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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 MARCH 31, 2003
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 April 30, 2003, 14,000,000 shares of common stock without par value were
outstanding, all of which were held by affiliates of the registrant.
HUNTINGTON PREFERRED CAPITAL, INC.
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets -
March 31, 2003 and 2002, and December 31, 2002 3
Consolidated Statements of Income -
For the three months ended March 31, 2003 and 2002 4
Consolidated Statements of Changes in Shareholders' Equity -
For the three months ended March 31, 2003 and 2002 5
Consolidated Statements of Cash Flows -
For the three months ended March 31, 2003 and 2002 6
Notes to Unaudited Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures about Market Risk 19
Item 4. Controls and Procedures 19
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 21
Signatures 22
Certifications 23 - 24
2
PART I. FINANCIAL INFORMATION
FINANCIAL STATEMENTS
HUNTINGTON PREFERRED CAPITAL, INC.
CONSOLIDATED BALANCE SHEETS
- ------------------------------------------------------------------------------------------------------------------------
MARCH 31, DECEMBER 31, MARCH 31,
(in thousands of dollars, except share data) 2003 2002 2002
- ------------------------------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
ASSETS
Cash and due from The Huntington National Bank $ 28,249 $ 534,254 $ 38,287
Interest bearing deposits with The Huntington National Bank 668,594 --- 653,245
Due from Huntington Preferred Capital Holdings, Inc. and The
Huntington National Bank 10,334 7,440 71,107
Loan participation interests
Commercial 284,225 344,858 557,975
Commercial real estate 3,951,895 3,922,467 3,831,498
Consumer 575,545 612,357 723,278
Residential real estate 132,123 153,808 229,228
- ------------------------------------------------------------------------------------------------------------------------
4,943,788 5,033,490 5,341,979
Less allowance for loan losses 125,884 140,353 171,007
- ------------------------------------------------------------------------------------------------------------------------
Net loan participation interests 4,817,904 4,893,137 5,170,972
- ------------------------------------------------------------------------------------------------------------------------
Premises and equipment 36,363 38,088 42,782
Accrued income and other assets 21,614 44,102 43,538
- ------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 5,583,058 $ 5,517,021 $ 6,019,931
========================================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Dividends payable and other liabilities $ 2,068 $ 670 $ 5,898
- ------------------------------------------------------------------------------------------------------------------------
Total Liabilities 2,068 670 5,898
- ------------------------------------------------------------------------------------------------------------------------
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; 2,000,000 shares authorized, issued, and outstanding 50,000 50,000 50,000
Preferred stock, Class D, variable-rate noncumulative and
conditionally exchangeable; $25 par and liquidation
value; 14,000,000 shares authorized, issued, and outstanding 350,000 350,000 350,000
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 4,715,351 4,715,351 5,082,511
Retained earnings 64,639 --- 130,522
- ------------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 5,580,990 5,516,351 6,014,033
- ------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 5,583,058 $ 5,517,021 $ 6,019,931
========================================================================================================================
See notes to unaudited consolidated financial statements.
3
HUNTINGTON PREFERRED CAPITAL, INC.
CONSOLIDATED STATEMENTS OF INCOME
THREE MONTHS ENDED
MARCH 31,
- -------------------------------------------------------------------------------------------------
(in thousands of dollars) 2003 2002
- -------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
Interest and fee income
Interest on loan participation interests
Commercial $ 3,955 $ 7,309
Commercial real estate 46,957 53,880
Consumer 13,379 20,044
Residential real estate 2,251 4,560
- -------------------------------------------------------------------------------------------------
66,542 85,793
Fees from loan participation interests 2,733 2,441
Interest bearing deposits with The Huntington
National Bank 1,854 1,878
- -------------------------------------------------------------------------------------------------
TOTAL INTEREST AND FEE INCOME 71,129 90,112
- -------------------------------------------------------------------------------------------------
Provision for loan losses --- 16,839
- -------------------------------------------------------------------------------------------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 71,129 73,273
- -------------------------------------------------------------------------------------------------
Non-interest income
Rental income 1,806 1,535
Collateral fees 160 ---
- -------------------------------------------------------------------------------------------------
TOTAL NON-INTEREST INCOME 1,966 1,535
- -------------------------------------------------------------------------------------------------
Non-interest expense
Servicing fees 1,575 1,729
Depreciation and amortization 1,401 1,452
Other 382 458
- -------------------------------------------------------------------------------------------------
TOTAL NON-INTEREST EXPENSE 3,358 3,639
- -------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 69,737 71,169
Income taxes 24 (117)
- -------------------------------------------------------------------------------------------------
NET INCOME BEFORE PREFERRED DIVIDENDS 69,713 71,286
DIVIDENDS ON PREFERRED STOCK 5,074 5,981
- -------------------------------------------------------------------------------------------------
NET INCOME APPLICABLE TO COMMON SHARES $ 64,639 $ 65,305
=================================================================================================
See notes to unaudited consolidated financial statements.
