May 15 (Bloomberg) -- HSBC Finance Corp., a division of HSBC Holdings Plc, said profit slumped 39 percent in the first quarter. The U.S. mortgage lender flagged loan defaults may rise.

Net income in the three months to March 31 fell to $541 million from $888 million last year, mainly as HSBC Finance had to almost double the provisions set aside for credit losses to $1.7 billion, the Illinois-based company said in a statement filed to the Securities and Exchange Commission today.

``The delinquencies in adjustable mortgages are going to increase into the year,'' Krista Yue, an analyst at Deutsche Bank AG, said by phone from Hong Kong today. The ``continued drag of the U.S. mortgage portfolio is going to limit any meaningful earnings expansion in 2007'' for HSBC Holdings, she said.

HSBC Finance, which generally serves consumers with limited credit history, posted a 19 percent drop in net income last year as loan defaults in the U.S. climbed amid higher interest rates. HSBC, Europe's largest bank by market value, bought the subprime lender, formerly known as Household International, for $15.5 billion in 2003.

The U.S. contributes to the bulk of HSBC Finance's revenue, according to Bloomberg data. Subprime refers to mortgages granted to people with poor credit histories or high debts.

Rising Rates

The ability of HSBC Finance's customers to repay the mortgages could be affected this year as interest rates on the remainder of their loans rise, the company said.

``Many adjustable rate loans are expected to require a significantly higher monthly payment following their first adjustment'' given that interest rates have risen in the past three years, the company said in the statement.

``A customer's financial situation at the time of the interest-rate reset could affect our customer's ability to repay the loan after the adjustment,'' it said, referring to loans offered at lower rates in the first few years of repayment that are subsequently increased.

This year, interest rates will be reset for the first time on about $9 billion worth of HSBC Finance's adjustable mortgage loans, followed next year by adjustments on $4.7 billion of the loans, the company said.

HSBC's second-half profit fell 5.7 percent last year to $7.06 billion as loan impairment charges and other credit risk provisions surged 36 percent during the year to $10.6 billion. Profit at its North American operations fell 21 percent to $4.7 billion in 2006, the bank said in March.

Subprime borrowers made up about a fifth of all new U.S. mortgages last year. Late payments on the loans reached a four- year high of 13.3 percent in the fourth quarter, the Washington- based Mortgage Bankers Association said in March.

HSBC's Hong Kong-traded shares fell 0.4 percent to HK$146.30 by the 12:30 p.m. lunch break.

To contact the reporter on this story: Chia-Peck Wong in Hong Kong at cpwong@bloomberg.net.

Last Updated: May 15, 2007 01:21 EDT