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Derivative Financial Instruments
9 Months Ended
Sep. 30, 2012
Derivative Financial Instruments

11.    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 to 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 highly 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.

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.

The changes in fair value of a derivative designated in a qualifying fair value hedge, along with the effective portion of 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 a net gain of $17 million and a loss of $3 million during the three and nine months ended September 30, 2012, respectively, compared to net losses of $45 million and $46 million during the three and nine months ended September 30, 2011, respectively, which are reported in other income in the consolidated statement of income (loss) 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 amount 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 decreased the carrying amount of our debt by $3 million and $9 million during the three and nine months ended September 30, 2012, respectively, compared to $1 million and $6 million during the three and nine months ended September 30, 2011, respectively. We amortized $3 million and $9 million of basis adjustments related to terminated and/or re-designated fair value hedge relationships during the three and nine months ended September 30, 2012, respectively, compared to $3 million and $8 million during the three and nine months ended September 30, 2011, respectively. The total accumulated unamortized basis adjustment amounted to an increase in the carrying amount of our debt of $53 million as of both September 30, 2012 and December 31, 2011. Basis adjustments for active fair value hedges of available-for-sale securities increased the carrying amount of the securities by $44 million and $231 million during the three and nine months ended September 30, 2012, respectively, compared to an increase in carrying amount of $1.2 billion and $1.3 billion during the three and nine months ended September 30, 2011, respectively. Total accumulated unamortized basis adjustments for active fair value hedges of available-for-sale securities amounted to an increase in carrying amount of $937 million and $1.1 billion as of September 30, 2012 and December 31, 2011, 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)  
   

Balance Sheet

Location

    Fair Value as of    

Balance Sheet

Location

  Fair Value as of  
     

September 30,

2012

   

December 31,

2011

     

September 30,

2012

   

December 31,

2011

 
     (in millions)  

Interest rate contracts

    Other assets      $ 9      $ 4      Interest, taxes and
other liabilities
  $ 933      $ 1,134   
   

 

 

   

 

 

     

 

 

   

 

 

 

 

 

(1) 

The derivative asset and derivative liabilities presented above may be eligible for netting. 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 fair value hedges and the hedged items in fair value hedges and their location on the consolidated statement of income (loss).

 

    Gain (Loss) on
Derivative
    Gain (Loss) on
Hedged Items
    Gain (Loss) on
Derivative
    Gain (Loss) on
Hedged Items
 
    Interest
Income
(Expense)
    Other
Income
    Interest
Income
(Expense)
    Other
Income
    Interest
Income
(Expense)
    Other
Income
    Interest
Income
(Expense)
    Other
Income
 
     2012     2011  
    (in millions)  

Three Months Ended September 30,

               

Interest rate contracts/AFS securities

  $ (33   $ (41   $ 141      $ 58      $ 4      $ (1,322   $ 187      $ 1,278   

Interest rate contracts/commercial loans

    -        -        -        -        (6     1        -        (1

Interest rate contracts/subordinated debt

    3       3        (15     (3     14        10        (32     (11
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ (30   $ (38   $ 126      $ 55      $ 12      $ (1,311   $ 155      $ 1,266   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Nine Months Ended September 30,

   

Interest rate contracts/AFS securities

  $ (117   $ (326   $ 482      $ 323      $ (18   $ (1,640   $ 506      $ 1,598   

Interest rate contracts/commercial loans

    -        -        -        -        (17     1        -        (3

Interest rate contracts/subordinated debt

    10       9        (46     (9     38        4        (70     (6
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ (107   $ (317   $ 436      $ 314      $ 3      $ (1,635   $ 436      $ 1,589   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cash Flow Hedges  We own or issue floating rate financial instruments and enter into forecasted transactions that give rise to cash flow risk exposure. 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 and certain commercial loans.