4
HUNTINGTON PREFERRED CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
PREFERRED, CLASS A PREFERRED, CLASS B PREFERRED, CLASS C
------------------ ------------------- ------------------
(in thousands) SHARES STOCK SHARES STOCK SHARES STOCK
- ----------------------------------------------------------------------------------------------------------
Three Months Ended March 31, 2002:
Balance, beginning of period 1 $ 1,000 400 $ 400,000 2,000 $ 50,000
Comprehensive Income:
Net income
Total comprehensive 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, end of period (Unaudited) 1 $ 1,000 400 $ 400,000 2,000 $ 50,000
==========================================================================================================
THREE MONTHS ENDED MARCH 31, 2003:
BALANCE, BEGINNING OF PERIOD 1 $ 1,000 400 $ 400,000 2,000 $ 50,000
COMPREHENSIVE INCOME:
NET INCOME
TOTAL COMPREHENSIVE 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, END OF PERIOD (UNAUDITED) 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
- -----------------------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31, 2002:
Balance, beginning of period 14,000 $350,000 --- $ --- 14,000 $ 5,082,511 $ 65,217 $ 5,948,728
Comprehensive Income:
Net income 71,286 71,286
-----------
Total comprehensive income 71,286
-----------
Dividends declared on Class A preferred stock (80) (80)
Dividends declared on Class B preferred stock (1,864) (1,864)
Dividends declared on Class C preferred stock (985) (985)
Dividends declared on Class D preferred stock (3,052) (3,052)
- -----------------------------------------------------------------------------------------------------------------------------------
Balance, end of period (Unaudited) 14,000 $350,000 --- $ --- 14,000 $ 5,082,511 $130,522 $ 6,014,033
===================================================================================================================================
THREE MONTHS ENDED MARCH 31, 2003:
BALANCE, BEGINNING OF PERIOD 14,000 $350,000 --- $ --- 14,000 $ 4,715,351 $ --- $ 5,516,351
COMPREHENSIVE INCOME:
NET INCOME 69,713 69,713
-----------
TOTAL COMPREHENSIVE INCOME 69,713
-----------
DIVIDENDS DECLARED ON CLASS A PREFERRED STOCK (80) (80)
DIVIDENDS DECLARED ON CLASS B PREFERRED STOCK (1,380) (1,380)
DIVIDENDS DECLARED ON CLASS C PREFERRED STOCK (985) (985)
DIVIDENDS DECLARED ON CLASS D PREFERRED STOCK (2,629) (2,629)
- -----------------------------------------------------------------------------------------------------------------------------------
BALANCE, END OF PERIOD (UNAUDITED) 14,000 $350,000 --- $ --- 14,000 $ 4,715,351 $ 64,639 $ 5,580,990
===================================================================================================================================
See notes to unaudited consolidated financial statements.
5
HUNTINGTON PREFERRED CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS ENDED
MARCH 31,
----------------------------
(in thousands of dollars) 2003 2002
- ----------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
OPERATING ACTIVITIES
Net Income before preferred dividends $ 69,713 $ 71,286
Adjustments to reconcile net income to net
cash provided by operating activities:
Provision for loan losses --- 16,839
Depreciation and amortization 1,401 1,452
Loss on disposal of fixed assets 324 ---
Decrease (increase) in accrued interest and other assets 13,357 (255)
(Increase) decrease in due from/to Huntington
Preferred Capital Holdings, Inc. and The
Huntington National Bank (2,894) 222,702
Increase in accounts payable and other
liabilities (62) (114)
- ----------------------------------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES 81,839 311,910
- ----------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Participation interests acquired (1,342,367) (954,427)
Sales and repayments on loans underlying
participation interests 1,426,731 968,730
Proceeds from the sale of fixed assets --- 407
- ----------------------------------------------------------------------------------------------
NET CASH PROVIDED BY INVESTING ACTIVITIES 84,364 14,710
- ----------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Dividends paid on preferred stock (3,614) ---
- ----------------------------------------------------------------------------------------------
NET CASH USED FOR FINANCING ACTIVITIES (3,614) ---
- ----------------------------------------------------------------------------------------------
CHANGE IN CASH AND CASH EQUIVALENTS 162,589 326,620
CASH AND CASH EQUIVALENTS:
AT BEGINNING OF PERIOD 534,254 364,912
- ----------------------------------------------------------------------------------------------
AT END OF PERIOD $ 696,843 $ 691,532
==============================================================================================
Supplemental information:
Income taxes paid $ --- $ ---
Interest paid --- ---
See notes to unaudited consolidated financial statements.
6
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
1 - ORGANIZATION
Huntington Preferred Capital, Inc. (HPCI) was organized under Ohio law
in 1992 and designated as a real estate investment trust (REIT) in 1998. HPCI's
common stock is owned by three related parties, HPC Holdings-III, Inc.
(HPCH-III), a Nevada corporation, Huntington Preferred Capital II, Inc. (HPCII),
also a REIT and an Ohio corporation, and Huntington Bancshares Incorporated
(Huntington), a Maryland corporation headquartered in Columbus, Ohio. HPCI and
HPCII are subsidiaries of HPCH-III, which is a subsidiary of Huntington
Preferred Capital Holdings, Inc. (Holdings), an Indiana corporation. 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), a taxable REIT subsidiary formed in March
2001 for the purpose of holding certain assets (primarily leasehold
improvements).
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 2002 Annual Report on Form 10-K (2002 Annual Report), which include
descriptions of significant accounting policies, should be read in conjunction
with these interim financial statements.
In preparing financial statements in conformity with GAAP, management
of HPCI is required to make estimates, assumptions, and judgments that affect
the reported amounts of assets and liabilities as of the date of the balance
sheet and reported amounts of revenue and expenses during the reporting period.
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. Actual results could differ from those estimates. A material estimate
that is particularly susceptible to significant change relates to the
determination of the allowance for loan losses.
Cash and cash equivalents used in the Statement of Cash Flows are
defined as the sum of "Cash and due from The Huntington National Bank" and
"Interest bearing deposits with The Huntington National Bank".
All of HPCI's common stock is owned by Huntington, HPCII, and HPCH-III
and, therefore, earnings per common share information is not presented.
3 - LOAN PARTICIPATION INTERESTS
Participation interests are categorized based on the collateral
securing the underlying loan. At March 31, loan participation interests were
comprised of the following:
- -----------------------------------------------------------
(in thousands of dollars) 2003 2002
- -----------------------------------------------------------
Commercial $ 284,225 $ 557,975
Commercial real estate 3,951,895 3,831,498
Consumer 575,545 723,278
Residential real estate 132,123 229,228
- -----------------------------------------------------------
TOTAL LOAN PARTICIPATIONS $ 4,943,788 $ 5,341,979
===========================================================
There are no underlying loans outstanding which would be considered a
concentration of lending in any particular industry, group of industries, or
business activity. Underlying loans are, however, generally secured by real
estate and concentrated to borrowers in the four states of Ohio, Michigan,
Indiana, and Kentucky, which comprise 96.1% of the portfolio at March 31, 2003.
