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EX-32.B - EXHIBIT 32.B - Wells Fargo Real Estate Investment Corp.wfe-2016630xex32b.htm
EX-32.A - EXHIBIT 32.A - Wells Fargo Real Estate Investment Corp.wfe-2016630xex32a.htm
EX-31.B - EXHIBIT 31.B - Wells Fargo Real Estate Investment Corp.wfe-2016630xex31b.htm
EX-31.A - EXHIBIT 31.A - Wells Fargo Real Estate Investment Corp.wfe-2016630xex31a.htm
EX-12 - EXHIBIT 12 - Wells Fargo Real Estate Investment Corp.wfe-2016630xex12.htm
 
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
(Mark One)
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2016
or
 
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from to

Commission file number 1-36768
Wells Fargo Real Estate Investment Corporation
(Exact name of registrant as specified in its charter)
Delaware
 
56-1986428   
(State of incorporation)
 
(I.R.S. Employer Identification No.)    
90 South 7th Street
Minneapolis, Minnesota 55402
(Address of principal executive offices)
(Zip Code)

(855) 825-1437
(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.
                        
Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer þ Smaller reporting company ¨
(Do not check if a smaller                                                       reporting company.)
 
Indicate by check mark whether the registrant is a shell company (defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ
 
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:
   
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ¨ No ¨
 
APPLICABLE ONLY TO CORPORATE ISSUERS:
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

As of July 29, 2016, there were 12,900,000 shares of the registrant’s common stock outstanding.

 



FORM 10-Q
CROSS-REFERENCE INDEX
 
PART I
Financial Information
 
 
 
 
Item 1.
Financial Statements
Page
  
  
  
  
  
Notes to Financial Statements
 
  
1


  
2


  
3


  
4


  
5


 
 
 
 
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Financial Review)
 
  
  
  
  
  
  
  
  
  
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
PART II
Other Information
 
 
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 6.
 
 
 
 
 
 
 
 
 
 







1



PART I - FINANCIAL INFORMATION
FINANCIAL REVIEW
Summary Financial Data
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
% Change
 
 
 
 
 
 
 
 
  
Quarter ended
 
 
June 30, 2016 from
 
 
Six months ended
 
 
 
 
($ in thousands, except per share data)
Jun 30,
2016

 
Mar 31,
2016

 
Jun 30,
2015

 
Mar 31,
2016

 
Jun 30,
2015

 
Jun 30,
2016

 
Jun 30,
2015

 
% Change

 
For the period
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
$
148,728

 
145,029

 
158,900

 
3
 %
 
(6
)
 
$
293,757

 
307,612

 
(5
)%
 
Net income applicable to common stock
144,331

 
140,632

 
154,503

 
3

 
(7
)
 
284,963

 
298,818

 
(5
)
 
Diluted earnings per common share
11.19

 
10.90

 
11.98

 
3

 
(7
)
 
22.09

 
23.16

 
(5
)
 
Profitability ratios
 
 
 
 
 
 
 
 
 
 
 
 
 
 


 
Return on average assets
4.48
%
 
4.49

 
4.92

 

 
(9
)
 
4.48
%
 
4.84

 
(7
)
 
Return on average stockholders’ equity
4.81

 
4.67

 
5.15

 
3

 
(7
)
 
4.74

 
5.00

 
(5
)
 
Average stockholders’ equity to average assets
93.16

 
96.14

 
95.53

 
(3
)
 
(2
)
 
94.63

 
96.73

 
(2
)
 
Common dividend payout ratio (1)
96.96

 
99.54

 
90.57

 
(3
)
 
7

 
98.23

 
93.70

 
5

 
Dividend coverage ratio (2)
3,594

 
3,652

 
3,571

 
(2
)
 
1

 
3,594

 
3,571

 
1

 
Total revenue
$
170,168

 
166,719

 
169,274

 
2

 
1

 
$
336,887

 
335,174

 
1

 
Average loans
13,013,458

 
12,897,134

 
12,502,729

 
1

 
4

 
12,955,296

 
12,568,638

 
3

 
Average assets
13,357,024

 
12,989,389

 
12,964,593

 
3

 
3

 
13,173,207

 
12,827,752

 
3

 
Net interest margin
5.02
%
 
5.06

 
5.22

 
(1
)
 
(4
)
 
5.04
%
 
5.25

 
(4
)
 
Net loan charge-offs
$
5,726

 
6,433

 
7,152

 
(11
)
 
(20
)
 
$
12,159

 
17,440

 
(30
)
 
As a percentage of average total loans (annualized)
0.18
%
 
0.20

 
0.23

 
(10
)
 
(22
)
 
0.19
%
 
0.28

 
(32
)
 
At period end
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans, net of unearned income
$
14,028,200

 
12,482,597

 
13,129,852

 
12

 
7

 
$
14,028,200

 
13,129,852

 
7

 
Allowance for loan losses
117,422

 
118,773

 
163,881

 
(1
)
 
(28
)
 
117,422

 
163,881

 
(28
)
 
As a percentage of total loans
0.84
%
 
0.95

 
1.25

 
(12
)
 
(33
)
 
0.84
%
 
1.25

 
(33
)
 
Assets
$
14,049,883

 
12,599,088

 
13,085,290

 
12

 
7

 
$
14,049,883

 
13,085,290

 
7

 
Total stockholders’ equity
12,417,870

 
12,413,539

 
12,375,335

 

 

 
12,417,870

 
12,375,335

 

 
Total nonaccrual loans and foreclosed assets
245,224

 
266,870

 
310,685

 
(8
)
 
(21
)
 
245,224

 
310,685

 
(21
)
 
As a percentage of total loans
1.75
%
 
2.14

 
2.37

 
(18
)
 
(26
)
 
1.75
%
 
2.37

 
(26
)
 
Loans 90 days or more past due and still accruing (3)
$
7,769

 
7,057

 
9,111

 
10

 
(15
)
 
$
7,769

 
9,111

 
(15
)
 
(1)
Dividends declared per common share as a percentage of earnings per common share.
(2)
The dividend coverage ratio is considered a non-GAAP financial measure. Management believes the dividend coverage ratio is a useful financial measure because the certificate of designation for the Series A preferred stock limits, among other matters, our ability to pay dividends on our common stock or make any payment of interest or principal on our line of credit with the Bank if the dividend coverage ratio for the four prior fiscal quarters is less than 150%. The dividend coverage ratio is expressed as a percentage and calculated by dividing the four prior fiscal quarters' GAAP net income, excluding gains (or losses) from sales of property (consistent with the National Association of Real Estate Investment Trusts definition of “funds from operations”), by the amount that would be required to pay annual dividends on the Series A and Series B preferred stock.
(3)
The carrying value of purchased credit-impaired (PCI) loans contractually 90 days or more past due is excluded. These PCI loans are considered to be accruing because they continue to earn interest from accretable yield, independent of performance in accordance with their contractual terms.



