Derivative Financial Instruments

6 Months Ended

Jun. 30, 2011

Derivative Financial Instruments [Abstract]

10. Derivative Financial Instruments

In the normal course of business, we enter into derivative contracts for trading, market making and risk management purposes. For financial reporting purposes, a derivative instrument is designated in one of the following categories: (a) financial instruments held for trading, (b) hedging instruments designated as a qualifying hedge under derivative accounting principles or (c) a non-qualifying economic hedge. The derivative instruments held are predominantly swaps, futures, options and forward contracts. All freestanding derivatives, including bifurcated embedded derivatives, are stated at fair value. Where we enter into enforceable master netting arrangements with counterparties, the master netting arrangements permit us to net those derivative asset and liability positions and to offset cash collateral held and posted with the same counterparty.

Derivatives Held for Risk Management Purposes Our risk management policy requires us to identify, analyze and manage risks arising from the activities conducted during the normal course of business. We use derivative instruments as an asset and liability management tool to manage our exposures in interest rate, foreign currency and credit risks in existing assets and liabilities, commitments and forecasted transactions. The accounting for changes in fair value of a derivative instrument will depend on whether the derivative has been designated and qualifies for hedge accounting under derivative accounting principles.

Accounting principles for qualifying hedges require detailed documentation that describes the relationship between the hedging instrument and the hedged item, including, but not limited to, the risk management objectives and hedging strategy and the methods to assess the effectiveness of the hedging relationship. We designate derivative instruments to offset the fair value risk and cash flow risk arising from fixed-rate and floating-rate assets and liabilities as well as forecasted transactions. We assess the hedging relationships, both at the inception of the hedge and on an ongoing basis, using a regression approach to determine whether the designated hedging instrument is highly effective in offsetting changes in the fair value or cash flows of the hedged item. We discontinue hedge accounting when we determine that a derivative is not expected to be effective going forward or has ceased to be highly effective as a hedge, the hedging instrument is terminated, or when the designation is removed by us.

In the tables that follow below, the fair value disclosed does not include swap collateral that we either receive or deposit with our interest rate swap counterparties. Such swap collateral is recorded on our balance sheet at an amount which approximates fair value and is netted on the balance sheet with the fair value amount recognized for derivative instruments.

Fair Value Hedges In the normal course of business, we hold fixed-rate loans and securities and issue fixed-rate senior and subordinated debt obligations. The fair value of fixed-rate (USD and non-USD denominated) assets and liabilities fluctuates in response to changes in interest rates or foreign currency exchange rates. We utilize interest rate swaps, interest rate forward and futures contracts and foreign currency swaps to minimize the effect on earnings caused by interest rate and foreign currency volatility.

For reporting purposes, changes in fair value of a derivative designated in a qualifying fair value hedge, along with the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings. We recognized net losses of $11 million and $1 million during the three and six months ended June 30, 2011, respectively compared to net gains of $17 million and $22 million during the three and six months ended June 30, 2010, respectively, which are reported in other income in the consolidated statement of income which represents the ineffective portion of all fair value hedges. The interest accrual related to the derivative contract is recognized in interest income.

The changes in fair value of the hedged item designated in a qualifying hedge are captured as an adjustment to the carrying value of the hedged item (basis adjustment). If the hedging relationship is terminated and the hedged item continues to exist, the basis adjustment is amortized over the remaining life of the hedged item. We recorded basis adjustments for active fair value hedges which increased the carrying value of our debt by $5 million and $28 million during the six months ended June 30, 2011 and 2010, respectively. We amortized $2 million and $5 million of basis adjustments related to terminated and/or re-designated fair value hedge relationships during the three and six months ended June 30, 2011, respectively. We amortized $2 million and $4 million of basis adjustments related to terminated and/or re-designated fair value hedge relationships during the three and six months ended June 30, 2010, respectively. The total accumulated unamortized basis adjustment amounted to an increase in the carrying value of our debt of $64 million and $73 million as of June 30, 2011 and December 31, 2010, respectively. Basis adjustments for active fair value hedges of available-for-sale securities increased the carrying value of the securities by $163 million and $128 million during the three and six months ended June 30, 2011 compared to an increase in the carrying value of the securities by $341 million and $364 million during the three and six months ended June 30, 2010, respectively. Total accumulated unamortized basis adjustments for active fair value hedges of available-for-sale securities amounted to an increase in carrying value of $128 million and an increase in carrying value of $71 million as of June 30, 2011 and December 31, 2010, respectively.

The following table presents the fair value of derivative instruments that are designated and qualifying as fair value hedges and their location on the balance sheet.

