Capital Markets

CFOs React: HSBC’s Iain Mackay

Early recognition of subprime exposures has helped the bank manage the fortunes of its struggling consumer finance company.
David KatzOctober 31, 2008

Chalk it up to the bank’s early recognition of its subprime exposures, a parent company with a good name and plenty of geographical diversity, or lots of espresso and chocolate chip cookies, but Iain Mackay, the CFO of HSBC North America Holdings, seems surprisingly chipper these days for the finance chief of a huge U.S. bank.

To be sure, the bank, which touts itself as one of the top 10 financial services outfits in the United States, has an albatross around its neck. In 2003, it acquired Household International (previously known by a more familiar name, Household Finance Corp.), a consumer finance company then under a cloud related to charges of predatory lending. In November 2006, although the company, now called HSBC Finance Corp., reported a 96 percent profit surge, to $551 million for the quarter ended September 30, 2006, over the previous year’s quarter, it acknowledged some scary portentsin its mortgage business.

“Real estate markets in a large portion of the United States have continued to slow, as evidenced by a general slowing in the rate of appreciation, or actual decline in some markets, in property values and an increase in the period of time available properties remain on the market.” it reported in its 10-Q. In the second quarter of 2006, the company started “to experience deterioration in the performance of 2005 mortgage loan originations in our Mortgage Services business,” it noted.

By May 2007, the company was reporting a 39 percent drop in net income, to $541 million for the three months ended March 31, compared to $888 million in the prior-year quarter. The loss stemmed largely from higher provisions for credit losses, including parts of its 2005 and 2006 mortgage services portfolio that had fallen “into various stages of delinquency,” according to the filing.

Today, fixing the finance company is at the top of MacKay’s priorities in the face of the current crisis. The CFO and other top executives are planning to slash the finance company’s home-mortgage business by as much as 70 percent by the end of this year and to cut branches where home loans are originated in half compared to 2006.

Still, Mackay (pronounced Ma-kigh) has other fish to fry. Besides overseeing the finances of the bank’s consumer finance unit, he heads up those of HSBC’s U.S. and Canadian businesses, including personal financial services and commercial, private, and global banking. HSBC’s assets total $560 billion.

The finance chief’s worries are mitigated a great deal, in comparison to some of his peers, by his ability to draw on the from resources of the North American Bank’s London-based parent, HSBC Holdings, and other members of the banking group in Asia, Europe, Latin America and the Middle East. An edited version of a recent interview had with Mackay follows.

How is the credit crunch affecting you at HSBC North America?

The most obvious impact is around our behavior as it relates to underwriting customers. Our focus on managing those things which we can control — our underwriting being one of them—has been a constant. We’re trying to insure that we’re putting paper on our balance sheet that will provide some level of return over the longer term. So as a consequence of the distress in the economic environment—and some of that distress frankly being caused by the credit crunch—our appetite for underwriting paper has diminished significantly.

The volumes that we are underwriting within our consumer finance business are in the region of 60 to 70 percent smaller than those compatible volumes of a year ago. Within our banking business we are focused on slowing down our rate of growth, and we’re managing portfolios very closely in commercial real estate. We’re also managing our portfolios across middle market and large-cap [lending] elements very carefully.

On the liability side of our balance sheet, throughout our history we’ve got a record of borrowing before we can lend. We’re building a fairly strong deposit base before we take a significant asset position on the other side of the balance sheet.

Specifically within the finance company, it’s a well understood fact that it’s largely funded through the wholesale [loan] market, and the wholesale market has been to all intents and purposes closed for the last couple of moths. Our good fortune—or call it foresight, has been that we really anticipated this quite some time ago. We have to a certain extent pre-funded our 2008 and even some of our 2009 obligations.

The finance company, which is the old Household International, was acquired by HSBC back in 2003. At that time the business was strongly focused on credit cards, retail cards, and branch-based consumer lending origination. There was also broker origination, but it was a relatively small channel.

Over the last five years, the mortgage brokerage grew quite significantly— until early 2007, when we really closed off that channel. In very late 2006, it became quite obvious to us through observing the behavior of the originations through the mortgage brokerage that there was some distress in the subprime market.

At that time the balance sheet of the finance company totaled about $180 billion. And of that, real estate secured was a shade underneath $100 billion. Substantially all of the real estate secured assets are near or subprime assets. As of the second quarter of this year, the real estate secured was about $80 billion, all near or subprime. Of that, about $30 billion [stemmed from] the old broker correspondent channel originations and $50 billion [from] the retail consumer-lending branch network, which at the end of 2006 consisted of 1400 branches is now 750 branches. By the end of the year we’ll have just over 700 branches.

