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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
Commission File Number: 000-33243
HUNTINGTON PREFERRED CAPITAL, INC.
OHIO 31-1356967
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
41 SOUTH HIGH STREET, COLUMBUS, OHIO 43287
Registrant's telephone number (614) 480-8300
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 and (2) has been subject to such filing requirements for
the past 90 days.
Yes X No
======= =======
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes No X
======= =======
As of October 31, 2002, 14,000,000 shares of common stock without par value were
outstanding, all which was held by affiliates of the registrant.
HUNTINGTON PREFERRED CAPITAL, INC.
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets -
September 30, 2002 and 2001, and December 31, 2001 3
Consolidated Statements of Income -
For the three and nine months ended September 30, 2002 and 2001 4
Consolidated Statements of Changes in Shareholders' Equity -
For the nine months ended September 30, 2002 and 2001 5
Consolidated Statements of Cash Flows -
For the nine months ended September 30, 2002 and 2001 6
Notes to Unaudited Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 13
Item 3. Quantitative and Qualitative Disclosures about Market Risk 22
Item 4. Controls and Procedures 22
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 23
Signatures 24
Certifications 25 - 26
2
PART I. FINANCIAL INFORMATION
FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
- ------------------------------------------------------------------------------------------------------------------------
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30,
(in thousands of dollars, except share data) 2002 2001 2001
- ------------------------------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
(Restated) (Restated)
ASSETS
Cash on deposit with The Huntington National Bank $ 59,063 $ -- $ 46,699
Interest bearing deposits with The Huntington National Bank 960,993 364,912 614,378
Due from Huntington Preferred Capital Holdings, Inc. and The
Huntington National Bank 63,033 293,809 280,282
Loan participation interests:
Commercial 426,482 646,509 486,941
Consumer 651,825 783,735 1,048,513
Residential mortgage 182,032 270,671 533,901
Commercial mortgage 3,921,836 3,678,061 4,309,108
- ------------------------------------------------------------------------------------------------------------------------
Total loan participation interests 5,182,175 5,378,976 6,378,463
Less allowance for loan losses 167,015 175,690 91,931
- ------------------------------------------------------------------------------------------------------------------------
Net loan participation interests 5,015,160 5,203,286 6,286,532
- ------------------------------------------------------------------------------------------------------------------------
Premises and equipment 39,526 44,641 785
Accrued income and other assets 44,269 42,111 50,045
- ------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $6,182,044 $5,948,759 $7,278,721
========================================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Dividends payable $ 9,878 $ -- $ 15,090
Other liabilities -- 31 --
- ------------------------------------------------------------------------------------------------------------------------
Total Liabilities 9,878 31 15,090
- ------------------------------------------------------------------------------------------------------------------------
SHAREHOLDERS' EQUITY
Preferred stock, Class A, 8.000% noncumulative, non- exchangeable; $1,000
par and liquidation value per share;
1,000 shares authorized, issued and outstanding 1,000 1,000 1,000
Preferred stock, Class B, variable-rate noncumulative and
conditionally exchangeable; $1,000 par and liquidation
value per share; authorized 500,000 shares; 400,000
shares issued and outstanding 400,000 400,000 400,000
Preferred stock, Class C, 7.875% noncumulative and
conditionally exchangeable; $25 par and liquidation
value; authorized 2,000,000 shares; 2,000,000; 2,000,000; and
no shares issued and outstanding, respectively 50,000 50,000 --
Preferred stock, Class D, variable-rate noncumulative and
conditionally exchangeable; $25 par and liquidation
value; authorized 14,000,000 shares; 14,000,000; 14,000,000;
and no shares issued and outstanding, respectively 350,000 350,000 --
Preferred stock, $25 par value, 10,000,000 shares
authorized; no shares issued or outstanding -- -- --
Common stock - without par value; 14,000,000 shares
authorized, issued, and outstanding 5,082,511 5,082,511 6,341,717
Retained earnings 288,655 65,217 520,914
- ------------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 6,172,166 5,948,728 7,263,631
- ------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $6,182,044 $5,948,759 $7,278,721
- ------------------------------------------------------------------------------------------------------------------------
See notes to unaudited consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
- --------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
- ---------------------------------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------
(Restated) (Restated)
Interest and fee income
Interest on loan participation interests
Commercial $ 5,421 $ 8,881 $ 19,170 $ 31,054
Consumer 18,198 25,102 57,124 72,418
Residential mortgage 3,403 10,438 11,814 31,942
Commercial mortgage 53,512 75,875 161,682 236,498
- ---------------------------------------------------------------------------------------------------------
80,534 120,296 249,790 371,912
Fees from loan participation interests 2,135 3,703 7,313 8,462
Interest bearing deposits with The Huntington
National Bank 4,033 6,115 9,195 23,426
- ---------------------------------------------------------------------------------------------------------
TOTAL INTEREST AND FEE INCOME 86,702 130,114 266,298 403,800
Provision for loan losses -- 6,428 19,839 17,106
- ---------------------------------------------------------------------------------------------------------
INTEREST AND FEE INCOME AFTER PROVISION FOR LOAN LOSSES 86,702 123,686 246,459 386,694
- ---------------------------------------------------------------------------------------------------------
Non-interest income 1,721 15 5,062 43
Non-interest expense 3,152 2,102 10,048 6,289
- ---------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 85,271 121,599 241,473 380,448
Income taxes 22 -- (70) --
- ---------------------------------------------------------------------------------------------------------
NET INCOME BEFORE PREFERRED DIVIDENDS 85,249 121,599 241,543 380,448
DIVIDENDS ON PREFERRED STOCK 5,892 15,090 18,105 15,090
- ---------------------------------------------------------------------------------------------------------
NET INCOME APPLICABLE TO COMMON SHARES $79,357 $106,509 $223,438 $365,358
- ---------------------------------------------------------------------------------------------------------
See notes to unaudited consolidated financial statements.
4
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(UNAUDITED)
- --------------------------------------------------------------------------------
PREFERRED, CLASS A PREFERRED, CLASS B PREFERRED, CLASS C
------------------ ------------------ ------------------
(in thousands) SHARES STOCK SHARES STOCK SHARES STOCK
- -------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30, 2001:
Balance, December 31, 2000 1 $1,000 400 $400,000 -- $ --
Net income
Dividends declared on Class B preferred stock Common shares issued in
18,666.66667-to-1 stock split
- -------------------------------------------------------------------------------------------------------------------------------
Balance, September 30, 2001 1 $1,000 400 $400,000 -- $ --
- -------------------------------------------------------------------------------------------------------------------------------
NINE MONTHS ENDED SEPTEMBER 30, 2002:
BALANCE, DECEMBER 31, 2001 1 $1,000 400 $400,000 2,000 $50,000
NET INCOME
DIVIDENDS DECLARED ON CLASS A PREFERRED STOCK
DIVIDENDS DECLARED ON CLASS B PREFERRED STOCK
DIVIDENDS DECLARED ON CLASS C PREFERRED STOCK
DIVIDENDS DECLARED ON CLASS D PREFERRED STOCK
- -------------------------------------------------------------------------------------------------------------------------------
BALANCE, SEPTEMBER 30, 2002 1 $1,000 400 $400,000 2,000 $50,000
- -------------------------------------------------------------------------------------------------------------------------------
PREFERRED, CLASS D PREFERRED COMMON
-------------------- --------------- ----------------- RETAINED
(in thousands) SHARES STOCK SHARES STOCK SHARES STOCK EARNINGS TOTAL
- ----------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30, 2001:
Balance, December 31, 2000 (restated) -- $ -- -- $-- 1 $6,341,717 $155,556 $6,898,273
Net income 380,448 380,448
Dividends declared on Class B preferred stock (15,090) (15,090)
Common shares issued in 18,666.66667-to-1
stock split 13,999 --
- ----------------------------------------------------------------------------------------------------------------------------------
Balance, September 30, 2001 (restated) -- $ -- -- $-- 14,000 $6,341,717 $520,914 $7,263,631
- ----------------------------------------------------------------------------------------------------------------------------------
NINE MONTHS ENDED SEPTEMBER 30, 2002:
BALANCE, DECEMBER 31, 2001 (RESTATED) 14,000 $350,000 -- $-- 14,000 $5,082,511 $65,217 $5,948,728
NET INCOME 241,543 241,543
DIVIDENDS DECLARED ON CLASS A PREFERRED STOCK (80) (80)
DIVIDENDS DECLARED ON CLASS B PREFERRED STOCK (5,764) (5,764)
DIVIDENDS DECLARED ON CLASS C PREFERRED STOCK (2,954) (2,954)
DIVIDENDS DECLARED ON CLASS D PREFERRED STOCK (9,307) (9,307)
- ----------------------------------------------------------------------------------------------------------------------------------
BALANCE, SEPTEMBER 30, 2002 14,000 $350,000 -- $-- 14,000 $5,082,511 $288,655 $6,172,166
- ----------------------------------------------------------------------------------------------------------------------------------
See notes to unaudited consolidated financial statements.
