SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
Commission file Number 000-33243
HUNTINGTON PREFERRED CAPITAL, INC.
(Exact name of registrant as specified in its charter)
OHIO 31-1356967
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
HUNTINGTON CENTER, 41 S. HIGH STREET, COLUMBUS, OH 43287
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(Address of principal executive offices) (Zip Code)
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Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). [ ] Yes [X] No
All common stock is held by affiliates of the registrant as of December 31,
2002. As of March 28, 2003, 14,000,000 shares of common stock without par value
were outstanding. The aggregate market value of the common stock held by
non-affiliates of the registrant as of the close of business on June 28, 2002:
$0.00
Documents Incorporated By Reference
Part III of this Form 10-K incorporates by reference certain information from the registrant's definitive Information Statement for the 2003 Annual Shareholders' Meeting.
HUNTINGTON PREFERRED CAPITAL, INC.
INDEX
Part I.
Item 1. Business 3
Item 2. Properties 18
Item 3. Legal Proceedings 18
Item 4. Submission of Matters to a Vote of Security Holders 18
Part II.
Item 5. Market for Registrant's Common Equity and Related Shareholder Matters 19
Item 6. Selected Financial Data 19
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 20
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 30
Item 8. Financial Statements and Supplementary Data 30
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 45
Part III.
Item 10. Directors and Executive Officers of the Registrant 45
Item 11. Executive Compensation 45
Item 12. Security Ownership of Certain Beneficial Owners and Management 45
Item 13. Certain Relationships and Related Transactions 45
Item 14. Controls and Procedures 45
Part IV.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 46
Signatures 47
Certifications 48-49
Exhibits 50-51
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HUNTINGTON PREFERRED CAPITAL, INC.
Part I
ITEM 1: BUSINESS
GENERAL
Huntington Preferred Capital, Inc. (HPCI) is an Ohio company incorporated in July 1992 under the name Airbase Realty, Inc. The name was changed to Huntington Preferred Capital, Inc. in May 2001. HPCI's principal business objective is to acquire, hold, and manage real estate assets and other authorized investments that will generate net income for distribution to its shareholders. Since May 1998, HPCI has been operating as a real estate investment trust (REIT) for federal income tax purposes. HPCI has one wholly owned subsidiary, HPCLI, Inc. (HPCLI), an Ohio corporation, which holds certain non-interest-earning assets. At December 31, 2002, these assets amounted to $37.3 million. The following chart outlines the relationship among affiliated entities at December 31, 2002.
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| Huntington Bancshares Incorporated |
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|
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| | | |
| 100% Common | | |100% Common
-------------------------------- | | -----------------------
| The Huntington | | | | HPC Holdings-II, |
| National Bank | | | | Inc. |
-------------------------------- | | -----------------------
| | | 0.09% | |
| | 99.91% Common | Common | | 00% B Preferred
| ------------------- | |
| | | | Public & Private Preferred
| | | | | Shareholders
| | | | |
| ------------------------- | | |
| | Huntington Preferred | | 0.13% Common | | 10.9% A Preferred
| |Capital Holdings, Inc. | | | | 100% C Preferred
| ------------------------- | | |
| | | | |
| 10% Common | 100% Common | | |
| | | | |
| ------------------------- | | |
| |HPC Holdings-III, Inc. | | | |
| ------------------------- | | |
| | | | |
| 90% Common | 67.37% Common | | |
| | 89.1% A Preferred | | |
| | 100% D Preferred* | | |
| | | | |
-------------------------- | | | |
| Huntington Preferred | | | | |
| Capital II, Inc. | | | | |
-------------------------- | | | |
| | | | |
| 32.5% Common | | | |
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|Huntington Preferred |
| Capital, Inc. |
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|
| 100% Common
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| HPCLI, Inc. |
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*HPCH-III may sell to third party investors at some future date.
HPCI is a subsidiary of HPC Holdings-III, Inc. (HPCH-III), a Nevada corporation. HPCH-III is a subsidiary of Huntington Preferred Capital Holdings, Inc. (Holdings), an Indiana corporation that is consolidated as a subsidiary of The Huntington National Bank (the Bank). The Bank is an interstate national banking association organized under the laws of the United States and headquartered in Columbus, Ohio. The Bank is the only bank subsidiary of Huntington Bancshares Incorporated (Huntington). The Bank owns 99.91% of the outstanding shares of Holdings and Huntington owns the remaining 0.09%. HPCH-III owns 67.37% of HPCI's common shares, 89.1% of HPCI's Class A preferred securities, and 100% of HPCI's Class D preferred securities. Huntington Preferred Capital II, Inc. (HPCII) owns 32.5% of HPCI's common shares while Huntington owns the remaining portion. The remaining portion of HPCI's Class A preferred securities are restricted and owned by past and present employees of Huntington. HPCI's Class B preferred securities are owned by HPC Holdings-II, Inc., a non-bank subsidiary of Huntington. All of HPCI's Class C preferred securities were sold to Holdings, which were subsequently sold by Holdings to the public in an underwritten public offering that closed on November 7, 2001.
HPCI's Class B, Class C, and Class D preferred securities will be exchanged, without any approval or action on the part of the security holders, for Class B, Class C, and Class D preferred securities of the Bank, if such an exchange is directed by the Office of the Comptroller of the Currency (OCC) in the event the Bank becomes, or may in the near term become, undercapitalized or if the Bank is placed in conservatorship or receivership. The preferred securities of the Bank have substantially equivalent terms as to dividends, liquidation preference, and redemption as to the preferred securities of HPCI. At December 31, 2002, the Bank's net loans and total deposits were $20.5 billion and $18.1 billion, respectively, compared with Huntington's net loans of $20.6 billion and total deposits of $17.5 billion. Total assets for Huntington were $27.6 billion compared with $27.5 billion for the Bank at the end of 2002. Net income for 2002 was $356.0 million for the Bank versus $363.2 million for Huntington. The Bank's financial condition, results of operations, and cash flows approximate those of Huntington. The financial statements of Huntington are available to the public over the Internet at the web site of the Securities and Exchange Commission (SEC) at http://www.sec.gov or at the SEC's public reference rooms at 450 Fifth Street, N.W., Washington, D.C. 20549.
On February 15, 2002, the Bank sold its Florida retail and commercial operations as part of a comprehensive strategic and financial restructuring plan designed to refocus its operations on core activities in the Midwest. At the end of 2001, in anticipation of the sale by the Bank, HPCI completed its distribution of participation interests in Florida-related loans to its common shareholders, Holdings and Huntington. This distribution approximated $1.3 billion and consisted of cash and the net book value of participation interests in loans that were included in the sale, including the related accrued interest and allowance for loan losses, representing approximately 17% of HPCI's total assets at December 31, 2001.
GENERAL DESCRIPTION OF ASSETS
The Internal Revenue Code requires a REIT to invest at least 75% of the total value of its assets in real estate assets, which includes residential real estate loans and commercial real estate loans, including participation interests in residential or commercial real estate loans, mortgage-backed securities eligible to be held by REITs, cash, cash equivalents which includes receivables, government securities, and other real estate assets (REIT Qualified Assets). REITs may invest up to 25% of the value of its total assets in non-mortgage-related securities as defined in the Investment Company Act. Under the Investment Company Act, the term "security" is defined broadly to include, among other things, any note, stock, treasury stock, debenture, evidence of indebtedness, or certificate of interest or participation in any profit sharing agreement or a group or index of securities. The Internal Revenue Code also requires that the value of any one issuer's securities, other than those securities included in the 75% test, may not exceed 5% by value of the total assets of the REIT. In addition, under the Internal Revenue Code, the REIT may not own more than 10% of the voting securities nor more than 10% of the value of the outstanding securities of any one issuer, other than those securities included in the 75% test and the securities of wholly-owned, qualified REIT subsidiaries.
As of December 31, 2002, 89.3% of HPCI's assets were invested in REIT Qualifying Assets and 10.7% were invested in commercial and consumer loans and other assets that were not REIT Qualifying Assets. HPCI's assets consisted of the following at December 31, 2002:
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Percentage
of Total
(in thousands of dollars) Amount Assets
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Loan participation interests:
Commercial real estate $3,922,467 71.1%
Commercial 344,858 6.3%
Consumer secured by real property 541,450 9.8%
Residential real estate 153,808 2.8%
Consumer not secured by real property 70,907 1.3%
Allowance for loan losses (140,353) -2.5%
Non-interest bearing deposits with The Huntington National Bank 534,254 9.7%
Other assets 89,630 1.5%
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HPCI did not hold any securities nor intend to hold securities in any one issuer that exceed 5% of its total assets or more than 10% of the voting securities of any one issuer other than its permitted investment in its wholly owned subsidiary, HPCLI.
Commercial and Commercial Real Estate Loans. HPCI owns participation interests in unsecured commercial loans and commercial loans secured by non-real property such as industrial equipment, aircraft, livestock, furniture and fixtures, and inventory. Participation interests acquired in commercial real estate loans are secured by real property such as office buildings, multi-family properties of five units or more, industrial, warehouse, and self-storage properties, office and industrial condominiums, retail space, strip shopping centers, mixed use commercial properties, mobile home parks, nursing homes, hotels and motels, churches, and farms. Commercial and commercial real estate loans may not be fully amortizing. This means that the loans may have a significant principal balance or "balloon" payment due on maturity. Additionally, there is no requirement regarding the percentage of any commercial or commercial real estate property that must be leased at the time HPCI acquires a participation interest in a commercial or commercial real estate loan secured by such property nor are commercial loans required to have third party guarantees.
The credit quality of a commercial or commercial real estate loan may depend on, among other factors, the existence and structure of underlying leases; the physical condition of the property, including whether any maintenance has been deferred; the creditworthiness of tenants; the historical and anticipated level of vacancies; rents on the property and on other comparable properties located in the same region; potential or existing environmental risks; the availability of credit to refinance the loan at or prior to maturity; and, the local and regional economic climate in general. Foreclosures of defaulted commercial or commercial real estate loans generally are subject to a number of complicating factors, including environmental considerations, which are not generally present in foreclosures of residential real estate loans.
