Stephen Green, Esq.
Group Chairman
HSBC Holdings Plc
8 Canada Square
London E14 5HQ

New York, 16 January 2008

Dear Stephen,

When we last wrote to you, some six weeks ago, we expressed our appreciation and support for many new elements of HSBC’s strategy first explained to the market during your Strategy Update on 23 November 2007. These included a discernable greater focus on areas of comparative advantage (as opposed to geographic diversification), a more disciplined approach to capital allocation (including a commitment to dispose of underperforming businesses), and the objective of deriving 60% of the Group’s profits from faster growing emerging market countries. At the time we also advanced the view that HSBC’s U.S. sub-prime business is potentially a much greater problem than you or your management team appeared to believe (or were prepared to admit). The issue we are most concerned about is contagion.

Since November last year, the market environment for U.S. sub-prime related debt has continued to deteriorate and there are signs that the problems may be spreading across the portfolio from sub-prime mortgages originated by third parties, to home equity loans and mortgages originated by HSBC, credit card loans, car loans and other forms of consumer finance. It is difficult to predict the full extent of the downturn, but most respected analysts appear to believe that the worst is still to come. We note, in passing, that Goldman Sachs, your house broker, has reiterated its belief that HSBC will require a further US$ 13 billion of provisions to cover losses in its U.S. sub-prime loan book and HSBC’s shares currently trade at 750p, or 100p less than they were trading at before Christmas.

The depressing picture in the U.S. stands in marked contrast to the excellent performance of HSBC’s emerging markets businesses, which are the cornerstone of your strategy going forward and amongst the most compelling reasons to own HSBC stock today. Far from supporting the thesis that earnings diversification adds value, the relationship between these two business areas has led to uncertainty in the market over the extent to which profits in the emerging markets are simply going to be used to fund the enormous losses in the United States. These concerns about contagion are essential to understanding why the share price has fallen so sharply.

In our letter we also noted that the CIBM division’s results are dominated by trading profits, primarily in fixed income securities and derivatives. Here too, there are risks of contagion from the sub-prime related crisis, even though a large proportion of the trading book consists of government securities which are clearly not affected. The securitization, repackaging, releveraging and widespread distribution of U.S. mortgage related assets have led to huge and as yet unquantifiable collateral damage in the capital markets, with several of the world’s largest banks now seeking to raise additional capital on an emergency basis. We take some comfort from the fact that HSBC has a stronger balance sheet than most and that it has relatively limited direct exposure to the CDO market, but do not believe that its trading book is immune from the indirect consequences of this crisis.

During this period of market turmoil, HSBC’s investors have unfortunately not benefited from the Group’s strong capital base or from its pre-eminent emerging markets franchise. In terms of total shareholder return (TSR), HSBC continues to underperform its international peers: from 23 November, when you gave your Strategy Update, to today’s closing, HSBC ranked 24/29 with respect to its chosen peers, 23/27 with respect to its listed emerging market peers with a market cap of US$ 20 billion or more and 47/55 overall. Its performance over the period is only marginally better than that of Citigroup, which is now seeking a second emergency capital injection, and is actually worse than that of UBS and Morgan Stanley, which have also had to seek new capital under similar circumstances.

The market’s reaction is disappointing but not surprising. The reasons for this are evident: despite widespread recognition of the attractions of HSBC’s emerging markets franchise, there is almost universal concern, as we have said, about its exposure to the U.S. sub-prime crisis[1]. We acknowledge again that it may well be too late for HSBC to reverse the Household acquisition by selling the business now and we understand there are technical reasons which prevent HSBC from taking a large one-time provision to protect the Group’s earnings from the predictably deteriorating performance of its U.S. business in the future (i.e., a “kitchen sinking”). Furthermore, the bad news associated with the above-mentioned sub-prime related provisions may be compounded by the need for a substantial goodwill impairment charge at Group level (with Goldman Sachs estimating that US$ 10 billion of goodwill is at risk). Your repeated assurances that HSBC is “well capitalised” in this context may be necessary to prevent Household’s funding costs from rising but are generally considered by the market as implying that HSBC will give unlimited support to Household throughout the cycle. In short, HSBC appears to be caught in a vicious spiral and the market, fearing the “inevitability” of further bad news and seeing no end to the problems, has understandably taken to “shorting” the stock.[2]

We have suggested that HSBC could break out of this vicious spiral by structurally “ring-fencing” the Household business, as discussed below. We are convinced that the announcement of a decisive break with Household, and possibly other poorly performing businesses as well, would result in a dramatic re-rating of HSBC, thereby obliging investors to cover their short positions and initiating a virtuous spiral.