5
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
- --------------------------------------------------------------------------------
NINE MONTHS ENDED
SEPTEMBER 30,
- ---------------------------------------------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001
- ---------------------------------------------------------------------------------------------------------------------
(Restated)
OPERATING ACTIVITIES
Net Income $ 241,543 $ 380,448
Adjustments to reconcile net income to net cash
provided by operating activities
Provision for Loan Losses 19,839 17,106
Depreciation 4,329 12
Loss on sale of fixed assets 483 --
Decrease (Increase) in Due from/to Huntington Preferred Capital Holdings,
Inc. and The Huntington National Bank 230,776 (55,731)
Net increase in accrued interest and other assets / accounts
payable and other liabilities (233,139) (336,766)
- ---------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES 263,831 5,069
- ---------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
(Increase) decrease in interest bearing deposits in banks (596,081) 204,494
Participation interests acquired (3,313,460) (4,673,821)
Sales and repayments on loans underlying participation interests 3,712,697 4,450,351
Proceeds from sales of fixed assets 303 --
Purchase of premises and equipment -- (797)
- ---------------------------------------------------------------------------------------------------------------------
NET CASH USED FOR INVESTING ACTIVITIES (196,541) (19,773)
- ---------------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Proceeds from issuance of Class A preferred stock -- --
Proceeds from issuance of Class B preferred stock -- --
Dividends paid on common stock -- --
Dividends paid on preferred stock (8,227) --
Return of capital to Huntington Preferred
Capital Holdings, Inc. -- --
- ---------------------------------------------------------------------------------------------------------------------
NET CASH USED FOR FINANCING ACTIVITIES (8,227) --
- ---------------------------------------------------------------------------------------------------------------------
CHANGE IN CASH AND DUE FROM BANKS 59,063 (14,704)
CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD -- 61,403
- ---------------------------------------------------------------------------------------------------------------------
CASH AND DUE FROM BANKS AT END OF PERIOD $ 59,063 $ 46,699
- ---------------------------------------------------------------------------------------------------------------------
Supplemental information:
Dividends declared, not paid, on preferred stock $ 9,878 $ 15,090
Income taxes paid -- --
Interest paid -- --
See notes to unaudited consolidated financial statements.
6
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - ORGANIZATION
Huntington Preferred Capital, Inc. (HPCI) is a real estate investment trust
(REIT) organized under Ohio law in 1992. HPCI is owned by three related parties,
Huntington Preferred Capital Holdings, Inc. (Holdings), an Indiana corporation,
Huntington Preferred Capital II, Inc. (HPCII), an Ohio corporation, and
Huntington Bancshares Incorporated (Huntington), a Maryland corporation
headquartered in Columbus, Ohio. HPCII is a subsidiary of Holdings and Holdings
is a subsidiary of The Huntington National Bank (the Bank), a national banking
association organized under the laws of the United States and also headquartered
in Columbus, Ohio. The Bank is a wholly owned subsidiary of Huntington. HPCI has
one subsidiary, HPCLI, Inc. (HPCLI).
NOTE 2 - BASIS OF PRESENTATION
The unaudited interim consolidated financial statements reflect all
adjustments, consisting of normal and/or recurring accruals, which are, in the
opinion of management, necessary for a fair presentation of the consolidated
financial position, results of operations, and cash flows for the periods
presented. These unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United States
(GAAP). As permitted by the Securities and Exchange Commission, certain
information and footnote disclosures normally included in financial statements
have been omitted. The Notes to the Consolidated Financial Statements appearing
in HPCI's 2001 amended Annual Report on Form 10-K/A (2001 Annual Report), which
include descriptions of significant accounting policies, should be read in
conjunction with these interim financial statements.
The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect amounts reported in the
financial statements. Actual results could differ from those estimates.
NOTE 3 - RESTATEMENT OF PRIOR PERIODS
On August 19, 2002, HPCI restated its consolidated financial statements for
the first quarter 2002, and the years ended December 31, 2001, 2000, and 1999
after it discovered and corrected a discrepancy in Huntington's systems and
methodology used to allocate interest income, fees, loan losses, and related
provision expense between the Bank and HPCI. Specifically, the system allocating
this financial information between the Bank and HPCI was modified in October
1999 to determine such allocations as of the third business day before the end
of each month. This change was made to facilitate a more timely closing of
HPCI's books. The result was that certain interest income, fees, charge-offs,
and related provision expense from that date through the end of the month were
incorrectly not reported in HPCI's financial results, beginning in the fourth
quarter of 1999 through the first quarter of 2002. Since HPCI and the Bank are
fully consolidated subsidiaries of Huntington, and the impact of all
inter-company allocations was properly eliminated in preparing the Huntington
financial statements, this restatement had no impact on Huntington's previously
reported consolidated results of operations, financial condition, or cash flows.
Restated financial information is included in Item 1 of HPCI's 2001 Annual
Report. Financial information included in this report for the three and nine
months ended September 30, 2001, has also been restated. Net income before and
after preferred dividends were increased by $8.0 million and $20.8 million for
the three and nine month periods, respectively. Due from Holdings and the Bank
and Retained earnings were increased by $85.5 million at September 30, 2001, for
the cumulative effect of the restatement.
NOTE 4 - LOAN PARTICIPATION INTERESTS
Participation interests in loans, which are predominantly collateralized by real
estate, are generally acquired from the Bank by Holdings at the Bank's carrying
value, which is the principal amount outstanding plus accrued interest, net of
unearned income, if any, and an allowance for loan losses.
7
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Similarly, participation interests in loans are generally acquired from Holdings
by HPCI at Holdings' carrying value. By the nature of HPCI's status as a REIT,
the composition of the loans underlying the participation interests are highly
concentrated in real estate. Underlying loans are also concentrated in the
Bank's primary markets of Ohio, Michigan, Indiana, and Kentucky. Loans in these
markets comprise 95.1% of the Bank's portfolio at September 30, 2002. There are,
however, no underlying loans outstanding which would be considered a
concentration of lending in any particular industry, group of industries, or
business activity.
