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, 2013

 

Commission File Number 000-33243

 

Huntington Preferred Capital, Inc.

 

Ohio 31-1356967
(State or other jurisdiction of
incorporation or organization) 		(I.R.S. Employer
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.

x Yes ¨ 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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

x Yes ¨ 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. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

  Large accelerated filer ¨ Accelerated filer ¨
  Non-accelerated filer x (Do not check if a smaller reporting company) Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

¨ Yes x No

 

As of May 13, 2013, 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 1. FINANCIAL INFORMATION  
       
  Item 1. Financial Statements (Unaudited)  
       
    Condensed Balance Sheets at March 31, 2013 and December 31, 2012 4
       
    Condensed Statements of Comprehensive Income for the three-months ended March 31, 2013 and 2012 5
       
    Condensed Statements of Changes in Shareholders' Equity for the three-months ended March 31, 2013 and 2012 6
       
    Condensed Statements of Cash Flows for the three-months ended March 31, 2013 and 2012 7
       
    Notes to Unaudited Condensed Financial Statements 8
       
  Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 25
       
  Item 3. Quantitative and Qualitative Disclosures about Market Risk 34
       
  Item 4. Controls and Procedures 34
       
PART II. OTHER INFORMATION  
       
  Item 6. Exhibits 34
       
Signatures   36

 

2
 

 

Glossary of Acronyms and Terms

 

The following listing provides a comprehensive reference of common acronyms and terms used throughout the document:

 

ACL   Allowance for Credit Losses
Agreements   Third Amended and Restated Loan Participation Agreement, dated May 12, 2005, between the Bank and HPCI and the Third Amended and Restated Loan Subparticipation Agreement, dated May 12, 2005, between Holdings and HPCI
ALPL   Allowance for Loan Participation Losses
ARM   Adjustable Rate Mortgage
ASC   Accounting Standards Codification
ASU   Accounting Standards Update
AULPC   Allowance for Unfunded Loan Participation Commitments
Bank   The Huntington National Bank
CFPB   Consumer Financial Protection Bureau
Codification   FASB Accounting Standards Codification
the Company   (see HPCI)
CRE   Commercial Real Estate
Dodd-Frank Act   Dodd-Frank Wall Street Reform and Consumer Protection Act
Exchange Act   Securities Exchange Act of 1934, as amended
EVE   Economic Value of Equity
Fannie Mae   (see FNMA)
FFO   Funds from Operations
FHFA   Federal Housing Finance Agency
FHLB   Federal Home Loan Bank
FHLMC   Federal Home Loan Mortgage Corporation
FICO   Fair Isaac Corporation
Form 10-K   HPCI's Annual Report on Form 10-K for the year ended December 31, 2012
FNMA   Federal National Mortgage Association
FRB   Federal Reserve Bank
Freddie Mac   (see FHLMC)
GAAP   Generally Accepted Accounting Principles in the United States of America
Holdings   Huntington Preferred Capital Holdings, Inc.
HPCI   Huntington Preferred Capital, Inc.
HPCII   Huntington Preferred Capital II, Inc.
Huntington   Huntington Bancshares Incorporated
IRC   Internal Revenue Code
IRS   Internal Revenue Service
LGD   Loss Given Default
LIBOR   London Interbank Offered Rate
LTV   Loan to Value
MD&A   Management's Discussion and Analysis of Financial Condition and Results of Operations
NCO   Net Charge-off
NPAs   Nonperforming Assets
N.R.   Not relevant. Denominator of calculation is a gain in the current period compared with a loss in the prior period, or vice-versa.
OCC   Office of the Comptroller of the Currency
OLEM   Other Loans Especially Mentioned
PD   Probability of Default
Problem loans   Includes nonperforming assets (Table 4), accruing loan participation interests past due 90 days or more (aging analysis section of Footnote 3), Criticized commercial real estate loan participation interests (credit quality indicators section of Footnote 3), and troubled debt restructured loan participation interests (TDR loan  participation interests section of Footnote 3).
RBC   Risk-Based Capital
REIT   Real Estate Investment Trust
SAD   Special Assets Division
SEC   Securities and Exchange Commission
TDR   Troubled Debt Restructuring
UCS   Uniform Classification System

 

3
 

 

Part 1. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Huntington Preferred Capital, Inc.
Condensed Balance Sheets
(Unaudited)

 