At December 31, 2002, $3.3 billion, or 65%, of the commercial and commercial real estate loans underlying HPCI's participation interests in such loans were secured by a first mortgage or first lien and most bear variable or floating interest rates. At this same date, HPCI's participation interests in commercial loans that are unsecured was $146.9 million, or 3.4% of the total commercial and commercial real estate loan participations.
Consumer Loans. HPCI owns participation interests in consumer loans secured by automobiles, trucks, equipment, or a first or junior mortgage primarily on the borrower's primary residence. Many of these mortgage loans were made for reasons such as home improvements, acquisition of furniture and fixtures, and debt consolidation. These loans are predominately repaid on an installment basis and income is accrued based on the outstanding balance of the loan over terms that range from 6 to 360 months. Of the loans underlying the consumer loan participations, most bear interest at fixed rates.
Residential Real Estate Loans. HPCI owns participation interests in adjustable rate, fixed rate, conforming, and nonconforming residential real estate loans. Conforming residential real estate loans comply with the requirements for inclusion in a loan guarantee or purchase program sponsored by either the FHLMC or FNMA. Under current regulations, the maximum principal balance allowed on conforming residential real estate loans ranges from
$322,700 for one-unit residential loans to $620,500 for four-unit residential loans. Nonconforming residential real estate loans are residential real estate loans that do not qualify in one or more respects for purchase by FNMA or FHLMC under their standard programs. A majority of the nonconforming residential real estate loans underlying the participation interests acquired by HPCI to date are nonconforming because they have original principal balances which exceeded the requirements for FHLMC or FNMA programs, the original terms are shorter than the minimum requirements for FHLMC or FNMA programs at the time of origination, the original balances are less than the minimum requirements for FHLMC or FNMA programs, or generally because they vary in certain other respects from the requirements of such programs other than the requirements relating to creditworthiness of the mortgagors.
Each residential real estate loan is evidenced by a promissory note secured by a mortgage or deed of trust or other similar security instrument creating a first or second lien on single-family residential properties. Residential real estate properties underlying residential real estate loans consist of individual dwelling units, individual condominium units, two- to four-family dwelling units, and townhouses.
Geographic Distribution. The following table shows the geographic location of the properties securing the loans underlying HPCI's loan participations at December 31, 2002:
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Percentage by
Aggregate Aggregate
Number Principal Principal
State (in thousands of dollars) of Loans Balance Balance
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Ohio 25,325 $ 2,769,144 55.0%
Michigan 11,705 1,458,357 29.0%
Indiana 3,481 343,007 6.8%
Kentucky 2,051 252,703 5.0%
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42,562 4,823,211 95.8%
All other locations 1,179 210,279 4.2%
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Total loan participation interests 43,741 $ 5,033,490 100.0%
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Principal Balances. The following table shows data with respect to the principal balance of the loans underlying HPCI's loan participations at December 31, 2002:
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Percentage by
Aggregate Aggregate
Number Principal Principal
Size (in thousands of dollars) of Loans Balance Balance
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Less than $50,000 33,625 $ 539,941 10.7%
Greater than $50,000 to $100,000 3,967 273,254 5.4%
Greater than $100,000 to $250,000 2,882 457,333 9.1%
Greater than $250,000 to $500,000 1,489 523,769 10.4%
Greater than $500,000 to $1,000,000 867 606,783 12.1%
Greater than $1,000,000 to $3,000,000 668 1,096,893 21.8%
Greater than $3,000,000 to $5,000,000 134 496,590 9.9%
Greater than $5,000,000 to $10,000,000 88 604,254 12.0%
Greater than $10,000,000 21 434,673 8.6%
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Total loan participation interests 43,741 $ 5,033,490 100.0%
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Interest Rate. Some of the loans underlying HPCI's loan participations bear interest at fixed rates and some bear interest at variable rates based on indices such as LIBOR and the prime rate. The following table shows data with respect to interest rates of the loans underlying HPCI's loan participations at December 31, 2002:
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Fixed Rate Variable Rate
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Percentage by Percentage by
Aggregate Aggregate Aggregate Aggregate
(in thousands of Number Principal Principal Number Principal Principal
dollars) of Loans Balance Balance of Loans Balance Balance
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under 5.00% 149 $ 26,584 2.2% 2,655 $ 2,622,152 68.9%
5.00% to 5.99% 322 32,233 2.6% 1,794 370,021 9.7%
6.00% to 6.99% 1,826 157,548 12.8% 1,213 269,314 7.1%
7.00% to 7.99% 5,598 375,074 30.5% 1,238 329,605 8.7%
8.00% to 8.99% 7,441 278,448 22.7% 788 159,784 4.2%
9.00% to 9.99% 6,537 173,596 14.1% 390 49,590 1.3%
10.00% to 10.99% 3,638 87,328 7.1% 34 3,709 0.1%
11.00% to 11.99% 1,407 32,037 2.6% 3 28 0.0%
12.00% and over 8,705 66,202 5.4% 3 237 0.0%
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Total 35,623 $ 1,229,050 100.0% 8,118 $ 3,804,440 100.0%
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Loan Delinquencies. The following table provides delinquency information for the loans underlying HPCI's loan participations at December 31, 2002.
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Fixed Rate Variable Rate
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Percentage by Percentage by
Aggregate Aggregate Aggregate Aggregate
(in thousands of Number Principal Principal Number Principal Principal
dollars) of Loans Balance Balance of Loans Balance Balance
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Current 27,167 $ 1,053,865 85.7% 7,253 $ 3,500,150 92.0%
1 to 30 days 5,801 119,943 9.8% 559 212,327 5.6%
31 to 60 days 1,537 24,490 2.0% 111 27,996 0.7%
61 to 90 days 467 9,622 0.8% 30 19,414 0.5%
over 90 days 651 21,130 1.7% 165 44,553 1.2%
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Total 35,623 $ 1,229,050 100.0% 8,118 $ 3,804,440 100.0%
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Other Assets. Non-interest bearing balances with The Huntington National Bank represent cash received by the Bank from borrowers for the payment of principal and interest on the underlying loans deposited in a demand deposit account of the Bank. Interest bearing deposits in the Bank consist of available funds invested nightly in an investment product that provides HPCI with a market return for overnight funds. These funds are available for the acquisition of additional participation interests. Due from Holdings and the Bank represents unsettled cash transactions involving HPCI's participation interests in loans that occur in the ordinary course of business. Other assets include premises and equipment related to real property located in Indiana and also accrued interest on the loans underlying its loan participation interests, which is calculated by the Bank's loan accounting systems.
DIVIDEND POLICY AND RESTRICTIONS
HPCI expects to pay an aggregate amount of dividends with respect to the outstanding shares of its capital stock equal to substantially all of its REIT taxable income, which excludes capital gains. In order to remain qualified as a REIT, HPCI must distribute annually at least 90% of its REIT taxable income to shareholders. Dividends are declared at the discretion of the board of directors after considering its distributable funds, financial condition, and capital needs, the impact of current and pending legislation and regulations, economic conditions, tax considerations, its continued qualification as a REIT, and other factors. Although there can be no assurances, HPCI expects that both its cash available for distribution and its REIT taxable income will be in excess of amounts needed to pay dividends on the preferred securities in the foreseeable future because substantially all of HPCI's real estate assets and other authorized investments are interest-bearing; all outstanding preferred securities represent in the aggregate only approximately 15% of HPCI's capitalization; HPCI does not anticipate incurring any indebtedness
other than permitted indebtedness, which includes acting as a co-borrower or guarantor of certain obligations of the Bank that HPCI does not anticipate will involve a pledge of more than 25% of its assets; and, HPCI expects its interest-earning assets will continue to exceed the liquidation preference of its preferred securities.
Payment of dividends on the preferred securities could also be subject to regulatory limitations if the Bank becomes "undercapitalized" for purposes of regulations issued by the OCC. Under these regulations, the Bank will be deemed "undercapitalized" if it has a total risk-based capital ratio of less than 8.0%; a Tier 1 risk-based capital ratio of less than 4.0%; and a leverage ratio of less than 4.0% or less than 3% if the institution has been awarded the highest supervisory rating. At December 31, 2002, the Bank's total risk-based capital ratio was 10.24%, its Tier 1 risk-based capital ratio was 6.40%, and its leverage ratio was 6.62%. The Bank currently intends to maintain its capital ratios in excess of the "well-capitalized" levels under these regulations. However, there can be no assurance that the Bank will be able to maintain its capital in excess of the "well-capitalized" levels. The exercise of the OCC's power to restrict dividends on preferred securities would, however, also have the effect of restricting the payment of dividends on common shares. The inability to pay dividends on common shares would prevent HPCI from meeting the statutory requirement for a REIT to distribute 90% of its taxable income and, therefore, would cause HPCI to fail to qualify for the favorable tax treatment accorded to REITs.
CONFLICT OF INTERESTS AND RELATED POLICIES
The Bank continues to control 98.6% of the voting power of HPCI's outstanding securities. Accordingly, the Bank will continue to have the right to elect all of HPCI's directors, including its independent directors, unless HPCI fails to pay dividends on its Class C and Class D preferred securities. In addition, all of HPCI's officers and five of its nine directors are also officers of Huntington or the Bank. Because of the nature of HPCI's relationship with Holdings, HPCII, HPCH-III, and the Bank, conflicts of interest have arisen and may arise in the future with respect to certain transactions, including without limitation, HPCI's acquisition of assets from the Bank and its affiliates, HPCI's disposition of assets to the Bank, servicing of the loans underlying HPCI's participation interests, particularly with respect to loans placed on nonaccrual status, as well as the modification of the participation agreement between the Bank and Holdings and the subparticipation agreement between Holdings and HPCI. Any future modification of these agreements will require the approval of a majority of HPCI's independent directors. HPCI's board of directors also has broad discretion to revise its investment and operating strategy without shareholder approval.
It is the intention of HPCI and the Bank that any agreements and transactions between them be fair to all parties and consistent with market terms for such types of transactions. The requirement in HPCI's articles of incorporation that certain actions be approved by a majority of HPCI's independent directors also is intended to ensure fair dealings among HPCI, Holdings, and the Bank. HPCI's independent directors serve on its audit committee and review material agreements and significant transactions among HPCI, Holdings, the Bank, and their respective affiliates.