Spinning off Household to HSBC’s shareholders

The main difficulty associated with spinning off Household is that the business is not capable of funding itself on its own and therefore requires a strong parent. The structure that you have in place is, however, a very expensive way of giving Household the support that it needs since it also gives Household’s creditors an unquantifiable claim over the rest of the Group’s net assets. An alternative and less expensive method of dealing with the issue would be to strengthen the balance sheet of Household significantly so as to make it self-financing within reasonably foreseeable parameters. We assume, for the sake of this illustration, that US$ 15 billion of additional capital would be sufficient to achieve this.

While this is undoubtedly a very substantial amount of capital, it is relatively insignificant when compared with at least US$ 60 billion in opportunity cost (to the shareholders) of HSBC not trading at the multiples at which it might otherwise trade, given its mix of attractive businesses. Uncontaminated by sub-prime and with a much greater emerging markets focus, we believe that the shares should trade at the very least at £ 10, and probably more.

We have argued that HSBC has a number of underperforming businesses which add little if anything to HSBC’s global strategy. These include CCF, which lacks scale within the context of the French market, and HSBC Bank USA, which lacks scale within the context of the U.S. market (and probably has the wrong profile for the wealth management business which you seek in this key market). If these two businesses were to be sold for cash and the proceeds used to provide the additional financial support needed by Household, we believe that the latter could then be spun off to HSBC’s shareholders. This does not mean that HSBC’s shareholders would lose the benefits of this US$ 15 billion of capital since, if a shareholder continued to hold both the HSBC shares and the Newco shares, the recapitalisation of Household would be tantamount to a transfer from one “pocket” to another.

There would be numerous benefits associated with such a strategic move:

• Uncontaminated by direct sub-prime exposure (including the risk of goodwill impairment charges), HSBC would recover its premium rating associated with its substantial exposure to fast growing economies in Asia and Latin America. Following the spin-off of Household and sale of CCF and HSBC Bank USA, the share of Group earnings attributable to emerging markets would increase from 50% to approximately 66%.
• The increase in HSBC’s stock market rating would allow the Group to grow further by acquisition with less dilution: this would be particularly important in allowing HSBC to take advantage of acquisition opportunities in Asia, where multiples tend to be higher.
• We believe that the sale of CCF and HSBC Bank USA, combined with the spin-off of Household, should result in a noticeable improvement in HSBC’s ROE and ROA. CCF, HSBC Bank USA and Household each have a lower ROE and ROA than the Group[3].
• We believe that the transaction would also result in HSBC’s Tier 1 ratio increasing at a time when all its major competitors will be seeing deterioration in their ratios[4].
• The spin-off would also result in reduced exposure to the US dollar, which is viewed by many analysts as a negative for HSBC compared to some of its emerging markets peers.
• As a standalone entity with new (and highly motivated) management, we believe that Household would be better placed to engage in the restructuring that is required to emerge from the sub-prime crisis as a leader in this market. Household would also cease to be a very major distraction for HSBC’s existing management team.
• A spin-off of this business does not mean that HSBC shareholders would be deprived of the benefits of a successful turnaround: they could, if they so desired, increase their exposure (or decrease it). We believe that the overall increase in the value of the parts compared with the Group at present could be very significant.
• We have heard the argument that HSBC cannot walk away from Household because of concerns that regulators in other parts of the world might have. We believe that this is a spurious argument. It is much more likely that regulators in other parts of the world would welcome the steps we propose because they would reduce the exposure of the businesses for which they are responsible to HSBC’s problems in the U.S.

The situation discussed in this letter is evolving very quickly and time is, therefore, of essence. The window of opportunity to execute the above mentioned strategy (or some variant thereof) is probably very short. As mentioned before, HSBC was the first of its peers to identify the problems associated with sub-prime but was slow off the mark compared to those of its peers who sold or liquidated assets when this was still possible. We would recommend that the Board review these and other “ring-fencing” solutions as soon as practically possible since Citigroup, UBS, Merrill Lynch and other distressed competitors may soon be entering the market with similar solutions.

We believe that HSBC’s shareholders will strongly support the Board’s recognition that we are going through an unusually severe period of turbulence and also believe that they are prepared to accept changes to the course which the Board has mapped out for the Company in the past. The current crisis has further to go and will probably result in significant changes in the structure of the financial services industry, particularly amongst the global players. There will be winners and losers: HSBC has the possibility of emerging as a winner if the Board is prepared to move more quickly than it has in the past.

Yours sincerely,

Eric Knight
Chief Executive

Glen Suarez
Director of Investments