7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
PARTICIPATIONS IN NON-PERFORMING LOANS AND PAST DUE LOANS
At March 31, 2003 and 2002, the participations in loans in non-accrual
status and loans past due 90 days or more and still accruing interest, were as
follows:
- -------------------------------------------------------------------------------------------
(in thousands of dollars) 2003 2002
- -------------------------------------------------------------------------------------------
Commercial $ 33,367 $ 126,724
Commercial real estate 27,041 42,737
Consumer --- ---
Residential real estate 5,499 8,458
- -------------------------------------------------------------------------------------------
TOTAL PARTICIPATIONS IN NON-ACCRUAL LOANS $ 65,907 $ 177,919
===========================================================================================
PARTICIPATIONS IN ACCRUING LOANS PAST DUE 90 DAYS OR MORE $ 15,575 $ 28,337
===========================================================================================
4 - ALLOWANCE FOR LOAN LOSSES
A summary of the transactions in the allowance for loan losses (ALL) follows
for each of the quarters ended March 31:
- ---------------------------------------------------------------------------
(in thousands of dollars) 2003 2002
- ---------------------------------------------------------------------------
BALANCE, BEGINNING OF YEAR $ 140,353 $ 175,690
Allowance of loan participations acquired 11,657 6,561
Net loan losses (26,126) (28,083)
Provision for loan losses --- 16,839
- ---------------------------------------------------------------------------
BALANCE, END OF YEAR $ 125,884 $ 171,007
===========================================================================
During the first quarter of 2003, a total of $12.2 million of interest
receivables was determined to be uncollectible and charged off against the
allowance for loan losses. These interest receivables related to loans that were
previously charged off.
5 - DIVIDENDS
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 fixed 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. Dividends of $80,000 for 2003 were declared and have been
set aside for payment in December 2003 to the holders of record on November 30,
2003.
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 the 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. Quarterly dividends
of $1.4 million, based on a LIBOR rate of 1.38%, were declared in the first
quarter 2003, compared with dividends declared of $1.9 million for the same
period in 2002.
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
8
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
the following three quarterly dividend periods. Dividends declared to the
holders of the Class C preferred securities totaled $984,375, or $0.4921875 per
share, in the first quarter of 2003 and 2002. Dividends were paid on March 31,
2003 and April 1, 2002, respectively.
The holder of Class D preferred securities, HPCH-III (Holdings, prior to
December 27, 2002), 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. Dividends declared to the holder of the Class D
preferred securities totaled $2.6 million and $3.1 million in the first quarter
of 2003 and 2002, respectively. Dividends were paid on March 31, 2003 and April
1, 2002, respectively.
6 - RELATED PARTY TRANSACTIONS
HPCI holds a 100% subparticipation interest in Holdings' 99% participation
interests in loans originated by the Bank and its subsidiaries. The
participation and subparticipation interests are in commercial, commercial real
estate, residential real estate, and consumer loans that were either directly
underwritten by the Bank and its subsidiaries or acquired by the Bank.
Participation interests in loans are acquired from the Bank through Holdings by
HPCI at the Bank's carrying value, which is the principal amount outstanding
plus accrued interest, net of unearned income, if any, less an ALL. HPCI expects
to continue to purchase such interests, net of ALL, in the future from Holdings,
the Bank, or their affiliates.
Under HPCI's subparticipation agreement with Holdings and Holding's
participation agreement with the Bank, the Bank performs the servicing of the
commercial, commercial real estate, residential real estate, 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 real estate, and
consumer loans underlying the participation interests and 2.35% of the
interest income collected on the underlying residential real estate loans.
Servicing fee expense paid to the Bank totaled $1.6 million for the three months
ended March 31, 2003 and $1.7 million for the same period a year ago. In its
capacity as servicer, the Bank collects and holds the 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 consolidated financial statements.
HPCI, Huntington, and the Bank share personnel to handle day-to-day
operations of the company such as accounting, financial analysis, tax reporting,
and other administrative functions. On a monthly basis, HPCI reimburses the Bank
and Huntington for the cost related to the time spent by employees for
performing these functions. The personnel costs were $40,000 for each of the
three month periods ended March 31, 2003 and 2002.
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). Prior to February 2001, Holdings was the
owner of 100% of the outstanding common stock of HPCI. 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. On December 27, 2002, Holdings contributed
its ownership in HPCI's Class A and Class D preferred securities and its
remaining common stock to HPCH-III. The following table represents the current
ownership of HPCI's common and preferred stock:
9
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- ------------------------------------------------------------------------------------------------------------
Number of Number of Preferred Securities
Common ------------------------------------------------------
Owner at March 31, 2003: Shares Class A Class B Class C Class D
- ------------------------------------------------------------------------------------------------------------
Holdings --- --- --- --- ---
HPCH-III 9,431,333 892 --- --- 14,000,000
HPCII 4,550,000 --- 400,000 --- ---
Huntington 18,667 --- --- --- ---
- ------------------------------------------------------------------------------------------------------------
Total held by related parties 14,000,000 892 400,000 --- 14,000,000
============================================================================================================
Other shareholders --- 108 --- 2,000,000 ---
============================================================================================================
At March 31, 2003, 10.8% of the Class A preferred securities are owned
by current and past employees of Huntington and its subsidiaries in addition to
the 89.2% owned by HPCH-III. The Class A preferred securities are non-voting.
