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Guarantee Arrangements, Pledged Assets and Repurchase Agreements
6 Months Ended
Jun. 30, 2018
Commitments and Contingencies Disclosure [Abstract]  
Guarantee Arrangements, Pledged Assets and Collateral
Guarantee Arrangements, Pledged Assets and Repurchase Agreements
 
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 at June 30, 2018 and December 31, 2017. Following the table is a description of the various arrangements.
 
June 30, 2018
 
December 31, 2017
  
Carrying
Value
 
Notional / Maximum
Exposure to Loss
 
Carrying
Value
 
Notional / Maximum
Exposure to Loss
 
(in millions)
Credit derivatives(1)(2)
$
(158
)
 
$
42,543

 
$
303

 
$
42,328

Financial standby letters of credit, net of participations(3)(4)

 
5,456

 

 
5,128

Performance standby letters of credit, net of participations(3)(4)

 
3,629

 

 
3,580

Total
$
(158
)
 
$
51,628

 
$
303

 
$
51,036

 
(1) 
Includes $23,033 million and $25,639 million of notional issued for the benefit of HSBC affiliates at June 30, 2018 and December 31, 2017, respectively.
(2) 
For credit derivatives, the maximum loss is represented by the notional amounts without consideration of mitigating effects from collateral or recourse arrangements.
(3) 
Includes $1,194 million and $1,264 million of both financial and performance standby letters of credit issued for the benefit of HSBC affiliates at June 30, 2018 and December 31, 2017, respectively.
(4) 
For standby letters of credit, maximum loss represents losses to be recognized assuming the letters of credit have been fully drawn and the obligors have defaulted with zero recovery.
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 position at any time. The following table summarizes our net credit derivative positions at June 30, 2018 and December 31, 2017:
 
June 30, 2018
 
December 31, 2017
  
Carrying / Fair
Value
 
Notional
 
Carrying / Fair
Value
 
Notional
 
(in millions)
Sell-protection credit derivative positions
$
(158
)
 
$
42,543

 
$
303

 
$
42,328

Buy-protection credit derivative positions
335

 
48,538

 
(188
)
 
47,962

Net position(1)
$
177

 
$
5,995

 
$
115

 
$
5,634

 
(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 client and is a guarantee that the client 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 client 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 client is required to perform some non-financial contractual obligation, such as the performance of a specific act, whereas a financial standby letter of credit is issued where the client's contractual obligation is of a financial nature, such as the repayment of a loan or debt instrument. At June 30, 2018, the total amount of outstanding financial standby letters of credit (net of participations) and performance guarantees (net of participations) were $5,456 million and $3,629 million, respectively. At December 31, 2017, the total amount of outstanding financial standby letters of credit (net of participations) and performance guarantees (net of participations) were $5,128 million and $3,580 million, 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 client's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit amounting to $46 million and $48 million at June 30, 2018 and December 31, 2017, respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $18 million and $26 million at June 30, 2018 and December 31, 2017, respectively.
The following table summarizes the credit ratings related to guarantees including the ratings of counterparties against which we sold credit protection and financial standby letters of credit at June 30, 2018 as an indicative proxy of payment risk:
 
Average
Life
(in years)
 
Credit Ratings of the Obligors or the Transactions
Notional/Contractual Amounts
Investment
Grade
 
Non-Investment
Grade
 
Total
 
 
 
(dollars are in millions)
Sell-protection Credit Derivatives(1)
 
 
 
 
 
 
 