Derivative Assets⁽¹⁾

Derivative Liabilities⁽¹⁾

Fair Value as of

Balance Sheet

June 30,

December 31,

Balance Sheet

June 30,

December 31,

Location

2011

2010

Location

2011

2010

(in millions)

Interest rate contracts

Other assets

140

Interest, taxes & other liabilities

168

164


⁽¹⁾		The derivative asset and derivative liabilities presented above may be eligible for netting and consequently may be shown net against a different line item on the consolidated balance sheet. Balance sheet categories in the above table represent the location of the assets and liabilities absent the netting of the balances.

The following table presents the gains and losses on derivative instruments designated and qualifying as hedging instruments in fair value hedges and their locations on the consolidated statement of income.


		Amount of Gain (Loss) Recognized
		in Income on Derivatives
	Location of Gain (Loss)	Three Months Ended						Six Months Ended
	Recognized in Income on	June 30,						June 30,
	Derivatives	2011			2010			2011			2010

		(in millions)

Interest rate contracts	Other income	$	(369	)	$	(473	)	$	(324	)	$	(486	)
Interest rate contracts	Interest income		(7	)		20			(9	)		37

Total		$	(376	)	$	(453	)	$	(333	)	$	(449	)

The following table presents information on gains and losses on the hedged items in fair value hedges and their location on the consolidated statement of income.


	Gain (Loss) on						Gain (Loss) on						Gain (Loss) on						Gain (Loss) on
	Derivative						Hedged Items						Derivative						Hedged Items
	Interest						Interest						Interest						Interest
	Income			Other			Income			Other			Income			Other			Income			Other
	(Expense)			Income			(Expense)			Income			(Expense)			Income			(Expense)			Income

Three Months Ended June 30,	2011												2010

	(in millions)

Interest rate contracts/AFS securities	$	(13	)	$	(370	)	$	187		$	367		$	(15	)	$	(473	)	$	88		$	485
Interest rate contracts/commercial loans		(6	)		-			-			(1	)		-			-			-			-
Interest rate contracts/subordinated debt		12			1			(20	)		(8	)		35			-			(22	)		5

Total	$	(7	)	$	(369	)	$	167		$	358		$	20		$	(473	)	$	66		$	490

Six Months Ended June 30,
Interest rate contracts/AFS securities	$	(22	)	$	(318	)	$	319		$	320		$	(18	)	$	(513	)	$	132		$	524
Interest rate contracts/commercial loans		(11	)		1			-			(2	)		(1	)		1			1			(1	)
Interest rate contracts/subordinated debt		24			(7	)		(38	)		5			56			26			(63	)		(15	)

Total	$	(9	)	$	(324	)	$	281		$	323		$	37		$	(486	)	$	70		$	508

Cash Flow Hedges We own or issue floating rate financial instruments and enter into forecasted transactions that give rise to variability in future cash flows. As a part of our risk management strategy, we use interest rate swaps, currency swaps and futures contracts to mitigate risk associated with variability in the cash flows. We also hedge the variability in interest cash flows arising from on-line savings deposits.

Changes in fair value associated with the effective portion of a derivative instrument designated as a qualifying cash flow hedge are recognized initially in accumulated other comprehensive income (loss). When the cash flows for which the derivative is hedging materialize and are recorded in income or expense, the associated gain or loss from the hedging derivative previously recorded in accumulated other comprehensive income (loss) is recognized in earnings. If a cash flow hedge of a forecasted transaction is de-designated because it is no longer highly effective, or if the hedge relationship is terminated, the cumulative gain or loss on the hedging derivative to that date will continue to be reported in accumulated other comprehensive income (loss) unless the hedged forecasted transaction is no longer expected to occur, at which time the cumulative gain or loss is released into earnings. As of June 30, 2011 and December 31, 2010, active cash flow hedge relationships extend or mature through June 2031 and December 2012, respectively. During the three and six months ended June 30, 2011, $2 million and $5 million, respectively, of losses related to terminated and/or re-designated cash flow hedge relationships were amortized to earnings from accumulated other comprehensive income (loss). During the next twelve months, we expect to amortize $13 million of remaining losses to earnings resulting from these terminated and/or re-designated cash flow hedges. During the three and six months ended June 30, 2010, $2 million and $5 million, respectively, of losses related to terminated and/or re-designated cash flow hedge relationships were amortized to earnings from accumulated other comprehensive income (loss). The interest accrual related to the derivative contract is recognized in interest income.

The following table presents the fair value of derivative instruments that are designated and qualifying as cash flow hedges and their location on the consolidated balance sheet.

Derivative Assets⁽¹⁾

Derivative Liabilities⁽¹⁾

Fair Value as of

Balance Sheet

June 30,

December 31,

Balance Sheet

June 30,

December 31,

Location

2011

2010

Location

2011

2010

(in millions)

Interest rate contracts

Other assets

Interest, taxes & other liabilities


⁽¹⁾		The derivative assets and derivative liabilities presented above may be eligible for netting and consequently may be shown net against a different line item on the consolidated balance sheet. Balance sheet categories in the above table represent the location of the assets and liabilities absent the netting of the balances.