All of the Class B preferred securities are owned by HPC Holdings-II, Inc., a
non-bank subsidiary of Huntington and are non-voting. In 2001, the Class C
preferred securities were obtained by Holdings, who sold the securities to the
public. Various board members and executive officers of HPCI purchased a portion
of the Class C preferred securities in the open market. At December 31, 2002, a
total of 7,100 shares, or 0.355%, were beneficially owned by HPCI board members
and executive officers in the aggregate. All of the Class D preferred securities
owned by HPCH-III are being held for possible sale to the public in the future.
Dividends paid to the Class C and D shareholders in the first quarter of 2003
were $984,375 and $2,629,375, respectively.
Both the Class C and D preferred securities are entitled to one-tenth
of one vote per share on all matters submitted to HPCI shareholders. The Class C
and D preferred securities are exchangeable, without shareholder approval or any
action of shareholders, for preferred securities of the Bank with substantially
equivalent terms as to dividends, liquidation preference, and redemption if the
Office of the Comptroller of the Currency (OCC) so directs only under the
following circumstances where the Bank becomes or may in the near term become
undercapitalized, or the Bank is placed in conservatorship or receivership. The
Class C and Class D preferred securities are redeemable at HPCI's option on or
after December 31, 2021, and December 31, 2006, respectively, with prior consent
of the OCC.
HPCI's premises and equipment were acquired from the Bank through
Holdings. Leasehold improvements were subsequently contributed to HPCLI for its
common shares in the fourth quarter of 2001. HPCLI charges rent to the Bank for
use of applicable facilities by the Bank. The amount of rental income received
by HPCLI during the quarter ended March 31, 2003 and 2002 was $1.8 million and
$1.5 million, respectively, and is reflected as a component of non-interest
income in the consolidated statements of income.
HPCI has a non-interest bearing receivable from Holdings of $10.3
million at March 31, 2003, and $7.4 million at March 31, 2002. These balances
represent unsettled cash transactions involving its participation interests that
occur in the ordinary course of business.
The Bank is eligible to obtain advances from various federal and
government-sponsored agencies such as the Federal Home Loan Bank of Cincinnati.
From time to time, HPCI may be asked to act as guarantor of the Bank's
obligations under such advances and/or pledge all or a portion of its assets in
connection with those advances. See Note 7 for further information regarding the
pledging of HPCI's assets in association with the Bank's advances.
10
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
HPCI maintains and transacts all of its cash activity through a
non-interest bearing demand deposit account with the Bank. In addition, to the
extent that it does not jeopardize qualification as a REIT, HPCI invests
available funds in Eurodollar deposits with the Bank for a term of not more than
30 days. The following amounts were on deposit with the Bank at March 31:
- -------------------------------------------------------------
(in thousands of dollars) 2003 2002
- -------------------------------------------------------------
Non-interest bearing $ 28,249 $ 38,287
Interest bearing 668,594 653,245
- -------------------------------------------------------------
Total deposits with the Bank $ 696,843 $ 691,532
=============================================================
7 - 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 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 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 guarantor or has pledged its assets as collateral will
have a liquidation preference over the holders of HPCI's securities. Any such
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 guarantee and/or pledge.
The Bank is currently eligible to obtain one or more advances from the
FHLBC based upon the amount of FHLBC capital stock owned by the Bank. As of
March 31, 2003, the Bank's total borrowing capacity under this facility was
capped at $1.3 billion. As of this same date, the Bank had borrowings of $1.2
billion under this facility in addition to a standby letter of credit that was
issued and outstanding in the amount of $1.8 million.
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 pledged collateral held by HPCI. As of March 31,
2003, HPCI's pledged collateral was limited to 1-4 family residential mortgages
and second mortgage loans. As of that same date, HPCI's participation interests
in 1-4 family residential mortgages and second mortgage loans pledged as
collateral aggregated $494 million, which represented 80% of its eligible
collateral. The Bank paid $160,000 to HPCI in the first quarter of 2003,
representing twelve basis points per year on the collateral pledged, as
compensation for making such assets available to the Bank as collateral. No fees
were received in the first three months of 2002.
8 - SEGMENT REPORTING
HPCI's operations consist 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 and
its affiliates.
11
ITEM 2. MANAGEMENTS'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
INTRODUCTION
Huntington Preferred Capital, Inc. (HPCI) is an Ohio corporation
operating as a Real Estate Investment Trust (REIT) for federal income tax
purposes. HPCI'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.
HPCI 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. 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 provides 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
Management's discussion and analysis of financial condition and results
of operations contain 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 HPCI's 2002 Annual Report on Form 10-K (2002 Annual 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 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.
CRITICAL ACCOUNTING POLICIES
Note 1 to HPCI's consolidated financial statements included in its 2002
Annual Report 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
12
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.
OVERVIEW
HPCI's income is primarily derived from its participation interests in
loans acquired from the Bank through Holdings. Income varies based on the level
of these assets and interest rates earned on these assets. 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's net income before preferred dividends was $69.7 million for the
first three months of 2003 versus $71.3 million for the same period a year ago.
Net income available to common shareholders was $64.6 million for the first
quarter of 2003, compared with $65.3 million for the year-ago first quarter.
HPCI had total assets and total equity (including preferred stock) of
$5.6 billion at March 31, 2003, down slightly from $6.0 billion a year earlier.