Single name credit default swaps ("CDS")
3.1
 
$
24,417

 
$
7,342

 
$
31,759

Index credit derivatives
4.5
 
5,293

 
3,910

 
9,203

Total return swaps
2.1
 
1,297

 
284

 
1,581

Subtotal
 
 
31,007

 
11,536

 
42,543

Standby Letters of Credit(2)
1.0
 
7,563

 
1,522

 
9,085

Total
 
 
$
38,570

 
$
13,058

 
$
51,628

 
(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 credit ratings 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 client. The credit grades are assigned and used for managing risk and determining level of credit exposure appetite based on the client'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.
Non Credit-Risk Related Guarantees and Other Arrangements
Visa covered litigation  In 2008, we received Class B Shares as part of Visa's initial public offering ("IPO"). Pursuant to the IPO, we, along with all the other Class B shareholders, agreed to indemnify Visa for the claims and obligations arising from certain specific covered litigation. The Class B Shares are not eligible to be converted into publicly traded Class A Shares until settlement of the covered litigation described in Note 27, "Litigation and Regulatory Matters," in our 2017 Form 10-K and in Note 20, "Litigation and Regulatory Matters," in this Form 10-Q. Accordingly, the Class B Shares are considered restricted and are only transferable under limited circumstances, which include transfers to other Class B shareholders.
Beginning in late 2016 and into 2017, we sold substantially all of our remaining Visa Class B Shares to a third party. The net pre-tax gains associated with these sales (which included net pre-tax gains of approximately $166 million and $312 million during the three and six months ended June 30, 2017, respectively) were recorded as a component of other income in the consolidated statement of income. Under the terms of the sale agreements, we entered into swap agreements with the purchaser to retain the litigation risk associated with the Class B Shares sold until the related litigation is settled and the Class B Shares can be converted into Class A Shares. These swaps had a carrying value of $59 million and $52 million at June 30, 2018 and December 31, 2017, respectively. The swap agreements we entered into with the purchaser requires us to (a) make periodic payments, calculated by reference to the market price of Class A Shares and (b) make or receive payments based on subsequent changes in the conversion rate of Class B Shares into Class A Shares. In the third quarter of 2017, we entered into a total return swap position to economically hedge the periodic payments made under these swap agreements. The payments under the derivative will continue until the Class B Shares are able to be converted into Class A Shares. During the second quarter of 2018, we recorded a loss of $7 million related to a change in the Visa Class B Share conversion rate announced by Visa as a result of the outstanding litigation. The fair value of the swap agreements is estimated using a discounted cash flow methodology and is dependent upon the final resolution of the related litigation. Changes in fair value between periods are recognized in other income. See Note 9, "Derivative Financial Instruments," for further information.
Clearing houses and exchanges  We are a member of various exchanges and clearing houses that trade and clear securities and/or derivatives contracts. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, members of a clearing house may be required to contribute to a guaranty fund to backstop members' obligations to the clearing house. 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 clearing house. Our guarantee obligations would arise only if the exchange or clearing house had exhausted its resources. Any potential contingent liability under these membership agreements cannot be estimated.
Mortgage Loan Repurchase Obligations  We have provided various representations and warranties related to the origination and sale of mortgage loans including, 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 government 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. From 2013 to 2017, agency-eligible mortgage loan originations were sold directly to PHH Mortgage and PHH Mortgage is responsible for origination representations and warranties for all loans purchased. With the insourcing of our mortgage fulfillment operations, effective with applications starting January 2, 2018, we are now responsible for origination representations and warranties for all new agency-eligible mortgage loan originations sold to third parties.
In estimating our repurchase liability arising from breaches of representations and warranties, we consider historical losses on residual risks not covered by settlement agreements adjusted for any risk factors not captured in the historical losses as well as the level of outstanding repurchase demands received. Outstanding repurchase demands received totaled $2 million and $3 million at June 30, 2018 and December 31, 2017, respectively.
The following table summarizes the change in our estimated repurchase liability during the three and six months ended June 30, 2018 and 2017 for obligations arising from the breach of representations and warranties associated with mortgage loans sold:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(in millions)
Balance at beginning of period
$
10

 
$
11

 
$
10

 
$
12

Decrease in liability recorded through earnings
(1
)
 
(1
)
 
(1
)
 
(1
)
Realized losses

 
1

 

 

Balance at end of period
$
9

 
$
11

 
$
9

 
$
11


Our repurchase liability of $9 million at June 30, 2018 represents our best estimate of the loss that has been incurred, including interest, arising from breaches of representations and warranties associated with mortgage loans sold. 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 continue to evaluate our methods of determining the best estimate of loss based on 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 $25 million at June 30, 2018. 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.
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 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 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 Matters" in Note 27, "Litigation and Regulatory Matters," in our 2017 Form 10-K and in Note 20, "Litigation and Regulatory Matters," in this Form 10-Q for additional discussion of related exposure. The outstanding principal balance on these loans was approximately $3.9 billion and $4.1 billion at June 30, 2018 and December 31, 2017, respectively.
Pledged Assets
Pledged assets included in the consolidated balance sheet consisted of the following:
 