In July 2001, Huntington announced a comprehensive strategic and financial
restructuring plan, which included divesting its Florida retail and corporate
banking businesses. In September 2001, Huntington announced that it entered into
an agreement to sell its Florida operations to SunTrust Banks, Inc. (SunTrust).
In December 2001, HPCI distributed its participation interests in
Florida-related loans to its common shareholders. This distribution approximated
$1.3 billion and consisted of cash and the net book value of participation
interests in loans and related accrued interest, net of $18.6 million of
allowance for loan losses (ALL), which were included in the sale to SunTrust.
This distribution represented approximately 17% of HPCI's total assets as of
December 31, 2001. The sale by Huntington to SunTrust closed in February 2002.
NOTE 5 - ALLOWANCE FOR LOAN LOSSES
An allowance for loan losses is transferred to HPCI from the Bank through
Holdings on loans underlying the participations at the time the participations
are acquired. The allowance for loan losses reflects HPCI management's judgment
as to the level considered appropriate to absorb inherent losses in the loan
participation portfolio. This judgment is based on a review of individual loans
underlying the participations, historical loss experience of similar loans owned
by the Bank, economic conditions, portfolio trends, and other factors. When
necessary, the allowance for loan losses will be adjusted through a provision
for loan losses charged or credited to earnings. Loan losses are charged against
the allowance when management believes the loan balance, or a portion thereof,
is uncollectible. Subsequent recoveries, if any, are credited to the allowance.
The following table sets forth a summary of the transactions in the
allowance for loan losses for the periods indicated:
- ------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
- ------------------------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001 2002 2001
- ------------------------------------------------------------------------------------------------
BALANCE, BEGINNING OF PERIOD $163,359 $90,724 $175,690 $91,826
Allowance for loan participations acquired, net 13,546 3,662 30,807 3,396
Net loan losses (9,890) (8,883) (59,321) (20,397)
Provision for loan losses -- 6,428 19,839 17,106
- ------------------------------------------------------------------------------------------------
BALANCE, END OF PERIOD $167,015 $91,931 $167,015 $91,931
- ------------------------------------------------------------------------------------------------
NOTE 6 - ISSUANCE OF PREFERRED SECURITIES
In October 2001, HPCI created three new classes of preferred securities,
Class C and Class D preferred securities and blank check preferred securities
(which are unclassified as to term, dividends, voting rights, etc). HPCI issued
the Class C and D preferred securities in October 2001 to Holdings and received
a capital contribution of common equity in exchange for $452.6 million of
participation interests in performing and non-performing commercial loans,
commercial real estate loans, and consumer loans, with $86.5 million of specific
loan loss reserves, $45.4 million of leasehold improvements, and $3.5 million of
accrued interest that Holdings had acquired from the Bank. The underlying
consumer loans
8
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
included a combination of automobile, truck, and equipment loans.
HPCI transferred the leasehold improvements to HPCLI in exchange for its common
shares. Holdings then sold the Class C preferred securities to the public in
November 2001 for cash consideration of $25 per share totaling $50 million. HPCI
did not receive any of Holdings' proceeds from the sale of the securities.
NOTE 7 - DIVIDENDS AND STOCK SPLIT
Holders of Class A preferred securities are entitled to receive, if, when,
and as declared by the Board of Directors of HPCI out of funds legally
available, dividends at a rate of $80.00 per share per annum of the initial
liquidation preference ($1,000.00 per share). Dividends on the Class A preferred
securities, if declared, are payable annually in December to holders of record
on the record date fixed for such purpose by the Board of Directors in advance
of payment. In March 2002, dividends on the Class A preferred securities were
declared and set apart for payment in December 2002 to the holders of the Class
A preferred securities.
The holder of the Class B preferred securities, HPC Holdings-II, Inc., a
direct non-bank subsidiary of Huntington, is entitled to receive, if, when, and
as declared by the Board of Directors of HPCI out of funds legally available,
dividends at a variable rate equal to three-month LIBOR published on the first
day of each calendar quarter. Dividends on the Class B preferred securities,
which are declared quarterly, are payable annually and are non-cumulative. No
dividend, except payable in common shares, may be declared or paid upon Class B
preferred securities unless dividend obligations are satisfied on the Class A,
Class C, and Class D preferred securities. For the first, second, and third
quarters of 2002, the Board of Directors of HPCI declared dividends of $1.9
million, $2.0 million, and $1.9 million, respectively. These dividends were
based on LIBOR rates of 1.86375%, 1.86%, and 2.04%, respectively, and, in each
case, payable in December 2002. Dividends of $15.1 million were declared in
September 2001 for the first, second, and third quarters of 2001.
Holders of Class C preferred securities are entitled to receive, if, when,
and as declared by the Board of Directors of HPCI out of funds legally
available, dividends at a fixed rate of 7.875% per annum, payable quarterly.
Dividends accrue in each quarterly period from the first day of each period,
whether or not dividends are paid with respect to the preceding period.
Dividends are not cumulative and if no dividend is paid on the Class C preferred
securities for a quarterly dividend period, the payment of dividends on HPCI's
common stock and other HPCI-issued securities ranking junior to the Class C
preferred securities (i.e., Class B preferred securities) will be prohibited for
that period and at least the following three quarterly dividend periods. In the
first, second, and third quarters of 2002, the Board of Directors declared
quarterly dividends totalling $984,375 for each period. These dividends were
paid April 1, 2002, July 1, 2002, and October 1, 2002, respectively. No
dividends were declared or paid for the same periods in the prior year because
these securities were not outstanding in those periods.
The holder of Class D preferred securities, Holdings, is entitled to
receive, if, when, and as declared by the Board of Directors of HPCI out of
funds legally available, dividends at a variable rate established at the
beginning of each calendar quarter equal to LIBOR plus 1.625%, payable
quarterly. Dividends accrue in each quarterly period from the first day of each
period, whether or not dividends are paid with respect to the preceding period.
Dividends are not cumulative and if no dividend is paid on the Class D preferred
securities for a quarterly dividend period, the payment of dividends on HPCI's
common stock and other HPCI-issued securities ranking junior to the Class D
preferred securities (i.e., Class B preferred securities) will be prohibited for
that period and at least the following three quarterly dividend periods. For the
first, second, and third quarters of 2002, the Board of Directors declared
dividends of $3.0 million, $3.2 million, and $3.1 million, respectively.
Dividends on the Class D preferred securities were paid on the same dates as
those paid on the Class C preferred securities. No dividends were declared or
paid for the same periods in the prior year because these securities were not
outstanding in those periods.
9
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In April 2001, the Board of Directors declared a 18,666.67-for-1 stock
split on its common stock outstanding. The result of the transaction increased
the number of issued and outstanding common shares from 750 to 14 million in
order for Holdings to maintain 80% voting control for corporate matters.
NOTE 8 - RELATED PARTY TRANSACTIONS
HPCI holds a 100% subparticipation interest in Holdings' 99% participation
interest in loans originated by the Bank and its subsidiaries. The participation
and subparticipation interests are in commercial, commercial mortgage,
residential mortgage, and consumer loans collateralized by real property that
were either directly underwritten by the Bank and its subsidiaries or acquired
by the Bank. HPCI expects to continue to purchase such interests, net of ALL, in
the future from Holdings.