    March 31,     December 31,  
(dollar amounts in thousands, except share data)   2013     2012  
Assets:                
Cash and interest-bearing deposits with The Huntington National Bank   $ 254,441     $ 719,222  
Due from The Huntington National Bank     60,333       —  
Loan participation interests:                
Commercial real estate     2,766,220       2,875,870  
Consumer and residential real estate     418,654       439,073  
Total loan participation interests     3,184,874       3,314,943  
Allowance for loan participation losses     (61,032 )     (59,451 )
Net loan participation interests     3,123,842       3,255,492  
Accrued income and other assets     8,560       8,671  
Total assets   $ 3,447,176     $ 3,983,385  
                 
Liabilities and shareholders' equity:                
Liabilities:                
Allowance for unfunded loan participation commitments   $ 824     $ 1,057  
Dividends and distributions payable     2,074       500,000  
Due to The Huntington National Bank     —       62,942  
Other liabilities     340       870  
Total liabilities     3,238       564,869  
                 
Shareholders' equity:                
Preferred securities, 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  
Preferred securities, 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  
Preferred securities, 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  
Preferred securities, Class E, variable-rate noncumulative and conditionally exchangeable; $250 par and liquidation value; 1,400,000 shares authorized, issued, and outstanding     350,000       350,000  
Preferred securities, $25 par, 10,000,000 shares authorized; no shares issued or outstanding     —       —  
Common stock - without par value; 14,000,000 shares authorized, issued and outstanding     2,617,516       2,617,516  
Retained earnings     25,422       —  
Total shareholders' equity     3,443,938       3,418,516  
Total liabilities and shareholders' equity   $ 3,447,176     $ 3,983,385  

 

See notes to unaudited condensed financial statements.

 

4
 
Huntington Preferred Capital, Inc.
Condensed Statements of Comprehensive Income
(Unaudited)

 

    Three Months Ended  
    March 31,  
(dollar amounts in thousands)   2013     2012  
Interest and fee income:                
Interest on loan participation interests:                
Commercial real estate   $ 24,686     $ 28,583  
Consumer and residential real estate     5,976       6,625  
Total loan participation interest income     30,662       35,208  
Fees from loan participation interests     334       245  
Interest on deposits with The Huntington National Bank     124       174  
Total interest and fee income     31,120       35,627  
                 
Provision (reduction in allowance) for credit losses     1,059       (16,126 )
                 
Interest income after provision (reduction in allowance) for credit losses     30,061       51,753  
                 
Noninterest income:                
Rental income     18       18  
Collateral fees     294       326  
Total noninterest income     312       344  
                 
Noninterest expense:                
Servicing costs     1,471       1,645  
Franchise tax     196       —  
Other     186       159  
Total noninterest expense     1,853       1,804  
                 
Income before provision for income taxes     28,520       50,293  
Provision for income taxes     40       —  
Net income   $ 28,480     $ 50,293  
                 
Comprehensive income   $ 28,480     $ 50,293  
                 
Dividends declared on preferred securities     3,058       3,578  
                 
Net income applicable to common shares (1)   $ 25,422     $ 46,715  

 

(1) All of HPCI’s common stock is owned by HPCII and Holdings and, therefore, net income per share is not presented.

 

See notes to unaudited condensed financial statements.

 

5
 
Huntington Preferred Capital, Inc.
Condensed Statements of Changes in Shareholders' Equity
(Unaudited)

 

    Preferred             Retained        
(dollar amounts in thousands, except number of shares)   Class A     Class B     Class C     Class E     Preferred     Common     Earnings     Total  
                                                                 
Three Months Ended March 31, 2012:                                                                
                                                                 
Balance, beginning of period   $ 1,000     $ 400,000     $ 50,000     $ 350,000     $ —     $ 2,810,116     $ 166,822     $ 3,777,938  
                                                                 
Net income                                                     50,293       50,293  
                                                                 
Dividends declared on Class A preferred securities                                                     (80 )     (80 )
Dividends declared on Class B preferred securities                                                     (583 )     (583 )
Dividends declared on Class C preferred securities                                                     (984 )     (984 )
Dividends declared on Class E preferred securities                                                     (1,931 )     (1,931 )
Balance, end of period   $ 1,000     $ 400,000     $ 50,000     $ 350,000     $ —     $ 2,810,116     $ 213,537     $ 3,824,653  
                                                                 
Three Months Ended March 31, 2013:                                                                
                                                                 
Balance, beginning of period   $ 1,000     $ 400,000     $ 50,000     $ 350,000     $ —     $ 2,617,516     $ —     $ 3,418,516  
                                                                 
Net income                                                     28,480       28,480  
                                                                 
