Fair Value Measurements

Accounting principles related to fair value measurements provide a framework for measuring fair value that focuses on the 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. Amendments to the fair value measurement guidance, which became effective in 2012 clarifies that financial instruments do not have alternative uses 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 risks 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 elected to apply the measurement exception to a group of derivative instruments with offsetting credit risks and market risks, which primarily relate to interest rate, foreign currency, debt and equity price risk, and commodity price risk as of the reporting date.

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 major 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 the default risk of HSBC USA.

For derivative instruments, we calculate the credit risk adjustment by applying the probability of default of the counterparty to the expected exposure, and multiplying the result by the expected loss given default. We estimate the implied probability of default based on the counterparty's credit spread observed in the credit default swap market. Where credit default spreads of the counterparty are not available, we use the credit default spread of specific proxy (e.g. the credit default swap spread of the counterparty's parent). Where specific proxy credit default swaps are not available, we apply a blended approach based on a mixture of proxy credit default swap referencing to credit names of similar credit standing in the same industry sector and the historical rating-based probability of default.

During 2012, we changed our estimate of credit valuation adjustments on derivative assets and debit valuation adjustments on derivative liabilities to be based on a market-implied probability of default calculation rather than a ratings-based historical counterparty probability of default calculation, consistent with recent changes in industry practice.

Liquidity risk adjustment - The liquidity risk adjustment (primarily in the form of bid-offer adjustment) reflects the cost that would be incurred to close out the market risks by hedging, disposing or unwinding the position. Valuation models generally produce mid market values. The bid-offer adjustment is made in such a way that results in a measure that reflects the exit price that most represents the fair value of the financial asset of financial liability under consideration or, where applicable, the fair value of the net market risk exposure of a group of financial assets or financial liabilities.

Model valuation adjustment - Where fair value measurements are determined using an internal valuation model based on unobservable inputs, certain valuation inputs may be less readily determinable. There may be a range of possible valuation inputs 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. In addition, the values derived from valuation techniques are affected by the choice of valuation model and model limitation. When different valuation techniques are available, the choice of valuation model can be subjective. Furthermore, the valuation model applied may have measurement limitations. In those cases, an additional valuation adjustment is also applied to mitigate the measurement risk.

Fair Value Hierarchy The Fair Value Framework establishes a three-tiered fair value hierarchy as follows:

Level 1 quoted market price - Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2 valuation technique using observable inputs - 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 measurements determined using valuation models where all significant inputs are observable, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 valuation technique with significant unobservable inputs - Level 3 inputs are unobservable inputs for the asset or liability and include situations where fair values are measured using valuation techniques based on one or more significant unobservable input.

Classification within the fair value hierarchy is based on whether the lowest hierarchical level input that is significant to the fair value measurement is observable. As such, the classification within the fair value hierarchy is dynamic and can be transferred to other hierarchy levels in each reporting period. Transfers between leveling categories are assessed, determined and recognized at the end of each reporting period.

Valuation Control Framework We have established a control framework 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 Finance. Finance has established an independent price validation process to ensure that the assets and liabilities measured at fair value are properly stated.

A valuation committee, chaired by the Head of Business Finance of Global Banking and Markets, meets monthly to review, monitor and discuss significant valuation matters arising from credit and market risks. The committee is responsible for establishing valuation policies and procedures, approving the internal valuation techniques and models developed by the Quantitative Risk and

Valuation Group (“QRVG”), reviewing and approving valuation adjustments pertaining to, among other things, unobservable inputs, market liquidity, selection of valuation model and counterparty credit risk. Significant valuation risks identified in business activities are corroborated and addressed by the committee members and, where applicable, are escalated to the Chief Financial Officer of HUSI and the Audit Committee of the Board of Directors.

Where fair value measurements are determined based on information obtained from independent pricing services or brokers, Finance applies appropriate validation procedures to substantiate fair value. For price validation purposes, quotations from at least two independent pricing sources are obtained for each financial instrument, where possible.

The following factors are considered in determining fair values:


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


▪	collaboration of pricing by referencing to other independent market data such as market transactions and relevant benchmark indices;


▪	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;


▪	the source of the fair value information; and


▪	whether the security is traded in an active or inactive market.

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 structured such instrument and market consensus pricing based on inputs from a large number of survey participants. Any significant discrepancies among the external quotations are reviewed and adjustments to fair values are recorded where appropriate. Where the transaction volume of a specific instrument has been reduced and the fair value measurement becomes less transparent, Finance will apply more detailed procedures to understand and challenge the appropriateness of the unobservable inputs and the valuation techniques used by the independent pricing service. Where applicable, Finance will develop a fair value estimate using its own pricing model inputs to test reasonableness. Where fair value measurements are determined using internal valuation models, Finance will validate the fair value measurement by either developing unobservable inputs based on the industry consensus pricing surveys in which we participate or back testing by observing the actual settlements occurring soon after the measurement date. Any significant valuation adjustments are reported to and discussed with the valuation committee.

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 value and estimated fair value of our financial instruments at June 30, 2013 and December 31, 2012.



June 30, 2013	Carrying Value		Fair Value		Level 1		Level 2		Level 3
	(in millions)
Financial assets:
Short-term financial assets	$	31,526	$	31,526	$	1,311	$	29,820	$	395
Securities purchased under resale agreements	1,399		1,399		—		1,399		—
Non-derivative trading assets	18,447		18,447		1,530		14,772		2,145
Derivatives	10,452		10,452		104		10,226		122
Securities	54,511		54,572		29,573		24,999		—
Commercial loans, net of allowance for credit losses	46,965		47,838		—		—		47,838
Commercial loans designated under fair value option and held for sale	3		3		—		3		—
Commercial loans held for sale	17		17		—		17		—
Consumer loans, net of allowance for credit losses	19,135		16,054		—		—		16,054
Consumer loans held for sale:
Residential mortgages	275		276		—		—		276
Other consumer	64		64		—		—		64
Financial liabilities:
Short-term financial liabilities	$	21,922	$	21,922	$	—	$	21,922	$	—
Deposits:
Without fixed maturities	100,648		100,648		—		100,648		—
Fixed maturities	3,137		3,160		—		3,160		—
Deposits designated under fair value option	7,950		7,950		—		5,288		2,662
Non-derivative trading liabilities	5,036		5,036		236		4,800		—
Derivatives	11,211		11,211		32		11,079		100
Long-term debt	14,308		14,649		—		14,649		—
Long-term debt designated under fair value option	6,626		6,626		—		6,168		458