2


This Quarterly Report, including the Financial Review and the Financial Statements and related Notes, contains forward-looking statements, which may include forecasts of our financial results and condition, expectations for our operations and business, and our assumptions for those forecasts and expectations. Do not unduly rely on forward-looking statements. Actual results may differ materially from our forecasts and expectations due to several factors. Factors that could cause our results to differ materially from our forward looking statements are described in this Report, including in the “Forward-Looking Statements” section, and the “Risk Factors” section in our Annual Report on Form 10-K for the year ended December 31, 2015 (2015 Form 10-K).

When we refer to “WFREIC,” the “Company,” “we,” “our,” and “us” in this Report, we mean Wells Fargo Real Estate Investment Corporation, and where relevant, Wells Fargo Bank, National Association, acting on our behalf; “WPFC” refers to Wachovia Preferred Funding Corp.; the “Bank” refers to Wells Fargo Bank, National Association; and “Wells Fargo” refers to Wells Fargo & Company.

Financial Review
OVERVIEW

The Company is engaged in acquiring, holding and managing predominantly domestic mortgage assets and other authorized investments that generate net income for distribution to our shareholders. We are classified as a real estate investment trust (REIT) for federal income tax purposes.
We are a direct subsidiary of WPFC and an indirect subsidiary of Wells Fargo and the Bank.
As of June 30, 2016, we had $14.0 billion in assets, consisting substantially of real estate loan participation interests (loans). Our interests in mortgage and other assets have been acquired from the Bank pursuant to loan participation and servicing and assignment agreements among the Bank, certain of its subsidiaries and us. The Bank originated the loans, purchased them from other financial institutions or acquired them as part of the acquisition of other financial institutions. Substantially all of our loans are serviced by the Bank.
REIT Tax Status
For the tax year ended December 31, 2015, we complied with the relevant provisions of the Internal Revenue Code of 1986, as amended (the Code) to be taxed as a REIT. These provisions for qualifying as a REIT for federal income tax purposes are complex, involving many requirements, including among others, distributing at least 90% of our REIT taxable income to shareholders and satisfying certain asset, income and stock ownership tests. To the extent we meet those provisions, we will not be subject to federal income tax on net income. We continue to monitor each of these complex tests. We believe that we continue to satisfy each of these requirements and therefore continue to qualify as a REIT.
In the event we do not continue to qualify as a REIT, earnings and cash provided by operating activities available for distribution to shareholders would be reduced by the amount of any applicable income tax obligation. Given the level of earning assets, we currently expect there would be sufficient earnings and ample cash to pay preferred dividends. The preferred and common dividends we pay as a REIT are ordinary investment income not eligible for the dividends-received deduction for corporate shareholders or for the favorable qualified dividend tax rate applicable to non-corporate taxpayers. If we were not a REIT, preferred and common dividends we pay generally would qualify for the dividends received deduction for corporate shareholders and the favorable qualified dividend tax rate applicable to non-corporate taxpayers.
 
Financial Performance
We earned net income of $148.7 million in second quarter 2016, or $11.19 diluted earnings per common share, compared with $158.9 million in second quarter 2015, or $11.98 diluted earnings per common share. For the first half of 2016, net income was $293.8 million or $22.09 diluted earnings per common share, compared with $307.6 million or $23.16 diluted earnings per common share for the same period a year ago. The decrease in net income in the second quarter and first half of 2016 was predominantly attributable to a decrease in net interest income and a higher level of provision for credit losses.
Loans
Total loans were $14.0 billion at June 30, 2016, compared with $13.3 billion at December 31, 2015. Net loans represented 99% of assets at both June 30, 2016, and December 31, 2015.
Credit quality, as measured by net charge-off rates, nonaccruals and delinquencies, continued to improve during second quarter 2016 reflecting the benefit of a continued improving housing market. Net charge-offs were $5.7 million in second quarter 2016 (0.18% annualized as a percent of average loans), compared with $7.2 million in second quarter 2015 (0.23% annualized as a percent of average loans). Nonaccrual loans were $241.5 million at June 30, 2016, compared with $268.0 million at December 31, 2015. Loans 90 days or more past due and still accruing were $7.8 million at June 30, 2016, compared with $13.1 million at December 31, 2015.
We did not have a release from our allowance for credit losses (the amount by which net charge-offs exceed our provision for credit losses) in second quarter 2016. In second quarter 2015 we released $11.4 million from the allowance. The higher level of provision reflected moderation in the rate of delinquency improvement. Future allowance levels will be based on a variety of factors, including loan portfolio composition, size and performance, and the general economic environment, including housing market conditions.
Capital Distributions
Dividends declared to holders of our Series A preferred stock totaled $4.4 million and $8.8 million in the second quarter and first half, respectively, of both 2016 and 2015. Dividends declared to holders of our Series B preferred stock totaled $14 thousand and $28 thousand in the second quarter and first half, respectively, of both 2016 and 2015.
Dividends declared to the holder of our common stock totaled $140.0 million and $280.0 million for the second quarter and first half, respectively, of both 2016 and 2015.


3


Earnings Performance

Net Income
We earned net income of $148.7 million and $158.9 million in second quarter 2016 and 2015, respectively. For the first half of 2016, net income was $293.8 million, compared with $307.6 million for the same period a year ago. The decrease in net income in the second quarter and first half of 2016 was predominantly attributable to a decrease in net interest income and a higher level of provision for credit losses.

Net Interest Income
Net interest income is the interest earned on loans and cash and cash equivalents less the interest paid on our Bank line of credit. Net interest income was $166.0 million in second quarter 2016, compared with $168.8 million a year ago and $328.9 million for the first half of 2016, compared with $334.6 million a year ago. The decrease in the second quarter and first half of 2016 was attributable to the reinvestment of higher yielding loan pay-downs and payoffs into lower yielding loans, partially offset by a higher average balance of interest-earning assets.
Net interest margin is the average yield on interest-earning assets minus the average interest paid for funding. Interest-earning assets predominantly consist of loans. Net interest margin and average yield on total interest-earning assets were both 5.02% in second quarter 2016, compared with 5.22% for both a year ago. Net interest margin and average yield on total interest-earning assets for the first half of 2016 were 5.04% and 5.05%, respectively, compared with 5.25% for both a year ago. The decrease in net interest margin and average yield for the second quarter and first half of 2016 was attributable to the reinvestment of higher yielding loan pay-downs and payoffs into lower yielding loans. Interest income in second quarter 2016 included net accretion and amortization of adjustments on loans of $20.4 million compared with $25.5 million a year ago. Interest income included net accretion and amortization of adjustments on loans of $37.8 million for the first half of 2016, compared with $42.0 million a year ago. Loan pay-downs and payoffs annualized represented 23.5% and 26.7% of average loan balances during second quarter 2016 and 2015, respectively. Loan pay-downs and payoffs annualized represented 23.7% and 24.1% of average loan balances during the first half of 2016 and 2015, respectively.