Under HPCI's subparticipation agreement with Holdings and Holdings'
participation agreement with the Bank, the Bank performs the servicing of the
commercial, commercial mortgage, residential mortgage, and consumer loans
underlying the participations held by HPCI in accordance with normal industry
practice. The servicing fee the Bank charges is 0.125% per year of the
outstanding principal balances of the commercial, commercial mortgage, and
consumer loans underlying the participation interests and 0.282% per year of the
interest and fee income collected on the underlying residential mortgages.
Servicing fee expense paid to the Bank totaled $1.6 million and $5.1 million for
the three and nine months ended September 30, 2002, respectively. Servicing fee
expense paid for the same periods in the prior year amounted to $2.1 million and
$6.1 million. In its capacity as servicer, the Bank collects and holds the
commercial and mortgage loan payments received on behalf of HPCI until the end
of each month. At month end, the payments are transferred to HPCI and,
accordingly, HPCI does not reflect any receivables for payments from the Bank in
the accompanying unaudited consolidated financial statements.
HPCI and Holdings share personnel with the Bank and Huntington to handle
day-to-day operations of HPCI such as accounting, financial analysis, tax
reporting, and other administrative functions. On a monthly basis, HPCI
reimburses the Bank for the cost related to the time spent by employees for
performing these functions. The personnel costs were approximately $40,000 for
each quarterly period in 2002 and 2001.
In February 2001, Huntington purchased 18,667 shares of the 14 million
outstanding common shares of HPCI from Holdings (after adjusting for the April
2001 18,666.67-for-1 stock split). On July 1, 2002, Holdings exchanged 4.55
million common shares of HPCI and certain other assets for two classes of
HPCII's preferred stock. The following table represents the current ownership of
HPCI's common stock:
- ---------------------------------
Number
of
Common % of
Owner Shares Total
- ---------------------------------
Holdings 9,431,333 67.4
HPCII 4,550,000 32.5
Huntington 18,667 0.1
- -------------------------------
Total 14,000,000 100.0
- -------------------------------
For all periods presented prior to February 2001 in the unaudited
consolidated financial statements, Holdings was the owner of 100% of the
outstanding common stock of HPCI.
10
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Of the outstanding shares of Class A preferred securities, 89.1% are owned
by Holdings while present and past employees of Huntington and its subsidiaries
own 10.9%. All of the Class B preferred securities are owned by HPC Holdings-II,
Inc. In 2001, the Class C preferred securities were issued to Holdings in
exchange for certain assets and Holdings sold them to the public in an
underwritten offering. Various board members and executive officers of HPCI
purchased some of these shares in the offering or in the open market. At
September 30, 2002, the group as a whole beneficially owned a total of 5,205
shares, or 0.26%. This was unchanged from the quarter ended June 30, 2002. All
of the Class D preferred securities are owned by Holdings for possible sale to
the public in the future.
HPCI's premises and equipment were acquired from the Bank through Holdings
in 2000 and 2001. Leasehold improvements were subsequently contributed to HPCLI
for its common shares. HPCLI charges rent to the Bank for use of various
facilities. The amount of rental income received by HPCLI was $1.5 million for
each of the first three quarters in 2002 and is reflected as a component of
non-interest income in the unaudited consolidated statements of income.
HPCI has a receivable due from Holdings amounting to $63.0 million and
$280.3 million at September 30, 2002 and 2001, respectively. These balances
represent unsettled cash transactions involving its participation interests that
occurred in the ordinary course of business.
HPCI maintains and transacts all of its cash activity through a demand
deposit account with the Bank. HPCI invests funds in Eurodollar deposits with
the Bank overnight or for a term of not more than 30 days. Total funds on
deposit with the Bank were $1.02 billion and $661.1 million at September 30,
2002 and 2001, respectively.
NOTE 9 - COMMITMENTS AND CONTINGENCIES
The Bank is eligible to obtain advances from various federal and
government-sponsored agencies such as the Federal Home Loan Bank of Cincinnati
(FHLBC). From time to time, HPCI may be asked to act as co-borrower or guarantor
of the Bank's obligations under such advances and/or pledge all or a portion of
its assets in connection with those advances. Any such borrowing, guarantee,
and/or pledge would rank senior to HPCI's common and preferred securities upon
liquidation. Accordingly, any federal or government-sponsored agencies that make
advances to the Bank where HPCI has acted as co-borrower or guarantor or has
pledged its assets as collateral will have a liquidation preference over the
holders of HPCI's securities. Any such borrowing, guarantee, and/or pledge in
connection with the Bank's advances from federal or government-sponsored
agencies falls within the definition of Permitted Indebtedness (as defined in
HPCI's articles of incorporation) and, therefore, HPCI is not required to obtain
the consent of the holders of its common or preferred securities for any such
borrowing, guarantee, and/or pledge.
The Bank is currently eligible to obtain one or more advances from the FHLB
based upon the amount of FHLBC capital stock owned by the Bank. As of September
30, 2002 the Bank's total borrowing capacity under this facility was capped at
$1.120 billion. As of this same date, the Bank had borrowings of $613.0 million
under this facility. In addition, there was a standby letter of credit
outstanding in the amount of $10.1 million that had not been drawn upon.
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. The agreement also provides that the Bank will pay HPCI a
monthly fee based upon the eligible collateral held by HPCI. As of September 30,
2002, HPCI's pledged collateral was limited to 1-4 family residential mortgages
and second mortgage
11
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
loans. As of that same date, HPCI's participation interests in such 1-4 family
residential mortgages and second mortgage loans aggregated $600 million. The
Bank paid $273,000 and $191,000 to HPCI in the second and third quarters of
2002, respectively, as compensation for making such assets available to the Bank
as collateral since February 2002 for possible advances under this FHLBC
facility.
NOTE 10 - SEGMENT REPORTING
HPCI's operations consist primarily of acquiring, holding, and managing its
participation interests. Accordingly, HPCI only operates in one segment. HPCI
has no external customers and transacts all of its business with the Bank
through Holdings.
12
ITEM 2. MANAGEMENTS'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
INTRODUCTION
Organization
Huntington Preferred Capital, Inc. (HPCI) is an Ohio corporation that
was incorporated in July 1992 under the name Airbase Realty, Inc. HPCI changed
its name to Huntington Preferred Capital, Inc. in May 2001. Its principal
business objective is to acquire, hold, and manage mortgage assets and other
authorized investments that will generate net income for distribution to
shareholders. Since May 1998, the company has been operating as a REIT for
federal income tax purposes.
HPCI is owned by Huntington Preferred Capital Holdings, Inc.
(Holdings), Huntington Preferred Capital II, Inc. (HPCII), and Huntington
Bancshares Incorporated (Huntington). HPCII is a subsidiary of Holdings, which
is owned by The Huntington National Bank (the Bank) and Huntington. All of the
day-to-day activities and the servicing of the loans underlying HPCI's
participation interests are administered by the Bank. HPCI has one wholly-owned
subsidiary, HPCLI.
Participation and Subparticipation Agreements
A participation agreement between the Bank and Holdings and a
subparticipation agreement between Holdings and HPCI require the Bank to service
loans underlying its participation portfolio in a manner substantially the same
as for similar work performed by the Bank for transactions on its behalf. HPCI,
however, has retained the right to elect to foreclose on mortgaged properties
and the Bank has agreed to follow any such direction from HPCI in this regard.
The Bank also collects and remits principal and interest payments, maintains
perfected collateral positions, and submits and pursues insurance claims. In
addition, the Bank and Huntington provides to HPCI accounting, tax, financial,
reporting, and other administrative services as required. The Bank is required
to pay all expenses related to the performance of its duties under the
participation and subparticipation agreements. Loan participation interests were
all acquired from Holdings and Holdings acquired them from the Bank.