The following table presents information on gains and losses on derivative instruments designated and qualifying as hedging instruments in cash flow hedges and their locations on the income statement.

Gain (Loss)

Recognized in

Income on the

Gain (Loss)

Derivative

Recognized

Location of Gain

Reclassified

Location of Gain

(Ineffective

in Accumulated

(Loss) Reclassified

From Accumulated

(Loss) Recognized

Portion and

Other Comprehensive

From Accumulated

Other Comprehensive

in Income

Amount

Income (Loss) on

Other Comprehensive

Income (Loss)

on the Derivative

Excluded from

on Derivative

Income (Loss)

into Income

(Ineffective Portion and

Effectiveness

(Effective Portion)

into Income

(Effective Portion)

Amount Excluded from

Testing)

2011

2010

(Effective Portion)

2011

2010

Effectiveness Testing)

2011

2010

(in millions)

Three Months Ended June 30,

Interest rate contracts

)

Other income

)

Other income

Six Months Ended June 30,

Interest rate contracts

(14

)

Other income

)

Other income

)

Trading and Other Derivatives In addition to risk management, we enter into derivative instruments for trading and market making purposes, to repackage risks and structure trades to facilitate clients’ needs for various risk taking and risk modification purposes. We manage our risk exposure by entering into offsetting derivatives with other financial institutions to mitigate the market risks, in part or in full, arising from our trading activities with our clients. In addition, we also enter into buy protection credit derivatives with other market participants to manage our counterparty credit risk exposure. Where we enter into derivatives for trading purposes, realized and unrealized gains and losses are recognized in trading revenue or residential mortgage banking revenue (loss). Credit losses arising from counterparty risk on over-the-counter derivative instruments and offsetting buy protection credit derivative positions are recognized as an adjustment to the fair value of the derivatives and are recorded in trading revenue.

Derivative instruments designated as economic hedges that do not qualify for hedge accounting are recorded at fair value through profit and loss. Realized and unrealized gains and losses are recognized in other income or residential mortgage banking revenue (loss) while the derivative asset or liability positions are reflected as other assets or other liabilities. As of June 30, 2011, we have entered into credit default swaps which are designated as economic hedges against the credit risks within our loan portfolio. In the event of an impairment loss occurring in a loan that is economically hedged, the impairment loss is recognized as provision for credit losses while the gain on the credit default swap is recorded as other income (expense). In addition, we also from time to time have designated certain forward purchase or sale of to-be-announced (“TBA”) securities to economically hedge mortgage servicing rights. Changes in the fair value of TBA positions, which are considered derivatives, are recorded in residential mortgage banking revenue.

The following table presents the fair value of derivative instruments held for trading purposes and their location on the consolidated balance sheet.

Derivative Assets⁽¹⁾

Derivative Liabilities⁽¹⁾

Fair Value as of

Balance Sheet

June 30,

December 31,

Balance Sheet

June 30,

December 31,

Location

2011

2010

Location

2011

2010

(in millions)

Interest rate contracts

Trading assets

32,414

32,047

Trading liabilities

33,309

32,526

Foreign exchange contracts

Trading assets

17,781

16,367

Trading liabilities

18,789

16,742

Equity contracts

Trading assets

1,040

950

Trading liabilities

1,055

986

Precious Metals contracts

Trading assets

853

1,004

Trading liabilities

1,019

2,073

Credit contracts

Trading assets

11,615

12,766

Trading liabilities

11,337

12,506

Other

Trading assets

Trading liabilities

Total

63,703

63,138

65,509

64,856


⁽¹⁾		The derivative assets and derivative liabilities presented above may be eligible for netting and consequently may be shown net against a different line item on the consolidated balance sheet. Balance sheet categories in the above table represent the location of the assets and liabilities absent the netting of the balances.

The following table presents the fair value of derivative instruments held for other purposes and their location on the balance sheet.


	Derivative Assets⁽¹⁾					Derivative Liabilities⁽¹⁾
		Fair Value as of					Fair Value as of
	Balance Sheet	June 30,		December 31,		Balance Sheet	June 30,		December 31,
	Location	2011		2010		Location	2011		2010

	(in millions)

Interest rate contracts	Other assets	$	431	$	420	Interest, taxes & other liabilities	$	60	$	82
Foreign exchange contracts	Other assets		105		96	Interest, taxes & other liabilities		3		4
Equity contracts	Other assets		103		221	Interest, taxes & other liabilities		7		10
Credit contracts	Other assets		1		2	Interest, taxes & other liabilities		14		17

Total		$	640	$	739		$	84	$	113


⁽¹⁾		The derivative assets and derivative liabilities presented above may be eligible for netting and consequently may be shown net against a different line item on the consolidated balance sheet. Balance sheet categories in the above table represent the location of the assets and liabilities absent the netting of the balances.