June 30, 2018
 
December 31, 2017
 
(in millions)
Interest bearing deposits with banks
$
3,040

 
$
2,952

Trading assets(1)
2,986

 
3,185

Securities available-for-sale(2)
7,043

 
7,210

Securities held-to-maturity(2)
1,894

 
2,131

Loans(3) 
16,489

 
17,404

Other assets(4)
2,566

 
2,253

Total
$
34,018

 
$
35,135

 
(1) 
Trading assets are primarily pledged against liabilities associated with repurchase agreements.
(2) 
Securities are primarily pledged against derivatives, public fund deposits, trust deposits and various short-term and long term borrowings, as well as providing capacity for potential secured borrowings from the Federal Home Loan Bank of New York ("FHLB") and the Federal Reserve Bank of New York.
(3) 
Loans are primarily residential mortgage loans pledged against current and potential borrowings from the FHLB and the Federal Reserve Bank of New York.
(4) 
Other assets represent cash on deposit with non-banks related to derivative collateral support agreements.
Debt securities pledged as collateral under repurchase agreements 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 could be sold or repledged was $1,335 million and $524 million at June 30, 2018 and December 31, 2017, respectively. The fair value of trading assets that could be sold or repledged was $2,982 million and $3,185 million at June 30, 2018 and December 31, 2017, respectively.
The fair value of collateral we accepted under security resale agreements but was not reported on the consolidated balance sheet was $13,919 million and $34,759 million at June 30, 2018 and December 31, 2017, respectively, discussed further below. Of this collateral, $12,419 million and $32,459 million could be sold or repledged at June 30, 2018 and December 31, 2017, respectively, of which $1,333 million and $1,231 million, respectively, had been sold or repledged as collateral under repurchase agreements or to cover short sales.
The above discussion does not include a security-for-security lending transaction of $500 million at June 30, 2018 under which we acted as lender and received securities that can be sold or repledged as collateral. We recognized the securities received as a component of other assets and the obligation to return those securities as a component of interest, taxes and other liabilities. In July 2018, the security-for-security lending transaction matured and the securities we had received as collateral were returned to the borrower.
Repurchase Agreements
We enter into purchases 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 accounted for as secured lending and secured borrowing transactions, respectively.
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 resale and repurchase agreements that are subject to offset at June 30, 2018 and December 31, 2017:
 
 
 
 
 
 
 
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)
At June 30, 2018
 
 
 
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
 
 
 
Securities purchased under resale agreements
$
12,919

 
$
2,743

 
$
10,176

 
$
10,171

 
$

 
$
5

Liabilities:
 
 
 
 
 
 
 
 
 
 
 
Securities sold under repurchase agreements
$
5,486

 
$
2,743

 
$
2,743

 
$
2,737

 
$

 
$
6

 
 
 
 
 
 
 
 
 
 
 
 
At December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
 
 
 
Securities purchased under resale agreements
$
33,974

 
$
1,356

 
$
32,618

 
$
32,616

 
$

 
$
2

Liabilities:
 
 
 
 
 
 
 
 
 
 
 
Securities sold under repurchase agreements
$
4,721

 
$
1,356

 
$
3,365

 
$
3,364

 
$

 
$
1

 
(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.
The following table provides the class of collateral pledged and remaining contractual maturity of repurchase agreements accounted for as secured borrowings at June 30, 2018 and December 31, 2017:
 
Overnight and Continuous
 
Up to 30 Days
 
31 to 90 Days
 
91 Days to One Year
 
Greater Than One Year
 
Total
 
(in millions)
At June 30, 2018
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury, U.S. Government sponsored and U.S. Government agency securities
$
2,702

 
$
780

 
$
298

 
$
591

 
$
1,000

 
$
5,371

Foreign debt securities

 
115

 

 

 

 
115

Total repurchase agreements accounted for as secured borrowings
$
2,702

 
$
895

 
$
298

 
$
591

 
$
1,000

 
$
5,486

 
 
 
 
 
 
 
 
 
 
 
 
At December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury, U.S. Government sponsored and U.S. Government agency securities
$
1,166

 
$
838

 
$
888

 
$
284

 
$
1,464

 
$
4,640

Foreign debt securities

 
81

 

 

 

 
81

Total repurchase agreements accounted for as secured borrowings
$
1,166

 
$
919

 
$
888

 
$
284

 
$
1,464

 
$
4,721