Guarantee Arrangements, Pledged Assets and Collateral

Guarantee Arrangements As part of our normal operations, we enter into credit derivatives and various off-balance sheet guarantee arrangements with affiliates and third parties. These arrangements arise principally in connection with our lending and client intermediation activities and include standby letters of credit and certain credit derivative transactions. The contractual amounts of these arrangements represent our maximum possible credit exposure in the event that we are required to fulfill the maximum obligation under the contractual terms of the guarantee.

The following table presents total carrying value and contractual amounts of our sell protection credit derivatives and major off-balance sheet guarantee arrangements as of September 30, 2013 and December 31, 2012. Following the table is a description of the various arrangements.



	September 30, 2013					December 31, 2012
	Carrying Value			Notional/Maximum Exposure to Loss		Carrying Value			Notional/Maximum Exposure to Loss
	(in millions)
Credit derivatives⁽¹⁾⁽⁴⁾	$	(331	)	$	198,020	$	(76	)	$	237,548
Financial standby letters of credit, net of participations⁽²⁾⁽³⁾	—			5,165		—			5,554
Performance (non-financial) guarantees⁽³⁾	—			3,119		—			2,878
Liquidity asset purchase agreements⁽³⁾	—			2,216		—			2,212
Total	$	(331	)	$	208,520	$	(76	)	$	248,192


⁽¹⁾	Includes $38.6 billion and $44.2 billion of notional issued for the benefit of HSBC affiliates at September 30, 2013 and December 31, 2012, respectively.


⁽²⁾	Includes $862 million and $808 million issued for the benefit of HSBC affiliates at September 30, 2013 and December 31, 2012, respectively.


⁽³⁾	For standby letters of credit and liquidity asset purchase agreements, maximum loss represents losses to be recognized assuming the letter of credit and liquidity facilities have been fully drawn and the obligors have defaulted with zero recovery.


⁽⁴⁾	For credit derivatives, the maximum loss is represented by the notional amounts without consideration of mitigating effects from collateral or recourse arrangements.

Credit-Risk Related Guarantees

Credit derivatives Credit derivatives are financial instruments that transfer the credit risk of a reference obligation from the credit protection buyer to the credit protection seller who is exposed to the credit risk without buying the reference obligation. We sell credit protection on underlying reference obligations (such as loans or securities) by entering into credit derivatives, primarily in the form of credit default swaps, with various institutions. We account for all credit derivatives at fair value. Where we sell credit protection to a counterparty that holds the reference obligation, the arrangement is effectively a financial guarantee on the reference obligation. Under a credit derivative contract, the credit protection seller will reimburse the credit protection buyer upon occurrence of a credit event (such as bankruptcy, insolvency, restructuring or failure to meet payment obligations when due) as defined in the derivative contract, in return for a periodic premium. Upon occurrence of a credit event, we will pay the counterparty the stated notional amount of the derivative contract and receive the underlying reference obligation. The recovery value of the reference obligation received could be significantly lower than its notional principal amount when a credit event occurs.

Certain derivative contracts are subject to master netting arrangements and related collateral agreements. A party to a derivative contract may demand that the counterparty post additional collateral in the event its net exposure exceeds certain predetermined limits and when the credit rating falls below a certain grade. We set the collateral requirements by counterparty such that the collateral covers various transactions and products, and is not allocated to specific individual contracts.

We manage our exposure to credit derivatives using a variety of risk mitigation strategies where we enter into offsetting hedge positions or transfer the economic risks, in part or in entirety, to investors through the issuance of structured credit products. We actively manage the credit and market risk exposure in the credit derivative portfolios on a net basis and, as such, retain no or a limited net sell protection position at any time. The following table summarizes our net credit derivative positions as of September 30, 2013 and December 31, 2012.



