HSBC Finance
Further Thoughts (following publication of the 2007 10-K)

Last week, Knight Vinke published a report indicating that HSBC Finance ("HFC") is structurally unable to support its $150 billion of debt and suggested four methods of "ring fencing" this business so as to prevent it from affecting HSBC’s thriving emerging markets business. We pointed out that, had HSBC not acquired Household in 2003, its share price would most likely be 200p to 300p higher than where it was last week (and we note that it has further declined since then). HSBC’s Board responded to this by saying that it would be "irresponsible" for HSBC to walk away from HFC.

In our mind, this raises a question as to where HSBC’s Board’s responsibilities truly lie. Is it to HSBC’s shareholders or is it to HFC’s bondholders? HFC’s debt is not guaranteed by HSBC, is trading at over 300 basis points over the cost of HSBC’s debt (i.e. as "junk" debt), and we believe is now increasingly held by specialist distressed debt investors. These, mostly U.S. based, professional investors are well versed in the ins and outs of Chapter 11 proceedings and appear to have already priced into the bonds the high probability of this occurring.

With absolutely no access to customer deposits and only limited access to the debt markets (by its own admission HFC is facing "a reduction in the number of financial institutions willing to provide direct financing"[1]) HFC is increasingly dependent on asset sales and support from its parent for funding. With delinquencies rising (and ARM loans being restructured in the borrowers’ favour), we believe that net interest and loan repayments received may not cover the operating cash flow needs of the business. We have observed that net new lending has virtually come to a standstill and is projected to go into negative territory next year. Even more worrying, however, is the fact that debt repayments due over the next three years amount to over $80 billion. Selling assets is not a solution: in its 10-K, HFC discloses that the fair value of its consumer lending portfolio is $26.7 billion lower than the value at which the loans are carried in the 2007 accounts[2] and a forced sale of these assets might result in even greater losses.

We are of the view that HFC is carrying far too much debt (debt currently stands at 93.7% of tangible managed assets), that it will require significant additional capital from its parent just to survive and that, even after the U.S. property market finally recovers, this business will probably not be worth anything to HSBC’s shareholders. We note that Goldman Sachs issued a report last week indicating that HSBC may have to inject a further $12 billion into HFC in order to keep it afloat and that, even after the capital injection, they value HFC at nil.

Acquiring Household International was a catastrophic strategic mistake. Holding onto the business, without considering the value destruction and opportunity cost to shareholders of doing so, is worse. Unless the Board feels that its primary responsibilities are to HFC’s bondholders, this would truly be "irresponsible".

Knight Vinke Asset Management

8 March, 2008