Over the course of the last 17 to 18 months, we’ve curtailed our appetite principally by managing down the size of the branch network in consumer lending. We closed off the mortgage services broker correspondent channel originations in first quarter of 2007, recognizing that it was an underwriting model that was very difficult to exercise real control over.

Although we’ve prefunded much of our obligations looking out through and into 2009, [consumer lending] is a business in which it’s just really really difficult to make money in the current environment. As you see property values declining, as you see unemployment increasing, the equity that people can leverage in their properties to refi out and debt-consolidate or build improvements into their homes is just becoming more and more limited. And the risk appetite that we have traditionally had within HSBC doesn’t really put us in the position where we’d like to double down in this market.

What’s your biggest worry now?

Increasing losses in this environment. My main focus as CFO is making sure that we have resources in terms of capital to support the increasing delinquencies and charge-offs within those consumer-finance books of business. When I think of my day-to-day responsibilities, making sure we work with our parents, HSBC Holdings plc in the U.K., to make sure we have strong enough liquidity and capital to work through this economic cycle and put our consumer finance portfolios back on their feet.

Have you found the hesitancy many banks have recently shown in lending to other banks— and the corresponding difficulty of bank borrowers— terribly troublesome?

Systemically yes, but individually no. One of the boons in my job is that I’ve got a great brand name behind me from a banking perspective. You know, I’ve been able to go out and turn my commercial paper every day without difficulty, without exception, for as long as this downturn and funding crisis has existed.

In terms of issuing term debt from the finance company, we haven’t this year because we haven’t needed to. We’re running down the portfolio, and the portfolio is paying off in a manner that helps us to meet any of our debt obligations. So in the context of the finance company, no real issue.

In the context of lending to other banks, we’re in the market and we intend to stay in the market and play a responsible role. The challenge there of course is getting other people to play.

Under current conditions in North America, how do you maintain enough capital to fund your risk?

Well, we keep making money. On a group consolidated basis, on June 30 we generated $10 billion dollars worth of profit before tax. Now, clearly, there’s an element of that profit which goes to supporting our capital base in the U.S., which through the elevated loan impairment charges we’re taking, has the effect of consuming some of that capital that our colleagues around the group are generating on our behalf.

When we incur elevated levels of loan-impairment, our parent, HSBC Holdings plc, has stepped in each and every occasion and contributed the capital necessary to maintain our targets. And that comes from group resources, and by that I mean the profitability that our colleagues in Asia, Europe Latin America and the Middle East. Basically, the rest of the world generates it and every other region within the world of HSBC continues to be strongly profitable.

So part of our responsibility going forward is to manage the portfolio within our risk appetite, run down the subprime book, and try to release some of that capital back to group.

As CFO, what skills and resources have helped you weather the current storm?

Large quantities of espresso coffee and chocolate chip cookies. One element is patience and perspective. You can be very tempted to sit and stare at your Bloomberg screen every day and worry about what has been happening in the marketplace. But from my standpoint, when I walk in every morning, the view is really on what’s within my control. I can manage my liquidity position within reasonable bounds through managing the commercial paper programs that we operate, through managing the attrition within our portfolios in terms where do we extend credit and where do we pull back on credit.

What I really draw on on a daily basis is a very strong team of finance and credit professionals. They work around me to help manage a strong treasury position, the accounting interpretations, and a prudent and conservative approach to reserving within our various portfolios. We also have a very strong collaboration with our credit and compliance teams around how we manage our appetite for risk within the various asset categories. Obviously I draw on more than 20 years of experience as a finance professional. I draw on a fair amount of other experience of other financial crises, though not one of this depth and probable duration.

As a finance executive in an industry which has opposed fair-value accounting, where do you stand on the current controversy concerning the marking to market of illiquid assets?

Fair-value accounting hasn’t put us as an industry in the position in which we find ourselves today. If you look at extent of leverage within investment banks and certain commercial banks within the U.S. household, there’s not a cause-effect relationship [between fair-value accounting and the current financial crisis]. I think fair value appropriately applied is an appropriate accounting model. If we’ve learned anything from this, it’s that we need to stay grounded in the economic raison d’être for financial institutions, which is to provide credit in a responsible matter.

What’s your exposure to credit-default swaps and have they caused any problems for you?

We use credit-default swaps as a hedging tool within our global banking and markets business. Have we come a cropper on them? Structurally, no. But just because of widening spreads within that marketplace, we have experienced some mark-to-market pressure. If you total up credit-default swaps across our entire traded book within the U.S. bank, the marks we’ve taken over the last 18 months are in the region of $2.2 billion. But we’ve had no exposure to collateralized debt obligations.

From a portfolio perspective, credit-default swaps are within the book. But in terms of have they represented or do they represent a significant risk to the institutions? I’d have to say that’s not the case.

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