December 31, 2012	Carrying Value		Fair Value		Level 1		Level 2		Level 3
	(in millions)
Financial assets:
Short-term financial assets	$	15,074	$	15,074	$	1,359	$	13,279	$	436
Securities purchased under resale agreements	3,149		3,149		—		3,149		—
Non-derivative trading assets	25,491		25,491		2,484		20,061		2,946
Derivatives	11,986		11,986		30		11,785		171
Securities	69,336		69,547		43,421		26,126		—
Commercial loans, net of allowance for credit losses	43,833		45,153		—		—		45,153
Commercial loans designated under fair value option and held for sale	465		465		—		465		—
Commercial loans held for sale	16		16		—		16		—
Consumer loans, net of allowance for credit losses	18,778		15,173		—		—		15,173
Consumer loans held for sale:
Residential mortgages	472		485		—		—		485
Other consumer	65		65		—		—		65
Financial liabilities:
Short-term financial liabilities	$	15,421	$	15,421	$	—	$	15,421	$	—
Deposits:
Without fixed maturities	104,414		104,414		—		104,414		—
Fixed maturities	4,565		4,574		—		4,574		—
Deposits designated under fair value option	8,692		8,692		—		6,056		2,636
Non-derivative trading liabilities	5,974		5,974		207		5,767		—
Derivatives	15,202		15,202		21		15,054		127
Long-term debt	14,465		15,163		—		15,163		—
Long-term debt designated under fair value option	7,280		7,280		—		6,851		429

Loan 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 value 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 residential mortgage loans has been heavily influenced by the prevailing economic conditions during the past few years, including changes in house prices, unemployment, consumer behavior, and discount rates. For certain consumer loans, 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 loans, 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, 2013 and December 31, 2012 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, 2013 and December 31, 2012, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value.



	Fair Value Measurements on a Recurring Basis
June 30, 2013	Level 1		Level 2		Level 3		Gross Balance		Netting⁽¹⁾			Net Balance
	(in millions)
Assets:
Trading Securities, excluding derivatives:
U.S. Treasury, U.S. Government agencies and sponsored enterprises	$	1,530	$	197	$	—	$	1,727	$	—		$	1,727
Collateralized debt obligations	—		75		227		302		—			302
Asset-backed securities:
Residential mortgages	—		167		—		167		—			167
Corporate and other domestic debt securities	—		2		1,498		1,500		—			1,500
Debt Securities issued by foreign entities:
Corporate	—		681		285		966		—			966
Government	—		4,229		135		4,364		—			4,364
Equity securities	—		24		—		24		—			24
Precious metals trading	—		9,397		—		9,397		—			9,397
Derivatives⁽²⁾:
Interest rate contracts	74		57,233		1		57,308		—			57,308
Foreign exchange contracts	5		15,972		175		16,152		—			16,152
Equity contracts	—		1,698		140		1,838		—			1,838
Precious metals contracts	768		2,881		—		3,649		—			3,649
Credit contracts	—		5,236		669		5,905		—			5,905
Derivatives netting	—		—		—		—		(74,400		)	(74,400		)
Total derivatives	847		83,020		985		84,852		(74,400		)	10,452
Securities available-for-sale:
U.S. Treasury, U.S. Government agencies and sponsored enterprises	29,533		16,797		—		46,330		—			46,330
Obligations of U.S. states and political subdivisions	—		869		—		869		—			869
Asset-backed securities:
Residential mortgages	—		1		—		1		—			1
Commercial mortgages	—		166		—		166		—			166
Home equity	—		245		—		245		—			245
Other	—		104		—		104		—			104
Corporate and other domestic debt securities	—		24		—		24		—			24
Debt Securities issued by foreign entities:
Corporate	—		891		—		891		—			891
Government-backed	40		4,023		—		4,063		—			4,063
Equity securities	—		165		—		165		—			165
Loans⁽³⁾	—		3		—		3		—			3
Mortgage servicing rights⁽⁴⁾	—		—		225		225		—			225
Total assets	$	31,950	$	121,080	$	3,355	$	156,385	$	(74,400	)	$	81,985
Liabilities:
Deposits in domestic offices⁽⁵⁾	$	—	$	5,288	$	2,662	$	7,950	$	—		$	7,950
Trading liabilities, excluding derivatives	236		4,800		—		5,036		—			5,036
Derivatives⁽²⁾:
Interest rate contracts	83		57,217		2		57,302		—			57,302
Foreign exchange contracts	4		15,522		71		15,597		—			15,597
Equity contracts	—		1,335		223		1,558		—			1,558
Precious metals contracts	148		1,960		—		2,108		—			2,108
Credit contracts	—		5,492		444		5,936		—			5,936
Derivatives netting	—		—		—		—		(71,290		)	(71,290		)
Total derivatives	235		81,526		740		82,501		(71,290		)	11,211
Long-term debt⁽⁶⁾	—		6,168		458		6,626		—			6,626
Total liabilities	$	471	$	97,782	$	3,860	$	102,113	$	(71,290	)	$	30,823



	Fair Value Measurements on a Recurring Basis
December 31, 2012	Level 1		Level 2		Level 3		Gross Balance		Netting⁽¹⁾			Net Balance
	(in millions)
Assets:
Trading Securities, excluding derivatives:
U.S. Treasury, U.S. Government agencies and sponsored enterprises	$	2,484	$	369	$	—	$	2,853	$	—		$	2,853
Collateralized debt obligations	—		—		466		466		—			466
Asset-backed securities:
Residential mortgages	—		221		—		221		—			221
Corporate and other domestic debt securities	—		1,035		1,861		2,896		—			2,896
Debt Securities issued by foreign entities:
Corporate	—		468		299		767		—			767
Government	—		5,609		311		5,920		—			5,920
Equity securities	—		27		9		36		—			36
Precious metals trading	—		12,332		—		12,332		—			12,332
Derivatives⁽²⁾:
Interest rate contracts	98		71,717		8		71,823		—			71,823
Foreign exchange contracts	4		13,831		16		13,851		—			13,851
Equity contracts	—		1,593		166		1,759		—			1,759
Precious metals contracts	135		649		7		791		—			791
Credit contracts	—		5,961		1,168		7,129		—			7,129
Derivatives netting	—		—		—		—		(83,367		)	(83,367		)
Total derivatives	237		93,751		1,365		95,353		(83,367		)	11,986
Securities available-for-sale:
U.S. Treasury, U.S. Government agencies and sponsored enterprises	43,379		17,316		—		60,695		—			60,695
Obligations of U.S. states and political subdivisions	—		912		—		912		—			912
Asset-backed securities:
Residential mortgages	—		1		—		1		—			1
Commercial mortgages	—		214		—		214		—			214
Home equity	—		258		—		258		—			258
Other	—		84		—		84		—			84
Corporate and other domestic debt securities	—		26		—		26		—			26
Debt Securities issued by foreign entities:
Corporate	—		831		—		831		—			831
Government-backed	42		4,480		—		4,522		—			4,522
Equity securities	—		173		—		173		—			173
Loans⁽³⁾	—		465		—		465		—			465
Mortgage servicing rights⁽⁴⁾	—		—		168		168		—			168
Total assets	$	46,142	$	138,572	$	4,479	$	189,193	$	(83,367	)	$	105,826
Liabilities:
Deposits in domestic offices⁽⁵⁾	$	—	$	6,056	$	2,636	$	8,692	$	—		$	8,692
Trading liabilities, excluding derivatives	207		5,767		—		5,974		—			5,974
Derivatives⁽²⁾:
Interest rate contracts	90		71,567		1		71,658		—			71,658
Foreign exchange contracts	25		13,582		11		13,618		—			13,618
Equity contracts	—		1,244		173		1,417		—			1,417
Precious metals contracts	19		712		7		738		—			738
Credit contracts	—		6,754		597		7,351		—			7,351
Derivatives netting	—		—		—		—		(79,580		)	(79,580		)
Total derivatives	134		93,859		789		94,782		(79,580		)	15,202
Long-term debt⁽⁶⁾	—		6,851		429		7,280		—			7,280
Total liabilities	$	341	$	112,533	$	3,854	$	116,728	$	(79,580	)	$	37,148


