Asset-backed securities	$	17	$	-	$	(2	)	$	-	$	-	$	-	$	-	$	-	$	15	$	(2	)
Total assets	$	17	$	-	$	(2	)	$	-	$	-	$	-	$	-	$	-	$	15	$	(2	)

			Total Gains and (Losses) Included in
	Jan. 1, 2011		Income		Other Comp. Income			Purchases		Issuances		Settlement		Transfers Into Level 3		Transfers Out of Level 3		June 30, 2011		Current Period Unrealized Gains (Losses)
	(in millions)
Assets:
Securities available-for-sale:
Asset-backed securities	$	18	$	-	$	(3	)	$	-	$	-	$	-	$	-	$	-	$	15	$	(1	)
Total assets	$	18	$	-	$	(3	)	$	-	$	-	$	-	$	-	$	-	$	15	$	(1	)

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 June 30, 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 June 30, 2012								Total Gains (Losses) for the Three Months Ended June  30, 2012			Total Gains (Losses) for the Six Months Ended June  30, 2012
	Level 1		Level 2		Level 3		Total
	(in millions)
Receivables held for sale:
Real estate secured	$	-	$	-	$	3,287	$	3,287	$	(1,349	)	$	(1,349	)
Personal non-credit card		-		-		3,469		3,469		(310	)		(310	)
Total receivables held for sale		-		-		6,756		6,756		(1,659	)		(1,659	)
Real estate owned (1)		-		253		-		253		(27	)		(53	)
Total assets at fair value on a non-recurring basis	$	-	$	253	$	6,756	$	7,009	$	(1,686	)	$	(1,712	)

	Non-Recurring Fair  Value Measurements as of June 30, 2011								Total Gains (Losses) for the Three Months Ended June  30, 2011			Total Gains (Losses) for the Six Months Ended June  30, 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)		-		625		-		625		(39	)		(114	)
Total assets at fair value on a non-recurring basis	$	-	$	625	$	5	$	630	$	(39	)	$	(113	)

⁽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.

The following table presents quantitative information about non-recurring fair value measurements of assets and liabilities classified as Level 3 in the fair value hierarchy as of June 30, 2012:

Financial Instrument Type	Fair Value (in millions)	Valuation Technique(s)	Significant Unobservable Inputs	Range of Inputs
Real estate secured receivables held for sale at fair value	$3,287	Third party appraisal valuation based on estimated loss severities, including collateral values, cash flows and market discount rate	Loss severity rates Market discount rate	25%-75% 10%-15%
Personal non-credit card receivables held for sale at fair value	$3,469	Third party appraisal valuation based on estimated loss rates, cash flows and market discount rate	Loss rate	13%-21%
			Market discount rate	10%-15%

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. government sponsored enterprises – As our government sponsored mortgage-backed securities 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.

• U.S. Treasuries – 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. 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.

• 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.

• 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; value estimates from a third party valuation specialist’s measurement of the fair value of a pool of receivables; 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; and trading input from other market participants which includes observed primary and secondary trades. 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 hold discussions directly with potential investors. Portfolio risk management personnel provide further validation through discussions with third party brokers. Since some receivables pools may have features which are unique, fair value measurement process uses significant unobservable 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.

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.