 
We expect continued downward pressure on our average yield on total interest-earning assets as we invest available funds in the current low interest rate environment. The Company believes it has the ability to increase interest income over time by investing in real estate 1-4 family loans, commercial loans and other REIT-eligible assets; however, interest income in any one period can be affected by a variety of factors, including mix and size of the earning asset portfolio. See the “Risk Management - Asset/Liability Management - Interest Rate Risk” section in this Report for more information on interest rates and interest income.
The Company has a $2.2 billion line of credit with the Bank. Interest expense related to borrowings on the line of credit was $153 thousand and $757 thousand in the second quarter and first half of 2016, compared with $31 thousand and $267 thousand for the same periods a year ago. Average borrowings for second quarter 2016 and 2015 were $116.9 million and $32.5 million, respectively, at a weighted average interest rate of 0.53% and 0.38%, respectively. Average borrowings for the first half of 2016 and 2015, were $307.1 million and $141.5 million, respectively, at a weighted average interest rate of 0.50% and 0.38%, respectively. The increase in weighted average interest rate in the second quarter and first half of 2016 was attributable to an increase in the average federal funds rate.
Table 1 presents the components of interest-earning assets and interest-bearing liabilities and related average yields to provide an analysis of year-over-year changes that influenced net interest income.



4


Table 1: Interest Income
 
Quarter ended June 30,
 
 
 
 
 
 
2016

 
 
 
 
 
2015

(in thousands)
Average
balance

 
Interest
income/expense

 
Yields/rates

 
Average
balance

 
Interest
income/expense

 
Yields/rates

Earning assets
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
2,563,489

 
16,683

 
2.62
%
 
$
3,002,562

 
17,618

 
2.35
%
Real estate 1-4 family mortgage loans
10,449,969

 
149,261

 
5.73

 
9,500,167

 
150,944

 
6.36

Interest-bearing deposits in banks and other interest-earning assets
252,464

 
239

 
0.38

 
462,484

 
292

 
0.25

Total interest-earning assets
$
13,265,922

 
166,183

 
5.02

 
$
12,965,213

 
168,854

 
5.22

Funding sources
 
 
 
 
 
 
 
 
 
 
 
Line of credit with Bank
$
116,897

 
153

 
0.53

 
$
32,458

 
31

 
0.38

Total interest-bearing liabilities
$
116,897

 
153

 
0.53

 
$
32,458

 
31

 
0.38

Net interest margin and net interest income
 
 
$
166,030

 
5.02
%
 
 
 
$
168,823

 
5.22
%
 
Six months ended June 30,
 
 
 
 
 
 
2016

 
 
 
 
 
2015

(in thousands)
Average
balance

 
Interest
income/expense

 
Yields/rates

 
Average
balance

 
Interest
income/expense

 
Yields/rates

Earning assets
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
2,676,070

 
33,609

 
2.53
%
 
$
3,064,433

 
36,216

 
2.38
%
Real estate 1-4 family mortgage loans
10,279,226

 
295,826

 
5.77

 
9,504,205

 
298,325

 
6.30

Interest-bearing deposits in banks and other interest-earning assets
126,232

 
239

 
0.38

 
241,748

 
304

 
0.25

Total interest-earning assets
$
13,081,528

 
329,674

 
5.05

 
$
12,810,386

 
334,845

 
5.25

Funding sources
 
 
 
 
 
 
 
 
 
 
 
Line of credit with Bank
$
307,081

 
757

 
0.50

 
$
141,469

 
267

 
0.38

Total interest-bearing liabilities
$
307,081

 
757

 
0.50

 
$
141,469

 
267

 
0.38

Net interest margin and net interest income
 
 
$
328,917

 
5.04
%
 
 
 
$
334,578

 
5.25
%

Provision for Credit Losses
Second quarter 2016 provision for credit losses was $5.9 million, compared with a reversal of provision for credit losses of $4.2 million a year ago. We did not have a release from our allowance for credit losses in second quarter 2016. In second quarter 2015 we released $11.4 million from the allowance. The higher level of provision reflected moderation in the rate of delinquency improvement. For the first half of 2016, the provision for credit losses was $11.4 million, compared with a reversal of provision for credit losses of $891 thousand a year ago. The higher level of provision in the first half of 2016 reflected a lower level of allowance release as delinquency improvement moderated compared with a year ago. See the “Balance Sheet Analysis” and "Risk Management-Allowance for Credit Losses” sections in this Report for additional information on the allowance for credit losses.
 
Noninterest Income
Noninterest income in second quarter 2016 was $4.1 million, compared with $451 thousand a year ago and $8.0 million and $596 thousand in the first half of 2016 and 2015, respectively. In the second quarter and first half of 2016 noninterest income predominantly consisted of pledge fees.
We may pledge our loans in an aggregate amount not exceeding 80% of our total assets at any time as collateral on behalf of the Bank for the Bank’s access to secured borrowing facilities through the Federal Home Loan Banks or the discount window of Federal Reserve Banks. In exchange for the pledge of
 
our loan assets, the Bank will pay us a fee that is consistent with market terms. We earned $4.0 million and $7.7 million in pledge fees during the second quarter and first half of 2016, respectively, compared with $318 thousand for both periods a year ago. The increase was attributable to a higher average pledged loan balance as well as a higher pledge fee rate in the second quarter and first half of 2016 compared with the same periods a year ago. See Note 5 (Transactions With Related Parties) to Financial Statements in this Report for more details.

Noninterest Expense
Noninterest expense in second quarter 2016 was $15.5 million, compared with $14.6 million a year ago and $31.7 million and $28.5 million in the first half of 2016 and 2015, respectively. Noninterest expense predominantly consists of loan servicing costs, management fees, and foreclosed assets expense.
The loans in our portfolio are predominantly serviced by the Bank pursuant to the terms of participation and servicing and assignment agreements. In limited instances, the Bank has delegated servicing responsibility to third parties that are not affiliated with us or the Bank. Depending on the loan type, the monthly servicing fee charges are based in part on (a) outstanding principal balances, (b) a flat fee per month, or (c) a total loan commitment amount. Loan servicing costs in second quarter 2016 were $8.8 million, compared with $8.7 million in second quarter 2015 and $17.5 million for both the first half of 2016 and 2015.