There are no provisions in HPCI's articles of incorporation limiting any of its officers, directors, shareholders, or affiliates from having any direct or indirect pecuniary interest in any asset to be acquired or disposed of by HPCI or in any transaction in which it has an interest or from engaging in acquiring, holding, and managing its assets. It is expected that the Bank will have direct interests in transactions with HPCI including, without limitation, the sale of assets to HPCI; however, it is not anticipated that any of HPCI's officers or directors will have any interests in such assets, other than as borrowers or guarantors of loans underlying HPCI's participation interests, in which case such loans would be on substantially the same terms, including interest rates and collateral on loans, as those prevailing at the time for comparable transaction with others and would not involve more than the normal risk of collectibility or present other unfavorable features. At December 31, 2002, there were no direct or indirect pecuniary interests in any asset of HPCI by any of its officers or directors.
OTHER MANAGEMENT POLICIES AND PROGRAMS
General. In administering HPCI's participation interests and other authorized investments, the Bank has a high degree of autonomy. HPCI, however, has certain policies to guide its administration with respect to the Bank's underwriting standards, the acquisition and disposition of assets, credit risk management, and certain other activities. These policies, which are discussed below, may be amended or revised from time to time at the discretion of HPCI's board of directors, subject in certain circumstances to the approval of a majority of HPCI's independent directors, but without a vote of its shareholders.
Underwriting Standards. The Bank has represented to Holdings, and Holdings has represented to HPCI, that most of the loans underlying HPCI's participation interests were originated generally in accordance with underwriting policies customarily employed by the Bank during the period in which the loans were originated. The Bank
emphasizes "in-market" lending, which means lending to borrowers that are located where the Bank or its affiliates have branches or loan origination offices. The Bank avoids transactions perceived to have unacceptably high risk, as well as excessive industry and other concentrations.
Some of the loans, however, were acquired by the Bank in connection with the acquisition of other financial institutions. Prior to acquiring any financial institution, the Bank performed a number of due diligence procedures to, among other things, assess the overall quality of the target institution's loan portfolio. These procedures included the examination of underwriting standards used in the origination of loan products by the target institution, the review of loan documents and the contents of selected loan files, and the verification of the past due status and payment histories of selected borrowers. Through its due diligence procedures, the Bank obtained a sufficient level of comfort pertaining to the underwriting standards used by the target institution and their influence on the quality of the portfolio. Even though the Bank did not and does not warrant those standards, the Bank found them acceptable in comparison to HPCI's underwriting standards in cases where the Bank had made a favorable decision to acquire the institution as a whole.
Asset Acquisition and Disposition Policies. It is HPCI's policy to purchase from the Bank participation interests generally in loans that:
- are performing, meaning they have no more than two payments past due,
- are in accruing status,
- are not made to related parties of HPCI or the Bank,
- are secured by real property such that they are REIT qualifying, and
- have not been previously sold, securitized, or charged-off either in
whole or in part.
HPCI's policy also allows for investment in assets that are not REIT-Qualified Assets up to but not exceeding the statutory limitations imposed on organizations that qualify as REITs. In the past, Holdings has purchased from the Bank and sold to HPCI participation interests in loans not secured by real property because of available proceeds from loan repayments and pay-offs. Management, under this policy, also has the discretion to purchase other assets to maximize its return to shareholders.
It is anticipated that from time to time HPCI will receive participation interests in additional real estate loans from the Bank on a basis consistent with secondary market standards pursuant to the loan participation and subparticipation agreements, out of proceeds received in connection with the repayment or disposition of loan participation interests in HPCI's portfolio. Although HPCI is permitted to do so, it has no present plans or intentions to purchase loans or loan participation interests from unaffiliated third parties. It is currently anticipated that participation interests in additional loans acquired by HPCI will be of the types described above under the heading "General Description of Assets," although HPCI is not precluded from purchasing additional types of loans or loan participation interests.
HPCI may continue to acquire from time to time limited amounts of participation interests in loans that are not commercial or residential loans, such as automobile loans and equipment loans, or other authorized investments. Although currently there is no intention to acquire any mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans that will be secured by single-family residential, multi-family, or commercial real estate properties located throughout the United States, HPCI is not restricted from doing so. HPCI does not intend to acquire any interest-only or principal-only mortgage-backed securities. HPCI also will not be precluded from investing in mortgage-backed securities when the Bank is the sponsor or issuer. At December 31, 2002, HPCI did not hold any mortgage-backed securities.
HPCI currently anticipates that it will not acquire the right to service any loan underlying a participation interest that it acquires in the future and that the Bank will act as servicer of any such additional loans. HPCI anticipates that any servicing arrangement that it enters into in the future with the Bank will contain fees and other terms that would be substantially equivalent to or more favorable to HPCI than those that would be contained in servicing arrangements entered into with third parties unaffiliated with HPCI.
HPCI's current policy is not to acquire any participation interest in any commercial real estate loan that constitutes more than 5.0% of the total book value of HPCI's real estate assets at the time of acquisition. In addition, HPCI's current policy prohibits the acquisition of any loan or any interest in a loan other than an interest resulting from the acquisition of mortgage-backed securities, which loan is collateralized by real estate located in West Virginia or that is made to a municipality or other tax-exempt entity.
HPCI's current policy is to reinvest the proceeds of its assets in other interest-earning assets such that its Funds from Operations (FFO), which represents cash flows from operations, over any period of four fiscal quarters will be anticipated to equal or exceed 150% of the amount that would be required to pay full annual dividends on the Class A, Class C, and Class D preferred securities, except as may be necessary to maintain its status as a REIT. HPCI's articles of incorporation provide that it cannot amend or change this policy with respect to the reinvestment of proceeds without the consent or affirmative vote of the holders of at least two-thirds of the Class C preferred securities and two thirds of the Class D preferred securities, voting as separate classes.
Credit Risk Management Policies. It is expected that participation interests in each commercial or residential real estate loan acquired in the future will represent a first lien position and will be originated by the Bank, one of its affiliates, or an unaffiliated third party in the ordinary course of its real estate lending activities based on the underwriting standards generally applied by or substantially similar to those applied by the Bank at the time of origination for its own account. It is also expect that all loans will be serviced by or through the Bank pursuant to the participation agreement and subparticipation agreement, which require servicing in conformity with any loan servicing guidelines promulgated by HPCI and, in the case of residential real estate loans, with FNMA and FHLMC guidelines and procedures.
Other Policies. HPCI intends to operate in a manner that will not subject it to regulation under the Investment Company Act. Unless otherwise approved by its board of directors, HPCI does not intend to:
- invest in the securities of other issuers for the purpose of
exercising control over such issuers;
- underwrite securities of other issuers;
- actively trade in loans or other investments;
- offer securities in exchange for property; or
- make loans to third parties, including, its officers, directors, or
other affiliates.
The Investment Company Act exempts entities that, directly or through majority-owned subsidiaries, are "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate" (Qualifying Interests). Under current interpretations by the staff of the SEC, in order to qualify for this exemption, HPCI, among other things, must maintain at least 55% of its assets in Qualifying Interests and also may be required to maintain an additional 25% in either Qualifying Interests or other real estate-related assets. The assets that HPCI may acquire therefore may be limited by the provisions of the Investment Company Act. HPCI intends to operate its business in a manner that will maintain its exemption under the Investment Company Act.
HPCI has no present intention of repurchasing any of its capital securities, and any such action would be taken only in conformity with applicable federal and state laws and regulations and the requirements for qualifying as a REIT.
HPCI intends to distribute to its shareholders, in accordance with the Securities and Exchange Act of 1934, as amended, annual reports containing financial statements prepared in accordance with generally accepted accounting principles in the United States and certified by its independent auditors. HPCI's articles of incorporation provide that it will maintain its status as a reporting company under the Exchange Act for so long as any of the Class C preferred securities are outstanding and held by unaffiliated shareholders.
HPCI currently makes investments and operates its business in such a manner consistent with the requirements of the Internal Revenue Code to qualify as a REIT. However, future economic, market, legal, tax, or other considerations may cause its board of directors, subject to approval by a majority of its independent directors, to determine that it is in HPCI's best interest and the best interest of its shareholders to revoke HPCI's REIT status. The Internal Revenue Code prohibits HPCI from electing REIT status for the five taxable years following the year of such revocation.
EMPLOYEES
At December 31, 2002, HPCI had five executive officers and two additional officers, but no other employees. Day-to-day activities and the servicing of the loans underlying HPCI's participation interests are administered by the Bank. All of HPCI's officers are also officers or employees of Huntington, the Bank, and/or Holdings. HPCI maintains corporate records and audited financial statements that are separate from those of Huntington, the Bank, and Holdings.
Although there are no restrictions or limitations contained in HPCI's articles of incorporation or bylaws, HPCI does not anticipate that its officers or directors will have any direct or indirect pecuniary interest in any asset to be acquired or disposed of by HPCI or in any transaction in which HPCI has an interest or will engage in acquiring, holding, and managing assets, other than as borrowers or guarantors of loans underlying HPCI's participation interests, in which case such loans would be on substantially the same terms, including interest rates and collateral on loans, as those prevailing at the time for comparable transaction with others and would not involve more than the normal risk of collectibility or present other unfavorable features.
SERVICING
The loans underlying HPCI's participation interests are serviced by the Bank pursuant to the terms of the participation agreement between the Bank and Holdings and the subparticipation agreement between Holdings and HPCI. The Bank has delegated servicing responsibility of the residential real estate loans to The Huntington Mortgage Company (HMC), a wholly-owned subsidiary of the Bank. Beginning in 2003, HMC will operate as a division of the Bank as a result of the merger of HMC into the Bank at the end of 2002.
The participation and subparticipation agreements require the Bank to service the loans underlying HPCI's participation interests in a manner substantially the same as for similar work performed by the Bank for transactions on its own behalf. The Bank or its affiliates collect and remit principal and interest payments, maintain perfected collateral positions, and submit and pursue insurance claims. The Bank and its affiliates also provide accounting and reporting services required by HPCI for its participation interests. HPCI may direct the Bank to dispose of any loans that become classified, are placed in a non-performing status, or are renegotiated due to the financial deterioration of the borrower. The Bank is required to pay all expenses related to the performance of its duties under the participation and subparticipation agreements, including any payment to its affiliates for servicing the loans. The Bank or its affiliates may institute foreclosure proceedings at the direction of HPCI, exercise any power of sale contained in any mortgage or deed of trust, obtain a deed in lieu of foreclosure, or otherwise acquire title to a mortgaged property underlying a real estate loan by operation of law or otherwise in accordance with the terms of the participation and subparticipation agreement.