Dividends declared on Class A preferred securities                                                     (80 )     (80 )
Dividends declared on Class B preferred securities                                                     (305 )     (305 )
Dividends declared on Class C preferred securities                                                     (984 )     (984 )
Dividends declared on Class E preferred securities                                                     (1,689 )     (1,689 )
Balance, end of period   $ 1,000     $ 400,000     $ 50,000     $ 350,000     $ —     $ 2,617,516     $ 25,422     $ 3,443,938  
                                                                 
Shares outstanding:                                                                
December 31, 2011     1,000       400,000       2,000,000       1,400,000       —       14,000,000                  
March 31, 2012     1,000       400,000       2,000,000       1,400,000       —       14,000,000                  
December 31, 2012     1,000       400,000       2,000,000       1,400,000       —       14,000,000                  
March 31, 2013     1,000       400,000       2,000,000       1,400,000       —       14,000,000                  

 

See notes to unaudited condensed financial statements.

 

6
 
Huntington Preferred Capital, Inc.
Condensed Statements of Cash Flows
(Unaudited)

 

    Three Months Ended  
    March 31,  
(dollar amounts in thousands)   2013     2012  
             
Operating activities                
Net income   $ 28,480     $ 50,293  
Adjustments to reconcile net income to net cash provided by operating activities:                
Provision (reduction in allowance) for credit losses     1,059       (16,126 )
Change in due to/from The Huntington National Bank     911       (2,736 )
Other, net     (320 )     1,308  
Net cash provided by (used for) operating activities     30,130       32,739  
                 
Investing activities                
Net participation interests acquired     (293,241 )     (391,251 )
Sales and repayments of loans underlying participation interests     299,314       456,135  
Net cash provided by (used for) investing activities     6,073       64,884  
                 
Financing activities                
Dividends paid on preferred securities     (984 )     (984 )
Dividends paid on common stock     (307,400 )     —  
Return of capital to common shareholders     (192,600 )     —  
Net cash provided by (used for) financing activities     (500,984 )     (984 )
                 
Increase (decrease) in cash and cash equivalents     (464,781 )     96,639  
Cash and cash equivalents at beginning of period     719,222       228,958  
Cash and cash equivalents at end of period   $ 254,441     $ 325,597  
                 
Supplemental information:                
Dividends and distributions declared, not paid   $ 2,074     $ 2,594  
Non-cash change in loan participation activity with The Huntington National Bank     124,186       31,103  

 

See notes to unaudited condensed financial statements.

 

7
 

Huntington Preferred Capital, Inc.

 

Notes to Unaudited Condensed Financial Statements

 

Note 1 - Organization

 

HPCI was organized under Ohio law in 1992, and designated as a REIT in 1998. 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. Two related parties own HPCI’s common stock: HPCII and Holdings.

 

HPCII and Holdings are direct and indirect subsidiaries of the Bank, a national banking association organized under the laws of the United States and headquartered in Columbus, Ohio. The Bank is a wholly owned subsidiary of Huntington. Huntington is a multi-state diversified financial holding company organized under Maryland law and headquartered in Columbus, Ohio. At March 31, 2013, the Bank, on a consolidated basis with its subsidiaries, accounted for over 99% of Huntington’s consolidated total assets and essentially all of the year-to-date net income. Thus, for purposes of presenting consolidated financial statements for the Bank, Management considers information for the Bank and for Huntington to be substantially the same.

 

Note 2 - Basis of Presentation and New Accounting Pronouncements

 

The accompanying unaudited condensed financial statements of HPCI reflect all adjustments consisting of normal recurring accruals, which are, in the opinion of Management, necessary for a fair presentation of the financial position, the results of operations, and cash flows for the periods presented. These unaudited condensed financial statements have been prepared according to the rules and regulations of the SEC and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been omitted. The preparation of financial statements in conformity with GAAP requires Management to make estimates and assumptions that affect amounts reported in the financial statements. Actual results could differ from those estimates. Cash and cash equivalents used in the Condensed Statements of Cash Flows is defined as “Cash and interest-bearing deposits with The Huntington National Bank.” In conjunction with applicable accounting standards, all material subsequent events have been either recognized in the Unaudited Condensed Financial Statements or disclosed in the Notes to Unaudited Condensed Financial Statements. The Notes to the Financial Statements appearing in the Form 10-K, include descriptions of significant accounting policies, as updated by the information contained in this report, and should be read in conjunction with these interim financial statements. All of HPCI’s common stock is owned by affiliates; therefore, net income per common share information is not presented.

 

HPCI 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, was not subject to federal income taxes. HPCI is also included in certain of Huntington’s unitary and combined state income and franchise tax returns. On March 8, 2012, HPCI’s board of directors adopted Huntington’s Policy Statement on Intercorporate State Tax Allocation, dated January 1, 2012. As a result, beginning in 2012, Huntington’s unitary and combined state income and franchise tax provision was allocated to each member of the unitary and combined group based on the filing group’s effective tax rate. Under the intercompany state tax allocation agreement with Huntington, HPCI provided and remitted state income and franchise taxes to Huntington.