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


⁽²⁾	Includes trading derivative assets of $9.0 billion and $10.5 billion and trading derivative liabilities of $10.3 billion and $13.8 billion as of June 30, 2013 and December 31, 2012, respectively, as well as derivatives held for hedging and commitments accounted for as derivatives.


⁽³⁾	Includes leveraged acquisition finance and other commercial loans held for sale or risk-managed on a fair value basis for which we have elected to apply the fair value option. See Note 7, “Loans Held for Sale,” for further information.


⁽⁴⁾	See Note 8, “Intangible Assets,” for additional information.


⁽⁵⁾	Represents structured deposits risk-managed on a fair value basis for which we have elected to apply the fair value option.


⁽⁶⁾	Includes structured notes and own debt issuances which we have elected to measure on a fair value basis.

Transfers between leveling categories are recognized at the end of each reporting period.

Transfers between Levels 1 and 2 There were no transfers between Levels 1 and 2 during June 30, 2013 and 2012.

Information on Level 3 assets and liabilities The following table summarizes additional information about changes in the fair value of Level 3 assets and liabilities during the three months ended June 30, 2013 and 2012. As a risk management practice, we may risk manage the Level 3 assets and liabilities, in whole or in part, using securities and derivative positions that are classified as Level 1 or Level 2 measurements within the fair value hierarchy. Since those Level 1 and Level 2 risk management positions are not included in the table below, the information provided does not reflect the effect of such risk management activities related to the Level 3 assets and liabilities.



	Apr. 1, 2013			Total Gains and (Losses) Included in⁽¹⁾						Purch- ases		Issu- ances			Settle- ments			Transfers Into Level 3			Transfers Out of Level 3			Jun. 30, 2013			Current Period Unrealized Gains (Losses)
	Apr. 1, 2013			Trading Revenue (Loss)			Other Revenue			Purch- ases		Issu- ances			Settle- ments			Transfers Into Level 3			Transfers Out of Level 3			Jun. 30, 2013			Current Period Unrealized Gains (Losses)
	(in millions)
Assets:
Trading assets, excluding derivatives:
Collateralized debt obligations	$	481		$	83		$	—		$	216	$	—		$	(553	)	$	—		$	—		$	227		$	56
Corporate and other domestic debt securities	1,524			21			—			16		—			(63		)	—			—			1,498			21
Corporate debt securities issued by foreign entities	294			(9		)	—			—		—			—			—			—			285			(9		)
Government debt securities issued by foreign entities	143			(7		)	—			—		—			(1		)	—			—			135			(9		)
Equity securities	11			(7		)	—			—		—			(4		)	—			—			—			(7		)
Derivatives⁽²⁾:
Interest rate contracts	6			(1		)	(6		)	—		—			—			—			—			(1		)	(7		)
Foreign exchange contracts	134			(18		)	—			—		—			(6		)	(6		)	—			104			(28		)
Equity contracts	34			(81		)	—			—		—			(27		)	6			(15		)	(83		)	(92		)
Credit contracts	364			(105		)	—			—		—			(34		)	—			—			225			(82		)
Mortgage servicing rights⁽⁴⁾	190			—			30			—		5			—			—			—			225			30
Total assets	$	3,181		$	(124	)	$	24		$	232	$	5		$	(688	)	$	—		$	(15	)	$	2,615		$	(127	)
Liabilities:
Deposits in domestic offices	$	(2,876	)	$	154		$	—		$	—	$	(81	)	$	110		$	(177	)	$	208		(2,662		)	$	175
Long-term debt	(618		)	15			—			—		(59		)	68			—			136			(458		)	18
Total liabilities	$	(3,494	)	$	169		$	—		$	—	$	(140	)	$	178		$	(177	)	$	344		$	(3,120	)	$	193



	Jan. 1, 2013			Total Gains and (Losses) Included in⁽¹⁾						Purch- ases		Issu- ances			Settle- ments			Transfers Into Level 3			Transfers Out of Level 3			Jun. 30, 2013			Current Period Unrealized Gains (Losses)
	Jan. 1, 2013			Trading Revenue (Loss)			Other Revenue			Purch- ases		Issu- ances			Settle- ments			Transfers Into Level 3			Transfers Out of Level 3			Jun. 30, 2013			Current Period Unrealized Gains (Losses)
	(in millions)
Assets:
Trading assets, excluding derivatives:
Collateralized debt obligations	$	466		$	118		$	—		$	237	$	—		$	(594	)	$	—		$	—		$	227		$	87
Corporate and other domestic debt securities	1,861			28			—			31		—			(422		)	—			—			1,498			24
Corporate debt securities issued by foreign entities	299			(14		)	—			—		—			—			—			—			285			(14		)
Government debt securities issued by foreign entities	311			15			—			—		—			(191		)	—			—			135			10
Equity securities	9			(5		)	—			—		—			(4		)	—			—			—			(5		)
Derivatives⁽²⁾:
Interest rate contracts	7			(1		)	(7		)	—		—			—			—			—			(1		)	(8		)
Foreign exchange contracts	5			(4		)	—			—		—			116			(13		)	—			104			106
Equity contracts	(7		)	(20		)	—			—		—			(48		)	13			(21		)	(83		)	(73		)
Credit contracts	571			(155		)	—			—		—			(145		)	(46		)	—			225			(274		)
Mortgage servicing rights⁽⁴⁾	168			—			46			—		11			—			—			—			225			51
Total assets	$	3,690		$	(38	)	$	39		$	268	$	11		$	(1,288	)	$	(46	)	$	(21	)	$	2,615		$	(96	)
Liabilities:
Deposits in domestic offices	$	(2,636	)	$	113		$	—		$	—	$	(485	)	$	219		$	(160	)	$	287		(2,662		)	$	149
Long-term debt	(429		)	(16		)	—			—		(270		)	119			—			138			(458		)	7
Total liabilities	$	(3,065	)	$	97		$	—		$	—	$	(755	)	$	338		$	(160	)	$	425		$	(3,120	)	$	156