Under the participation and subparticipation agreements, the Bank has the right in its discretion to give consents, waivers, and modifications of the loan documents to the same extent as if the loans were wholly owned by the Bank; provided, however, without the written consent of Holdings, the Bank may not waive any payment default, extend the maturity of the loans, reduce the rate or rates of interest with respect to the loans, forgive or reduce the principal sum of the loans, increase the lending formula or advance rates, or amend or modify the financial covenants contained in the loan documents in any way that would make such financial covenants less restrictive.
The Bank has the right to accept payment or prepayment of the whole principal sum and accrued interest in accordance with the terms of the loans, waive prepayment charges in accordance with the Bank's policy for loans in which no participation interest has been granted, and accept additional security for the loans. No specific term is specified in the participation agreement and subparticipation agreement; the agreements may be terminated by mutual agreement of the parties at any time, without penalty. Due to the relationship among HPCI, Holdings, and the Bank, it is not anticipated that these agreements will be terminated by any party in the foreseeable future.
The Bank, in its role as servicer under the terms of the loan participation agreement, receives a loan servicing fee designed as a reimbursement for costs incurred to service the underlying loan. The amount and terms of the fee are determined by mutual agreement of the Bank, Holdings, and HPCI from time to time during the term of the participation agreement and subparticipation agreement. Periodically, a review and analysis of loan servicing operations is conducted by the Bank. As a result, among other things, the cost to service an individual loan is calculated and is used as a basis to determine fair compensation for services rendered. The loan servicing fee is subject to adjustment annually based upon the Bank's review and analysis at the end of each calendar year during the term of the participation agreement.
HPCI paid servicing fees of $6.7 million for the year ended December 31, 2002, $8.3 million for the year ended December 31, 2001, and $7.8 million for the year ended December 31, 2000. In 2002, the annual servicing fee with respect to the commercial real estate, commercial, and consumer loans was equal to the outstanding principal balance of each loan multiplied to a fee of 0.125% and the annual servicing fee with respect to residential real estate loans is equal to 0.282% of the interest income collected. Neither the participation agreement nor the subparticipation agreement limits or caps the servicing fees that are paid to the Bank.
COMPETITION
Competition in the form of price and service from other banks and financial companies such as savings and loans, credit unions, finance companies, and brokerage firms is intense in most of the markets served by Huntington and its subsidiaries. Mergers between and the expansion of financial institutions both within and outside Ohio have provided significant competitive pressure in major markets. Since 1995, when federal interstate banking legislation became effective that made it permissible for bank holding companies in any state to acquire banks in any other state, and for banks to establish interstate branches (subject to certain limitations by individual states), actual or potential competition in each of Huntington's markets has been intensified. Internet banking also competes with Huntington's business. This competition impacts Huntington's ability to attract new business, particularly in the form of loans secured by real estate, and, therefore, also affects HPCI's availability to invest in participation interests in such loans.
REGULATORY MATTERS
HPCI is an indirect subsidiary of the Bank and therefore, regulatory authorities have the right to examine HPCI and its activities and, under certain circumstances, to impose restrictions on the Bank or HPCI. The Bank is subject to examination and supervision by the OCC. In addition to the impact of federal and state regulation, the Bank is affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.
BUSINESS RISKS
HPCI, like all other companies, is subject to a number of risks, many of which are outside of HPCI's control. HPCI's management strives to limit those risks while maximizing profitability. Among the risks that HPCI assumes are: (1) credit risk, which is the risk that underlying loan customers or other counterparties will be unable to perform their contractual obligations, (2) operational risk, which is the risk of loss resulting from the inadequate or failed internal processes, people, and systems or from external events, and (3) interest rate risk, which is the risk that interest income on HPCI's participation interests will fall as interest rates fall. In addition to the other information in this report, readers should carefully consider that the following important factors, among others, could materially impact HPCI's business, future results of operations, and future cash flows.
HPCI RELIES ON THE BANK'S CREDIT UNDERWRITING STANDARDS AND ON-GOING PROCESS OF CREDIT ASSESSMENT; THERE CAN BE NO ASSURANCE THAT THE BANK'S STANDARDS AND ASSESSMENTS WILL PROTECT HPCI FROM SIGNIFICANT CREDIT LOSSES ON LOANS UNDERLYING ITS PARTICIPATION INTERESTS.
To date, HPCI has purchased, and intends to continue to purchase, all of its participation interests in loans originated by or through the Bank and its affiliates. After HPCI purchases the participation interests, the Bank continues to service the underlying loans. Accordingly, in managing its credit risk, HPCI relies on the Bank's credit underwriting standards and on-going process of credit assessment. The Bank's exposure to credit risk is managed through the use of consistent underwriting standards that emphasize "in-market" lending while avoiding highly leveraged transactions as well as excessive industry and other concentrations. The Bank's credit administration function employs risk management techniques to ensure that underlying loans adhere to corporate policy and problem loans underlying HPCI's participation interests are promptly identified. There can be no assurance that the Bank's credit underwriting standards and its on-going process of credit assessment will protect HPCI from significant credit losses on loans underlying its participation interests.
THE LOANS UNDERLYING HPCI'S PARTICIPATION INTERESTS ARE CONCENTRATED IN FOUR STATES, AND ADVERSE CONDITIONS IN THOSE STATES, IN PARTICULAR, COULD NEGATIVELY IMPACT RESULT OF OPERATIONS AND ABILITY TO PAY DIVIDENDS.
At December 31, 2002, 95.8% of the properties underlying HPCI's loan participation interests (as a percentage of loan principal balances) were located in Ohio, Michigan, Indiana, and Kentucky. Because of the concentration of its interests in those states, in the event of adverse economic conditions in those states, HPCI would likely experience higher rates of loss and delinquency on its loan participation interests than if the underlying loans were more geographically diversified. Additionally, the loans underlying its loan participation interests may be subject to a greater risk of default than other comparable loans in the event of adverse economic, political, or business developments or natural hazards that may affect Ohio, Michigan, Indiana, or Kentucky and the ability of property owners in those states to make payments of principal and interest on the underlying loans. In the event of any adverse development or natural disaster, HPCI's results of operations and ability to pay dividends on preferred and common securities could be adversely affected.
THE LOANS UNDERLYING PARTICIPATION INTERESTS ARE SUBJECT TO LOCAL ECONOMIC CONDITIONS THAT COULD NEGATIVELY AFFECT THE VALUE OF THE COLLATERAL SECURING SUCH LOANS AND/OR THE RESULTS OF HPCI'S OPERATIONS.
The value of the collateral underlying HPCI's loans and/or the results of its operations could be affected by various conditions in the economy, all of which are beyond HPCI's control. These include local and other economic conditions affecting real estate and other collateral values; the continued financial stability of a borrower and the borrower's ability to make loan principal and interest payments, which may be adversely affected by job loss, recession, divorce, illness, or personal bankruptcy. These also include the ability of tenants to make lease payments; the ability of a property to attract and retain tenants, which may be affected by conditions such as an oversupply of space or a reduction in demand for rental space in the area, the attractiveness of properties to tenants, competition from other available space, and the ability of the owner to pay leasing commissions, provide adequate maintenance and insurance, pay tenant improvement costs, and make other tenant concessions. Furthermore, interest rate levels and the availability of credit to refinance loans at or prior to maturity and increased operating costs, including energy costs, real estate taxes, and costs of compliance with environmental controls and regulations are also various conditions in the economy that effect the value of the underlying collateral and the result of HPCI's operations.
HPCI'S ACQUISITION OF PARTICIPATION INTERESTS IN COMMERCIAL REAL ESTATE LOANS SUBJECTS IT TO RISKS THAT ARE NOT PRESENT IN PARTICIPATION INTERESTS IN RESIDENTIAL REAL ESTATE LOANS.
At December 31, 2002, 71.1% of HPCI's assets, as measured by aggregate outstanding principal amount, consisted of participation interests in commercial real estate loans. Commercial real estate loans generally tend to have shorter maturities than residential real estate loans and may not be fully amortizing, meaning that they may have a significant principal balance or "balloon" payment due on maturity. Commercial real estate properties tend to be unique and are more difficult to value than single-family residential real estate properties. They are also subject to relatively greater environmental risks and to the corresponding burdens and costs of compliance with environmental laws and regulations. Due to these risks, HPCI may experience higher rates of default on its participation interests in commercial real estate loans than if its participation interests were more diversified and included a greater percentage of underlying residential and other loans.
A DECLINE IN THE BANK'S CAPITAL LEVELS MAY RESULT IN PREFERRED SECURITIES BEING SUBJECT TO A CONDITIONAL EXCHANGE INTO BANK PREFERRED SECURITIES AT A TIME WHEN THE BANK'S FINANCIAL CONDITION IS DETERIORATING. CONSEQUENTLY, THE LIKELIHOOD OF DIVIDEND PAYMENTS, AS WELL AS THE LIQUIDATION PREFERENCE, TAXATION, VOTING RIGHTS, AND LIQUIDITY OF SECURITIES WOULD BE NEGATIVELY IMPACTED.
The returns from a shareholder's investment in HPCI's preferred securities will be dependent to a significant extent on the performance and capital of the Bank. A decline in the performance and capital levels of the Bank or the placement of the Bank into conservatorship or receivership could result in the exchange, if so directed by the OCC, of HPCI's preferred securities for Bank preferred securities, without shareholder approval or any shareholder action. This would represent an investment in the Bank and not in HPCI. Under these circumstances, there would likely be a significant loss associated with this investment. Also, since preferred shareholders of HPCI would become preferred shareholders of the Bank at a time when the Bank's financial condition has deteriorated, it is unlikely that the Bank would be in a financial position to make any dividend payments on the Bank preferred securities.
In the event of a liquidation of the Bank, the claims of depositors and creditors of the Bank would be entitled to priority in payment over the claims of holders of equity interests such as the Bank preferred securities, and, therefore, preferred shareholders likely would receive substantially less than would have been received had the preferred securities not been exchanged for Bank preferred securities.