 

ASU 2013-02— Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The ASU requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. The amendments are effective prospectively for reporting periods beginning after December 15, 2012

The amendments should be applied retrospectively. The amendment had no impact on HPCI’s Unaudited Condensed Financial Statements.

 

Note 3 – Loan Participation Interests and Allowance for Credit Losses

 

Loan participation interests are categorized based on the collateral underlying the loan. At March 31, 2013 and December 31, 2012, loan participation interests were comprised of the following:

 

    March 31,     December 31,  
(dollar amounts in thousands)   2013     2012  
             
Commercial real estate   $ 2,766,220     $ 2,875,870  
Consumer and residential real estate     418,654       439,073  
Total loan participation interests     3,184,874       3,314,943  
Allowance for loan participation losses     (61,032 )     (59,451 )
Net loan participation interests   $ 3,123,842     $ 3,255,492  

 

8
 

 

Underlying loans are generally collateralized by real estate. As shown in the table above, the Company’s primary loan participation interest portfolios are: CRE and consumer and residential real estate. Classes are generally disaggregations of a portfolio. The classes within the CRE portfolio are: retail properties, multi family, office, industrial and warehouse, and other CRE. The classes within the consumer and residential real estate portfolio are: first-lien loan participation interests and junior-lien loan participation interests.

 

Other than the credit risk concentration related to loan participation interests secured by real estate as described above, there were no underlying loans outstanding that would be considered a concentration of lending in any particular industry, group of industries, or business activity. Loans made to borrowers in the five states of Ohio, Michigan, Indiana, Pennsylvania, and Kentucky comprised approximately 94% of the portfolio at both March 31, 2013 and December 31, 2012.

 

Loan Participation Interest Purchases and Sales

 

The following table summarizes significant portfolio purchase activity during the three-month periods ended March 31, 2013 and 2012:

 

          Consumer and        
    Commercial     Residential        
(dollar amounts in thousands)   Real Estate     Real Estate     Total  
Portfolio loan participation interests purchased during the:                        
                         
Three-month period ended March 31, 2013   $ 175,751     $ —     $ 175,751  
Three-month period ended March 31, 2012     431,890       —       431,890  

 

There were no significant portfolio loan participation interest sales during the three-month periods ended March 31, 2013 and 2012.

 

NPAs and Past Due Loan Participation Interests

 

Loan participation interests are considered past due when the contractual amounts due with respect to principal and interest are not received within 30 days of the contractual due date.

 

Any loan participation interest in any portfolio may be placed on nonaccrual status prior to the policies described below when collection of principal or interest is in doubt.

 

Loan participation interests in all classes within the CRE portfolio are placed on nonaccrual status at 90-days past due. First-lien consumer and residential real estate loan participation interests are placed on nonaccrual status at 150-days past due. Junior-lien consumer and residential real estate loan participation interests are placed on nonaccrual status at the earlier of 120-days past due or when the related first-lien loan has been identified as nonaccrual. When a loan participation interest with discharged non-reaffirmed debt in a Chapter 7 bankruptcy filing is identified, and the loan participation interest is determined to be collateral dependent, the consumer and residential real estate loan participation interest is placed on nonaccrual status.

 

For all classes within all portfolios, when a loan participation interest is placed on nonaccrual status, any accrued interest income is reversed with current year accruals charged to interest income, and prior year amounts charged-off as a credit loss.

 

For all classes within all portfolios, cash receipts received on NPAs are applied against principal until the loan has been collected in full, after which time any additional cash receipts are recognized as interest income. However, for secured non-reaffirmed debt in a Chapter 7 bankruptcy, payments are applied to principal and interest when the borrower has demonstrated a capacity to continue payment of the debt and collection of the debt is reasonably assured. For unsecured non-reaffirmed debt in a Chapter 7 bankruptcy where the carrying value has been fully charged-off, payments are recorded as loan recoveries.

 

9
 

 

Regarding all classes within CRE portfolio, the determination of a borrower’s ability to make the required principal and interest payments is based on an examination of the borrower’s current financial statements, industry, management capabilities, and other qualitative measures. For all classes within the consumer and residential real estate portfolio, the determination of a borrower’s ability to make the required principal and interest payments is based on multiple factors, including number of days past due and, in some instances, an evaluation of the borrower’s financial condition. When, in Management’s judgment, the borrower’s ability to make required principal and interest payments resumes and collectability is no longer in doubt, the loan participation interest is returned to accrual status. For these loan participation interests that have been returned to accrual status, cash receipts are applied according to the contractual terms of the loan.