	Apr. 1, 2012			Total Gains and (Losses) Included in⁽¹⁾						Purch- ases		Issu- ances			Settle- ments			Transfers Into Level 3			Transfers Out of Level 3		Jun. 30, 2012			Current Period Unrealized Gains (Losses)
	Apr. 1, 2012			Trading Revenue (Loss)			Other Revenue			Purch- ases		Issu- ances			Settle- ments			Transfers Into Level 3			Transfers Out of Level 3		Jun. 30, 2012			Current Period Unrealized Gains (Losses)
	(in millions)
Assets:
Trading assets, excluding derivatives:
Collateralized debt obligations	$	661		$	18		$	—		$	24	$	—		$	(45	)	$	—		$	—	$	658		$	16
Corporate and other domestic debt securities	1,753			(2		)	—			19		—			(171		)	—			—		1,599			(6		)
Corporate debt securities issued by foreign entities	294			25			—			389		—			(20		)	—			—		688			25
Equity securities	13			(1		)	—			—		—			—			—			—		12			(1		)
Derivatives⁽²⁾:
Interest rate contracts	9			—			3			—		—			—			—			—		12			3
Foreign exchange contracts	(5		)	(18		)	—			—		(5		)	2			—			1		(25		)	(17		)
Equity contracts	(53		)	13			—			—		—			(10		)	(1		)	5		(46		)	(1		)
Credit contracts	984			(13		)	—			—		—			(50		)	—			—		921			(22		)
Mortgage servicing rights⁽⁴⁾	228			—			(47		)	—		6			—			—			—		187			(46		)
Total assets	$	3,884		$	22		$	(44	)	$	432	$	1		$	(294	)	$	(1	)	$	6	$	4,006		$	(49	)
Liabilities:
Deposits in domestic offices	$	(2,964	)	$	(21	)	$	—		$	—	$	(269	)	$	79		$	(46	)	$	313	(2,908		)	$	(14	)
Long-term debt	(160		)	10			—			—		(132		)	1			(7		)	1		(287		)	5
Total liabilities	$	(3,124	)	$	(11	)	$	—		$	—	$	(401	)	$	80		$	(53	)	$	314	$	(3,195	)	$	(9	)



	Jan. 1, 2012			Total Gains and (Losses) Included in⁽¹⁾						Purch- ases		Issu- ances			Settle- ments			Transfers Into Level 3			Transfers Out of Level 3			Jun. 30, 2012			Current Period Unrealized Gains (Losses)
	Jan. 1, 2012			Trading Revenue (Loss)			Other Revenue			Purch- ases		Issu- ances			Settle- ments			Transfers Into Level 3			Transfers Out of Level 3			Jun. 30, 2012			Current Period Unrealized Gains (Losses)
	(in millions)
Assets:
Trading assets, excluding derivatives:
Collateralized debt obligations	$	703		$	57		$	—		$	25	$	—		$	(127	)	$	—		$	—		$	658		$	49
Corporate and other domestic debt securities	1,679			18			—			101		—			(199		)	—			—			1,599			8
Corporate debt securities issued by foreign entities	253			66			—			389		—			(20		)	—			—			688			66
Equity securities	13			(1		)	—			—		—			—			—			—			12			(1		)
Derivatives⁽²⁾:
Interest rate contracts	9			—			3			—		—			—			—			—			12			3
Foreign exchange contracts	(1		)	(19		)	—			—		(5		)	2			(3		)	1			(25		)	(19		)
Equity contracts	(83		)	63			—			—		—			(29		)	(1		)	4			(46		)	22
Credit contracts	1,353			(388		)	—			—		—			(44		)	—			—			921			(355		)
Loans⁽³⁾	11			—			—			—		—			—			—			(11		)	—			(12		)
Mortgage servicing rights⁽⁴⁾	220			—			(47		)	—		14			—			—			—			187			(47		)
Total assets	$	4,157		$	(204	)	$	(44	)	$	515	$	9		$	(417	)	$	(4	)	$	(6	)	$	4,006		$	(286	)
Liabilities:
Deposits in domestic offices	$	(2,867	)	$	(77	)	$	—		$	—	$	(556	)	$	160		$	(43	)	$	475		(2,908		)	$	(50	)
Long-term debt	(86		)	9			—			—		(221		)	5			(7		)	13			(287		)	4
Total liabilities	$	(2,953	)	$	(68	)	$	—		$	—	$	(777	)	$	165		$	(50	)	$	488		$	(3,195	)	$	(46	)


⁽¹⁾	Includes realized and unrealized gains and losses.


⁽²⁾	Level 3 net derivatives included derivative assets of $1.0 billion and derivative liabilities of $740 million as of June 30, 2013 and derivative assets of $2.4 billion and derivative liabilities of $2.2 billion as of June 30, 2012.


⁽³⁾	Includes Level 3 corporate lending activities risk-managed on a fair value basis for which we have elected the fair value option.


⁽⁴⁾	See Note 8, “Intangible Assets,” for additional information.

The following table presents quantitative information about the unobservable inputs used to determine the recurring fair value measurement of assets and liabilities classified as Level 3 fair value measurements as of June 30, 2013 and December 31, 2012.