5


Management fees represent reimbursements made to the Bank for general overhead expenses, including allocations of technology support and a combination of finance and accounting, risk management and other general overhead expenses incurred on our behalf. Management fees are calculated based on Wells Fargo’s total allocable costs multiplied by a formula. The formula is based on our proportion of Wells Fargo’s consolidated: (1) full-time equivalent employees, (2) total average assets and (3) total revenue. Management fees were $3.5 million in second quarter 2016, compared with $2.7 million in second quarter 2015 and $7.4 million and $5.5 million in the first half of 2016 and 2015, respectively. The increase in management fees for the second quarter and first half of 2016 related to an increase in Wells Fargo’s general overhead expenses, including technology and risk management expenses.
Foreclosed assets expense was $3.2 million in second quarter 2016 compared with $2.8 million in second quarter 2015 and $6.5 million and $4.9 million in the first half of 2016 and 2015, respectively. The increase in the second quarter and first half of 2016 was due to higher costs of maintaining our foreclosed assets, including tax and insurance expenses. Substantially all of our foreclosed assets consist of residential 1-4 family real estate assets.


6


Balance Sheet Analysis

Total Assets
Our assets predominantly consist of commercial and consumer loans, although we have the authority to hold assets other than loans. Total assets were $14.0 billion at June 30, 2016, and $13.2 billion at December 31, 2015.
Loans
Loans, net of unearned income were $14.0 billion at June 30, 2016, and $13.3 billion at December 31, 2015. In the second quarter and first half of 2016, we acquired $2.3 billion of consumer loans from the Bank at their estimated fair value, compared with $1.7 billion in the second quarter and first half of 2015. At June 30, 2016 and December 31, 2015, consumer loans represented 82% and 78% of loans, respectively, and commercial loans represented the balance of our loan portfolio.
Allowance for Loan Losses
The allowance for loan losses decreased $3.5 million to $117.4 million at June 30, 2016, from $120.9 million at December 31, 2015, due to recognition of interest income on certain impaired loans in addition to decreasing commercial loan balances and continued performance improvement in residential real estate, partially offset by consumer loan growth through acquisition.
At June 30, 2016, the allowance for loan losses included $103.0 million for consumer loans and $14.4 million for commercial loans; however, the entire allowance is available to absorb credit losses inherent in the total loan portfolio. The total allowance reflects management’s estimate of credit losses inherent in the loan portfolio at the balance sheet date. See the “Risk Management — Credit Risk Management — Allowance for Credit Losses” section in this Report for a description of how management estimates the allowance for loan losses and the allowance for unfunded credit commitments.
Accounts Receivable—Affiliates, Net
Accounts payable and receivable from affiliates result from intercompany transactions in the normal course of business related to loan pay-downs and payoffs, interest receipts, servicing costs, management fees and other transactions with the Bank or its affiliates.

 
Line of Credit with Bank
We draw upon our $2.2 billion line of credit to finance loan acquisitions. At June 30, 2016 and December 31, 2015, we had $1.6 billion and $828.1 million outstanding, respectively.

Retained Earnings (Deficit)
We expect to distribute annually an aggregate amount of dividends with respect to outstanding capital stock equal to approximately 100% of our REIT taxable income for federal income tax purposes before dividends paid deduction. Because our net income determined under GAAP may vary from the determination of REIT taxable income, periodic distributions may exceed our GAAP net income.
The retained deficit included within our balance sheet results from cumulative distributions that have exceeded GAAP net income, predominantly due to the impact on REIT taxable income of purchase accounting adjustments attributable to the Company during the years 2009 through 2013, from the 2008 acquisition of Wachovia Corporation by Wells Fargo.
For further information on the differences between taxable income before dividends paid deduction reported on our income tax returns and net income as reported in our statement of income, see the "Balance Sheet Analysis" section in our 2015 Form 10-K.
    

        



7


Risk Management

Our board of directors has overall responsibility for overseeing the Company’s risk management structure. This oversight is accomplished through the audit committee of the board of directors and a management-level committee that reviews the allowance for credit losses and is supplemented by certain elements of Wells Fargo’s risk management framework. For more information about how we manage these risks, see the “Risk Management” section in our 2015 Form 10-K. The discussion that follows provides an update regarding these risks.
 
Credit Risk Management Loans represent the largest component of our assets and their related credit risk is among the most significant risks we manage. We define credit risk as the risk of loss associated with a borrower or counterparty default (failure to meet obligations in accordance with agreed upon terms).
Table 2 represents loans by segment and class of financing receivable and the weighted average maturity for those loans calculated using contractual maturity dates.

Table 2: Total Loans Outstanding by Portfolio Segment and Class of Financing Receivable and Weighted Average Contractual Maturity
 
Loans outstanding
 
 
Weighted average maturity in years
(in thousands)
Jun 30, 2016

 
Dec 31, 2015

 
Jun 30, 2016
 
Dec 31, 2015
Commercial:
 
 
 
 
 
 
 
Commercial and industrial
$
36,424

 
46,712

 
0.6
 
0.8
Secured by real estate
2,467,673

 
2,871,021

 
3.0
 
3.1
Total commercial
2,504,097

 
2,917,733

 
2.9
 
3.0
Consumer:
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
10,288,415

 
8,950,429

 
23.8
 
23.0
Real estate 1-4 family junior lien mortgage
1,235,688

 
1,388,018

 
16.0
 
16.2
Total consumer
11,524,103

 
10,338,447

 
22.9
 
22.1
Total loans
$
14,028,200

 
13,256,180

 
19.4
 
17.9
The discussion that follows provides analysis of the risk elements of our various loan portfolios and our credit risk management and measurement practices. See Note 2 (Loans and Allowance for Credit Losses) to Financial Statements in this Report for more analysis and credit metric information.
In order to maintain our REIT status, the composition of our loan portfolio is highly concentrated in real estate.
 
We continually evaluate our credit policies and modify as necessary. Measuring and monitoring our credit risk is an ongoing process that tracks delinquencies, collateral values, FICO scores, economic trends by geographic areas, loan-level risk grading for certain portfolios (typically commercial) and other indications of credit risk. Our credit risk monitoring process is designed to enable early identification of developing risk and to support our determination of an appropriate allowance for credit losses.





8


LOAN PORTFOLIO BY GEOGRAPHY Table 3 is a summary of the geographical distribution of our loan portfolio for the top five states by loans outstanding.