	September 30, 2013						December 31, 2012
	Carrying (Fair) Value			Notional			Carrying (Fair) Value			Notional
	(in millions)
Sell-protection credit derivative positions	$	(331	)	$	198,020		$	(76	)	$	237,548
Buy-protection credit derivative positions	366			204,971			120			247,384
Net position⁽¹⁾	$	35		$	(6,951	)	$	44		$	(9,836	)

⁽¹⁾

Positions are presented net in the table above to provide a complete analysis of our risk exposure and depict the way we manage our credit derivative portfolio. The offset of the sell-protection credit derivatives against the buy-protection credit derivatives may not be legally binding in the absence of master netting agreements with the same counterparty. Furthermore, the credit loss triggering events for individual sell protection credit derivatives may not be the same or occur in the same period as those of the buy protection credit derivatives thereby not providing an exact offset.

Standby letters of credit A standby letter of credit is issued to a third party for the benefit of a customer and is a guarantee that the customer will perform or satisfy certain obligations under a contract. It irrevocably obligates us to pay a specified amount to the third party beneficiary if the customer fails to perform the contractual obligation. We issue two types of standby letters of credit: performance and financial. A performance standby letter of credit is issued where the customer is required to perform some nonfinancial contractual obligation, such as the performance of a specific act, whereas a financial standby letter of credit is issued where the customer's contractual obligation is of a financial nature, such as the repayment of a loan or debt instrument. As of September 30, 2013, the total amount of outstanding financial standby letters of credit (net of participations) and performance guarantees were $5.2 billion and $3.1 billion, respectively. As of December 31, 2012, the total amount of outstanding financial standby letters of credit (net of participations) and performance guarantees were $5.6 billion and $2.9 billion, respectively.

The issuance of a standby letter of credit is subject to our credit approval process and collateral requirements. We charge fees for issuing letters of credit commensurate with the customer's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, which represent the value of the stand-ready obligation to perform under these guarantees, amounting to $40 million and $46 million at September 30, 2013 and December 31, 2012, respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $19 million and $19 million at September 30, 2013 and December 31, 2012, respectively.

The following table summarizes the credit ratings of credit risk related guarantees including the credit ratings of counterparties against which we sold credit protection and financial standby letters of credit as of September 30, 2013 as an indicative proxy of payment risk:



	Average Life (in years)	Credit Ratings of the Obligors or the Transactions
Notional/Contractual Amounts	Average Life (in years)	Investment Grade		Non-Investment Grade		Total
	(dollars are in millions)
Sell-protection Credit Derivatives⁽¹⁾
Single name CDS	2.4	$	116,525	$	22,946	$	139,471
Structured CDS	1.8	22,433		3,045		25,478
Index credit derivatives	3.2	21,197		666		21,863
Total return swaps	8.7	10,055		1,153		11,208
Subtotal		170,210		27,810		198,020
Standby Letters of Credit⁽²⁾	1.1	6,813		1,471		8,284
Total		$	177,023	$	29,281	$	206,304


⁽¹⁾	The credit ratings in the table represent external credit ratings for classification as investment grade and non-investment grade.


⁽²⁾	External ratings for most of the obligors are not available. Presented above are the internal credit ratings which are developed using similar methodologies and rating scale equivalent to external credit ratings for purposes of classification as investment grade and non-investment grade.

Our internal groupings are determined based on HSBC's risk rating systems and processes which assign a credit grade based on a scale which ranks the risk of default of a customer. The groupings are determined and used for managing risk and determining level of credit exposure appetite based on the customer's operating performance, liquidity, capital structure and debt service ability. In addition, we also incorporate subjective judgments into the risk rating process concerning such things as industry trends, comparison of performance to industry peers and perceived quality of management. We compare our internal risk ratings to outside external rating agency benchmarks, where possible, at the time of formal review and regularly monitor whether our risk ratings are comparable to the external ratings benchmark data.

A non-investment grade rating of a referenced obligor has a negative impact to the fair value of the credit derivative and increases the likelihood that we will be required to perform under the credit derivative contract. We employ market-based parameters and, where possible, use the observable credit spreads of the referenced obligors as measurement inputs in determining the fair value of the credit derivatives. We believe that such market parameters are more indicative of the current status of payment/performance risk than external ratings by the rating agencies which may not be forward-looking in nature and, as a result, lag behind those market-based indicators.