Changes in fair value associated with the effective portion of a derivative instrument designated as a qualifying cash flow hedge are recognized initially in other comprehensive income (loss). When the hedged cash flows affect earnings, the associated gain or loss from the hedging derivative previously recognized in accumulated other comprehensive income (loss) is reclassified to 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 it is probable that the hedged forecasted transaction will not occur by the end of the of the specified periods forecasted at inception, at which time the cumulative gain or loss is released into earnings. As of September 30, 2012 and December 31, 2011, active cash flow hedge relationships extend or mature through July 2036. During the three and nine months ended September 30, 2012, $4 million and $12 million, respectively, of losses related to terminated and/or re-designated cash flow hedge relationships were reclassified to earnings from accumulated other comprehensive income (loss). During the next twelve months, we expect to reclassify $14 million of remaining losses in accumulated other comprehensive income to earnings resulting from these terminated and/or re-designated cash flow hedges. During the three and nine months ended September 30, 2011, $4 million and $9 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)  
    Balance Sheet
Location
    Fair Value as of     Balance Sheet
Location
  Fair Value as of  
      

September 30,

2012

   

December 31,

2011

     

September 30,

2012

   

December 31,

2011

 
    (in millions)  

Interest rate contracts

    Other assets      $ 45      $ 29      Interest, taxes &
other liabilities
  $ 274      $ 248   
   

 

 

   

 

 

     

 

 

   

 

 

 

 

 

(1) 

The derivative assets and derivative liabilities presented above may be eligible for netting. 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 (including amounts recognized in AOCI from all terminated cash flow hedges) and their locations in the consolidated statement of income (loss).

 

     Gain (Loss)
Recognized
in AOCI on
Derivative
(Effective
Portion)
    Location of Gain
(Loss) Reclassified
from AOCI
into Income
(Effective Portion)
     Loss
Reclassified
From AOCI
into Income
(Effective
Portion)
   

Location of Loss
Recognized
in Income
on the Derivative
(Ineffective Portion  and
Amount Excluded from

Effectiveness Testing)

     Loss
Recognized in
Income on the
Derivative
(Ineffective
Portion and
Amount
Excluded from
Effectiveness
Testing)
 
     2012      2011        2012     2011        2012      2011  
      (in millions)  

Three Months Ended September 30,

                    

Interest rate contracts

   $ 14       $ (205     Other income       $ (4   $ (4     Other income       $ -       $ (6

Nine Months Ended September 30,

                    

Interest rate contracts

   $ 4       $ (219     Other income       $ (12   $ (9     Other income       $ -       $ (7

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. Credit losses arising from counterparty risk on over-the-counter derivative instruments 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 earnings. Realized and unrealized gains and losses are recognized in other income or residential mortgage banking revenue while the derivative asset or liability positions are reflected as other assets or other liabilities. As of September 30, 2012, 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 (loss). 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         Fair Value as of  
     Balance Sheet
Location
 

September 30,

2012

   

December 31,

2011

   

Balance Sheet

Location

 

September 30,

2012

   

December 31,

2011

 
    (in millions)  

Interest rate contracts

  Trading assets   $ 74,031      $ 60,719      Trading liabilities   $ 74,065      $ 61,280   

Foreign exchange contracts

  Trading assets     14,147        15,654      Trading liabilities     13,677        15,413   

Equity contracts

  Trading assets     1,070        1,165      Trading liabilities     1,067        1,164   

Precious Metals contracts

  Trading assets     771        1,842      Trading liabilities     1,910        1,248   

Credit contracts

  Trading assets     8,218        14,388      Trading liabilities     8,486        14,285   
   

 

 

   

 

 

     

 

 

   

 

 

 

Total

    $ 98,237      $ 93,768        $ 99,205      $ 93,390   
   

 

 

   

 

 

     

 

 

   

 

 

 

 

 

(1) 

The derivative assets and derivative liabilities presented above may be eligible for netting. 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
Location
 

September 30,

2012

   

December 31,

2011

   

Balance Sheet

Location

 

September 30,

2012

   

December 31,

2011

 
    (in millions)  

Interest rate contracts

  Other assets   $ 986      $ 957      Interest, taxes and
other liabilities
  $ 113      $ 106   

Foreign exchange contracts

  Other assets     33        11      Interest, taxes and
other liabilities
    31        13   

Equity contracts

  Other assets     546        51      Interest, taxes and
other liabilities
    107        87   

Credit contracts

  Other assets     1        2      Interest, taxes and
other liabilities
    5        8   
   

 

 

   

 

 

     

 

 

   

 

 

 

Total

    $ 1,566      $ 1,021        $ 256      $ 214   
   

 

 

   

 

 

     

 

 

   

 

 

 

 

 

(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.

