Fair Value Option

9 Months Ended

Sep. 30, 2012

12. Fair Value Option

We report our results to HSBC in accordance with its reporting basis, International Financial Reporting Standards (“IFRSs”). We have elected to apply fair value option accounting to selected financial instruments in most cases to align the measurement attributes of those instruments under U.S. GAAP and IFRSs and to simplify the accounting model applied to those financial instruments. We elected to apply fair value option (“FVO”) reporting to certain commercial loans including commercial leveraged acquisition finance loans and related unfunded commitments, certain fixed rate long-term debt issuances and hybrid instruments which include all structured notes and structured deposits. Changes in fair value of these assets and liabilities are reported as gain (loss) on instruments designated at fair value and related derivatives in the consolidated statement of income (loss).

Loans We elected to apply FVO to all commercial leveraged acquisition finance loans held for sale and related unfunded commitments. The election allows us to account for these loans and commitments at fair value which is consistent with the manner in which the instruments are managed. As of September 30, 2012, commercial leveraged acquisition finance loans held for sale and related unfunded commitments of $424 million carried at fair value had an aggregate unpaid principal balance of $449 million. As of December 31, 2011, commercial leveraged acquisition finance loans held for sale and related unfunded commitments of $377 million carried at fair value had an aggregate unpaid principal balance of $448 million.

These loans are included in loans held for sale in the consolidated balance sheet. Interest from these loans is recorded as interest income in the consolidated statement of income (loss). Because a substantial majority of the loans elected for the fair value option are floating rate assets, changes in their fair value are primarily attributable to changes in loan-specific credit risk factors. The components of gain (loss) related to loans designated at fair value are summarized in the table below. As of September 30, 2012 and December 31, 2011, no loans for which the fair value option has been elected are 90 days or more past due or on nonaccrual status.

Long-Term Debt (Own Debt Issuances) We elected to apply FVO to certain fixed-rate long-term debt for which we had applied or otherwise would elect to apply fair value hedge accounting. The election allows us to achieve a similar accounting effect without meeting the rigorous hedge accounting requirements. We measure the fair value of these debt issuances based on inputs observed in the secondary market. Changes in fair value of these instruments are attributable to changes of our own credit risk and interest rates.

Fixed-rate debt accounted for under FVO at September 30, 2012 carried at a fair value of $2.0 billion had an aggregate unpaid principal balance of $1.8 billion. Fixed-rate debt accounted for under FVO at December 31, 2011 carried at a fair value of $1.7 billion had an aggregate unpaid principal balance of $1.8 billion. Interest on the fixed-rate debt accounted for under FVO is recorded as interest expense in the consolidated statement of income (loss). The components of gain (loss) related to long-term debt designated at fair value are summarized in the table below.

Hybrid Instruments We elected to apply fair value option accounting to all of our hybrid instruments, inclusive of structured notes and structured deposits, issued after January 1, 2006. As of September 30, 2012, interest bearing deposits in domestic offices included $9.4 billion of structured deposits accounted for under FVO which had an unpaid principal balance of $9.0 billion. As of December 31, 2011, interest bearing deposits in domestic offices included $9.8 billion of structured deposits accounted for under FVO which had an unpaid principal balance of $9.6 billion. Long-term debt at September 30, 2012 included structured notes of $5.7 billion accounted for under FVO which had an unpaid principal balance of $5.5 billion. Long-term debt at December 31, 2011 included structured notes of $3.4 billion accounted for under FVO which had an unpaid principal balance of $3.5 billion. Interest on this debt is recorded as interest expense in the consolidated statement of income (loss). We enter into derivative contracts to offset our exposure to interest rate risk on these instruments. The components of gain (loss) related to hybrid instruments designated at fair value which reflect the instruments described above are summarized in the table below.