Table 3: Loan Portfolio by Geography
 
June 30, 2016
 
(in thousands)
Commercial

 
Real estate
1-4 family
first
mortgage

 
Real estate
1-4 family
junior lien
mortgage

 
Total

 
% of
total
loans

California
$
907,739

 
1,116,485

 
14,397

 
2,038,621

 
15
%
Florida
212,763

 
694,053

 
163,632

 
1,070,448

 
8

New Jersey
140,490

 
663,104

 
255,286

 
1,058,880

 
8

New York
12,547

 
894,187

 
72,478

 
979,212

 
7

Virginia
65,981

 
756,100

 
124,947

 
947,028

 
7

All other states
1,164,577

 
6,164,486

 
604,948

 
7,934,011

 
55

Total loans
$
2,504,097

 
10,288,415

 
1,235,688

 
14,028,200

 
100
%

COMMERCIAL AND INDUSTRIAL LOANS (C&I) C&I loans were less than 1 percent of total loans at June 30, 2016. We believe the C&I loan portfolio is appropriately underwritten. Our credit risk management process for this portfolio focuses on a customer's ability to repay the loan through their cash flows. Substantially all of the loans in our C&I portfolio are unsecured
 
at June 30, 2016, with the remainder secured by short-term assets, such as accounts receivable, inventory and securities, as well as long-lived assets, such as equipment and other business assets. Generally, the collateral securing this portfolio represents a secondary source of repayment.
 




9


COMMERCIAL SECURED BY REAL ESTATE (CSRE) The CSRE portfolio consists of both mortgage loans and construction loans, where loans are secured by real estate. Table 4 summarizes CSRE loans by state and property type. To identify and manage newly emerging problem CSRE loans, we employ a high level of monitoring and regular customer interaction to understand and manage the risks associated with these loans,
 
including regular loan reviews and appraisal updates. We consider the creditworthiness of the customers and collateral valuations when selecting CSRE loans for acquisition. In future periods, we expect to consider acquisitions of CSRE loans in addition to other REIT qualifying assets such as real estate 1-4 family mortgage loans. 


Table 4: CSRE Loans by State and Property Type
 
June 30, 2016
 
(in thousands)
Total
CSRE loans

 
% of
total
CSRE loans

By state:
 
 
 
California
$
907,739

 
37
%
Florida
199,562

 
8

Arizona
127,375

 
5

Washington
125,623

 
5

New Jersey
122,915

 
5

All other states
984,459

 
40

Total loans
$
2,467,673

 
100
%
By property type:
 
 
 
Office buildings
$
711,696

 
29
%
Warehouses
449,280

 
18

Shopping centers
436,563

 
18

Retail establishments (restaurants, stores)
338,696

 
14

5+ multifamily residences
280,900

 
11

Manufacturing plants
66,175

 
2

Motels/hotels
46,560

 
2

Research and development
39,112

 
2

Real estate collateral pool - multifamily
28,513

 
1

Institutional
18,800

 
1

Other
51,378

 
2

Total loans
$
2,467,673

 
100
%


10


REAL ESTATE 1-4 FAMILY MORTGAGE LOANS The concentrations of real estate 1-4 family mortgage loans by state and the related combined loan-to-value (CLTV) ratio are presented in Table 5. CLTV means the ratio of the total loan balance of first and junior mortgages (including unused line amounts for credit line products) to property collateral value. Our underwriting and periodic review of loans secured by residential real estate collateral includes appraisals or estimates from automated valuation models (AVMs) to support property values. We also monitor changes in real estate values and underlying economic or market conditions for all geographic areas of our real estate 1-4 family mortgage portfolio as part of our credit risk management process. Additional information about AVMs and our policy for their use can be found in Note 2 (Loans and Allowance for Credit Losses) to Financial Statements in this Report and the "Risk Management - Credit Risk
 
Management - Real Estate 1-4 Family Mortgage Loans" section in our 2015 Form 10-K.
We continue to modify real estate 1-4 family mortgage loans to assist homeowners and other borrowers experiencing financial difficulties. For more information on our participation in the U.S. Treasury's Making Home Affordable (MHA) programs, see the "Risk Management - Credit Risk Management - Real Estate 1-4 Family Mortgage Loans" section in our 2015 Form 10-K.
The credit performance associated with our real estate 1-4 family mortgage portfolio continued to improve in second quarter 2016, as measured through net charge-offs and nonaccrual loans. Improvement in the credit performance was driven by an improving housing environment.


Table 5: Real Estate 1-4 Family Mortgage Loans CLTV by State
 
June 30, 2016
 
(in thousands)
Real estate
1-4 family
mortgage

 
Current
CLTV
ratio (1)

California
$
1,130,882

 
40
%
New York
966,665

 
63

New Jersey
918,390

 
66

Pennsylvania
894,813

 
63

Virginia
881,047

 
64

All other states
6,732,306

 
62

Total loans
$
11,524,103

 
60
%
(1)
Collateral values are generally determined using AVMs and are updated quarterly. AVMs are computer-based tools used to estimate market values of homes based on processing large volumes of market data including market comparables and price trends for local market areas.

REAL ESTATE 1-4 FAMILY FIRST MORTGAGE LOANS Net charge-offs (annualized) as a percentage of average loans improved to 0.16% in both second quarter and first half of 2016, compared with 0.18% and 0.20%, respectively, for the same periods a year ago. Nonaccrual loans were $182.8 million at
 
June 30, 2016, compared with $201.5 million at December 31, 2015.
Table 6 summarizes delinquency and loss rates by state for our real estate 1-4 family first mortgage portfolio.

Table 6: Real Estate 1-4 Family First Mortgage Portfolio Performance
 
Outstanding balance
 
 
% of loans
30 days
or more past due
 
Loss rate (annualized) quarter ended
(in thousands)
Jun 30,
2016

 
Dec 31,
2015

 
Jun 30,
2016

 
Dec 31,
2015
 
Jun 30,
2016
 
Mar 31,
2016

 
Dec 31,
2015
 
Sep 30,
2015
 
Jun 30,
2015
California
$
1,116,713

 
616,333

 
0.35
%
 
1.09
 
 
(0.04
)
 
 
 
New York
894,354

 
718,933

 
1.61

 
2.04
 
0.03
 
0.02

 
0.08
 
0.07
 
0.08
Virginia
755,353

 
638,886

 
1.25

 
2.30
 
0.05
 
0.12

 
0.08
 
0.04
 
0.11
Pennsylvania
700,825

 
690,624

 
4.12

 
4.42
 
0.28
 
0.32

 
0.43
 
0.65
 
0.50
Florida
692,017

 
680,362

 
2.44

 
2.68
 
0.12
 
0.15

 
0.12
 
0.56
 
0.68
Other
6,115,047

 
5,588,177

 
1.51

 
1.93
 
0.21
 
0.17

 
0.13
 
0.28
 
0.09
Total
10,274,309

 
8,933,315

 
1.62
%
 
2.16
 
0.16
 
0.15

 
0.14
 
0.25
 
0.18
PCI
14,106

 
17,114

 
 