The exchange of the preferred securities for Bank preferred securities would most likely be a taxable event to shareholders under the Internal Revenue Code and, in that event, shareholders would incur a gain or loss, as the case may be, measured by the difference between the basis in the preferred securities and the fair market value of the Bank preferred securities received in the exchange.
Although the terms of the Bank preferred securities are substantially similar to the terms of HPCI's preferred securities, there are differences, such as the Bank preferred securities do not have any voting rights or any right to elect independent directors if dividends are missed. In addition, the Bank preferred securities will not be listed on the NASDAQ Stock Market or any exchange and a market for them may never develop.
BANK REGULATORS MAY LIMIT HPCI'S ABILITY TO IMPLEMENT ITS BUSINESS PLAN AND MAY RESTRICT ITS ABILITY TO PAY DIVIDENDS.
Because HPCI is an indirect subsidiary of the Bank, regulatory authorities will have the right to examine HPCI and its activities and, under certain circumstances, to impose restrictions on the Bank or HPCI which could impact HPCI's ability to conduct business pursuant to its business plan and which could adversely effect its financial condition and results of operations.
If the OCC determines that the Bank's relationship with HPCI results in an unsafe and unsound banking practice, the OCC and other regulators of the Bank have the authority to restrict HPCI's ability to transfer assets, restrict its ability to make distributions to shareholders or redeem preferred securities, or to require the Bank to sever its relationship with HPCI or divest its ownership in HPCI. Certain of these actions by the OCC would likely result in HPCI's failure to qualify as a REIT.
Payment of dividends on the preferred securities could also be subject to regulatory limitations if the Bank becomes "undercapitalized" for purposes of regulations issued by the OCC. Under these regulations, the Bank will be deemed "undercapitalized" if it has a total risk-based capital ratio of less than 8.0%; a Tier 1 risk-based capital ratio of less than 4.0%; and a leverage ratio of less than 4.0% or less than 3% if the institution has been awarded the highest supervisory rating. At December 31, 2002, the Bank's total risk-based capital ratio was 10.24%, its Tier 1 risk-based capital ratio was 6.40%, and its leverage ratio was 6.62%. The Bank currently intends to maintain its capital ratios in excess of the "well-capitalized" levels under these regulations. However, there can be no assurance that the Bank will be able to maintain its capital in excess of the "well-capitalized" levels. The exercise of the OCC's power to restrict dividends on preferred securities would, however, also have the effect of restricting the payment of dividends on common shares. The inability to pay dividends on common shares would prevent HPCI from meeting the statutory requirement for a REIT to distribute 90% of its taxable income and, therefore, would cause HPCI to fail to qualify for the favorable tax treatment accorded to REITs.
Legal and regulatory limitations on the payment of dividends by the Bank could also affect HPCI's ability to pay dividends to unaffiliated third parties, including the preferred shareholders. Since HPCI, HPCII, HPCH-III, and Holdings are members of the Bank's consolidated group, payment of common and preferred dividends by the Bank and/or any member of its consolidated group to unaffiliated third parties, including payment of dividends to the shareholders of preferred securities, would require regulatory approval if aggregate dividends on a consolidated basis exceed certain limitations. Regulatory approval is required prior to the Bank's declaration of any dividends in excess of available retained earnings. The amount of dividends that may be declared without regulatory approval is further limited to the sum of net income for the current year and retained net income for the preceding two years, less any required transfers to surplus or common stock.
DIVIDENDS ARE NOT CUMULATIVE; PREFERRED SHAREHOLDERS ARE NOT ENTITLED TO RECEIVE DIVIDENDS UNLESS DECLARED BY HPCI'S BOARD OF DIRECTORS.
Dividends on the preferred securities are not cumulative. Consequently, if the board of directors does not declare a dividend on the preferred securities for any quarterly period, including if prevented by bank regulators, preferred shareholders will not be entitled to receive that dividend whether or not funds are or subsequently become available. The board of directors may determine that it would be in HPCI's best interests to pay less than the full amount of the stated dividends on the preferred securities or no dividends for any quarter even though funds are available. Factors that would generally be considered by the board of directors in making this determination are the amount of distributable funds, HPCI's financial condition and capital needs, the impact of current and pending legislation and regulations, economic conditions, tax considerations, and HPCI's continued qualification as a REIT. If full dividends on the Class A, Class C, and Class D preferred securities have not been paid for six full dividend periods, the holders of the Class C and Class D preferred securities, voting together as one class, will have the right to elect two independent directors in addition to those already on the board.
HPCI AND THE BANK MAINTAIN INTERNAL OPERATIONAL CONTROLS. IF HPCI'S AND/OR THE BANK'S SYSTEMS OF INTERNAL CONTROLS SHOULD FAIL TO WORK AS EXPECTED, THEIR SYSTEMS WERE TO BE USED IN AN UNAUTHORIZED MANNER, OR EMPLOYEES WERE TO SUBVERT THE SYSTEMS OF INTERNAL CONTROLS, SIGNIFICANT LOSSES TO HPCI COULD OCCUR.
HPCI is exposed to numerous types of operational risk. Operational risk generally refers to the risk of loss resulting from operations, including, but not limited to, the risk of fraud by employees or persons outside HPCI and the Bank, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes the potential
legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.
HPCI, directly and through the Bank, establishes and maintains systems of internal operational controls that provide management with timely and accurate information about its level of operational risk. While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels. The Bank and HPCI have also established procedures that are designed to ensure that policies relating to conduct, ethics, and business practices are followed. From time to time, HPCI experiences losses from operational risk, including the effects of operational errors.
Management believes that HPCI's and the Bank's current systems of internal controls are effective. While management continually monitors and improves their systems of internal controls, data processing systems, and corporate-wide processes and procedures, there can be no assurance that HPCI will not suffer such losses in the future.
HPCI IS DEPENDENT IN VIRTUALLY EVERY PHASE OF ITS OPERATIONS ON THE DILIGENCE AND SKILL OF THE OFFICERS AND EMPLOYEES OF THE BANK, AND ITS RELATIONSHIP WITH THE BANK MAY CREATE POTENTIAL CONFLICTS OF INTEREST.
The Bank is involved in virtually every aspect of HPCI's existence. As of December 31, 2002, all of its officers and five of its nine directors are also officers or directors of the Bank or its affiliates. Officers that are common with the Bank devote less than a majority of their time to managing HPCI's business. The Bank has the right to elect all of HPCI's directors, including independent directors, except under limited circumstances if it fails to pay future dividends. The Bank and its affiliates have interests that are not identical to HPCI's and, therefore, conflicts of interest could arise in the future with respect to transactions between or among the Bank, Holdings, HPCII, HPCH-III, and HPCI.
The Bank administers HPCI's day-to-day activities under the terms of participation and subparticipation agreements. The parties to these agreements are all affiliated and, accordingly, these agreements were not the result of arms-length negotiations and may be modified at any time in the future. Although the modification of the agreements requires the approval of a majority of independent directors, the Bank, through its direct and indirect ownership of HPCH-III's and HPCII's common stock and their ownership of HPCI's common stock, controls the election of all of the directors, including independent directors. Therefore, HPCI cannot assure shareholders modifications to the participation and subparticipation agreements will be on terms as favorable to it as those that could have been obtained from unaffiliated third parties.
Huntington, the owner of all the Bank's common shares, may have investment goals and strategies that differ from those of the holders of HPCI's preferred securities. In addition, neither Huntington nor the Bank has a policy addressing the treatment of new business opportunities. Thus, new business opportunities identified by Huntington or the Bank may be directed to affiliates other than HPCI. HPCI's board of directors has broad discretion to revise its investment and operating strategy without shareholder approval. The Bank, through its direct and indirect ownership of HPCH-III's and HPCII's common stock and their ownership of HPCI's common stock, controls the election of all of HPCI's directors, including independent directors. Consequently, HPCI's investment and operating strategies will largely be directed by Huntington and the Bank.
HPCI is dependent on the diligence and skill of the officers and employees of the Bank for the selection and structuring of the loans underlying its participation interests and other authorized investments. The Bank selected the amount, type, and price of loan participation interests and other assets that were acquired from the Bank and its affiliates. HPCI anticipates that it will continue to acquire all or substantially all of its assets from the Bank or its affiliates for the foreseeable future. Although these acquisitions are made within investment policies, neither HPCI nor the Bank obtained any third-party valuations. HPCI does not intend to do so in the future. Although HPCI has policies to guide the acquisition and disposition of assets, these policies may be revised or exceptions may be approved from time to time at the discretion of the board of directors without a vote of shareholders. Changes in or exceptions made to these policies could permit the acquisition of lower quality assets.
HPCI is dependent on the Bank and others for monitoring and servicing the loans underlying its participation interests. Conflicts could arise as part of such servicing, particularly with respect to loans that are placed on nonaccrual status. While HPCI believes that the Bank will diligently pursue collection of any non-performing assets, HPCI cannot assure shareholders that this will occur. HPCI's ability to make timely payments of dividends on the preferred and common securities will depend in part upon the Bank's prompt collection efforts on its behalf. HPCI pays substantial servicing fees to the Bank. HPCI paid servicing fees of $6.7 million in 2002, $8.3 million in 2001, and $7.8 million in 2000.
The Bank may seek to exercise its influence over HPCI's affairs so as to cause the sale of its assets and their replacement by lesser quality assets acquired from the Bank or elsewhere. This could adversely affect HPCI's business and its ability to make timely payment of dividends on the preferred and common securities.
HPCI'S ASSETS MAY BE USED TO SECURE CERTAIN OF THE BANK'S OBLIGATIONS THAT WILL HAVE A PREFERENCE OVER THE HOLDERS OF HPCI'S PREFERRED SECURITIES.
The Bank is eligible to obtain advances from various federal and government-sponsored agencies, such as the Federal Home Loan Bank of Cincinnati (FHLBC). Any such agency that makes advances to the Bank where HPCI has acted as a co-borrower or guarantor or has pledged its assets as collateral will have a preference over the holders of HPCI's preferred securities. These holders would receive their liquidation preference only to the extent there are assets available after satisfaction of HPCI's indebtedness, if any. HPCI is not required to obtain the consent of its shareholders in order to make such a pledge or act as co-borrower or guarantor.
