Guarantee Arrangements and Pledged Assets

6 Months Ended

Jun. 30, 2011

Guarantee Arrangements and Pledged Assets [Abstract]

Guarantee Arrangements and Pledged Assets

18. Guarantee Arrangements and Pledged Assets

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 a 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 June 30, 2011 and December 31, 2010. Following the table is a description of the various arrangements.


	June 30, 2011				December 31, 2010
	Carrying		Notional/Maximum		Carrying			Notional/Maximum
	Value		Exposure to Loss		Value			Exposure to Loss

	(in millions)

Credit derivatives⁽¹⁾⁽⁴⁾	$	47	$	343,937	$	(831	)	$	354,780
Financial standby letters of credit, net of participations⁽²⁾⁽³⁾		-		4,403		-			4,264
Performance (non-financial) guarantees⁽³⁾		-		2,896		-			2,895
Liquidity asset purchase agreements⁽³⁾		-		911		-			1,856

Total	$	47	$	352,147	$	(831	)	$	363,795


⁽¹⁾		Includes $47.0 billion and $49.4 billion issued for the benefit of HSBC affiliates at June 30, 2011 and December 31, 2010, respectively.

⁽²⁾		Includes $550 million and $486 million issued for the benefit of HSBC affiliates at June 30, 2011 and December 31, 2010, 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 Arrangements:

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 June 30, 2011 and December 31, 2010:


	June 30, 2011				December 31, 2010
	Carrying (Fair)				Carrying (Fair)
	Value		Notional		Value			Notional

	(in millions)

Sell-protection credit derivative positions	$	47	$	343,937	$	(831	)	$	354,780
Buy-protection credit derivative positions		724		334,112		1,631			346,246

Net position⁽¹⁾	$	771	$	9,825	$	800		$	8,534


⁽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 June 30, 2011, the total amount of outstanding financial standby letters of credit (net of participations) and performance guarantees were $4.4 billion and $2.9 billion, respectively. As of December 31, 2010, the total amount of outstanding financial standby letters of credit (net of participations) and performance guarantees were $4.3 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 $45 million and $47 million at June 30, 2011 and December 31, 2010, respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $24 million and $26 million at June 30, 2011 and December 31, 2010, respectively.

Below is a summary of 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 June 30, 2011 as an indicative proxy of payment risk:


		Credit Ratings of the Obligors or the Transactions

	Average
	Life	Investment		Non-Investment
Notional/Contractual Amounts	(in years)	Grade		Grade		Total

		(dollars are in millions)

Sell-protection Credit Derivatives⁽¹⁾
Single name CDS	2.8	$	147,737	$	69,441	$	217,178
Structured CDS	2.4		63,860		5,272		69,132
Index credit derivatives	3.3		43,332		465		43,797
Total return swaps	8.2		12,755		1,075		13,830

Subtotal			267,684		76,253		343,937
Standby Letters of Credit⁽²⁾	1.2		6,608		691		7,299

Total		$	274,292	$	76,944	$	351,236


⁽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.

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 June 30, 2011 and December 31, 2010, we have issued $911 million and $1.9 billion, respectively, of liquidity facilities to provide liquidity support to the commercial paper issued by various conduits. The decline since December 31, 2010 reflects the assignment of a significant majority of these facilities to HSBC Bank plc during the first quarter of 2011. See Note 17, “Variable Interest Entities,” for further information.

Structured products We structure and sell products that provide for the return of principal to investors on a future date. These structured products have various reference assets and we are obligated to cover any shortfall between the market value of the underlying reference portfolio and the principal amount due at maturity. We manage such shortfall risk by, among other things, establishing structural and investment constraints. Additionally, the structures require liquidation of the underlying reference portfolio when certain pre-determined triggers are breached and the proceeds from liquidation are required to be invested in zero-coupon bonds that would generate sufficient funds to repay the principal amount upon maturity. We may be exposed to market (gap) risk at liquidation and, as such, may be required to make up the shortfall between the liquidation proceeds and the purchase price of the zero coupon bonds. These structured products are accounted for on a fair value basis. The notional amounts of these structured products were not material as of June 30, 2011 and December 31, 2010. We have not made any payments under the terms of these structured products and we consider the probability of such payments to be remote.