Components of Gain on Instruments at Fair Value and Related Derivatives Gain (loss) on instruments designated at fair value and related derivatives includes the changes in fair value related to both interest and credit risk as well as the mark-to-market adjustment on derivatives related to the debt designated at fair value and net realized gains or losses on these derivatives. The components of gain (loss) on instruments designated at fair value and related derivatives related to the changes in fair value of fixed rate debt accounted for under FVO are as follows:


	Three Months Ended September 30,
	2012											2011
	Loans		Long- Term Debt			Hybrid Instruments			Total			Loans			Long- Term Debt			Hybrid Instruments			Total
	(in millions)
Interest rate component	$	1	$	14		$	(389	)	$	(374	)	$	(5	)	$	(296	)	$	300		$	(1	)
Credit risk component		14		(179	)		(39	)		(204	)		(41	)		368			48			375

Total mark-to-market on financial instruments designated at fair value		15		(165	)		(428	)		(578	)		(46	)		72			348			374
Net realized gains on the financial instrument		1		-			-			1			(3	)		-			-			(3	)
Mark-to-market on the related derivatives		-		(21	)		396			375			1			328			(338	)		(9	)
Net realized gain (losses) on the related derivatives		-		15			-			15			-			17			-			17

Gain (loss) on instruments designated at fair value and related derivatives	$	16	$	(171	)	$	(32	)	$	(187	)	$	(48	)	$	417		$	10		$	379


	Nine Months Ended September 30,
	2012											2011
	Loans		Long- Term Debt			Hybrid Instruments			Total			Loans			Long- Term Debt			Hybrid Instruments			Total
	(in millions)
Interest rate component	$	2	$	(26	)	$	(744	)	$	(768	)	$	(7	)	$	(312	)	$	(11	)	$	(330	)
Credit risk component		48		(269	)		(62	)		(283	)		(25	)		375			86			436

Total mark-to-market on financial instruments designated at fair value		50		(295	)		(806	)		(1,051	)		(32	)		63			75			106
Net realized gains on the financial instrument		-		-			-			-			(1	)		-			-			(1	)
Mark-to-market on the related derivatives		-		6			741			747			-			344			(58	)		286
Net realized gain (losses) on the related long-term debt derivatives		-		46			-			46			-			49			-			49

Gain (loss) on instruments designated at fair value and related derivatives	$	50	$	(243	)	$	(65	)	$	(258	)	$	(33	)	$	456		$	17		$	440

- Definition

The entire disclosure for a company's election to apply the fair value option for measurement and reporting of eligible financial assets and liabilities (as defined), as well as certain other eligible items (as defined) included in the statement of financial position, whether such option is elected for a single eligible item or a group of similar eligible items and is in addition to other disclosures concerning fair value which the company may be required to provide. Such disclosure might be expected to include: (1) for items included in the statement of financial position: (a) the reasons for electing a fair value option for each eligible item or group of similar eligible items; (b) if the fair value option is elected for some but not all eligible items within a group of similar eligible items: (i) a description of those similar items and the reasons for partial election and (ii) information of how the group of similar items relates to individual balance sheet line items; (c) for each line item in the statement of financial position that includes an item or items for which the fair value option has been elected: (i) information of how each line item in the statement of financial position relates to major categories of assets and liabilities presented in accordance with other fair value disclosures and (ii) the aggregate carrying amount of ineligible items included in each line item in the balance sheet, if any; (d) the difference between the aggregate fair value and the aggregate unpaid principal balance (assuming contractual principal amounts and fair value option elected) of: (i) loans and long-term receivables (other than securities otherwise reported at fair value) and (ii) long-term debt instruments; (e) for loans held as assets for which the fair value option has been elected: (i) the aggregate fair value of loans that are 90 days or more past due, (ii) if the policy is to recognize interest income separately from other changes in fair value, the aggregate fair value of loans in nonaccrual status, and (iii) the difference between the aggregate fair value and the aggregate unpaid principal balance for loans that are 90 days or more past due, in nonaccrual status, or both; (f) for investments that would have been accounted for under the equity method if the entity had not chosen to apply the fair value option, the information required for such investments, if material either individually or in the aggregate; (2) for items included in the income statement: (a) the amounts of gains and losses from fair value changes included in earnings and in which line in the income statement those gains and losses are reported whether or not combined with gains and losses from items required to be accounted for at fair value; (b) a description of how interest and dividends are measured and where they are reported in the income statement; (c) for loans and other receivables held as assets: (i) the estimated amount of gains or losses included in earnings attributable to changes in instrument-specific credit risk and (ii) how the gains or losses attributable to changes in instrument-specific credit risk were determined; (d) for liabilities with fair values that have been significantly affected during the reporting period by changes in the instrument-specific credit risk: (i) the estimated amount of gains and losses from fair value changes included in earnings that are attributable to changes in the instrument-specific credit risk, (ii) qualitative information about the reasons for those changes, and (iii) how the gains and losses attributable to changes in instrument-specific credit risk were determined; and (3) certain other disclosures as required or determined to be provided.

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