As of June 30, 2013
Financial Instrument Type	Fair Value (in millions)		Valuation Technique(s)	Significant Unobservable Inputs	Range of Inputs
Collateralized debt obligations	227		Broker quotes or consensus pricing and, where applicable, discounted cash flows	Prepayment rates	-% - 5%
				Conditional default rates	5% - 10%
				Loss severity rates	70% -95%
Corporate and other domestic debt securities	1,498		Discounted cash flows	Spread volatility on collateral assets	1% - 4%
				Correlation between insurance claim shortfall and collateral value	80%
Corporate and government debt securities issued by foreign entities	420		Discounted cash flows	Correlations of default among a portfolio of credit names of embedded credit derivatives	46% - 47%
Interest rate derivative contracts	(1	)	Market comparable adjusted for probability to fund	Probability to fund for rate lock commitments	8% - 100%
Foreign exchange derivative contracts⁽¹⁾	104		Option pricing model	Implied volatility of currency pairs	1% - 40%
Equity derivative contracts⁽¹⁾	(83	)	Option pricing model	Equity / Equity Index volatility	12% - 49%
				Equity / Equity and Equity / Index correlation	51% - 60%
Credit derivative contracts	225		Option pricing model	Correlation of defaults of a portfolio of reference credit names	47% - 53%
				Issuer by issuer correlation of defaults	83% - 95%
Mortgage servicing rights	225		Option adjusted discounted cash flows	Constant prepayment rates	6% - 26%
				Option adjusted spread	8% - 19%
				Estimated annualized costs to service	$91 - $256 per account
Deposits in domestic offices (structured deposits) ⁽¹⁾⁽²⁾	(2,662	)	Option adjusted discounted cash flows	Implied volatility of currency pairs	1% - 40%
				Equity / Equity Index volatility	12% - 49%
				Equity / Equity and Equity / Index correlation	51% - 60%
Long-term debt (structured notes) ⁽¹⁾⁽²⁾	(458	)	Option adjusted discounted cash flows	Implied volatility of currency pairs	1% - 40%
				Equity / Equity Index volatility	12% - 49%
				Equity / Equity and Equity / Index correlation	51% - 60%



As of December 31, 2012
Financial Instrument Type	Fair Value (in millions)		Valuation Technique(s)	Significant Unobservable Inputs	Range of Inputs
Collateralized debt obligations	466		Broker quotes or consensus pricing and, where applicable, discounted cash flows	Prepayment rates	-% - 6%
				Conditional default rates	4% - 14%
				Loss severity rates	50% - 100%
Corporate and other domestic debt securities	1,861		Discounted cash flows	Spread volatility on collateral assets	2% - 4%
				Correlation between insurance claim shortfall and collateral value	80%
Corporate and government debt securities issued by foreign entities	610		Discounted cash flows	Correlations of default among a portfolio of credit names of embedded credit derivatives	29%
Equity securities (investments in hedge funds)	9		Net asset value of hedge funds	Range of fair value adjustments to reflect restrictions on timing and amount of redemption and realization risks	30% - 100%
Interest rate derivative contracts	7		Market comparable adjusted for probability to fund	Probability to fund for rate lock commitments	8% - 100%
Foreign exchange derivative contracts⁽¹⁾	5		Option pricing model	Implied volatility of currency pairs	2% - 21%
Equity derivative contracts⁽¹⁾	(7	)	Option pricing model	Equity / Equity Index volatility	6% - 104%
				Equity / Equity and Equity / Index correlation	56% - 64%
Credit derivative contracts	571		Option pricing model	Correlation of defaults of a portfolio of reference credit names	32% - 45%
				Industry by industry correlation of defaults	44% - 67%
Mortgage servicing rights	168		Option adjusted discounted cash flows	Constant prepayment rates	9% - 45%
				Option adjusted spread	8% - 19%
				Estimated annualized costs to service	$98 - $263 per account
Deposits in domestic offices (structured deposits) ⁽¹⁾⁽²⁾	(2,636	)	Option adjusted discounted cash flows	Implied volatility of currency pairs	2% - 21%
				Equity / Equity Index volatility	6% - 104%
				Equity / Equity and Equity / Index correlation	56% - 64%
Long-term debt (structured notes) ⁽¹⁾⁽²⁾	(429	)	Option adjusted discounted cash flows	Implied volatility of currency pairs	2% - 21%
				Equity / Equity Index volatility	6% - 104%
				Equity / Equity and Equity / Index correlation	56% - 64%


⁽¹⁾	We are the client-facing entity and we enter into identical but opposite derivatives to transfer the resultant risks to our affiliates. With the exception of counterparty credit risks, we are market neutral. The corresponding intra-group derivatives are presented as equity derivatives and foreign currency derivatives in the table.


⁽²⁾	Structured deposits and structured notes contain embedded derivative features whose fair value measurements contain significant Level 3 inputs.

Significant Unobservable Inputs for Recurring Fair Value Measurements

Collateralized Debt Obligations (CDOs)


▪	Prepayment rate - The rate at which borrowers pay off the mortgage loans early. The prepayment rate is affected by a number of factors including the location of the mortgage collateral, the interest rate type of the mortgage loans, borrowers' credit and sensitivity to interest rate movement. The prepayment rate of our CDOs portfolio is tilted towards the low end of the range.


▪	Default rate - Annualized percentage of default rate over a group of collateral such as residential or commercial mortgage loans. The default rate and loss severity rate are positively correlated. The default rate of our portfolio is close to mid point of the range.


▪	Loss Severity Rate - Included in our Level 3 CDOs portfolio are collateralized loan obligations (CLOs) and trust preferred securities which are about equally distributed. The loss severity rate for trust preferred securities as of June 30, 2013 is about 1.8 times of CLOs.

Equity Securities (Investments in Hedge Funds)


▪	Equity Interest in Hedge Funds - As of June 30, 2013, HUSI owns interests in about 30 distressed hedge funds where the majority of the funds have been discounted at 50% to 60% to reflect our expectation of recovery.

Derivatives

▪

Correlation of Default - The default correlation of a group of credit exposures measures the likelihood that the credit references within a group will default together. The default correlation is not observable. For a Tranched Credit Default swap, HUSI, through its participation in the industry survey, estimates and validates the default correlation of benchmark market credit default swap indices which, after adjusting for any differences in the composition and the tenure between the market index and the bespoke tranche under measurement, is used as an input to measure a bespoke CDS tranche. The correlations of default of our credit derivative portfolio are not widely dispersed.

▪

Implied volatility - The implied volatility is a significant pricing input for freestanding or embedded options including equity, foreign currency and interest rate options. The level of volatility is a function of the nature of the underlying risk, the level of strike price and the years to maturity of the option. Depending on the underlying risk and tenure, we determine the implied volatility based on observable input where information is available. However, substantially all of the implied volatilities are derived based on historical information. The implied volatility for different foreign currency pairs is between 1% and 40% while the implied volatility for equity/equity or equity/equity index is between 12% and 49%, respectively at June 30, 2013. Although implied foreign currency volatility and equity volatility appear to be widely distributed at the portfolio level, the deviation of implied volatility on a trade-by-trade basis is narrower. The average deviation of implied volatility for the foreign currency pair and at-the-money equity option are 4.4% and 4.6%, respectively at June 30, 2013.

▪

Correlations of a group of foreign currency or equity - Correlation measures the relative change in values among two or more variables (i.e., equity or foreign currency pair). Variables can be positively or negatively correlated. Correlation is a key input in determining the fair value of a derivative referenced to a basket of variables such as equities or foreign currencies. A majority of the correlations are not observable, but are derived based on historical data. The correlation between equity/equity and equity/equity index was between 51% and 60% at June 30, 2013.