Forward-looking Statements
This interim 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 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 HPCI's 2001 amended Annual Report on Form 10-K/A (2001 Annual Report) and
other factors described from time to time in the company'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 HPCI'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.
Significant Accounting Policies
Note 3 to the consolidated financial statements included in the 2001
Annual Report lists significant accounting policies used in the development and
presentation of the financial statements. This
13
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 and its results of operations.
Issuance of 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. 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. HPCI 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.
Distribution of Florida Loan Participation Interests
On July 12, 2001, Huntington announced a comprehensive strategic and
financial restructuring plan, which included, among other things, divesting its
Florida retail and corporate banking businesses. On September 26, 2001,
Huntington announced that it had entered into an agreement to sell its Florida
operations to SunTrust Banks, Inc. (SunTrust). On December 31, 2001, in
anticipation of the sale of the Florida operations by Huntington, which closed
February 15, 2002, HPCI completed a $1.3 billion distribution to its common
shareholders. 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,
representing approximately 17% of total assets as of December 31, 2001.
Restatement of Prior Periods
On August 19, 2002, HPCI restated its consolidated financial statements for
the first quarter 2002, and the years ended December 31, 2001, 2000, and 1999
after the discovery and correction of a discrepancy in Huntington's systems and
methodology used to allocate interest income, fees, loan losses, and related
provision expense between the Bank and HPCI. Specifically, the system allocating
this financial information between the Bank and HPCI was modified in October
1999 to determine such allocations as of the third business day before the end
of each month. This change was made to facilitate a more timely closing of
HPCI's books. The result was that certain interest income, fees, charge-offs,
and related provision expense from that date through the end of the month were
incorrectly not reported in HPCI's financial results, beginning in the fourth
quarter of 1999 through the first quarter of 2002. Since HPCI and the Bank are
fully consolidated subsidiaries of Huntington, and the impact of all
inter-company allocations was properly eliminated in preparing Huntington's
financial statements, this restatement had no impact on Huntington's previously
reported consolidated results of operations, financial condition, or cash flows.
The restated financial information is included in Item 1 of HPCI's 2001 Annual
Report. Financial information included in this report for the three and nine
months ended September 30, 2001, has also been restated. Net income before and
after preferred dividends were increased by $8.0 million and $20.8 million for
the three and nine month periods, respectively. Due from Holdings and the Bank
and Retained earnings were increased by $85.5 million at September 30, 2001, for
the cumulative effect of the restatement.
OVERVIEW
HPCI's income is primarily derived from interest and fee income from
participation interests in loans acquired from the Bank through 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 preferred dividend obligations.
The preferred stock is equity and therefore, the dividends are not reflected as
interest expense.
14
HPCI had net income of $85.2 million before preferred dividends and
$79.4 million available to common shareholders for the third quarter of 2002.
This compared with $121.6 million and $106.5 million, respectively, for the same
period last year. On a year-to-date basis, net income before preferred dividends
was $241.5 million and $223.4 million available to common shareholders for 2002.
In 2001, net income before preferred dividends was $380.4 million and $365.4
million available to common shareholders for the nine-month period. The decrease
in both periods of 2002 versus 2001 was the result of lower participation
interests from runoff and reinvestment in lower-yielding assets and distribution
of Florida loan participation interests coupled with the lower interest rate
environment.
HPCI had total assets and total equity (including preferred stock) of
$6.2 billion at September 30, 2002 versus $7.3 billion of total assets and total
equity at the end of the same period a year ago. The change from the prior year
is due primarily to the distribution of participation interests in Florida
loans, which was completed in connection with Huntington's restructuring plan.
At the end of the most recent quarter, $5.2 billion, or 83.8%, of total assets
consisted of 99% participation interests in loans.
Gross loan participation interests (before the allowance for loan
losses), by type, and the percentage of total is presented in the following
table:
- ------------------------------------------------------------------------
AT SEPTEMBER 30, 2002 AT SEPTEMBER 30, 2001
% of % of
(in thousands of dollars) Amount Total Amount Total
- ------------------------------------------------------------------------
Commercial $ 426,482 8.2% $ 486,941 7.6%
Consumer 651,825 12.6 1,048,513 16.4
Residential mortgage 182,032 3.5 533,901 8.4
Commercial mortgage 3,921,836 75.7 4,309,108 67.6
- ------------------------------------------------------------------------
Total $5,182,175 100.0% $6,378,463 100.0%
- ------------------------------------------------------------------------
Interest-bearing and non-interest bearing cash balances of $1.0 billion were
on deposit with the Bank at September 30, 2002. This compares with cash balances
of $364.9 million at December 31, 2001 and $661.1 million at September 30, 2001.
In addition to cash flows from operating activities, these balances have
increased due to the excess of repayments on participation interests over new
investments. Interest-bearing balances are invested overnight or in Eurodollar
deposits with the Bank for a term of not more than 30 days. Average rates earned
on these deposits were 1.67% and 3.65% for the three months ended September 30,
2002 and 2001, respectively, and 1.77% and 4.62% for the respective nine-month
periods.
Amounts due from Holdings and the Bank at September 30, 2002, declined
to $63.0 million from $293.8 million at December 31, 2001, and $280.3 million at
the end of the third quarter last year. These represent amounts due from or due
to Holdings and/or the Bank that arise in the ordinary course of business for
unsettled transactions involving participation interests, fees, and other
related costs.
Shareholders' equity (including preferred stock) was $6.2 billion at
September 30, 2002, down from $7.3 billion at September 30, 2001, reflecting a
$1.3 billion distribution of the Florida-related participations at December 31,
2001, and the aggregate dividend payments on the common and preferred securities
during 2001 and the first nine months of 2002 offset by $400 million received
from the issuance of the Class C and D preferred securities in the last quarter
of 2001.
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 present, HPCI does not have any
interest-bearing liabilities and related interest expense. HPCI's capital
structure has provided funding for the acquisition of participation interests
and the continued cash flows from these participation interests in loans
provides sufficient funding such that outside borrowings are not required.