At March 31, 2003 and 2002, an aggregate of $4.9 billion and $5.3 billion,
respectively, consisted of 99% participation interests in loans. Participation
interests in specific underlying loans were as follows:
- ---------------------------------------------------------------------------------------------------------------
AT MARCH 31,
- ---------------------------------------------------------------------------------------------------------------
% OF % OF
TOTAL TOTAL
(in thousands of dollars) 2003 ASSETS 2002 ASSETS
- ---------------------------------------------------------------------------------------------------------------
Gross loan participation interests:
Commercial $ 284,225 5.1 $ 557,975 9.3
Commercial real estate 3,951,895 70.6 3,831,498 63.6
Consumer 575,545 10.3 723,278 12.0
Residential real estate 132,123 2.4 229,228 3.8
- ---------------------------------------------------------------------------------------------------------------
Total $ 4,943,788 88.4 $ 5,341,979 88.7
===============================================================================================================
Participation interests in commercial loans and residential real estate
loans declined 49% and 42%, respectively. HPCI has not acquired additional
participation interests in these loans over the past several quarters.
Participation interests in commercial real estate loans at March 31, 2003
increased 3% over levels at the end of the same period last year. At the
beginning of 2003, HPCI began to invest only in commercial real estate loans
that were fully collateralized by real estate. Participation interests in
consumer loans decreased 20% for the same comparable periods as scheduled
payment and prepayment activity in this portfolio outpaced the investment in new
participation interests, which was comprised largely of interests in home equity
loans secured by first and second mortgages.
Qualification as a REIT involves application of specific provisions of
the Internal Revenue Code relating to income and asset tests. A REIT must
satisfy six asset tests quarterly: (1) 75 percent of the value of the REIT's
total assets must consist of real estate assets, cash and cash items, and
Government securities; (2) not more than 25 percent of the value of the REIT's
total assets may consist of securities, other than those includible under the 75
percent test; (3) not more than five percent of the value of its total assets
may consist of securities of any one issuer, other than those securities
includible under the 75 percent test or securities of taxable REIT subsidiaries;
(4) not more than 10 percent of the outstanding voting power of any one issuer
may be held, other than those securities includible under the 75 percent test or
securities of taxable REIT subsidiaries; (5) not more that 10 percent of the
total value of the outstanding securities of any one issuer may be held, other
than those securities includible under the 75 percent test or securities of
taxable REIT subsidiaries; and (6) a REIT cannot own securities in one or more
taxable REIT subsidiaries which comprise more than 20 percent of its total
assets. Also, a REIT must annually satisfy two gross income tests: (1) 75
percent of its gross income must be from qualifying income closely connected
with real estate activities; and (2) 95 percent of its gross income must be
derived from sources qualifying for the 75 percent test plus dividends, interest
and gains from the sale of securities. At March 31,2003, HPCI had qualifying
assets that exceeded 75 percent of the value of its total assets.
HPCI intends to operate in a manner that will not cause it to be deemed
an investment company under the Investment Company Act. The Investment Company
Act exempts from registration as an investment company an
13
entity that is primarily engaged in the business of "purchasing or otherwise
acquiring mortgages and other liens on and interests in real estate" (Qualifying
Interests). Under positions taken by the SEC staff in no-action letters, in
order to qualify for this exemption, HPCI must invest at least 55 percent of its
assets in Qualifying Interests and an additional 25 percent of its assets in
real estate-related assets, although this percentage may be reduced to the
extent that more than 55 percent of its assets are invested in Qualifying
Interests. The assets in which HPCI may invest under the Internal Revenue Code
therefore may be further limited by the provisions of the Investment Company Act
and positions taken by the SEC staff. HPCI intends to operate its business in a
manner that will maintain its exemption from registration as an investment
company under the Investment Company Act.
Interest-bearing and non-interest bearing cash balances on deposit with
the Bank were $696.8 million at March 31, 2003, up slightly from $691.5 million
at March 31, 2002. Interest bearing balances are invested overnight or in
Eurodollar deposits with the Bank for a term of not more than 30 days.
Typically, cash is invested with the Bank in an interest bearing account.
Interest-bearing and non-interest bearing cash balances on deposit with the Bank
were $534.3 million at December 31, 2002.
At March 31, 2003, amounts due from Holdings and the Bank were $10.3
million, down from $71.1 million a year ago but up slightly from $7.4 million at
the most recent year end. 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.
Dividends payable and other liabilities declined from $5.9 million at the end of
the first quarter last year to $2.1 million at March 31, 2003. This decline was
due to the timing of the payment of dividends paid on the Class C and D
preferred securities.
Shareholders' equity (including preferred stock) was $5.6 billion at
March 31, 2003, down from $6.0 billion at March 31, 2002. This decline largely
reflected the impact of the declaration and payment of common and preferred
dividends and return of capital on December 31, 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 March 31, 2003 and 2002, 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.
For the three-month period ended March 31, HPCI's average balances,
interest and fee income, and yields are presented below:
- --------------------------------------------------------------------------------------------------------------
2003 2002
----------------------------------- ---------------------------------
AVERAGE AVERAGE
(in millions of dollars) BALANCE INCOME YIELD BALANCE INCOME YIELD
- --------------------------------------------------------------------------------------------------------------
Loan participation interests:
Commercial $ 323.4 $ 3.9 4.96% $ 607.1 $ 7.3 4.88%
Commercial real estate 3,893.3 47.0 4.89 3,733.8 53.9 5.85
Consumer 599.8 13.4 9.05 763.3 20.0 10.65
Residential real estate 146.1 2.2 6.16 256.3 4.6 7.12
- --------------------------------------------------------------------------------------------------------------
Total loan participations 4,962.6 66.5 5.44 5,360.5 85.8 6.49
- --------------------------------------------------------------------------------------------------------------
Interest bearing deposits
in banks 617.6 1.9 1.22 423.0 1.9 1.80
Fees from loan participation
interests 2.7 2.4
- --------------------------------------------------------------------------------------------------------------
Total $ 5,580.2 $ 71.1 5.17% $ 5,783.5 $ 90.1 6.31%
==============================================================================================================
Interest and fee income was $71.1 million for the first three months of
2003, compared with $90.1 million for the year ago quarter. Approximately 70% of
the decline in interest and fee income was due to the lower interest rate
environment and the remainder due to declines in average participation balances.