The Bank has obtained a line of credit from the FHLBC, which line was capped at $1.3 billion as of December 31, 2002. As of that same date, the Bank had borrowings of $1.0 billion under the facility. HPCI has entered into an agreement with the Bank with respect to the pledge of HPCI's assets to collateralize the Bank's borrowings from the FHLBC. The agreement provides that the Bank will not place at risk HPCI's assets in excess of an aggregate amount or percentage of such assets established from time to time by HPCI's board of directors, including a majority of HPCI's independent directors. HPCI's board has set this limit at $1 billion, which limit may be changed in the future by the board of directors, including a majority of HPCI's independent directors. As of December 31, 2002, HPCI's pledged collateral was limited to 1-4 family residential mortgages and second mortgage loans, which aggregated $543 million as of that same date. A default by the Bank on its obligations to the FHLBC could adversely affect HPCI's business and its ability to make timely dividend payments on preferred and common securities.
NEW, OR CHANGES IN EXISTING, TAX, ACCOUNTING, AND REGULATORY LAWS, REGULATIONS, RULES, AND STANDARDS COULD SIGNIFICANTLY IMPACT STRATEGIC INITIATIVES, RESULTS OF OPERATIONS, FINANCIAL CONDITION, AND ABILITY TO PAY DIVIDENDS.
Future governmental regulations could impose significant additional limitations on HPCI's operations. These regulations, along with the currently existing tax, accounting, securities, insurance, and monetary laws, regulations, rules, standards, policies, and interpretations control the methods by which companies conduct business, implement strategic initiatives and tax planning, and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time. Events that may not have a direct impact on HPCI, such as the bankruptcy of major U.S. companies, have resulted in legislators, regulators, and authoritative bodies, such as the Financial Accounting Standards Board, the Securities and Exchange Commission, and the Public Company Accounting Oversight Board, to respond by adopting and/or proposing substantive revisions to laws, regulations, rules, standards, policies, and interpretations. The nature, extent, and timing of the adoption of significant new laws, changes in existing laws, or repeal of existing laws may have a material impact on HPCI's business, results of operations, and ability to pay dividends; however, it is impossible to predict at this time the extent to which any such adoption, change, or repeal would impact HPCI.
THE EXTENDED DISRUPTION OF HUNTINGTON'S VITAL INFRASTRUCTURE COULD NEGATIVELY IMPACT HPCI'S BUSINESS, RESULTS OF OPERATIONS, FINANCIAL CONDITION, AND ABILITY TO PAY DIVIDENDS.
HPCI's operations depend upon, among other things, Huntington's and the Bank's infrastructure, including their equipment and facilities. Extended disruption of vital infrastructure by fire, power loss, natural disaster, telecommunications failure, computer hacking or viruses, terrorist activity or the domestic and foreign response to such activity, or other events outside of Huntington's or the Bank's control could have a material adverse impact on the financial services industry as a whole and on HPCI's business, results of operations, cash flows, financial condition, and ability to pay dividends in particular.
HPCI HAS NO CONTROL OVER CHANGES IN INTEREST RATES AND SUCH CHANGES COULD NEGATIVELY IMPACT ITS FINANCIAL CONDITION, RESULTS OF OPERATIONS, AND ABILITY TO PAY DIVIDENDS.
HPCI's income consists primarily of interest and fees on loans underlying its participation interests. At December 31, 2002, 24% of the loans underlying its participation interests, as measured by the aggregate outstanding principal amount, bore interest at fixed rates and the remainder bore interest at adjustable rates. Adjustable-rate loans decrease the risks associated with changes in interest rates but involve other risks. As interest rates rise, the payment by the borrower rises to the extent permitted by the terms of the loan, and the increased payment increases the potential for
default. At the same time, the marketability of the underlying property may be adversely affected by higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on the loans underlying HPCI's participation interests as the borrowers refinance their mortgages at lower interest rates. Under these circumstances, HPCI may find it more difficult to acquire additional participation interests with rates sufficient to support the payment of the dividends on the preferred securities. Because the rate at which dividends are required to be paid on the Class A and C preferred securities is fixed, there can be no assurance that a declining interest rate environment would not adversely affect HPCI's ability to pay full, or even partial, dividends on its preferred securities.
HPCI'S FINANCIAL STATEMENTS CONFORM WITH ACCOUNTING PRINCIPLES GENERALLY ACCEPTED IN THE UNITED STATES, WHICH REQUIRE MANAGEMENT TO MAKE ESTIMATES AND ASSUMPTIONS THAT AFFECT AMOUNTS REPORTED IN THE FINANCIAL STATEMENTS. ACTUAL RESULTS COULD DIFFER FROM THOSE ESTIMATES.
HPCI's financial statements include estimates related to accruals of income and expenses. These estimates are based on information available at the time the estimates are made. Factors involved in these estimates could change in the future leading to a change of those estimates, which could be material to HPCI's results of operations or financial condition.
HPCI COULD SUFFER ADVERSE TAX CONSEQUENCES IF IT FAILED TO QUALIFY AS A REIT.
No assurance can be given that HPCI will be able to continue to operate in such a manner so as to remain qualified as a REIT. Qualification as a REIT involves the application of highly technical and complex tax law provisions for which there are only limited judicial or administrative interpretations and involves the determination of various factual matters and circumstances not entirely within its control. No assurance can be given that new legislation or new regulations, administrative interpretations, or court decisions will not significantly change the tax laws in the future with respect to qualification as a REIT or the federal income tax consequences of such qualification in a way that would materially and adversely affect HPCI's ability to operate. Any such new legislation, regulation, interpretation, or decision could be the basis of a tax event that would permit HPCI to redeem all or any preferred securities. If HPCI were to fail to qualify as a REIT, the dividends on preferred securities, would not be deductible for federal income tax purposes. HPCI would face a tax liability that could consequently result in a reduction in HPCI's net earnings after taxes. A reduction in net earnings after taxes could adversely affect its ability to add interest-earning assets to its portfolio and pay dividends to its preferred security holders.
If in any taxable year HPCI fails to qualify as a REIT, unless it is entitled to relief under certain statutory provisions, it would also be disqualified from treatment as a REIT for the five taxable years following the year its qualification was lost. As a result, the amount of funds available for distribution to shareholders would be reduced for the year or years involved.
As a REIT, HPCI generally will be required each year to distribute as dividends to its shareholders at least 90% of REIT taxable income, excluding capital gains. Failure to comply with this requirement would result in earnings being subject to tax at regular corporate rates. In addition, HPCI would be subject to a 4% nondeductible excise tax on the amount by which certain distributions considered as paid with respect to any calendar year are less than the sum of 85% of ordinary income for the calendar year, 95% of capital gains net income for the calendar year, and 100% of undistributed taxable income from prior periods. Qualification as a REIT also involves application of other specific provisions of the Internal Revenue Code. Two specific provisions are an income test and an asset test. At least 75% of HPCI's gross income, excluding gross income from prohibited transactions, for each taxable year must be derived directly or indirectly from investments relating to real property or mortgages on real property. Additionally, at least 75% of HPCI's total assets must be represented by real estate assets. At December 31, 2002, HPCI had qualifying income and qualifying assets that exceeded 75%.
Although HPCI intends to operate in a manner designed to qualify as a REIT, future economic, market, legal, tax, or other considerations may cause it to determine that it is in its best interests and the best interests of holders of common and preferred securities to revoke the REIT election. As long as any class of preferred securities are outstanding, any such determination may be made without shareholder approval, but will require the approval of a majority of independent directors.
ENVIRONMENTAL LIABILITIES ASSOCIATED WITH REAL PROPERTY SECURING LOANS UNDERLYING HPCI'S PARTICIPATION INTERESTS COULD REDUCE THE FAIR MARKET VALUE OF ITS PARTICIPATION INTERESTS AND MAKE THE PROPERTY MORE DIFFICULT TO SELL.
In its capacity as servicer, the Bank at the direction of HPCI may be forced to foreclose on a defaulted commercial real estate loan and/or a residential real estate loan to recover its investment in the real estate loan. The Bank may be subject to environmental liabilities in connection with the underlying real property, which could exceed the value of the real property. Although the Bank exercises due diligence to discover potential environmental liabilities prior to the acquisition of any property through foreclosure, hazardous substances or wastes, contaminants, pollutants, or their sources may be discovered on properties during the Bank's ownership or after a sale to a third party. Even though HPCI may sell to the Bank, at fair value, the participation interest in any loan at the time the real property securing that loan becomes foreclosed property, the discovery of these liabilities, any associated costs for removal of hazardous substances, wastes, contaminants, or pollutants, and the difficulty in selling the underlying real estate, could have a material adverse effect on the fair value of that loan and therefore HPCI may not recover any or all of its investment in the underlying loan.
HPCI MAY REDEEM THE CLASS C AND CLASS D PREFERRED SECURITIES UPON THE OCCURRENCE OF CERTAIN SPECIAL EVENTS.
At any time following the occurrence of certain special events, HPCI will have the right to redeem the Class C and Class D preferred securities in whole, subject to the prior written approval of the OCC. The occurrence of such an event will not, however, give a preferred shareholder any right to request that such Class C or Class D preferred securities be redeemed. A special event includes:
- a tax event which occurs when HPCI receives an opinion of counsel to the effect that, as a result of a judicial decision or administrative pronouncement, ruling, or other action or as a result of certain changes in the tax laws, regulations, or related interpretations, there is a significant risk that dividends with respect to HPCI's capital stock will not be fully deductible by HPCI or it will be subject to a significant amount of additional taxes or governmental charges;
- an investment company event which occurs when HPCI receives an opinion of counsel to the effect that, as a result of certain changes in the applicable laws, regulations, or related interpretations, there is a significant risk that HPCI will be considered an investment company under the Investment Company Act of 1940; and
- a regulatory capital event which occurs when, as a result of certain changes in the applicable laws, regulations, or related interpretations, there is a significant risk that HPCI's Class C preferred securities will no longer constitute Tier 1 capital of the Bank (other than as a result of limitations on the portion of Tier 1 capital that may consist of minority interests in subsidiaries of the Bank).
GUIDE 3 INFORMATION
Information required by Industry Guide 3 relating to statistical disclosure by real estate investment trusts is set forth in Items 7 and 8.
ITEM 2: PROPERTIES
HPCI does not own any material physical property or real estate.