Mortgage Loan Repurchase Obligations

Sale of mortgage loans In the ordinary course of business, we originate and sell mortgage loans and provide various representations and warranties related to, among other things, the ownership of the loans, the validity of the liens, the loan selection and origination process, and the compliance to the origination criteria established by the agencies. In the event of a breach of our representations and warranties, we may be obligated to repurchase the loans with identified defects or to indemnify the buyers. Our contractual obligation arises only when the breach of representations and warranties are discovered and repurchase is demanded. Historically, these sales have been primarily to government sponsored entities (“GSEs”). With the conversion of our mortgage processing and servicing operations to PHH Mortgage in the second quarter of 2013, new agency eligible originations beginning with May 2013 applications are sold directly to PHH Mortgage and PHH Mortgage is responsible for origination representations and warranties for all loans purchased.

We typically first become aware that a GSE or other third party is evaluating a particular loan for repurchase when we receive a request to review the underlying loan file. Generally, the reviews focus on severely delinquent loans to identify alleged fraud, misrepresentation or file documentation issues. Upon completing its review, the GSE or other third party may submit a repurchase demand. Historically, most file requests have not resulted in repurchase demands. After receipt of a repurchase demand, we perform a detailed evaluation of the substance of the request and appeal any claim that we believe is either unsubstantiated or contains errors, leveraging both dedicated internal as well as retained external resources. In some cases, we ultimately are not required to repurchase a loan as we are able to resolve the purported defect. From initial inquiry to ultimate resolution, a typical case is usually resolved within 3 months, however some cases may take as long as 12 months to resolve. Acceptance of a repurchase demand will involve either a) repurchase of the loan at the unpaid principal balance plus accrued interest or b) reimbursement for any realized loss on a liquidated property (“make-whole” payment).

To date, a majority of the repurchase demands we have received primarily relate to prime loans sourced during 2004 through 2008 from the legacy broker channel which we exited in late 2008. Loans sold to GSEs and other third parties originated in 2004 through 2008 subject to representations and warranties for which we may be liable had an outstanding principal balance of approximately $12.6 billion and $15.1 billion at September 30, 2013 and December 31, 2012, respectively, including $8.1 billion and $9.6 billion, respectively, of loans sourced from our legacy broker channel.

The following table shows the trend in repurchase demands received on loans sold to GSEs and other third parties by loan origination vintage for the three and nine months ended September 30, 2013 and 2012:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
	(in millions)
Pre- 2004	$	1	$	2	$	4	$	5
2004	4		5		15		16
2005	13		6		20		19
2006	12		20		38		65
2007	25		51		86		170
2008	13		28		48		106
Post 2008	2		4		12		15
Total repurchase demands received⁽¹⁾	$	70	$	116	$	223	$	396


⁽¹⁾	Includes repurchase demands on loans sourced from our legacy broker channel of $55 million and $98 million for the three months ended September 30, 2013 and 2012, respectively, and $175 million and $330 million for the nine months ended September 30, 2013 and 2012, respectively.

The following table provides information about outstanding repurchase demands received from GSEs and other third parties at September 30, 2013 and December 31, 2012:



	September 30, 2013		December 31, 2012
	(in millions)
GSEs	$	64	$	86
Others	3		3
Total⁽¹⁾	$	67	$	89


⁽¹⁾	Includes repurchase demands on loans sourced from our legacy broker channel of $55 million and $65 million at September 30, 2013 and December 31, 2012, respectively.

In estimating our repurchase liability arising from breaches of representations and warranties, we consider the following:


•	The level of outstanding repurchase demands in inventory and our historical defense rate;


•	The level of outstanding requests for loan files and the related historical repurchase request conversion rate and defense rate on such loans; and


•	The level of potential future demands based on historical conversion rates of loans which we have not received a loan file request but are two or more payments delinquent or expected to become delinquent at an estimated conversion rate.