Sensitivity of Level 3 Inputs to Fair Value Measurements

Collateralized Debt Obligations - Probability of default, prepayment speed and loss severity rate are significant unobservable inputs. Significant increase (decrease) in these inputs will result in a lower (higher) fair value measurement of a collateralized debt obligation. A change in assumption for default probability is often accompanied by a directionally similar change in loss severity, and a directionally opposite change in prepayment speed.

Corporate and Domestic Debt Securities - The fair value measurements of certain corporate debt securities are affected by the fair value of the underlying portfolios of investments used as collateral and the make-whole guarantee provided by third party guarantors. The probability that the collateral fair value declines below the collateral call threshold concurrent with the guarantors failure to perform its make whole obligation is unobservable. The increase (decrease) in the probability the collateral value falls below the collateral call threshold is often accompanied by a directionally similar change in default probability of the guarantor.

Credit derivatives - Correlation of default among a basket of reference credit names is a significant unobservable input if the credit attributes of the portfolio are not within the parameters of relevant standardized CDS indices. Significant increase (decrease) in the unobservable input will result in a lower (higher) fair value measurement of the credit derivative. A change in assumption for default correlation is often accompanied by a directionally similar change in default probability and loss rates of other credit names in the basket.

Equity and foreign currency derivatives - The fair value measurement of a structured equity or foreign currency derivative is primarily affected by the implied volatility of the underlying equity price or exchange rate of the paired foreign currencies. The implied volatility is not observable. Significant increase (decrease) in the implied volatility will result in a higher (lower) fair value of a long position in the derivative contract.

Material Additions to and Transfers Into (Out of) Level 3 Measurements During the six months ended June 30, 2013, we transferred $46 million of credit derivatives from Level 2 to Level 3 as result of including specific fair value adjustments related to certain credit default swaps. During the three and six months ended June 30, 2013, we transferred $208 million and $287 million, respectively, of deposits in domestic offices and $136 million and $138 million, respectively, of long-term debt, which we have elected to carry at fair value, from Level 3 to Level 2 as a result of the embedded derivative no longer being unobservable as the derivative option is closer to maturity and there is more observability in short term volatility. Additionally, during the three and six months ended June 30, 2013, we transferred $177 million and $160 million, respectively, of long-term debt, which we have elected to carry at fair value, from Level 2 to Level 3 as a result of a change in the observability of underlying instruments that resulted in the embedded derivative being unobservable.

During the three and six months ended June 30, 2012, we transferred $313 million and $475 million, respectively, of deposits in domestic offices, which we have elected to carry at fair value, from Level 3 to Level 2 as a result of the embedded derivative no longer being unobservable as the derivative option is closer in maturity and there is more observability in short term volatility.

Assets and Liabilities Recorded at Fair Value on a Non-recurring Basis Certain financial and non-financial assets are measured at fair value on a non-recurring basis and therefore, are not included in the tables above. These assets include (a) mortgage and consumer loans classified as held for sale reported at the lower of amortized cost or fair value and (b) impaired loans or assets that are written down to fair value based on the valuation of underlying collateral during the period. These instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustment in certain circumstances (e.g., impairment). The following table presents the fair value hierarchy level within which the fair value of the financial and non-financial assets has been recorded as of June 30, 2013 and December 31, 2012. The gains (losses) during the three and six months ended June 30, 2013 and 2012 are also included.



	Non-Recurring Fair Value Measurements as of June 30, 2013								Total Gains (Losses) For the Three Months Ended Jun. 30 2013			Total Gains (Losses) For the Six Months Ended Jun. 30 2013
	Level 1		Level 2		Level 3		Total					Total Gains (Losses) For the Six Months Ended Jun. 30 2013
	(in millions)
Residential mortgage loans held for sale⁽¹⁾	$	—	$	134	$	68	$	202	$	—		$	3
Impaired commercial loans⁽²⁾	—		—		129		129		(1		)	(2		)
Impaired consumer loans⁽²⁾	—		249		45		294		(11		)	(31		)
Real estate owned⁽³⁾	22		—		—		22		—			2
Total assets at fair value on a non-recurring basis	$	22	$	383	$	242	$	647	$	(12	)	$	(28	)



	Non-Recurring Fair Value Measurements as of December 31, 2012								Total Gains (Losses) For the Three Months Ended Jun. 30 2012			Total Gains (Losses) For the Six Months Ended Jun. 30 2012
	Level 1		Level 2		Level 3		Total					Total Gains (Losses) For the Six Months Ended Jun. 30 2012
	(in millions)
Residential mortgage loans held for sale⁽¹⁾	$	—	$	10	$	67	$	77	$	(4	)	$	(6	)
Impaired commercial loans⁽²⁾	—		—		155		155		(12		)	(23		)
Impaired consumer loans⁽²⁾	—		600		118		718		(35		)	(60		)
Real estate owned⁽³⁾	24		—		—		24		—			2
Total assets at fair value on a non-recurring basis	$	24	$	610	$	340	$	974	$	(51	)	$	(87	)

⁽¹⁾

As of June 30, 2013 and December 31, 2012, the fair value of the loans held for sale was below cost. Certain residential mortgage loans held for sale have been classified as a Level 3 fair value measurement within the fair value hierarchy as the underlying real estate properties which determine fair value are illiquid assets as a result of market conditions and significant inputs in estimating fair value were unobservable. Additionally, the fair value of these properties is affected by, among other things, the location, the payment history and the completeness of the loan documentation.

⁽²⁾

Certain commercial and consumer loans have undergone troubled debt restructurings and are considered impaired. As a matter of practical expedient, we measure the credit impairment of a collateral-dependent loan based on the fair value of the collateral asset. The collateral often involves real estate properties that are illiquid due to market conditions. As a result, these loans are classified as a Level 3 fair value measurement within the fair value hierarchy.


⁽³⁾	Real estate owned are 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 unadjusted for transaction costs.

The following table presents quantitative information about non-recurring fair value measurements of assets and liabilities classified with Level 3 of the fair value hierarchy as of June 30, 2013 and December 31, 2012.



As of June 30, 2013
Financial Instrument Type	Fair Value (in millions)		Valuation Technique(s)	Significant Unobservable Inputs	Range of Inputs
Residential mortgage loans held for sale	$	68	Valuation of third party appraisal on underlying collateral	Loss severity rates	-% - 100%
Impaired commercial loans	129		Valuation of third party appraisal on underlying collateral	Loss severity rates	-% - 81%



As of December 31, 2012
Financial Instrument Type	Fair Value (in millions)		Valuation Technique(s)	Significant Unobservable Inputs	Range of Inputs
Residential mortgage loans held for sale	$	67	Valuation of third party appraisal on underlying collateral	Loss severity rates	-% - 100%
Impaired commercial loans	155		Valuation of third party appraisal on underlying collateral	Loss severity rates	1% - 79%

Significant Unobservable Inputs for Non-Recurring Fair Value Measurements

Residential mortgage loans held for sale represent subprime residential mortgage loans which were previously acquired with the intent of securitizing or selling them to third parties. The weighted average loss severity rate for these loans was approximately 59% at June 30, 2013. These severity rates are primarily impacted by the outstanding balances of the loans and the value of the underlying collateral securing the loans.