ITEM 3: LEGAL PROCEEDINGS
HPCI is not the subject of any material litigation. HPCI is not currently involved in nor, to management's knowledge, is currently threatened with any material litigation with respect to the loans underlying its participation interests other than routine litigation arising in the ordinary course of business.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the period covered by this report.
Part II
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
There is no established public trading market for HPCI's common stock. As of March 28, 2003, there were three common shareholders of record, all of which are affiliates of the Bank. During 2002, 2001, and 2000, dividends of $382.8 million, $539.2 million, and $458.3 million were paid to common shareholders, respectively, all of which were declared in December of each year.
Information regarding restrictions on dividends, as required by this item, is set forth in Item 1 "Dividend Policy and Restrictions". No HPCI securities were issued under compensation plans.
ITEM 6. SELECTED FINANCIAL DATA
The data presented below represents selected financial data relative to HPCI for, and as of the end of, the years ended December 31, 2002, 2001, 2000, 1999, and 1998 (in thousands of dollars):
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2002 2001 2000 1999 1998
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STATEMENTS OF INCOME:
Interest and fee income $ 347,754 $ 526,445 $ 549,718 $ 497,527 $ 298,420
Provision for loan losses (161) 48,510 2,293 --- ---
Non-interest income 6,759 1,646 --- --- ---
Non-interest expense 13,282 10,015 7,983 8,234 4,551
Net income before
preferred dividends 341,437 469,540 539,442 489,293 293,869
Dividends on preferred stock 23,814 21,827 80 80 ---
Net income applicable
to common shares 317,623 447,713 539,362 489,213 293,869
Dividends on common stock 382,840 539,170 458,335 413,760 293,869
Average yield on earning assets 5.82% 7.46% 8.28% 7.84% 8.48%
BALANCE SHEETS:
Loan participation interests, net
of allowance for loan losses $ 4,893,137 $ 5,203,286 $ 5,744,822 $ 5,939,286 $ 5,850,857
All other assets 623,884 745,473 1,153,451 280,076 150,041
Total assets 5,517,021 5,948,759 6,898,273 6,219,362 6,000,898
Total shareholders' equity 5,516,351 5,948,728 6,898,273 6,218,632 5,868,373
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All of HPCI's common stock is owned by Huntington, HPCII, and HPCH-III and therefore, earnings per common share information is not presented. At the end of all years presented, HPCI did not have any long-term liabilities.
ITEM 7. MANAGEMENTS'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
Huntington Preferred Capital, Inc. (HPCI or "the company") was incorporated in Ohio in July 1992 under the name Airbase Realty, Inc. The company changed its name to Huntington Preferred Capital, Inc. in May 2001. The company's principal business objective is to acquire, hold, and manage mortgage assets and other authorized investments that will generate net income for distribution to its shareholders. Since May 1998, the company has been operating as a real estate investment trust (REIT) for federal income tax purposes.
The company is a subsidiary of HPC Holdings-III, Inc. (HPCH-III), which is a subsidiary of Huntington Preferred Capital Holdings, Inc. (Holdings). Holdings is owned by The Huntington National Bank (the Bank) and Huntington Bancshares Incorporated (Huntington). All of HPCI's day-to-day activities and the servicing of the loans underlying its participation interests are administered by the Bank. HPCI has one wholly-owned subsidiary, HPCLI, Inc. (HPCLI).
A participation agreement between the Bank and Holdings and a subparticipation agreement between Holdings and HPCI require the Bank to service HPCI's loan portfolio in a manner substantially the same as for similar work performed by the Bank for transactions on its own behalf. The Bank collects and remits principal and interest payments, maintains perfected collateral positions, and submits and pursues insurance claims. The Bank and Huntington also provide to HPCI accounting and reporting services as required. The Bank is required to pay all expenses related to the performance of its duties under the participation and subparticipation agreements. These participation interests were all acquired from Holdings and Holdings acquired them from the Bank.
FORWARD-LOOKING STATEMENTS
This report, including management's discussion and analysis of financial condition and results of operations, contains forward-looking statements about HPCI, including descriptions of products or services, plans, or objectives of its management for future operations, and forecasts of its revenues, earnings, or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts.
By their nature, forward-looking statements are subject to numerous assumptions, risks, and uncertainties. A number of factors, including but not limited to, those set forth under the heading "Business Risks" included in Item 1 of this report and other factors described from time to time in HPCI's other filings with the Securities and Exchange Commission, could cause actual conditions, events, or results to differ significantly from those described in the forward-looking statements.
Forward-looking statements speak only as of the date they are made. HPCI does not update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.
The following discussion and analysis, the purpose of which is to provide investors and others with information that the company's management believes to be necessary for an understanding of its financial condition, changes in financial condition, and results of operations, should be read in conjunction with the financial statements, notes, and other information contained in this document.
CRITICAL ACCOUNTING POLICIES
Note 1 to HPCI's consolidated financial statements lists significant accounting
policies used in the development and presentation of its financial statements.
This discussion and analysis, the significant accounting policies, and other
financial statement disclosures identify and address key variables and other
qualitative and quantitative factors that are necessary for an understanding and
evaluation of HPCI, its financial position, results of operations, and cash
flows.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States (GAAP) requires HPCI's management to establish critical accounting policies and make accounting estimates, assumptions, and judgments that affect amounts recorded and reported in its financial statements. An accounting estimate requires assumptions about uncertain matters that could have a material effect on the financial statements of HPCI if a different amount within a range of estimates were used or if estimates changed from period
to period. Readers of this report should understand that estimates are made under facts and circumstances at a point in time and changes in those facts and circumstances could produce actual results that differ from when those estimates were made. A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for loan losses.
PREFERRED SECURITIES
In October 2001, HPCI issued to Holdings 2,000,000 shares of Class C preferred securities and 14,000,000 shares of Class D preferred securities and received a capital contribution of common equity in exchange for $452.6 million of gross participation interests in certain loans, $86.5 million of related specific loan loss reserves, $45.4 million of net leasehold improvements, and $3.5 million of accrued interest. These participation interests were in commercial, commercial real estate, and consumer loans and were acquired at fair market value. The underlying consumer loans included a combination of automobile, truck, and equipment loans. HPCI intends to hold these participation interests as long-term investments. Approximately 24% of these participation interests were non-performing in nature. The company transferred the leasehold improvements to HPCLI in exchange for its common shares. Holdings subsequently sold all of the Class C preferred securities in an underwritten public offering. HPCI did not receive any of Holdings' proceeds from the sale. On December 27, 2002, Holdings contributed its ownership in HPCI's Class A and Class D preferred securities to Huntington Preferred Capital II, Inc. (HPCII), a subsidiary of HPCH-III.
DISTRIBUTION OF FLORIDA LOAN PARTICIPATION INTERESTS
On December 31, 2001, in anticipation of the eventual sale by the Bank to SunTrust Banks, Inc. (SunTrust) of its Florida banking operations, which closed on February 15, 2002, HPCI completed its $1.3 billion distribution to common shareholders, Holdings and Huntington. This distribution consisted of cash and the net book value of participation interests in loans that were included in the sale to SunTrust, including the related accrued interest and allowance for loan losses. This distribution represented approximately 17% of HPCI's total assets as of December 31, 2001.
OVERVIEW
HPCI's income is primarily derived from its participation interests in loans acquired from the Bank and Holdings. Income varies based on the level of these assets and their relative interest rates. The cash flows from these assets are used to satisfy HPCI's preferred dividend obligations. The preferred stock is considered equity and therefore, the dividends are not reflected as interest expense.
HPCI reported net income before preferred dividends of $341.4 million for 2002, $469.5 million for 2001, and $539.4 million for 2000. Net income available to common shareholders was $317.6 million, $447.7 million, and $539.4 million for the same respective periods. Average assets approximated average shareholders' equity (including preferred stock) and, therefore, return on average assets (ROA) and return on average equity (ROE) were the same for all annual periods presented. ROA and ROE were 5.65% for 2002, 6.67% for 2001, and 8.14% for 2000.
At December 31, 2002 and 2001, HPCI had total assets and total equity (including preferred stock) of $5.5 billion and $5.9 billion, respectively. At the most recent year end, an aggregate of $5.0 billion, or 91.2%, of total assets consisted of 99% participation interests in loans. Before the allowance for loan losses, participation interests in commercial and commercial real estate loans were $4.3 billion, or 77.3% of total assets, $612.4 million, or 11.1%, in consumer loans, and $153.8 million, or 2.8%, in residential real estate loans. The consumer loan participations are comprised of interests in loans, most of which are secured by real estate. The composition of real estate qualifying assets increased during the recent twelve months from 88.2% at the end of 2001 to 89.3% at the end of 2002. The following table shows the composition of HPCI's gross participation interests in loans at the end of the most recent five years:
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(in thousands of dollars) 2002 2001 2000 1999 1998
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At December 31,
Commercial $ 344,858 $ 646,509 $ 614,956 $ 813,809 $1,110,669
Commercial real estate 3,922,467 3,678,061 3,894,527 3,688,669 3,226,583
Consumer 612,357 783,735 971,594 791,396 698,328
Residential real estate 153,808 270,671 355,571 749,563 903,076
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Total $ 5,033,490 $5,378,976 $5,836,648 $6,043,437 $5,938,656
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Qualification as a REIT involves application of specific provisions of the
Internal Revenue Code. Two specific provisions are an income test and an asset
test. At least 75% of HPCI's gross income, excluding gross income from
prohibited transactions, for each taxable year must be derived directly or
indirectly from investments relating to real property or mortgages on real
property. Additionally, real estate assets must represent at least 75% of HPCI's
total assets. At December 31, 2002, HPCI had qualifying income and qualifying
assets that exceeded 75%. Typically, cash is invested with the Bank in an
interest bearing account, however, late in 2002, after a rapid build-up in cash
due to loan prepayments, management moved the cash to a non-interest bearing
account in order to maintain qualifying income levels and HPCI's REIT status. In
addition, management made the decision to lower its level of cash through a
return of capital to its common shareholders at the end of 2002.
Interest-bearing and non-interest bearing cash balances on deposit with the Bank
were $534.3 million and $364.9 million at December 31, 2002 and 2001,
respectively. Funds, when invested, are invested overnight or in Eurodollar
deposits with the Bank for a term of not more than 30 days.