Interest and fee income is impacted by changes in the level of interest rates
and earning
15
assets. The yield on earning assets is the percentage of interest and fee income
to average earning assets. Average balances, interest and fee income, and yields
are presented below for the three- and nine- month periods ended September 30:
- -------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2002 SEPTEMBER 30, 2002
------------------------------------ ---------------------------------------
AVERAGE AVERAGE
(in millions of dollars) BALANCE INCOME YIELD BALANCE INCOME YIELD
- -------------------------------------------------------------------------------------------------------------
Loan participation interests:
Commercial $ 473.5 $ 5.4 4.54% $ 537.7 $ 19.2 4.77%
Consumer 679.2 18.2 10.63 718.1 57.1 10.64
Residential mortgage 195.6 3.4 6.96 224.7 11.8 7.01
Commercial mortgage 3,873.7 53.5 5.48 3,817.4 161.7 5.66
- -------------------------------------------------------------------------------------------------------------
Total loan participations 5,222.0 80.5 6.12 5,297.9 249.8 6.30
- -------------------------------------------------------------------------------------------------------------
Interest bearing deposits
in banks 908.8 4.1 1.76 694.8 9.2 1.77
Fees from loan participation
interests 2.1 7.3
- -------------------------------------------------------------------------------------------------------------
Total $6,130.8 $86.7 5.61% $5,992.7 $266.3 5.94%
=============================================================================================================
- ------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2001 SEPTEMBER 30, 2001
------------------------------------ ----------------------------------
AVERAGE AVERAGE
(in millions of dollars) BALANCE INCOME YIELD BALANCE INCOME YIELD
- ------------------------------------------------------------------------------------------------------------
Loan participation interests:
Commercial $ 509.6 $ 8.9 6.91% $ 557.1 $ 31.1 7.45%
Consumer 1,053.5 25.1 9.45 1,030.7 72.4 9.39
Residential mortgage 566.6 10.4 7.37 573.8 31.9 7.42
Commercial mortgage 4,180.5 75.9 7.20 4,095.9 236.5 7.72
- ------------------------------------------------------------------------------------------------------------
Total loan participations 6,310.2 120.3 7.57 6,257.5 371.9 7.94
- ------------------------------------------------------------------------------------------------------------
Interest bearing deposits
in banks 663.9 6.1 3.65 677.3 23.4 4.62
Fees from loan participation
interests 3.7 8.5
- ------------------------------------------------------------------------------------------------------------
Total $6,974.1 $130.1 7.41% $6,934.8 $403.8 7.62%
============================================================================================================
Interest and fee income was $86.7 million for the recent three-month
period compared with $130.1 million for the same period last year. As shown in
the table above, the yield on participation interests declined from 7.57% to
6.12% in comparable third quarter periods. For the nine months ended September
30, the yield on participations declined from 7.94% in 2001 to 6.30% in 2002.
Similar trends were exhibited in the second quarter and six-month comparisons
reported in HPCI's report on Form 10-Q for June 30, 2002. The decline in
interest income and associated yields was due to the previously mentioned
distribution of Florida-related participations in December 2001 and the
reduction of yields on the remaining portfolio of participation interests. The
table above includes cash basis interest received on participations in
non-accrual loans in the individual portfolios. Yields on these participation
interests would have been higher but were adversely impacted by the level of
interest income received on these non-accrual loans.
The table below exhibits the changes in interest and fee income for the
nine-month periods ended September 30 due to volume and rate variances for each
category of earning assets. The change in interest 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.
16
- ---------------------------------------------------------------------------------------------------------
2002 2001
- ---------------------------------------------------------------------------------------------------------
Increase (Decrease) From Increase (Decrease) From
Previous Year Due To: Previous Year Due To:
- ---------------------------------------------------------------------------------------------------------
Yield/ Yield/
(in millions of dollars) Volume Rate Total Volume Rate Total
- ---------------------------------------------------------------------------------------------------------
Interest bearing deposits in The
Huntington National Bank $ 0.6 $(14.8) $(14.2) $ 8.2 $ (4.9) $ 3.3
Loan participation interests:
Commercial (1.1) (10.8) (11.9) (11.3) (5.4) (16.7)
Consumer (24.4) 8.7 (15.7) 13.6 3.3 16.9
Residential mortgage (18.9) (1.7) (20.6) (12.4) 3.5 (8.9)
Commercial mortgage (15.6) (59.5) (75.1) 18.6 (17.5) 1.1
- ---------------------------------------------------------------------------------------------------------
INTEREST AND FEE INCOME $(59.4) $(78.1) $(137.5) $16.7 $(21.0) $(4.3)
=========================================================================================================
Provision and Allowance for Loan Losses
- ---------------------------------------
The provision for loan losses is the charge to earnings necessary to
maintain the ALL at a level adequate to absorb management's estimate of inherent
losses in the loan portfolio. There was no provision expense in the third
quarter and $19.8 million for the first nine months of 2002 based on
management's analysis of the adequacy of the ALL. Provision expense was $6.4
million and $17.1 million for the same respective periods in the prior year.
An ALL is transferred from the Bank to Holdings and from Holdings to
HPCI on loans underlying the participations at the time the participations are
acquired. Prior to the fourth quarter of 2001, HPCI transferred a portion of the
ALL related to loan paydowns and other similar transactions underlying the
participation interests back to the Bank. 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. As a
result, the ALL balances have grown over the recent twelve months.
At September 30, 2002, the ALL was $167.0 million, down from $175.7
million at December 31, 2001, and up from $91.9 million at the end of the third
quarter last year. This represents 3.22%, 3.27%, and 1.44% of total loan
participations at the end of each of the respective periods. The ALL increased
from September 2001 because of the acquisition of participation interests in
performing and non-performing loans in the fourth quarter of 2001, offset by the
distribution of the participation interests in Florida-related loans at the end
of 2001. The ALL covered 118.3% of the participations in non-performing loans at
September 30, 2002, compared with 88.9% and 109.7% at December 31, 2001 and
September 30, 2001, respectively. Additional information regarding the ALL and
asset quality appears in the "Credit Quality" section. The following table shows
the activity in the ALL for the three- and nine-month periods ended September
30:
- -----------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
- -----------------------------------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001 2002 2001
- -----------------------------------------------------------------------------------------------------------
BALANCE, BEGINNING OF PERIOD $163,359 $90,724 $175,690 $91,826
Allowance of loan participations acquired, net 13,546 3,662 30,807 3,396
Net loan losses:
Commercial (1,945) (3,364) (28,206) (9,879)
Consumer (4,433) (2,831) (17,200) (4,448)
Residential mortgage -- -- -- --
Commercial mortgage (3,512) (2,688) (13,915) (6,070)
- -----------------------------------------------------------------------------------------------------------
Total net loan losses (9,890) (8,883) (59,321) (20,397)
- -----------------------------------------------------------------------------------------------------------
Provision for loan losses -- 6,428 19,839 17,106
- -----------------------------------------------------------------------------------------------------------
BALANCE, END OF PERIOD $167,015 $91,931 $167,015 $91,931
===========================================================================================================
17
Total net loan losses for the third quarter of 2002 were $9.9 million,
or 0.75% (annualized) of average participation interests, down from $8.9
million, or 0.56%, for the same period last year. Net loan losses for the first
and second quarters of 2002 were $28.1 million, or 2.12%, and $21.3 million, or
1.61%, respectively. Trends in credit quality and net loan losses typically lag
in their timing to changes in general economic conditions. Indications of
general economic conditions appear to be mixed or unclear, however, management
believes that net loan losses in the next quarter will be comparable to the
recent quarter.
HPCI, through relying on methods utilized by Huntington, allocates the
ALL to each loan or 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 mortgage loan participations, expected loss factors are assigned
by credit grade at the individual underlying loan level. 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
segments is determined by developing expected loss ratios based on the risk
characteristics of the various segments and giving consideration to existing
economic conditions and trends.
Projected loss ratios incorporate factors such as trends in past due
and non-accrual amounts, recent loan loss experience, current economic
conditions, risk characteristics, and concentrations of various loan categories.
Actual loss ratios experienced in the future, however, could vary from those
projected as a loan's performance is a function of not only economic factors but
also other factors unique to each customer. The dollar exposure could
significantly vary from estimated amounts due to losses from large dollar single
client exposures, industry, product, or geographic concentrations, or changes in
general economic conditions. To ensure adequacy to a higher degree of
confidence, a portion of the ALL is considered unallocated. While amounts are
allocated to various portfolio segments, the total ALL, excluding impairment
reserves prescribed under provisions of Statement of Financial Accounting
Standard No. 114, is available to absorb losses from any segment of the
portfolio. The estimated total unallocated reserves was approximately 23% at
September 30, 2002, higher than 19% at the end of the second quarter 2002.