The following table summarizes the change in our estimated repurchase liability for loans sold to the GSEs and other third parties during the three and nine months ended September 30, 2013 and 2012 for obligations arising from the breach of representations and warranties associated with the sale of these loans:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	(in millions)
Balance at beginning of period	$	217		$	222		$	219		$	237
Increase in liability recorded through earnings	—			28			36			81
Realized losses	(19		)	(34		)	(57		)	(102		)
Balance at end of period	$	198		$	216		$	198		$	216

Our reserve for potential repurchase liability exposures relates primarily to previously originated mortgages through broker channels. Our mortgage repurchase liability of $198 million at September 30, 2013 represents our best estimate of the loss that has been incurred including interest, resulting from various representations and warranties in the contractual provisions of our mortgage loan sales. Because the level of mortgage loan repurchase losses is dependent upon economic factors, investor demand strategies and other external risk factors such as housing market trends that may change, the level of the liability for mortgage loan repurchase losses requires significant judgment. We have seen recent changes in investor demand trends and continue to evaluate our methods of determining the best estimate of loss based on these recent trends. As these estimates are influenced by factors outside our control, there is uncertainty inherent in these estimates making it reasonably possible that they could change. The range of reasonably possible losses in excess of our recorded repurchase liability is between zero and $160 million at September 30, 2013. This estimated range of reasonably possible losses was determined based upon modifying the assumptions utilized in our best estimate of probable losses to reflect what we believe to be reasonably possible adverse assumptions.

Written Put Options, Non Credit-Risk Related and Indemnity Arrangements

Liquidity asset purchase agreements We provide liquidity facilities to a number of multi-seller and single-seller asset-backed commercial paper conduits sponsored by affiliates and third parties. The conduits finance the purchase of individual assets by issuing commercial paper to third party investors. Each liquidity facility is transaction specific and has a maximum limit. Pursuant to the liquidity agreements, we are obligated, subject to certain limitations, to purchase the eligible assets from the conduit at an amount not to exceed the face value of the commercial paper in the event the conduit is unable to refinance its commercial paper. A liquidity asset purchase agreement is essentially a conditional written put option issued to the conduit where the exercise price is the face value of the commercial paper. As of September 30, 2013 and December 31, 2012, we have issued $2.2 billion and $2.2 billion, respectively, of liquidity facilities to provide liquidity support to the commercial paper issued by various conduits See Note 17, “Variable Interest Entities,” for further information.

Clearinghouses and exchanges We are a member of various exchanges and clearinghouses that trade and clear securities and/or futures contracts. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank"), members of a clearinghouse may be required to contribute to a guaranty fund to backstop members' obligations to the clearinghouse. As a member, we may be required to pay a proportionate share of the financial obligations of another member who defaults on its obligations to the exchange or the clearinghouse. Our guarantee obligations would arise only if the exchange or clearinghouse had exhausted its resources. Any potential contingent liability under these membership agreements cannot be estimated.

Pledged Assets Pledged assets included in the consolidated balance sheet consisted of the following.



	September 30, 2013		December 31, 2012
	(in millions)
Interest bearing deposits with banks	$	535	$	673
Trading assets⁽¹⁾	3,434		2,346
Securities available-for-sale⁽²⁾	19,976		17,236
Securities held-to-maturity	587		456
Loans⁽³⁾	3,953		2,142
Other assets⁽⁴⁾	2,692		2,265
Total	$	31,177	$	25,118


⁽¹⁾	Trading assets are primarily pledged against liabilities associated with repurchase agreements.


⁽²⁾	Securities available-for-sale are primarily pledged against derivatives, public fund deposits and various short-term and long term borrowings, as well as providing capacity for potential secured borrowings from the Federal Home Loan Bank and the Federal Reserve Bank.


⁽³⁾	Loans are primarily residential mortgage loans pledged against long-term borrowings from the Federal Home Loan Bank.


⁽⁴⁾	Other assets represent cash on deposit with non-banks related to derivative collateral support agreements.