The following table presents information on gains and losses on derivative instruments held for trading purposes and their locations on the statement of income.


		Amount of Gain (Loss) Recognized
		in Income on Derivatives
	Location of Gain (Loss)	Three Months Ended						Six Months Ended
	Recognized in Income on	June 30,						June 30,
	Derivatives	2011			2010			2011			2010

		(in millions)

Interest rate contracts	Trading revenue	$	(171	)	$	(66	)	$	(115	)	$	(93	)
Interest rate contracts	Residential mortgage banking revenue		32			117			(2	)		101
Foreign exchange contracts	Trading revenue		203			37			378			(70	)
Equity contracts	Trading revenue		2			(4	)		3			10
Precious Metals contracts	Trading revenue		(47	)		139			(78	)		304
Credit contracts	Trading revenue		102			64			90			31
Other	Trading revenue		(17	)		-			(4	)		12

Total		$	104		$	287		$	272		$	295

The following table presents information on gains and losses on derivative instruments held for other purposes and their locations on the statement of income.


		Amount of Gain (Loss) Recognized
		in Income on Derivatives
	Location of Gain (Loss)	Three Months Ended						Six Months Ended
	Recognized in Income	June 30,						June 30,
	on Derivatives	2011			2010			2011			2010

		(in millions)

Interest rate contracts	Other income	$	146		$	334		$	135		$	385
Interest rate contracts	Residential mortgage banking revenue		1			(10	)		(11	)		(15	)
Foreign exchange contracts	Other income		6			6			(1	)		6
Equity contracts	Other income		89			(267	)		192			(125	)
Credit contracts	Other income		(1	)		5			(3	)		(4	)

Total		$	241		$	68		$	312		$	247

Credit-Risk Related Contingent Features We enter into total return swap, interest rate swap, cross-currency swap and credit default swap contracts, amongst others which contain provisions that require us to maintain a specific credit rating from each of the major credit rating agencies. Sometimes the derivative instrument transactions are a part of broader structured product transactions. If HSBC Bank USA’s credit ratings were to fall below the current ratings, the counterparties to our derivative instruments could demand additional collateral to be posted with them. The amount of additional collateral required to be posted will depend on whether HSBC Bank USA is downgraded by one or more notches as well as whether the downgrade is in relation to long-term or short-term ratings. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a liability position as of June 30, 2011, is $8.0 billion for which we have posted collateral of $7.6 billion. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a liability position as of December 31, 2010, is $5.1 billion for which we have posted collateral of $7.3 billion. Substantially all of the collateral posted is in the form of cash which is reflected in either interest bearing deposits with banks or other assets. See Note 18, “Guarantee Arrangements and Pledged Assets,” for further details.

In the event of a credit downgrade, we do not expect HSBC Bank USA’s long-term ratings to go below A2 and A+ or the short-term ratings to go below P-2 and A-1 by Moody’s and S&P, respectively. The following tables summarize our obligation to post additional collateral (from the current collateral level) in certain hypothetical commercially reasonable downgrade scenarios. It is not appropriate to accumulate or extrapolate information presented in the table below to determine our total obligation because the information presented to determine the obligation in hypothetical rating scenarios is not mutually exclusive.


Moody’s	Long-Term Ratings
Short-Term Ratings	Aa3		A1		A2

	(in millions)

P-1	$	-	$	4	$	66
P-2		50		53		114


S&P	Long-Term Ratings
Short-Term Ratings	AA		AA−		A+

	(in millions)

A-1+	$	-	$	214	$	217
A-1		77		292		294

We would be required to post $80 million of additional collateral on total return swaps and certain other transactions if HSBC Bank USA is downgraded by S&P and Moody’s by two notches on our long term rating accompanied by one notch downgrade in our short term rating.

Notional Value of Derivative Contracts The following table summarizes the notional values of derivative contracts.


	June 30,		December 31,
	2011		2010

	(in billions)

Interest rate:
Futures and forwards	$	150.6	$	356.9
Swaps		2,036.1		1,773.0
Options written		74.0		62.9
Options purchased		75.2		63.9

		2,335.9		2,256.7

Foreign Exchange:
Swaps, futures and forwards		761.5		603.3
Options written		40.5		22.0
Options purchased		41.0		22.3
Spot		86.6		56.5

		929.6		704.1

Commodities, equities and precious metals:
Swaps, futures and forwards		33.8		36.1
Options written		8.9		9.1
Options purchased		17.0		16.4

		59.7		61.6

Credit derivatives		678.0		701.0

Total	$	4,003.2	$	3,723.4