 

    

Location of Gain (Loss)

 

Recognized in Income on Derivatives

   Amount of Gain (Loss) Recognized
in Income on Derivatives
 
        Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
             2012             2011             2012             2011      
          (in millions)  

Interest rate contracts

   Trading revenue    $ (24   $ (87   $ (8   $ (206

Interest rate contracts

   Residential mortgage banking revenue      7        120        28        118   

Foreign exchange contracts

   Trading revenue      3        (246     648        131   

Equity contracts

   Trading revenue      2        101        62        105   

Precious Metals contracts

   Trading revenue      44        175        96        97   

Credit contracts

   Trading revenue      (27     (176     (1,695     (86
     

 

 

   

 

 

   

 

 

   

 

 

 

Total

      $ 5      $ (113   $ (869   $ 159   
     

 

 

   

 

 

   

 

 

   

 

 

 

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

 

    

Location of Gain (Loss)

 

Recognized in Income on Derivatives

   Amount of Gain (Loss) Recognized
in Income on Derivatives
 
        Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
             2012             2011             2012             2011      
          (in millions)  

Interest rate contracts

   Other income    $ 15      $ 494      $ 120      $ 628   

Interest rate contracts

   Residential mortgage banking revenue      (5     3        -        (8

Foreign exchange contracts

   Other income      23        23        73        22   

Equity contracts

   Other income      351        (508     597        (316

Credit contracts

   Other income      -        5        (3     2   
     

 

 

   

 

 

   

 

 

   

 

 

 

Total

      $ 384      $ 17      $ 787      $ 328   
     

 

 

   

 

 

   

 

 

   

 

 

 

Credit-Risk Related Contingent Features  We enter into total return swap, interest rate swap, cross-currency swap and credit default swap contracts, 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 September 30, 2012, is $10.0 billion for which we have posted collateral of $10.3 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, 2011, is $10.3 billion for which we have posted collateral of $8.5 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 20, “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 (relative to the current collateral level) in certain hypothetical commercially reasonable downgrade scenarios. It is not appropriate to accumulate or extrapolate information presented in the tables 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    A1      A2      A3  
     (in millions)  

P-1

   $ -       $ 71       $ 230   

P-2

     2         6         230   

 

S&P    Long-Term Ratings  
Short-Term Ratings    AA-      A+      A  
     (in millions)  

A-1+

   $ -       $ -       $ 65   

A-1

     35         100         259   

We would be required to post $41 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.

 

     

September 30,

2012

    

December 31,

2011

 
     (in billions)  

Interest rate:

     

Futures and forwards

   $ 389.3       $ 320.3   

Swaps

     2,657.0         2,325.1   

Options written

     64.9         69.9   

Options purchased

     65.0         67.3   
  

 

 

    

 

 

 
     3,176.2         2,782.6   
  

 

 

    

 

 

 

Foreign Exchange:

     

Swaps, futures and forwards

     820.4         725.0   

Options written

     51.9         39.7   

Options purchased

     53.0         40.4   

Spot

     77.3         60.1   
  

 

 

    

 

 

 
     1,002.6         865.2   
  

 

 

    

 

 

 

Commodities, equities and precious metals:

     

Swaps, futures and forwards

     54.1         50.2   

Options written

     9.5         8.2   

Options purchased

     20.4         17.1   
  

 

 

    

 

 

 
     84.0         75.5   
  

 

 

    

 

 

 

Credit derivatives

     526.0         657.3   
  

 

 

    

 

 

 

Total

   $ 4,788.8       $ 4,380.6