Approximately three-quarters of
14
the loan participation portfolio is variable in nature with respect to interest
rate. As shown in the table above, the yield on HPCI's participation interests
declined from 6.49% to 5.44%. The table above includes interest received on
participations in loans that are on a non-accrual status in the individual
portfolios.
The table below shows changes in interest and fee income for the three
month periods ended March 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.
- --------------------------------------------------------------------------------------------------------------------------
2003 2002
- --------------------------------------------------------------------------------------------------------------------------
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 $ 0.7 $ (0.7) $ --- $ (4.6) $ (5.8) $ (10.4)
Loan participation interests:
Commercial (3.6) 0.1 (3.5) --- (4.6) (4.6)
Commercial real estate 2.3 (8.8) (6.5) (5.1) (22.7) (27.8)
Consumer (4.0) (2.6) (6.6) (5.9) 2.8 (3.1)
Residential real estate (1.8) (0.6) (2.4) (3.6) (1.1) (4.7)
- --------------------------------------------------------------------------------------------------------------------------
TOTAL EARNING ASSETS (6.4) (12.6) (19.0) (19.2) (31.4) (50.6)
- --------------------------------------------------------------------------------------------------------------------------
TOTAL INTEREST-BEARING LIABILITIES --- --- --- --- --- ---
- --------------------------------------------------------------------------------------------------------------------------
INTEREST AND FEE INCOME $(6.4) $(12.6) $(19.0) $(19.2) $ (31.4) $ (50.6)
==========================================================================================================================
PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES (ALL)
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 for loan losses for the
first quarter of 2003. This compared with an expense of $16.8 million for the
same period last year. The decline in provision expense in 2003 from 2002 was
indicative of the significantly lower level of non-performing loans underlying
HPCI's participation interests and slightly lower losses on loan participations.
The ALL was $125.9 million at March 31, 2003, down from $140.4 million
at December 31, 2002, and $171.0 million at March 31, 2002. This represents
2.55%, 2.79%, and 3.20% of total loan participations at the end of each
respective period. The ALL decreased from March and December of last year
because of the factors described above related to provision expense. The ALL
covered 191.0% of the participations in non-performing loans at the end of March
2003, compared to 145.4% and 96.1% at December 31, 2002 and March 31, 2002,
respectively. In management's judgment, the ALL is adequate at March 31, 2003 to
cover losses inherent in the loan participation portfolio. Additional
information regarding the ALL and asset quality appears in the "Credit Quality"
section. The following table shows the activity in HPCI's ALL for each of the
quarters ended March 31,:
- ----------------------------------------------------------------------------------------------------------------
(in thousands of dollars) 2003 2002
- ----------------------------------------------------------------------------------------------------------------
BALANCE, BEGINNING OF PERIOD $ 140,353 $ 175,690
Allowance of loan participations acquired, net 11,657 6,561
Net loan losses
Commercial (8,582) (14,203)
Commercial real estate (960) (6,009)
Consumer (14,534) (7,871)
Residential real estate (2,050) ---
- ----------------------------------------------------------------------------------------------------------------
Total net loan losses (26,126) (28,083)
- ----------------------------------------------------------------------------------------------------------------
Provision for loan losses --- 16,839
- ----------------------------------------------------------------------------------------------------------------
BALANCE, END OF PERIOD $ 125,884 $ 171,007
================================================================================================================
Total net charge-offs for the quarter ended March 31, 2003, were $26.1
million, or 2.11% (annualized) of average participation interests, slightly
lower than the $28.1 million, or 2.10%, recorded in the same quarterly period
one year ago but up significantly from $12.9 million, or 0.99%, for the last
quarter of 2002. During the first quarter of 2003, a total of $12.2 million of
interest receivables was determined to be uncollectible and charged off against
the allowance for loan losses. These interest receivables related to loans that
were previously charged off.
15
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.
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 and residential real
estate 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.
Expected loss ratios also incorporate factors such as trends in past
due and non-accrual amounts, recent underlying loan loss experience, current
economic conditions, risk characteristics, and concentrations of various
underlying loan categories. Actual loss ratios experienced in the future could
vary from those expected, as performance is a function of factors unique to each
customer as well as general economic conditions. To ensure adequacy of the total
ALL, it includes a general unallocated component. Management believes that an
unallocated reserve of 15% of the total allowance for loan losses at March 31,
2003 is appropriate given (1) the composition of the loans underlying HPCI's
participation interests, predominantly commercial real estate, commercial loans,
and lower quality consumer loans; and (2) the increase in uncertainties in the
general economic outlook and world events that could impact customers' ability
to make payments. Management will continue to monitor the need for an
unallocated reserve of this magnitude on a quarterly basis. 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 loan
participation portfolio.
NON-INTEREST INCOME AND NON-INTEREST EXPENSE
Non-interest income was $2.0 million for the first quarter of 2003
compared with $1.5 million for the comparable quarter a year ago. This largely
represents rental income received from the Bank related to land, buildings, and
leasehold improvements owned by HPCI. In addition, non-interest income includes
fees from the Bank for use of its assets as collateral for the Bank's advances
from the Federal Home Loan Bank of Cincinnati (FHLBC). These fees totaled
$160,000 for the first quarter of 2003. HPCI began receiving these fees after
the first quarter of last year. See Note 7 to the unaudited consolidated
financial statements for more information regarding use of HPCI's assets as
collateral for the Bank's advances from the FHLBC.
Non-interest expense was $3.4 million for the recent three months
versus $3.6 million for the first quarter of 2002. The predominant components of
HPCI's non-interest expense are the fees paid to the Bank for servicing the
loans underlying the participation interests and depreciation and amortization
on its premises and equipment. Servicing fees amounted to $1.6 million for the
first three months of 2003, down slightly from the $1.7 million recorded in
the same period of 2002 due to a decline in average loan participations. On an
annual basis, the service fee with respect to the commercial real estate,
commercial, and consumer loans is equal to the outstanding principal balance of
each loan multiplied by a fee of 0.125% and the service fee for residential
real estate loans is equal to 2.35% of the interest income collected.