 
 
 
 
 
 
 
 
 
 
 
 
  Total first mortgages
$
10,288,415

 
8,950,429

 
 
 
 
 
 
 
 
 
 
 
 
 
 


11


REAL ESTATE 1-4 FAMILY JUNIOR LIEN MORTGAGE LOANS Our junior lien portfolio includes real estate 1-4 family junior lien mortgage loans secured by real estate. Predominantly all of our junior lien loans are amortizing payment loans with fixed interest rates and repayment periods between 5 to 30 years. Junior lien loans with balloon payments at the end of the repayment term represent less than 1% of our junior lien loans. We frequently monitor the credit performance of our junior lien mortgage portfolio for trends and factors that influence the frequency and severity of loss. Net charge-offs (annualized) as a
 
percentage of average loans improved to 0.66% and 0.81% in second quarter 2016 and first half of 2016, respectively, compared with 0.90% and 1.14%, respectively, for the same periods a year ago. Nonaccrual loans were $55.9 million at June 30, 2016, compared with $64.7 million at December 31, 2015.
Table 7 summarizes delinquency and loss rates by state for our junior lien portfolio, which reflected the largest portion of our credit losses.

Table 7: Real Estate 1-4 Family Junior Lien Portfolio Performance
 
Outstanding balance
 
 
% of loans
30 days
or more past due

 
Loss rate (annualized) quarter ended
(in thousands)
Jun 30,
2016

 
Dec 31,
2015

 
Jun 30,
2016

 
Dec 31,
2015
 
Jun 30,
2016
 
Mar 31,
2016
 
Dec 31,
2015
 
Sep 30,
2015
 
Jun 30,
2015
New Jersey
$
255,015

 
281,657

 
4.42
%
 
5.38
 
1.27
 
0.84
 
0.81
 
1.73
 
0.82
Pennsylvania
190,717

 
212,776

 
4.56

 
5.57
 
0.86
 
0.64
 
0.21
 
1.32
 
1.02
Florida
163,603

 
185,249

 
2.94

 
3.16
 
0.52
 
1.00
 
0.78
 
0.41
 
1.10
Virginia
124,490

 
141,687

 
3.62

 
4.29
 
0.91
 
1.55
 
1.02
 
0.83
 
1.04
Georgia
93,011

 
106,239

 
1.88

 
3.27
 
0.26
 
0.38
 
2.75
 
0.54
 
1.28
Other
406,938

 
457,178

 
4.97

 
4.71
 
0.26
 
1.08
 
1.06
 
0.57
 
0.69
Total
1,233,774

 
1,384,786

 
4.16
%
 
4.62
 
0.66
 
0.95
 
0.97
 
0.92
 
0.90
PCI
1,914

 
3,232

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total junior lien mortgages
$
1,235,688

 
1,388,018

 
 
 
 
 
 
 
 
 
 
 
 
 
 

NONPERFORMING ASSETS (NONACCRUAL LOANS AND FORECLOSED ASSETS) Table 8 summarizes nonperforming assets (NPAs) for each of the last five quarters. We generally place loans on nonaccrual status when:
the full and timely collection of interest or principal becomes uncertain (generally based on an assessment of the borrower's financial condition and the adequacy of collateral, if any);
they are 90 days (120 days with respect to real estate 1-4 family first and junior lien mortgages) past due for interest
 
or principal, unless both well-secured and in the process of collection;
part of the principal balance has been charged off;
for junior lien mortgages, we have evidence that the related first lien mortgage may be 120 days past due or in the process of foreclosure regardless of the junior lien delinquency status; or
consumer loans are discharged in bankruptcy, regardless of their delinquency status. 

Table 8: Nonperforming Assets (Nonaccrual Loans and Foreclosed Assets)
(in thousands)
Jun 30,
2016

 
Mar 31,
2016

 
Dec 31,
2015

 
Sep 30,
2015

 
Jun 30,
2015

Nonaccrual loans:
 
 
 
 
 
 
 
 
 
Commercial:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$

 

 

 

 

Secured by real estate
2,783

 
3,733

 
1,706

 
9,164

 
10,404

Total commercial
2,783


3,733


1,706


9,164


10,404

Consumer:
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
182,814

 
196,967

 
201,531

 
206,821

 
224,674

Real estate 1-4 family junior lien mortgage
55,874

 
62,316

 
64,718

 
69,656

 
72,975

Total consumer
238,688


259,283


266,249


276,477


297,649

Total nonaccrual loans (1)
241,471


263,016


267,955


285,641


308,053

Foreclosed assets
3,753

 
3,854

 
1,996

 
1,156

 
2,632

Total nonperforming assets
$
245,224


266,870


269,951


286,797


310,685

As a percentage of total loans
1.75
%
 
2.14

 
2.04

 
2.18

 
2.37

(1)
Excludes PCI loans because they continue to earn interest income from accretable yield, independent of performance in accordance with their contractual terms.

Total NPAs were $245.2 million (1.75% of total loans) at June 30, 2016, and included $241.5 million of nonaccrual loans. Total NPAs were $270.0 million (2.04% of total loans) at
 
December 31, 2015, and included $268.0 million of nonaccrual loans. The decrease in second quarter 2016 was due in part to


12


improving economic conditions and the Bank's proactive credit risk management activities.
Typically, changes to nonaccrual loans period-over-period represent inflows for loans that are placed on nonaccrual status in accordance with our policy, offset by reductions for loans that are paid down, charged off while on nonaccrual status, or sold,
 
transferred to foreclosed properties, or are no longer classified as nonaccrual as a result of continued performance and an improvement in the borrower’s financial condition and loan repayment capabilities. Table 9 provides an analysis of the changes in nonaccrual loans.