Non-Interest Income and Non-Interest Expense
- --------------------------------------------
Non-interest income was $1.7 million for the third quarter of 2002.
This represents rental income of $1.5 million received from the Bank related to
land and land improvements and buildings acquired in 2000, and leasehold
improvements acquired by HPCI in 2001. The remaining portion of non-interest
income, which amounted to $0.2 million, was related to fees received from the
Bank for the pledge of HPCI's assets eligible for use as collateral for the
Bank's borrowings from the Federal Home Loan Bank. More information regarding
this arrangement can be found in Note 9 to the unaudited consolidated financial
statements. On a year-to-date basis, non-interest income was $5.1 million and
$43,000 for 2002 and 2001, respectively.
Non-interest expense was $3.2 million for the three months ended
September 30, 2002, and $2.1 million for the same period a year ago. Fees paid
to the Bank for servicing the loans underlying the participation interests
amounted to $1.6 million and $2.1 million for the third quarter of 2002 and
2001, respectively. The service fee with respect to the commercial mortgage,
commercial, and consumer loans is equal to the outstanding principal balance of
each loan multiplied by an annual fee of 0.125% and the service fee for
residential mortgage loans is equal to 0.282% of the interest and fee income
collected. Non-interest expense for the most recent three months of 2002 also
included depreciation on premises and equipment of $1.4 million. For the nine
months ended September 30, non-interest expense was $10.0 million for 2002 and
$6.3 million for 2001.
Provision for Income Taxes
- --------------------------
HPCI has elected to be treated as a REIT for Federal income tax
purposes and intends to maintain compliance with the provisions of the Code and
therefore is not subject to income taxes. HPCI's subsidiary, HPCLI, elected to
be treated as a taxable REIT subsidiary. HPCLI incurred a net loss for the
18
first nine months of 2002 and therefore, a credit for income taxes is reflected
in the accompanying consolidated financial statements.
INTEREST RATE RISK MANAGEMENT
HPCI's income consists primarily of interest and fee income on
participation interests in commercial, consumer, residential mortgage, and
commercial mortgage loans. If there is a decline in market interest rates, HPCI
would experience a reduction in interest income on its loan participation
interests and a corresponding decrease in funds available to be distributed to
shareholders. The reduction in interest income may result from downward
adjustments of the indices upon which the interest rates on variable rate loans
are based and from prepayments of loans with fixed interest rates.
HPCI's interest rate risk is not managed seperately as interest rate
risk management at Huntington is conducted on a centralized basis. A key element
used in interest rate risk management is an income simulation model, which
includes, among other things, assumptions for loan prepayments on the existing
portfolio and new loan volumes. Using that model for HPCI, as of September 30,
2002, and assuming no new loans volumes, interest income for the next 12 month
period would be expected to increase by 7.1% if rates rose 200 basis points
gradually and with a parallel shift of the yield curve above the forward rates
implied in the September 30, 2002, yield curve. Interest income would be
expected to decline 6.8% in the event of a gradual 200 basis point decline in
rates from the forward rates implied in the September yield curve.
CREDIT QUALITY
Credit risk exposure as it relates to HPCI is managed by the Bank
through the use of consistent underwriting standards, practices that minimize
exposure to higher risk credits (e.g. highly leveraged transactions or
nationally syndicated credits), and a strategy of diversification of exposure by
industry sector or other concentrations. The Bank's credit administration
function employs extensive risk management techniques, including forecasting, to
ensure loans adhere to corporate policy and problem loans are promptly
identified. These procedures provide executive management of the Bank with the
information necessary to implement policy adjustments where necessary, and take
corrective actions on a proactive basis. These procedures also include
evaluating the adequacy of the ALL, which includes an analysis of specific
credits and the application of relevant reserve factors that represent relative
risk, based on portfolio trends, current and historic loss experience, and
prevailing economic conditions, to specific portfolio segments.
Non-performing assets (NPAs) consist of participation interests in
underlying loans that are no longer accruing interest. As prescribed by the
Bank's policies, underlying commercial, commercial mortgage, and residential
mortgage loans are placed on non-accrual status and stop accruing interest when
collection of principal or interest is in doubt or generally when the underlying
loan is 90 days past due. When interest accruals are suspended, accrued interest
income is reversed with current year accruals charged to earnings and prior year
amounts generally charged off as a credit loss. Consumer loans are not placed on
non-accrual status but they are charged off in accordance with regulatory
statutes governing the Bank, which is generally no more than 120 days past due.
19
- -----------------------------------------------------------------------
NON-PERFORMING ASSETS AT SEPTEMBER 30,
- -----------------------------------------------------------------------
(in thousands of dollars) 2002 2001
- -----------------------------------------------------------------------
Participation interests in non-accrual loans
Commercial $ 92,427 $39,344
Real Estate
Commercial 42,653 36,266
Residential 6,150 8,202
- -----------------------------------------------------------------------
TOTAL NON-PERFORMING ASSETS $141,230 $83,812
=======================================================================
NON-PERFORMING ASSETS AS A % OF TOTAL
PARTICIPATION INTERESTS 2.73% 1.31%
ALLOWANCE FOR LOAN LOSSES AS A % OF NON-
PERFORMING ASSETS 118.26% 109.69%
At September 30, 2002, total NPAs were $141.2 million, a decline of
$12.0 million from $153.2 million at June 30, 2002. Total NPAs were $197.6
million at December 31, 2001, and $83.8 million at September 30, 2001. The
underlying non-performing loans represented 2.73% of total participation
interests at the most recent quarter end, compared with 3.67% and 1.31% at
December 31, 2001 and September 30, 2001, respectively. The increase in NPAs
from a year ago was due to the aforementioned acquisition of participation
interests in performing and non-performing loans in the fourth quarter of 2001
and the general deterioration of the economy. The amount of participation
interests in non-performing Florida-related loans distributed at the end of 2001
approximated $4.6 million.
Underlying loans past due ninety days or more but continuing to accrue
interest were $20.1 million, down from $22.7 million at June 30, 2002, and $24.5
million at the end of recent year.
Under the participation and subparticipation agreements, HPCI may
direct the Bank to foreclose on mortgaged properties or dispose of any
underlying loan that becomes classified as a problem loan, is placed in a
non-performing status, or is renegotiated due to the financial deterioration of
the borrower. The Bank has agreed to institute foreclosure proceedings at HPCI's
direction and may 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
property underlying a mortgage loan by operation of law or otherwise in
accordance with the terms of the participation and subparticipation agreement.
Any participation interests where the underlying loan's security is either
repossessed or goes into foreclosure proceedings is sold to the Bank at fair
market value. The Bank then incurs all costs associated with repossession and
foreclosure.
SIGNIFICANT CONCENTRATIONS OF CREDIT RISK
Concentration of credit risk generally arises with respect to
participation interests when a number of underlying loans have borrowers engaged
in similar business activities or activities in the same geographical region.
Concentration of credit risk indicates the relative sensitivity of performance
to both positive and negative developments affecting a particular industry.
There are no significant concentrations of underlying loans to borrowers engaged
in similar business activities. However, by the nature of this entity's status
as a REIT, the composition of the loans underlying the participation interests
is highly concentrated in real estate. Underlying loans are also concentrated in
the Bank's primary markets of Ohio, Michigan, Indiana, and Kentucky. At
September 30, 2002, 95.1% of the underlying loans in all participation interests
were located in these states. This balance sheet exposure to geographic
concentrations directly affects the credit risk of the underlying loans within
the participation interests. Consequently, the portfolio of underlying loans may
experience a higher default rate in the event of adverse economic, political, or
business developments or natural hazards in these states that may affect the
ability of borrowers to make payments of principal and interest on the
underlying loans.