Depreciation on premises and equipment was $1.4 million and $1.5 million for
the first quarter of 2003 and 2002, respectively.
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 Internal
Revenue Code and, therefore, is not subject to income taxes. HPCI's subsidiary,
HPCLI, elected to be treated as a taxable REIT subsidiary and, therefore, a
separate provision related to its income taxes is included in the accompanying
unaudited consolidated financial statements.
INTEREST RATE RISK MANAGEMENT
HPCI's income consists primarily of interest income on participation
interests in commercial, consumer, residential real estate, and commercial real
estate loans. If there is a decline in market interest rates, HPCI may
experience a reduction in interest income on its 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 underlying variable rate loans are based and
from prepayments of underlying loans with fixed interest rates as well as
reinvestment in lower-earning assets.
16
Huntington conducts its interest rate risk management on a centralized
basis and does not manage HPCI's interest rate risk separately. A key element
used in Huntington's 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
March 31, 2003, and assuming no new loan participation volumes, interest income
for the next 12 month period would be expected to increase by 8.5% if rates rose
200 basis points gradually and with a parallel shift of the yield curve above
the forward rates implied in the March 31, 2003 yield curve. Interest income
would be expected to decline 7.3% in the event of a gradual 200 basis point
decline in rates from the forward rates implied in the March yield curve.
CREDIT QUALITY
HPCI's exposure to credit risk is managed by personnel of the Bank
through its 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 loans adhere to corporate
policy and problem loans are promptly identified. These procedures provide
executive management of the Bank and HPCI with the information necessary to
implement policy adjustments where necessary, and to 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. In 2002, the Bank initiated a
company-wide project to revise its internal risk grading system for commercial
and commercial real estate credits. The Bank migrated from a single grading to a
dual risk grading system that measures the probability of default and loss in
event of default separately. The new dual risk grading system allows the Bank to
be significantly more specific in the risk assessment process. This dual grading
process is an industry standard and management believes that this change
positions the Bank to continue the focus on improving credit quality.
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.
Borrowers obligated in loans underlying HPCI's participation interests, however,
do not represent a particular concentration of similar business activity. HPCI's
balance sheet exposure to geographic concentrations directly affects the credit
risk of the underlying loans within the participation interests. The majority of
the loans underlying the participation interests are located in Ohio, Michigan,
Indiana, and Kentucky. At March 31, 2003, 96.1% of the underlying loans in all
participation interests consisted of loans located in these four states.
Consequently, the portfolio may experience a higher default rate in the event of
adverse economic, political, or business developments or natural hazards in
these states and may affect the ability of borrowers to make payments of
principal and interest on the underlying loans.
A participation interest acquired by HPCI in an underlying loan is
considered impaired when, based on current information and events, it is
determined that estimated cash flows are less than the cash flows estimated at
the date of purchase. An underlying loan originated by the Bank is considered
impaired when, based on current information and events, it is probable that it
will be unable to collect the scheduled payments of principal or interest when
due according to the contractual terms of the loan agreement. Factors considered
by management in determining impairment include payment status, collateral
value, and the probability of collecting scheduled principal and interest
payments when due. Loans that experience insignificant payment delays and
payment shortfalls generally are not classified as impaired. Management
determines the significance of payment delays and payment shortfalls on a
case-by-case basis, taking into consideration all of the circumstances
surrounding the loan and the borrower. This includes the length of the delay,
the reasons for the delay, the borrower's prior payment record, and the amount
of the shortfall in relation to the principal and interest owed. Loan impairment
is measured on a loan-by-loan basis by comparing the recorded investment in the
loan to the present value of expected future cash flows discounted at the loan's
effective interest rate, the loan's obtainable market price, or the fair value
of the collateral if the loan is collateral dependent.
Non-performing assets (NPAs) consist of participation interests in
underlying loans that are no longer accruing interest. Underlying commercial and
commercial real estate 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. Underlying residential real estate
loans are generally placed on non-accrual status within 180 days past due as to
principal and 210 days past due as to interest. 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.
17
Consumer loans are not placed on non-accrual status; rather they are
charged off in accordance with regulatory statutes governing the Bank, which is
generally no more than 120 days.
- ---------------------------------------------------------------------------------------------------
NON-PERFORMING ASSETS AT MARCH 31,
- ---------------------------------------------------------------------------------------------------
(in thousands of dollars) 2003 2002
- ---------------------------------------------------------------------------------------------------
Participation interests in non-accrual loans
Commercial $ 33,367 $ 126,724
Real Estate
Commercial 27,041 42,737
Residential 5,499 8,458
- ---------------------------------------------------------------------------------------------------
Total Non-Performing Assets $ 65,907 $ 177,919
===================================================================================================
NON-PERFORMING ASSETS AS A % OF TOTAL
PARTICIPATION INTERESTS 1.33% 3.33%
ALLOWANCE FOR LOAN LOSSES AS A % OF NON-
PERFORMING ASSETS 191.0% 96.1%
Total NPAs were $65.9 million, down from $96.5 million at December 31,
2002, and $177.9 million at March 31, 2002. As of the same dates, the underlying
non-performing loans represented 1.33%, 1.92%, and 3.33% of total participation
interests. There was an improvement in the level of participation interests in
non-performing loans during the recent three months. The change in
non-performing assets during the recent quarter included participation interests
in underlying loans transferring to nonaccrual status of $36.2 million, offset
by charge-offs of $10.4 million, sales of $3.0 million, payments received of
$47.5 million, and returns to accruing status of $5.9 million.