Table 9: Analysis of Changes in Nonaccrual Loans
 
Quarter ended
 
(in thousands)
Jun 30,
2016

 
Mar 31,
2016

 
Dec 31,
2015

 
Sep 30,
2015

 
Jun 30,
2015

Commercial:
 
 
 
 
 
 
 
 
 
Balance, beginning of period
$
3,733

 
1,706

 
9,164

 
10,404

 
3,663

Inflows
48

 
2,253

 
954

 
141

 
8,807

Outflows
(998
)
 
(226
)
 
(8,412
)
 
(1,381
)
 
(2,066
)
 Balance, end of period
2,783


3,733


1,706


9,164


10,404

Consumer:
 
 
 
 
 
 
 
 
 
Balance, beginning of period
259,283

 
266,249

 
276,477

 
297,649

 
309,218

Inflows
34,964

 
38,049

 
38,736

 
33,731

 
42,670

Outflows:
 
 
 
 
 
 
 
 
 
Returned to accruing
(24,507
)
 
(16,798
)
 
(21,503
)
 
(24,834
)
 
(24,635
)
Foreclosures
(5,212
)
 
(3,177
)
 
(3,403
)
 
(1,418
)
 
(3,490
)
Charge-offs
(9,696
)
 
(8,179
)
 
(8,340
)
 
(11,245
)
 
(9,197
)
Payment, sales and other
(16,144
)
 
(16,861
)
 
(15,718
)
 
(17,406
)
 
(16,917
)
Total outflows
(55,559
)

(45,015
)

(48,964
)

(54,903
)

(54,239
)
 Balance, end of period
238,688


259,283


266,249


276,477


297,649

Total nonaccrual loans
$
241,471


263,016


267,955


285,641


308,053





13


TROUBLED DEBT RESTRUCTURINGS (TDRs) The recorded investment of loans modified in TDRs is provided in Table 10. The allowance for loan losses for TDRs was $72.4 million and $74.5 million at June 30, 2016 and December 31, 2015, respectively. See Note 2 (Loans and Allowance for Credit Losses) to Financial Statements in this Report for more information. Those loans discharged in bankruptcy and reported as TDRs have been written down to net realizable collateral value.
In those situations where principal is forgiven, the entire amount of such principal forgiveness is immediately charged off to the extent not done so prior to the modification. We sometimes delay the timing on the repayment of a portion of principal (principal forbearance) and charge off the amount of forbearance if that amount is not considered fully collectible.
 
For more information on our nonaccrual policies when a restructuring is involved, see the "Risk Management - Credit Risk Management - Troubled Debt Restructurings (TDRs) section of our 2015 Form 10-K.
Table 11 provides an analysis of the changes in TDRs. Loans modified more than once are reported as TDR inflows only in the period they are first modified. Other than resolutions such as foreclosures, we may remove loans from TDR classification, but only if they have been refinanced or restructured at market terms and qualify as a new loan.

Table 10: Troubled Debt Restructurings (TDRs)
(in thousands)
Jun 30,
2016

 
Mar 31,
2016

 
Dec 31,
2015

 
Sep 30,
2015

 
Jun 30,
2015

Commercial:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$

 

 

 

 

Real estate mortgage
3,443

 
4,395

 
2,534

 
3,870

 
4,073

Total commercial TDRs
3,443

 
4,395

 
2,534

 
3,870

 
4,073

Consumer:
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
358,337

 
366,492

 
371,605

 
377,080

 
380,573

Real estate 1-4 family junior lien mortgage
107,280

 
109,306

 
112,597

 
114,491

 
116,203

Trial modifications
12,217

 
14,693

 
15,663

 
14,257

 
15,488

Total consumer TDRs
477,834

 
490,491

 
499,865

 
505,828

 
512,264

Total TDRs
$
481,277

 
494,886

 
502,399

 
509,698

 
516,337

 TDRs on nonaccrual status
$
150,789

 
159,021

 
159,998

 
162,115

 
165,248

 TDRs on accrual status
330,488

 
335,865

 
342,401

 
347,583

 
351,089

Total TDRs
$
481,277

 
494,886

 
502,399

 
509,698

 
516,337

Table 11: Analysis of Changes in TDRs
 
Quarter ended
 
(in thousands)
Jun 30,
2016

 
Mar 31,
2016

 
Dec 31,
2015

 
Sep 30,
2015

 
Jun 30,
2015

Commercial:
 
 
 
 
 
 
 
 
 
Balance, beginning of period
$
4,395

 
2,534

 
3,870

 
4,073

 
4,742

Inflows (1)

 
1,885

 

 

 

Outflows (2)
(952
)
 
(24
)
 
(1,336
)
 
(203
)
 
(669
)
Balance, end of period
3,443

 
4,395

 
2,534

 
3,870

 
4,073

Consumer:
 
 
 
 
 
 
 
 
 
Balance, beginning of period
490,491

 
499,865

 
505,828

 
512,264

 
517,838

Inflows (1)
10,060

 
10,876

 
9,989

 
12,631

 
12,920

Outflows:
 
 
 
 
 
 
 
 
 
Charge-offs
(1,959
)
 
(2,685
)
 
(3,003
)
 
(2,910
)
 
(2,864
)
Foreclosures
(2,339
)
 
(1,599
)
 
(1,284
)
 
(811
)
 
(1,833
)
Payments, sales and other (2)
(15,943
)
 
(14,995
)
 
(13,072
)
 
(14,115
)
 
(15,132
)
Net change in trial modifications (3)
(2,476
)
 
(971
)
 
1,407

 
(1,231
)
 
1,335

Balance, end of period
477,834

 
490,491

 
499,865

 
505,828

 
512,264

Total TDRs
$
481,277

 
494,886

 
502,399

 
509,698

 
516,337

(1)
Inflows include loans that both modify and resolve within the period as well as advances on loans that modified in a prior period.
(2)
Other outflows include normal amortization/accretion of loan basis adjustments. No loans were removed from TDR classification in the quarters ended June 30 and March 31, 2016, and December 31, September 30, and June 30, 2015, as a result of being refinanced or restructured at market terms and qualifying as new loans.
(3)
Net change in trial modifications includes: inflows of new TDRs entering the trial payment period, net of outflows for modifications that either (i) successfully perform and enter into a permanent modification, or (ii) did not successfully perform according to the terms of the trial period plan and are subsequently charged-off, foreclosed upon or otherwise resolved. Our experience is that substantially all of the mortgages that enter a trial payment period program are successful in completing the program requirements.


14


LOANS 90 DAYS OR MORE PAST DUE AND STILL ACCRUING Certain loans 90 days or more past due as to interest or principal are still accruing, because they are (1) well-secured and in the process of collection or (2) real estate 1-4 family mortgage loans exempt under regulatory rules from being classified as nonaccrual until later delinquency, usually 120 days past due.
Loans 90 days or more past due and still accruing at June 30, 2016 were down $5.3 million from December 31, 2015,
 
due to payoffs, modifications and other loss mitigation activities, and credit stabilization.
Table 12 reflects non-PCI loans 90 days or more past due and still accruing.