Concentration of credit risk also arises from the funds that HPCI
maintains in a demand deposit account with the Bank. HPCI invests funds in
Eurodollar deposits with the Bank overnight or for a term of not more than 30
days. Total funds on deposit with the Bank were $1.02 billion and $661.1 million
at September 30, 2002 and 2001, respectively.
20
LIQUIDITY AND CAPITAL RESOURCES
The objective of HPCI's liquidity management is to ensure the
availability of sufficient cash flows to meet all of its financial commitments.
In managing liquidity, management takes into account various legal and tax
limitations placed on a REIT.
HPCI's principal liquidity needs are to pay operating expenses and
dividends and acquire additional participation interests as the underlying loans
in its portfolio paydown or mature. Operating expenses and dividends are
expected to be funded through cash generated by operations, while the
acquisition of additional participation interests in loans is intended to be
funded with the proceeds obtained from repayment of principal balances by
individual borrowers and new capital contributions. HPCI intends to pay
dividends on its preferred stock and common stock in amounts necessary to
continue to preserve its status as a REIT under the Internal Revenue Code.
As mentioned previously, HPCI issued to Holdings Class C and D
preferred securities and received a capital contribution of common equity in
exchange for participation interests in certain loans and leasehold improvements
in the fourth quarter of 2001, which approximated $400 million in the aggregate.
HPCI 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 31, 2001, HPCI distributed cash and its participation
interests in Florida-related loans to its common shareholders, in anticipation
of the sale of the Florida operations by Huntington, which closed on February
15, 2002. This distribution approximated $1.3 billion.
In August 2002, HPCI's board of directors declared dividends on its
preferred securities. HPCI accrued for these dividend obligations to its
preferred security holders and paid dividends on the Class C and D preferred
securities on October 1, 2002. Dividends on the Class B preferred securities
were declared and are expected to be paid in December of this year along with
dividends on the Class B preferred securities that were declared in the first
and second quarters of 2002 and the dividends on the Class A preferred
securities that were declared in the first quarter of 2002. The amount of
dividends accrued for the third quarter of 2002 on the Class B preferred
securities was $1.9 million, $984,375 on the Class C preferred securities, and
$3.0 million on the Class D securities.
To the extent that the board of directors determines that additional
funding is required, management may raise such funds through additional equity
offerings, debt financings, or retention of cash flow, or a combination of these
methods. However, any cash flow retention must be consistent with the provisions
of the Internal Revenue Code requiring the distribution by a REIT of at least
90% of its REIT taxable income, excluding capital gains, and must take into
account taxes that would be imposed on undistributed income. Because of HPCI's
highly favorable liquidity position, management does not anticipate that
additional funding will be required for at least the next twelve months.
Furthermore, management is considering a distribution of equity in the form of
cash to its common shareholders late in the fourth quarter of 2002 to reduce
excess liquidity.
21
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Quantitative and qualitative disclosures for the current period are
found on page 19 of this report, which includes changes in market risk exposures
from disclosures presented in HPCI's 2001 Annual Report.
ITEM 4. CONTROLS AND PROCEDURES
On November 12, 2002, HPCI, in conjunction with Huntington, carried out
an evaluation, under the supervision and with the participation of its
management, including the President (Chief Executive Officer or CEO) along with
the Vice President (Chief Financial Officer or CFO), of the effectiveness of the
design and operation of its disclosure controls and procedures pursuant to
Exchange Act Rule 13a-14. Based upon that evaluation, the CEO along with the CFO
concluded that HPCI's disclosure controls and procedures are effective in timely
alerting the CEO and CFO to material information relating to HPCI (including its
consolidated subsidiary) required to be included in its periodic SEC filings.
There have been no significant changes in HPCI's internal controls or
in other factors that could significantly affect its internal controls
subsequent to the date it carried out this evaluation.
22
PART II. OTHER INFORMATION
In accordance with the instructions to Part II, the other specified items in
this part have been omitted because they are not applicable or the information
has been previously reported.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
3 (i) Amended and Restated Articles of Incorporation
(previously filed as Exhibit 3(a)(ii) to Amendment
No. 4 to Registration Statement of Form S-11 (File
No. 333-61182), filed with the Securities and
Exchange Commission on October 12, 2001, and
incorporated herein by reference.)
3 (ii) Code of Regulations (previously filed as Exhibit
3(b) to the Registrant's Registration Statement of
Form S-11 (File No. 333-61182), filed with the
Securities and Exchange Commission on May 17, 2001,
and incorporated herein by reference.)
10. Material contracts:
(a) Agreement between Huntington Preferred
Capital, Inc. and The Huntington National
Bank regarding pledging of loans underlying
its participation interests as collateral
for advances from Federal Home Loan Bank of
Cincinnati by The Huntington National Bank.
99.1 Principal Executive Officer Certification
99.2 Principal Financial Officer Certification
(b) Reports on Form 8-K
None.
23
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Huntington Preferred Capital, Inc.
----------------------------------
(Registrant)
Date: November 14, 2002 /s/ Michael J. McMennamin
---------------------------------
Michael J. McMennamin
President
(principal executive officer)
Date: November 14, 2002 /s/ John D. Van Fleet
---------------------------------
John D. Van Fleet
Vice President
(principal financial officer)
24
CERTIFICATION
I, Michael J. McMennamin, certify that:
1. I have reviewed this quarterly report on Form 10-Q of
Huntington Preferred Capital, Inc.;
2. Based on my knowledge, this quarterly report does not contain
any untrue statement of a material fact or omit to state a
material fact necessary to make the statements made, in light
of the circumstances under which such statements were made,
not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report,
fairly present in all material respects the financial
condition, results of operations, and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules
13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to
ensure that material information relating to the
registrant, including its consolidated subsidiaries,
is made known to us by others within those entities,
particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's
disclosure controls and procedures as of a date
within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions
about the effectiveness of the disclosure controls
and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of registrant's
board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or
operation of internal controls which could adversely
affect the registrant's ability to record, process,
summarize, and report financial data and have
identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves
management or other employees who have a significant
role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have
indicated in this quarterly report whether or not there were
significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and
material weaknesses.
Date: November 14, 2002
-----------------------------
/s/ Michael J. McMennamin
--------------------------------------------
Michael J. McMennamin, President
(chief executive officer)
CERTIFICATION
I, John D. Van Fleet, certify that:
1. I have reviewed this quarterly report on Form 10-Q of
Huntington Preferred Capital, Inc.;
2. Based on my knowledge, this quarterly report does not contain
any untrue statement of a material fact or omit to state a
material fact necessary to make the statements made, in light
of the circumstances under which such statements were made,
not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report,
fairly present in all material respects the financial
condition, results of operations, and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules
13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to
ensure that material information relating to the
registrant, including its consolidated subsidiaries,
is made known to us by others within those entities,
particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's
disclosure controls and procedures as of a date
within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions
about the effectiveness of the disclosure controls
and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of registrant's
board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or
operation of internal controls which could adversely
affect the registrant's ability to record, process,
summarize, and report financial data and have
identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves
management or other employees who have a significant
role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have
indicated in this quarterly report whether or not there were
significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and
material weaknesses.
Date: November 14, 2002
--------------------------
/s/ John D. Van Fleet
------------------------------------------
John D. Van Fleet, Vice President
(chief financial officer)