Debt securities pledged as collateral that can be sold or repledged by the secured party continue to be reported on the consolidated balance sheet. The fair value of securities available-for-sale that can be sold or repledged was $9.3 billion and $6.5 billion at September 30, 2013 and December 31, 2012, respectively. The fair value of trading assets that can be sold or repledged was $3.4 billion and $2.2 billion at September 30, 2013 and December 31, 2012, respectively.

The fair value of collateral we accepted but not reported on the consolidated balance sheet that can be sold or repledged was $4.3 billion and $5.7 billion at September 30, 2013 and December 31, 2012, respectively. This collateral was obtained under security resale agreements. Of this collateral, $2.1 billion and $1.3 billion has been sold or repledged as collateral under repurchase agreements or to cover short sales at September 30, 2013 and December 31, 2012, respectively.

Securitization Activity In addition to the repurchase risk described above, we have also been involved as a sponsor/seller of loans used to facilitate whole loan securitizations underwritten by our affiliate, HSI. In this regard, we began acquiring residential mortgage loans beginning in 2005 which were warehoused on our balance sheet with the intent of selling them to HSI to facilitate HSI’s whole loan securitization program which was discontinued in the second half of 2007. During 2005-2007, we purchased and sold $24 billion of such loans to HSI which were subsequently securitized and sold by HSI to third parties. See "Mortgage Securitization Activity and Litigation" in Note 20, "Litigation and Regulatory Matters" for additional discussion of related exposure.

Offsetting of Resale and Repurchase Agreements and Securities Borrowing and Lending Agreements

We enter into purchases and borrowings of securities under agreements to resell (resale agreements) and sales of securities under agreements to repurchase (repurchase agreements) identical or substantially the same securities. Resale and repurchase agreements are generally accounted for as secured lending and secured borrowing transactions, respectively.

The amounts advanced under resale agreements and the amounts borrowed under repurchase agreements are carried on the consolidated balance sheets at the amount advanced or borrowed, plus accrued interest to date. Interest earned on resale agreements is reported as interest income. Interest paid on repurchase agreements is reported as interest expense. We offset resale and repurchase agreements executed with the same counterparty under legally enforceable netting agreements that meet the applicable netting criteria as permitted by generally accepted accounting principles.

Repurchase agreements may require us to deposit cash or other collateral with the lender. In connection with resale agreements, it is our policy to obtain possession of collateral, which may include the securities purchased, with market value in excess of the principal amount loaned. The market value of the collateral subject to the resale and repurchase agreements is regularly monitored, and additional collateral is obtained or provided when appropriate, to ensure appropriate collateral coverage of these secured financing transactions.

The following table provides information about repurchase agreements and resell agreements that are subject to offset as of September 30, 2013 and December 31, 2012:



					Gross Amounts Not Offset in the Balance Sheet
	Gross Amounts Recognized		Gross Amounts Offset in the Balance Sheet⁽¹⁾	Net Amounts Presented in the Balance Sheet	Financial Instruments ⁽²⁾	Cash Collateral Received / Pledged	Net Amount ⁽³⁾
	(in millions)
As of September 30, 2013:
Assets:
Securities purchased under agreements to resell	$	4,524	2,308	2,216	2,216	—	$	—
Liabilities:
Securities sold under repurchase agreements	$	14,831	2,308	12,523	12,523	—	$	—

As of December 31, 2012:
Assets:
Securities purchased under agreements to resell	$	5,736	2,587	3,149	3,146	—	$	3
Liabilities:
Securities sold under repurchase agreements	$	9,404	2,587	6,817	6,817	—	$	—


⁽¹⁾	Represents recognized amount of resale and repurchase agreements with counterparties subject to legally enforceable netting agreements that meet the applicable netting criteria as permitted by generally accepted accounting principles.


⁽²⁾	Represents securities received or pledged to cover financing transaction exposures.


⁽³⁾	Represents the amount of our exposure that is not collateralized / covered by pledged collateral.