Table 12: Loans 90 Days or More Past Due and Still Accruing (1)
(in thousands)
Jun 30, 2016

 
Mar 31, 2016

 
Dec 31, 2015

 
Sep 30, 2015

 
Jun 30, 2015

Commercial:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$

 

 

 

 

Secured by real estate

 

 
2,252

 

 

Total commercial




2,252





Consumer:
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
5,476

 
5,001

 
8,365

 
6,139

 
5,395

Real estate 1-4 family junior lien mortgage
2,293

 
2,056

 
2,462

 
3,119

 
3,716

Total consumer
7,769


7,057


10,827


9,258


9,111

Total
$
7,769


7,057


13,079


9,258


9,111

(1)
PCI loans of $2.4 million, $3.1 million, $4.4 million, $4.6 million and $4.0 million at June 30 and March 31, 2016 and December 31, September 30 and June 30, 2015, respectively, are excluded from this disclosure even though they are 90 days or more contractually past due. These PCI loans are considered to be accruing because they continue to earn interest from accretable yield, independent of performance in accordance with their contractual terms.

NET CHARGE-OFFS Table 13 presents net charge-offs for second quarter 2016 and the previous four quarters. Net charge-offs in second quarter 2016 were $5.7 million (0.18% of average
 

total loans outstanding) compared with $7.2 million (0.23% of average total loans outstanding) in second quarter 2015. Substantially all net losses were in consumer real estate.

Table 13: Net Charge-offs
 
 
 
 
 
Quarter ended
 
 
Jun 30, 2016
 
 
Mar 31, 2016
 
 
Dec 31, 2015
 
 
Sep 30, 2015
 
 
Jun 30, 2015
 
($ in thousands)
Net loan
charge-
offs

 
% of
avg.
loans (1)

 
Net loan
charge-
offs

 
% of
avg.
loans (1)

 
Net loan
charge-
offs

 
% of
avg.
loans (1)

 
Net loan
charge-
offs

 
% of
avg.
loans (1)

 
Net loan
charge-
offs

 
% of
avg.
loans (1)

Total commercial
$
(1
)
 
%
 
$
(18
)
 
%
 
$
(467
)
 
(0.07
)%
 
$
(178
)
 
(0.03
)%
 
$
63

 
0.01
%
Consumer:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
3,630

 
0.16

 
3,281

 
0.15

 
3,030

 
0.14

 
5,556

 
0.25

 
3,474

 
0.18

Real estate 1-4 family junior lien mortgage
2,097

 
0.66

 
3,170

 
0.94

 
3,486

 
0.97

 
3,503

 
0.92

 
3,615

 
0.90

Total consumer
5,727

 
0.22

 
6,451

 
0.26

 
6,516

 
0.25

 
9,059

 
0.35

 
7,089

 
0.30

Total
$
5,726

 
0.18
%
 
$
6,433

 
0.20
%
 
$
6,049

 
0.18
 %
 
$
8,881

 
0.27
 %
 
$
7,152

 
0.23
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Quarterly net charge-offs (net recoveries) as a percentage of average loans are annualized.

ALLOWANCE FOR CREDIT LOSSES The allowance for credit losses, which consists of the allowance for loan losses and the allowance for unfunded credit commitments, is management’s estimate of credit losses inherent in the loan portfolio and unfunded credit commitments at the balance sheet date. The detail of the changes in the allowance for credit losses by portfolio segment (including charge-offs and recoveries by loan class) is in Note 2 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.
We apply a disciplined process and methodology to establish our allowance for credit losses each quarter. This process takes into consideration many factors, including historical and forecasted loss trends, loan-level credit quality ratings and loan grade-specific characteristics. The process involves subjective and complex judgments. In addition, we
 

review a variety of credit metrics and trends. These credit metrics and trends, however, do not solely determine the amount of the allowance as we use several analytical tools.
The ratio of the allowance for credit losses to total nonaccrual loans may fluctuate significantly from period to period due to such factors as the mix of loan types in the portfolio, borrower credit strength and the value and marketability of collateral. Substantially all of our nonaccrual loans were real estate 1-4 family first and junior lien mortgage loans at June 30, 2016.
The allowance for loan losses decreased $3.5 million to $117.4 million at June 30, 2016, from $120.9 million at December 31, 2015, due to recognition of interest income on certain impaired loans in addition to decreasing commercial loan balances and continued performance improvement in residential real estate, partially offset by consumer loan


15


growth through acquisition. Second quarter 2016 provision for credit losses was $5.9 million compared with a reversal of provision for credit losses of $4.2 million for the same period a year ago. We did not have a release from our allowance for credit losses in second quarter 2016. In second quarter 2015 we released $11.4 million from the allowance. The higher level of provision reflected moderation in the rate of delinquency improvement. For the first half of 2016, the provision for credit losses was $11.4 million compared with a reversal of provision for credit losses of $891 thousand a year ago. The higher level of provision in the first half of 2016 reflected a lower level of allowance release as delinquency improvement moderated compared with a year ago.
We believe the allowance for credit losses at June 30, 2016 was appropriate to cover credit losses inherent in the loan portfolio, including unfunded credit commitments, at that date. The allowance for credit losses is subject to change and reflects existing factors as of the date of determination,
 
including economic or market conditions and ongoing internal and external examination processes. Due to the sensitivity of the allowance for credit losses to changes in the economic and business environment, it is possible that we will incur incremental credit losses not anticipated as of the balance sheet date. Future allowance levels will be based on a variety of factors, including loan portfolio composition, size and performance, and the general economic environment, including housing market conditions. Our process for determining the allowance for credit losses is discussed in the “Critical Accounting Policy” section and Note 1 (Summary of Significant Accounting Policies) to Financial Statements in this Report and in our 2015 Form 10-K.
Table 14 presents an analysis of the allowance for credit losses.
 

Table 14: Allocation of the Allowance for Credit Losses (ACL)
 
Quarter ended
 
 
Jun 30, 2016
 
 
Mar 31, 2016
 
 
Dec 31, 2015
 
 
Sep 30, 2015
 
 
Jun 30, 2015
 
(in thousands)
ACL

 
Loans as % of total loans

 
ACL

 
Loans as % of total loans

 
ACL

 
Loans as % of total loans

 
ACL

 
Loans as % of total loans

 
ACL

 
Loans as % of total loans

Commercial:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
642

 
%
 
$
639

 
%
 
$
669

 
%
 
$
813

 
%
 
$
825

 
%
Secured by real estate
14,366

 
18

 
17,138

 
21

 
17,007

 
22

 
17,880

 
20

 
17,981

 
22

Total commercial
15,008

 
18

 
17,777

 
21

 
17,676

 
22

 
18,693

 
20

 
18,806

 
22

Consumer:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate 1-4 family first mortgage
56,648

 
73

 
56,160

 
68

 
56,689

 
68

 
60,582

 
68

 
81,166

 
66

Real estate 1-4 family junior lien mortgage
46,374

 
9

 
45,516

 
11

 
47,173

 
10

 
52,194

 
12

 
64,522

 
12

Total consumer
103,022

 
82

 
101,676

 
79

 
103,862

 
78

 
112,776

 
80

 
145,688

 
78

Total