Underlying loans past due ninety days or more but continuing to accrue
interest also declined to $15.6 million at March 31, 2003, from $26.1 million at
December 31, 2002, and $28.3 million at March 31, 2002.
Under the participation and subparticipation agreements, HPCI may
direct the Bank to dispose of any underlying loan that becomes classified, is
placed in a non-performing status, or is renegotiated due to the financial
deterioration of the borrower. The Bank may institute foreclosure proceedings at
the discretion 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 property underlying a mortgage loan by operation of law or otherwise in
accordance with the terms of the participation and subparticipation agreement.
Any participation interest in a loan is sold to the Bank at fair market value
where the security is either repossessed or goes into foreclosure proceedings.
The Bank then incurs all costs associated with repossession and foreclosure.
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
and to capitalize on opportunities for business expansion. In managing
liquidity, management takes into account various legal 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.
At March 31, 2003 and 2002, HPCI maintained interest bearing and
non-interest bearing cash balances with the Bank totaling $696.8 million and
$691.5 million, respectively. HPCI maintains and transacts all of its cash
activity with the Bank and invests available funds in Eurodollar deposits with
the Bank for a term of not more than 30 days.
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
18
must take into account taxes that would be imposed on undistributed income.
Management does not anticipate that additional funding will be required for at
least the next twelve months.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Quantitative and qualitative disclosures for the current period are
found beginning on page 16 of this report, which includes changes in market risk
exposures from disclosures presented in HPCI's 2002 Annual Report.
ITEM 4. CONTROLS AND PROCEDURES
On May 14, 2003, 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.
19
QUARTERLY STATEMENTS OF INCOME
2003 2002
--------- ----------------------------------------------------
(in thousands of dollars) FIRST FOURTH THIRD SECOND FIRST
- ------------------------------------------------------------------------------------------------------------------
Interest and fee income
Interest on loan participation interests
Commercial $ 3,955 $ 5,734 $ 5,421 $ 6,440 $ 7,309
Commercial real estate 46,957 50,951 53,512 54,290 53,880
Consumer 13,379 16,838 18,198 18,882 20,044
Residential real estate 2,251 2,807 3,403 3,851 4,560
- ------------------------------------------------------------------------------------------------------------------
66,542 76,330 80,534 83,463 85,793
- ------------------------------------------------------------------------------------------------------------------
Fees from loan participation interests 2,733 1,988 2,135 2,737 2,441
Interest bearing deposits in banks 1,854 3,138 4,033 3,284 1,878
- ------------------------------------------------------------------------------------------------------------------
TOTAL INTEREST AND FEE INCOME 71,129 81,456 86,702 89,484 90,112
- ------------------------------------------------------------------------------------------------------------------
Provision for loan losses --- (20,000) --- 3,000 16,839
- ------------------------------------------------------------------------------------------------------------------
NET INTEREST INCOME
AFTER PROVISION FOR LOAN LOSSES 71,129 101,456 86,702 86,484 73,273
- ------------------------------------------------------------------------------------------------------------------
Non-interest income
Rental income 1,806 1,520 1,530 1,533 1,535
Collateral fees 160 177 191 273 ---
- ------------------------------------------------------------------------------------------------------------------
TOTAL NON-INTEREST INCOME 1,966 1,697 1,721 1,806 1,535
- ------------------------------------------------------------------------------------------------------------------
Non-interest expense
Servicing fees 1,575 1,647 1,623 1,715 1,729
Depreciation and amortization 1,401 1,437 1,428 1,450 1,452
Other 382 150 101 92 458
- ------------------------------------------------------------------------------------------------------------------
TOTAL NON-INTEREST EXPENSE 3,358 3,234 3,152 3,257 3,639
- ------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 69,737 99,919 85,271 85,033 71,169
Income taxes 24 25 22 25 (117)
- ------------------------------------------------------------------------------------------------------------------
NET INCOME BEFORE PREFERRED DIVIDENDS 69,713 99,894 85,249 85,008 71,286
DIVIDENDS ON PREFERRED STOCK 5,074 5,709 5,892 6,232 5,981
- ------------------------------------------------------------------------------------------------------------------
NET INCOME APPLICABLE TO
COMMON SHARES (1) $ 64,639 $ 94,185 $ 79,357 $ 78,776 $ 65,305
==================================================================================================================
(1) All of HPCI's common stock is owned by Huntington, HPCII, and HPCH-III and,
therefore, earnings per common share information is not presented.
20
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
10. Material contracts:
(a) Amended and Restated Loan
Participation Agreement between The
Huntington National Bank and
Huntington Preferred Capital
Holdings, Inc.
(b) Amended and Restated Loan
Subparticipation Agreement between
Huntington Preferred Capital
Holdings, Inc. and Huntington
Preferred Capital, Inc.
(c) Loan Subparticipation Agreement
between Huntington Preferred
Capital Holdings, Inc. and HPC
Holdings-III, Inc.
(d) Loan Subparticipation Agreement
between HPC Holdings-III, Inc. and
Huntington Preferred Capital, Inc.;
(e) Loan Participation Agreement
between The Huntington National
Bank and Huntington Preferred
Capital, Inc.;
99.1 Principal Executive Officer Certification
99.2 Principal Financial Officer Certification
(b) Reports on Form 8-K
None.
21
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: May 15, 2003 /s/ Michael J. McMennamin
---------------------------
Michael J. McMennamin
President
(Principal Executive Officer)
Date: May 15, 2003 /s/ John D. Van Fleet
-----------------------------
John D. Van Fleet
Vice President
(Principal Financial Officer)
22
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: May 15, 2003
/s/ Michael J. McMennamin
------------------------------------
Michael J. McMennamin, President
(chief executive officer)
23
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: May 15, 2003
/s/ John D. Van Fleet
-------------------------------------
John D. Van Fleet, Vice President
(chief financial officer)
24