Amounts due from the Bank and Holdings at December 31, 2002 and 2001, were $7.4 million and $293.8 million, respectively. These represent amounts due from or due to the Bank and/or Holdings that arise in the ordinary course of business for unsettled transactions involving participation interests, fees, and other related costs.
Shareholders' equity (including preferred stock) declined from $5.9 billion at December 31, 2001, to $5.5 billion at December 31, 2002. This reflected the aggregate dividend payments on the common and preferred securities and the return of capital to HPCI's common shareholders during the recent year offset by the $341.4 million of net income in 2002.
RESULTS OF OPERATIONS
INTEREST AND FEE INCOME
HPCI's primary source of revenue is interest and fee income on its participation interests in loans. At December 31, 2002, 2001, and 2000, HPCI did not have any interest-bearing liabilities nor related interest expense. HPCI's capital structure has provided funding for acquisition of participation interests and the continued cash flows from its participation interests in loans provide sufficient funding such that outside borrowings are not required. Interest income is impacted by changes in the level of interest rates and earning assets. The yield on earning assets is the percentage of interest income to average earning assets.
Interest and fee income was $347.7 million for the recent twelve months compared with $526.4 million for the twelve months ended December 31, 2001. Interest and fee income was $549.7 million for 2000. The yield on earning assets contracted to 5.82% in 2002 from 7.46% and 8.28% in 2001 and 2000, respectively. The yield on participations in consumer loans increased to 10.60% in 2002 from 9.43% in 2001, which was indicative of the full-year impact from higher-yielding participation interests in consumer loans acquired in the fourth quarter 2001 in association with the issuance of the Class C and D preferred securities, partially offset by the distribution of the Florida-related participations at the end of 2001. In the table below, individual components include participations in non-accrual loans and related interest received. The amount of interest income that would have been recorded under original terms for participations in loans classified as non-accrual was $8.6 million for the twelve months ended December 31, 2002. Amounts actually received and recorded as interest income for these participations totaled $3.5 million in 2002.
HPCI's average balances, interest and fee income, and yields are presented below for the twelve-month periods ended December 31:
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2002 2001
----------------------------------- ------------------------------------
AVERAGE AVERAGE
(in millions of dollars) BALANCE INCOME YIELD BALANCE INCOME YIELD
-------------------------------------------------------------------------------------------------------------------
Loan participation interests:
Commercial $ 503.2 $ 24.9 4.95 % $ 560.1 $ 40.5 7.24 %
Commercial real estate 3,846.6 212.6 5.53 4,182.5 304.5 7.28
Consumer 697.5 74.0 10.60 1,068.0 100.8 9.43
Residential real estate 211.3 14.6 6.92 558.2 41.2 7.38
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Total loan participations 5,258.6 326.1 6.20 6,368.8 487.0 7.65
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Interest bearing deposits
in banks 716.6 12.3 1.72 692.8 27.9 4.02
Fees from loan participation
interests 9.3 11.5
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Total $ 5,975.2 $ 347.7 5.82 % $ 7,061.6 $ 526.4 7.46 %
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2000
----------------------------------
AVERAGE
(in millions of dollars) BALANCE INCOME YIELD
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Loan participation interests:
Commercial $ 721.9 $ 62.5 8.66 %
Commercial real estate 3,809.1 324.3 8.51
Consumer 865.8 78.3 9.04
Residential real estate 689.2 46.4 6.73
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Total loan participations 6,086.0 511.5 8.40
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Interest bearing deposits in banks 556.9 33.1 5.94
Fees from loan participation interests 5.1
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Total $6,642.9 $ 549.7 8.28 %
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The declines in interest and fee income experienced during 2002 were due to declines in interest rates and lower earning assets. The declines in the yields earned on participation interests in both 2002 and 2001 were indicative of the changes in the interest rate environment during the periods. The rate earned on participation interests declined 145 basis points in 2002 from 2001 while the rate earned on participation interests in 2001 declined 75 basis points from 2000 but was offset slightly by higher fees in 2001.
The table below shows changes in interest and fee income for the twelve months ended December 31 due to volume and rate variances for each category of earning assets. The change in interest and fees not solely due to changes in volume or rates has been allocated in proportion to the absolute dollar amounts of the change in volume and rate.
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2002 2001
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Increase (Decrease) From Increase (Decrease) From
Previous Year Due To: Previous Year Due To:
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(in millions of dollars) Volume Yield Total Volume Yield Total
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Interest bearing deposits in
The Huntington National Bank $ 0.9 $(16.5) $ (15.6) $ 7.0 $ (12.2) $ (5.2)
Loan participation interests:
Commercial (3.9) (11.8) (15.7) (12.9) (8.7) (21.6)
Commercial real estate (23.6) (69.1) (92.7) 30.3 (45.7) (15.4)
Consumer (38.8) 11.3 (27.5) 19.3 4.4 23.7
Residential real estate (24.8) (2.4) (27.2) (9.6) 4.8 (4.8)
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TOTAL EARNING ASSETS (90.2) (88.5) (178.7) 34.1 (57.4) (23.3)
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TOTAL INTEREST-BEARING LIABILITIES --- --- --- --- --- ---
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INTEREST AND FEE INCOME $(90.2) $(88.5) $(178.7) $ 34.1 $ (57.4) $ (23.3)
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PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES
The provision for loan losses is the charge to earnings necessary to maintain the allowance for loan losses (ALL) at a level adequate to absorb management's estimate of inherent losses in the loan portfolio. The provision for loan losses was a credit of $0.2 million for 2002, versus an expense of $48.5 million and $2.3 million for the years ended December 31, 2001 and 2000, respectively. The decline in provision expense in 2002 from 2001 was indicative of management's judgment regarding the adequacy of the allowance for loan losses at December 31, 2002.
The ALL was $140.4 million at December 31, 2002, down from $175.7 million at the end of 2001. This represents 2.79% and 3.27% of total loan participations at the end of 2002 and 2001, respectively. Non-performing loans were covered by the ALL 1.45 times at the end of 2002 compared with 0.9 times at the end of the prior year. Additional information regarding the ALL and asset quality appears in the "Credit Quality" section. The following table shows the activity in HPCI's ALL.
----------------------------------------------------------------------------------------------------------- (in thousands of dollars) 2002 2001 2000 1999 1998 ----------------------------------------------------------------------------------------------------------- BALANCE, BEGINNING OF YEAR $ 175,690 $ 91,826 $104,151 $ 87,799 $ --- Allowance of loan participations 37,020 113,291 (9,434) 25,988 88,789 acquired, net Distribution of participations in Florida-related loans --- (18,604) --- --- --- Net loan losses Commercial (29,686) (32,959) (1,274) (1,203) (58) Commercial real estate (21,599) (7,574) (1,321) (2,760) (401) Consumer (20,911) (18,800) (2,589) (5,673) (531) Residential real estate --- --- --- --- --- Provision (credit) for loan losses (161) 48,510 2,293 --- --- ----------------------------------------------------------------------------------------------------------- BALANCE, END OF YEAR $ 140,353 $ 175,690 $ 91,826 $104,151 $87,799 =========================================================================================================== |
Total net charge-offs were 1.37% in 2002, up from 0.93% and 0.09% of average loan participations in 2001 and 2000, respectively. Net charge-offs related to participations in commercial loans were 5.9% in both of the recent two years versus 0.18% in 2000. Net charge-offs related to consumer loans were up to 3.00% in 2002 from 1.76% in 2001 and 0.30% in 2000. Net charge-offs were 0.56%, 0.18%, and 0.03% for participations in commercial real estate loans in 2002, 2001, and 2000, respectively. The higher charge-off ratios in 2002 were the result of participation interests in lower-quality underlying loans acquired in association with the issuance of the Class C and D preferred securities in the fourth quarter of 2001.
An ALL is transferred to HPCI from the Bank to Holdings and then from Holdings on loans underlying the participations at the time the participations are acquired. Prior to the fourth quarter of 2001, HPCI had been transferring a portion of the ALL related to loan paydowns and other similar transactions underlying the participation interests back to the Bank through Holdings. Subsequently, with concerns over the general economy and the deteriorating credit quality in the loan participation portfolio, HPCI ceased transferring the allowance for such transactions.
It is HPCI's policy to perform a detailed analysis as of the end of each period to estimate the level of the ALL. HPCI, through reliance on methods utilized by Huntington, allocates the ALL to each loan participation category based on an expected loss ratio determined by continuous assessment of credit quality based on portfolio risk characteristics and other relevant factors such as historical performance, internal controls, and impacts from mergers and acquisitions. For the commercial and commercial real estate loan participations, expected loss factors are assigned by credit grade at the individual underlying loan level at the time the loan is originated by the Bank. On a periodic basis, management reevaluates these credit grades. The aggregation of these factors represents management's estimate of the inherent loss. The portion of the allowance allocated to the more homogeneous underlying consumer loan participations is determined by developing expected loss ratios based on the risk characteristics of the various portfolio segments and giving consideration to existing economic conditions and trends.
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2002 2001 2000 1999 1998
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% OF % OF % OF % OF % OF
LOAN LOAN LOAN LOAN LOAN
PART. PART. PART. PART. PART.
(in thousands TO TO TO TO TO
of dollars) ALL TOTAL ALL TOTAL ALL TOTAL ALL TOTAL ALL TOTAL
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Commercial $75,264 6.9% $103,119 12.0% $38,327 10.5% $38,270 13.5% $27,521 18.7%
Consumer 9,979 12.2% 17,030 14.6% 25,793 16.6% 31,693 13.1% 34,916 11.8%
Real estate
Residential 2,883 3.1% 1,766 5.0% 1,305 6.1% 1,936 12.4% 1,630 15.2%
Commercial 26,605 77.8% 33,886 68.4% 12,381 66.8% 12,923 61.0% 11,797 54.3%
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Total Allocated 114,731 100.0% 155,801 100.0% 77,806 100.0% 84,822 100.0% 75,864 100.0%
Total Unallocated 25,622 --- 19,889 --- 14,020 --- 19,329 --- 11,935 ---
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Total $140,353 100.0% $175,690 100.0% $91,826 100.0% $104,151 100.0% $87,799 100.0%
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% of Loan Part. 2.79% 3.27% 1.57% 1.72% 1.48%
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