Impaired loans represent commercial loans. Loss severity rates for impaired loans are also primarily impacted by the outstanding loan balance and the value of the underlying collateral securing the loan. The weighted average severity rate for these loans was approximately 22% at June 30, 2013. These severity rates are primarily impacted by the outstanding balances of the loans and the value of the underlying collateral securing the loans.

Valuation Techniques Following is a description of valuation methodologies used for assets and liabilities recorded at fair value and for estimating fair value for those financial instruments not recorded at fair value for which fair value disclosure is required.

Short-term financial assets and liabilities - The carrying amount of certain financial assets and liabilities recorded at cost is considered to approximate fair value because they are short-term in nature, bear interest rates that approximate market rates, and generally have negligible credit risk. These items include cash and due from banks, interest bearing deposits with banks, accrued interest receivable, customer acceptance assets and liabilities and short-term borrowings.

Federal funds sold and purchased and securities purchased and sold under resale and repurchase agreements - Federal funds sold and purchased and securities purchased and sold under resale and repurchase agreements are recorded at cost. A significant majority of these transactions are short-term in nature and, as such, the recorded amounts approximate fair value. For transactions with long-dated maturities, fair value is based on dealer quotes for instruments with similar terms and collateral.

Loans - Except for leveraged loans, selected residential mortgage loans and certain foreign currency denominated commercial loans, we do not record loans at fair value on a recurring basis. From time to time, we record impairments to loans. The write-downs can be based on observable market price of the loan or the underlying collateral value. In addition, fair value estimates are determined based on the product type, financial characteristics, pricing features and maturity.

•

Mortgage Loans Held for Sale – Certain residential mortgage loans are classified as held for sale and are recorded at the lower of amortized cost or fair value. The fair value of these mortgage loans is determined based on the valuation information observed in alternative exit markets, such as the whole loan market, adjusted for portfolio specific factors. These factors include the location of the collateral, the loan-to-value ratio, the estimated rate and timing of default, the probability of default or foreclosure and loss severity if foreclosure does occur.

•

Leveraged Loans – We record leveraged loans and revolvers held for sale at fair value. Where available, market consensus pricing obtained from independent sources is used to estimate the fair value of the leveraged loans and revolvers. In validating the fair value, we take into consideration the number of participants submitting pricing information, the range of pricing information and distribution, the methodology applied by the pricing services to cleanse the data and market liquidity. Where consensus pricing information is not available, fair value is estimated using observable market prices of similar instruments or inputs, including bonds, credit derivatives, and loans with similar characteristics. Where observable market parameters are not available, fair value is determined based on contractual cash flows, adjusted for the probability of default and estimated recoveries where applicable, discounted at the rate demanded by market participants under current market conditions. In those cases, we also consider the loan specific attributes and inherent credit risk and risk mitigating factors such as collateral arrangements.


•	Commercial Loans – Commercial loans and commercial real estate loans are valued by discounting the contractual cash flows, adjusted for prepayments and the borrower’s credit risk, using a discount rate that reflects the current rates offered to borrowers of similar credit standing for the remaining term to maturity and, when applicable, our own estimate of liquidity premium.


•	Commercial impaired loans – Fair value is determined based on the pricing quotes obtained from an independent third party appraisal.

•

Consumer Loans – The estimated fair value of our consumer loans were determined by developing an approximate range of value from a mix of various sources as appropriate for the respective pool of assets. These sources included estimates from an HSBC affiliate which reflect over-the-counter trading activity, forward looking discounted cash flow models using assumptions 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 value and market discount rates reflecting management’s estimate of the rate 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. Where available, such inputs are derived principally from or corroborated by observable market data. 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 and other market participants. Since an active market for these receivables does not exist, the fair value measurement process uses unobservable significant inputs specific to the performance characteristics of the various receivable portfolios.

Lending-related commitments - The fair value of commitments to extend credit, standby letters of credit and financial guarantees are not included in the table. The majority of the lending related commitments are not carried at fair value on a recurring basis nor are they actively traded. These instruments generate fees, which approximate those currently charged to originate similar commitments, which are recognized over the term of the commitment period. Deferred fees on commitments and standby letters of credit totaled $45 million and $46 million at June 30, 2013 and December 31, 2012, respectively.

Precious metals trading - Precious metals trading primarily include physical inventory which is valued using spot prices.

Securities - Where available, debt and equity securities are valued based on quoted market prices. If a quoted market price for the identical security is not available, the security is valued based on quotes from similar securities, where possible. For certain securities, internally developed valuation models are used to determine fair values or validate quotes obtained from pricing services. The following summarizes the valuation methodology used for our major security classes:


•	U.S. Treasury, U.S. Government agency issued or guaranteed and Obligations of U.S. state and political subdivisions – As these securities transact in an active market, fair value measurements are based on 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 government sponsored mortgage-backed securities which transact in an active market, fair value measurements are based on 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 primarily based on pricing information obtained from pricing services and is verified by internal review processes.


•	Asset-backed securities, including collateralized debt obligations – Fair value is primarily determined based on pricing information obtained from independent pricing services adjusted for the characteristics and the performance of the underlying collateral.

Additional information relating to asset-backed securities and collateralized debt obligations as of June 30, 2013 is presented in the following tables:

Trading asset-backed securities and related collateral:



		Prime				Alt-A				Subprime
Rating of Securities:⁽¹⁾	Collateral Type:	Level 2		Level 3		Level 2		Level 3		Level 2		Level 3		Total
		(in millions)
AAA -A	Residential mortgages	$	—	$	—	$	91	$	—	$	71	$	—	$	162
CCC-Unrated	Residential mortgages	—		—		—		—		5		—		5
		$	—	$	—	$	91	$	—	$	76	$	—	$	167

Trading collateralized debt obligations and related collateral:



Rating of Securities:⁽¹⁾	Collateral Type:	Level 2		Level 3
		(in millions)
AAA -A	Student loans	$	74	$	—
BBB -B	Corporate loans	—		—
	Other	—		228
	Total BBB -B	—		228
		$	74	$	228

Available-for-sale securities backed by collateral:



		Commercial Mortgages				Prime				Alt-A				Subprime
Rating of Securities:⁽¹⁾	Collateral Type:	Level 2		Level 3		Level 2		Level 3		Level 2		Level 3		Level 2		Level 3		Total
		(in millions)
AAA -A	Residential mortgages	$	165	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	165
	Home equity	—		—		—		—		106		—		—		—		106
	Total AAA -A	165		—		—		—		106		—		—		—		271
BBB -B	Home equity	—		—		—		—		79		—		—		—		79
	Other	—		—		—		—		104		—		—		—		104
	Total BBB -B	—		—		—		—		183		—		—		—		183
CCC -Unrated	Residential mortgages	—		—		—		—		1		—		—		—		1
	Home equity	—		—		—		—		61		—		—		—		61
	Total CCC -Unrated	—		—		—		—		62		—		—		—		62
		$	165	$	—	$	—	$	—	$	351	$	—	$	—	$	—	$	516


⁽¹⁾	We utilize Standard & Poor's ("S&P") as the primary source of credit ratings in the tables above. If S&P ratings are not available, ratings by Moody's and Fitch are used in that order.

•

Other domestic debt and foreign debt securities (corporate and government) - A significant portion of the domestic and foreign securities are classified as Level 3 measurements. 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 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, we survey the broker/dealer community to obtain relevant trade data including benchmark quotes and updated spreads.


•	Equity securities – Except for those legacy investments in hedge funds, since most of our securities are transacted in active markets, fair value measurements are determined based on quoted prices for the identical security. For mutual fund investments, we receive monthly statements from the investment manager with the estimated fair value.

Derivatives – Derivatives are recorded at fair value. Asset and liability positions in individual derivatives that are covered by legally enforceable master netting agreements, including receivables (payables) for cash collateral posted (received), are offset and presented net in accordance with accounting principles which allow the offsetting of amounts.

Derivatives traded on an exchange are valued using quoted prices. OTC derivatives, which comprise a majority of derivative contract positions, are valued using valuation techniques. The fair value for the majority of our derivative instruments are determined based on internally developed models that utilize independently corroborated market parameters, including interest rate yield curves, option volatilities, and currency rates. For complex or long-dated derivative products where market data is not available, fair value may be affected by the underlying assumptions about, among other things, the timing of cash flows, expected exposure, probability of default and recovery rates. The fair values of certain structured derivative products are sensitive to unobservable inputs such as default correlations of the referenced credit and volatilities of embedded options. These estimates are susceptible to significant change in future periods as market conditions change.

We use the Overnight Indexed Swap (OIS) curves as inputs to measure the fair value of collateralized interest rate derivatives.

Significant inputs related to derivative classes are broken down as follows:


•	Credit Derivatives – Use credit default curves and recovery rates which are generally provided by broker quotes and various pricing services. Certain credit derivatives may also use correlation inputs in their model valuation. Correlation is derived using market quotes from brokers and various pricing services.


•	Interest Rate Derivatives – Swaps use interest rate curves based on currency that are actively quoted by brokers and other pricing services. Options will also use volatility inputs which are also quoted in the broker market.


•	Foreign Exchange (“FX”) Derivatives – FX transactions use spot and forward FX rates which are quoted in the broker market.


•	Equity Derivatives – Use listed equity security pricing and implied volatilities from equity traded options position.


•	Precious Metal Derivative – Use spot and forward metal rates which are quoted in the broker market.

As discussed earlier, we make fair value adjustments to model valuations in order to ensure that those values represent appropriate estimates of fair value. These adjustments, which are applied consistently over time, are generally required to reflect factors such as bid-ask spreads and counterparty credit risk that can affect prices in arms-length transactions with unrelated third parties. Such adjustments are based on management judgment and may not be observable.

We estimate the counterparty credit risk for financial assets and own credit standing for financial liabilities (the “credit risk adjustments”) in determining the fair value measurement. For derivative instruments, we calculate the credit risk adjustment by applying the probability of default of the counterparty to the expected exposure, and multiplying the result by the expected loss given default. We also take into consideration the risk mitigating factors including collateral agreements and master netting arrangements in determining credit risk adjustments. We estimate the implied probability of default based on the credit spreads of the specific counterparties observed in the credit default swap market. Where credit default spread of the specific counterparty is not available, we use the credit default spread of specific proxy (e.g., the CDS spread of the parent). Where specific proxy credit default swap is not available, we apply a blended approach based on a combination of credit default swap referencing to credit names of similar credit standing in the same industry sector and the historical rating-based probability of default.

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, not less than once every 45 days to reflect observable local market data including local area sales data.

Mortgage servicing rights - We elected to measure residential mortgage servicing rights, which are classified as intangible assets, at fair value. The fair value for the residential mortgage servicing rights is determined based on an option adjusted approach which involves discounting servicing cash flows under various interest rate projections at risk-adjusted rates. The valuation model also incorporates our best estimate of the prepayment speed of the mortgage loans, current cost to service and discount rates which are unobservable. As changes in interest rates is a key factor affecting the prepayment speed and hence the fair value of the mortgage servicing rights, we use various interest rate derivatives and forward purchase contracts of mortgage-backed securities to risk-manage the mortgage servicing rights.

Structured notes – Certain structured notes were elected to be measured at fair value in their entirety under fair value option accounting principles. As a result, derivative features embedded in the structured notes are included in the valuation of fair value. The valuation of embedded derivatives may include significant unobservable inputs such as correlation of the referenced credit names or volatility of the embedded option. Other significant inputs include interest rates (yield curve), time to maturity, expected loss and loss severity.

Cash flows of the funded notes are discounted at the appropriate rate for the applicable duration of the instrument adjusted for our own credit spreads. The credit spreads applied to these instruments are derived from the spreads at which institutions of similar credit standing would offer for issuing similar structured instruments as of the measurement date. The market spreads for structured notes are generally lower than the credit spreads observed for plain vanilla debt or in the credit default swap market.

Long-term debt – We elected to apply fair value option to certain own debt issuances for which fair value hedge accounting otherwise would have been applied. These own debt issuances elected under FVO are traded in secondary markets and, as such, the fair value is determined based on observed prices for the specific instrument. The observed market price of these instruments reflects the effect of our own credit spreads. 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.

For long-term debt recorded at cost, fair value is determined based on quoted market prices where available. If quoted market prices are not available, fair value is based on dealer quotes, quoted prices of similar instruments, or internally developed valuation models adjusted for own credit risks.

Deposits – For fair value disclosure purposes, the carrying amount of deposits with no stated maturity (e.g., demand, savings, and certain money market deposits), which represents the amount payable upon demand, is considered to generally approximate fair value. For deposits with fixed maturities, fair value is estimated by discounting cash flows using market interest rates currently offered on deposits with similar characteristics and maturities.