Visa covered litigation We are an equity member of Visa Inc. (“Visa”). Prior to its initial public offering (“IPO”) on March 19, 2008, Visa completed a series of transactions to reorganize and restructure its operations and to convert membership interests into equity interests. Pursuant to the restructuring, we, along with all the Class B shareholders, agreed to indemnify Visa for the claims and obligations arising from certain specific covered litigations. Class B shares are convertible into listed Class A shares upon (i) settlement of the covered litigations or (ii) the third anniversary of the IPO, whichever is later. The indemnification is subject to the accounting and disclosure requirements. Visa used a portion of the IPO proceeds to establish a $3.0 billion escrow account to fund future claims arising from those covered litigations (the escrow was subsequently increased to $4.1 billion). In 2009 and 2010, Visa exercised its rights to sell shares of existing Class B shareholders in order to increase the escrow account and announced that it had deposited collectively an additional $2.0 billion into the escrow account. As a result, we re-evaluated our contingent liability recorded relating to this litigation and reduced our liability by $24 million during 2009 and 2010. In March 2011, Visa again exercised its rights to sell shares of existing Class B shareholders and funded an additional $400 million into the escrow account and we reduced our liability by $5 million. At June 30, 2011, the net contingent liability recorded was $4 million. We do not expect these changes to result in a material adverse effect on our results of operations.

Clearinghouses and exchanges We are a member of various exchanges and clearinghouses that trade and clear securities and/or futures contracts. 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. However, we believe that any potential requirement to make payments under these agreements is remote.

Mortgage Loan Repurchase Obligations

Sale of mortgage loans In the ordinary course of business, we originate and sell mortgage loans primarily to government sponsored entities (“GSEs”) 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.

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 many 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 12 months. 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, 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 $21.1 billion and $23.0 billion at June 30, 2011 and December 31, 2010, respectively, including $13.2 billion and $14.3 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 during the three and six months ended June 30, 2011 and 2010, respectively:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2011		2010		2011		2010

	(in millions)

Pre- 2004	$	2	$	5	$	3	$	8
2004		5		3		9		7
2005		6		5		14		11
2006		9		12		23		23
2007		30		48		70		95
2008		29		24		58		55
Post 2008		22		10		46		12

Total repurchase demands received⁽¹⁾	$	103	$	107	$	223	$	211


⁽¹⁾		Includes repurchase demands on loans sourced from our legacy broker channel of $75 million and $88 million for the three months ended June 30, 2011 and 2010, respectively. Includes repurchase demands on loans sourced from our legacy broker channel of $157 million and $180 million for the six months ended June 30, 2011 and 2010, respectively.

The following table provides information about outstanding repurchase demands received from GSEs and other third parties at June 30, 2011 and December 31, 2010:


	June 30,		December 31,
	2011		2010

	(in millions)

GSEs	$	77	$	92
Others		26		23

Total⁽¹⁾	$	103	$	115


⁽¹⁾		Includes repurchase demands on loans sourced from our legacy broker channel of $77 million and $87 million at June 30, 2011 and December 31, 2010, 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 six months ended June 30, 2011 and 2010 for obligations arising from the breach of representations and warranties associated with the sale of these loans:


	Three Months						Six Months
	Ended						Ended
	June 30,						June 30,
	2011			2010			2011			2010

				(in millions)

Balance at beginning of period	$	270		$	117		$	262		$	66
Increase (decrease) in liability recorded through earnings		(4	)		117			40			190
Realized losses		(29	)		(29	)		(65	)		(51	)

Balance at end of period	$	237		$	205		$	237		$	205

Our reserve for potential repurchase liability exposures relates primarily to previously originated mortgages through broker channels. Our mortgage repurchase liability of $237 million at June 30, 2011 represents our best estimate of the loss that has been incurred resulting from various representations and warranties in the contractual provisions of our mortgage loan sales. Because the level of mortgage loan repurchase losses are 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. 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.

Pledged Assets Pledged assets included in the consolidated balance sheet are summarized in the following table.


	June 30,		December 31,
	2011		2010

	(in millions)

Interest bearing deposits with banks	$	2,659	$	1,463
Trading assets⁽¹⁾		218		319
Securities available-for-sale⁽²⁾		16,937		19,765
Securities held to maturity		501		1,004
Loans⁽³⁾		2,483		2,691
Other assets⁽⁴⁾		4,927		5,598

Total	$	27,725	$	30,840


⁽¹⁾		Trading assets are primarily pledged against liabilities associated with consolidated variable interest entities.

⁽²⁾		Securities available-for-sale are primarily pledged against 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. At December 31, 2010, loans also include private label and credit card receivables pledged against long-term secured borrowings and the loans of a consolidated commercial paper conduit that collateralize the conduit’s outstanding commercial paper.

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