 

The following table presents NPAs by loan class at March 31, 2013 and December 31, 2012:

 

    2013     2012  
(dollar amounts in thousands)   March 31,     December 31,  
             
Commercial real estate:                
Industrial and warehouse   $ 2,079     $ 1,652  
Retail properties     1,844       4,771  
Office     7,518       13,745  
Multi family     1,069       1,109  
Other commercial real estate     6,197       6,624  
Total commercial real estate   $ 18,707     $ 27,901  
                 
Consumer and residential real estate:                
Secured by first-lien   $ 8,808     $ 7,190  
Secured by junior-lien     677       780  
Total consumer and residential real estate   $ 9,485     $ 7,970  
Total nonperforming assets   $ 28,192     $ 35,871  

 

The following table presents an aging analysis of loan participation interests, including past due loan participation interests, by loan class at March 31, 2013 and December 31, 2012: (1)

 

    March 31, 2013  
    Past Due           Total Loan     90 or more  
                90 or                 Participation     days past due  
(dollar amounts in thousands)   30-59 days     60-89 days     more days     Total     Current     Interests     and accruing  
                                           
Commercial real estate:                                                        
Industrial and warehouse   $ 561     $ —     $ 1,949     $ 2,510     $ 639,272     $ 641,782     $ —  
Retail properties     278       —       1,587       1,865       541,601       543,466       —  
Office     698       —       7,518       8,216       434,718       442,934       —  
Multi family     —       —       937       937       280,791       281,728       —  
Other commercial real estate     2,030       135       5,609       7,774       848,536       856,310       —  
Total commercial real estate   $ 3,567     $ 135     $ 17,600     $ 21,302     $ 2,744,918     $ 2,766,220     $ —  
                                                         
Consumer and residential real estate:                                                        
Secured by first-lien   $ 4,620     $ 1,890     $ 7,038     $ 13,548     $ 327,627     $ 341,175     $ 759  
Secured by junior-lien     1,703       403       1,207       3,313       74,166       77,479       474  
Total consumer and residential real estate   $ 6,323     $ 2,293     $ 8,245     $ 16,861     $ 401,793     $ 418,654     $ 1,233  
                                                         
Total loan participation interests   $ 9,890     $ 2,428     $ 25,845     $ 38,163     $ 3,146,711     $ 3,184,874     $ 1,233  

 

10
 

 

    December 31, 2012  
    Past Due           Total Loan     90 or more  
                90 or                 Participation     days past due  
(dollar amounts in thousands)   30-59 days     60-89 days     more days     Total     Current     Interests     and accruing  
                                           
Commercial real estate:                                                        
Industrial and warehouse   $ 3,177     $ 83     $ 1,021     $ 4,281     $ 672,218     $ 676,499     $ —  
Retail properties     24       —       4,506       4,530       571,118       575,648       —  
Office     52       367       13,634       14,053       457,323       471,376       —  
Multi family     424       —       975       1,399       300,819       302,218       —  
Other commercial real estate     1,226       1,435       5,078       7,739       842,390       850,129       —  
Total commercial real estate   $ 4,903     $ 1,885     $ 25,214     $ 32,002     $ 2,843,868     $ 2,875,870     $ —  
                                                         
Consumer and residential real estate:                                                        
Secured by first-lien   $ 4,418     $ 2,091     $ 9,123     $ 15,632     $ 339,292     $ 354,924     $ 2,713  
Secured by junior-lien     2,037       1,040       1,314       4,391       79,758       84,149       509  
Total consumer and residential real estate   $ 6,455     $ 3,131     $ 10,437     $ 20,023     $ 419,050     $ 439,073     $ 3,222  
                                                         
Total loan participation interests   $ 11,358     $ 5,016     $ 35,651     $ 52,025     $ 3,262,918     $ 3,314,943     $ 3,222  

  

(1) NPAs are included in this aging analysis based on the loan participation interest's past due status.

 

Allowance for Credit Losses

 

The ACL is comprised of the ALPL and the AULPC, and reflects Management’s judgment regarding the appropriate level necessary to absorb credit losses inherent in the loan participation interest portfolio. It is HPCI’s policy to utilize the Bank’s analysis as of the end of each reporting date to estimate the required level of the ALPL and AULPC. The determination of the ACL requires significant estimates, including the timing and amounts of expected future cash flows on impaired loan participation interests, consideration of economic conditions, and historical loss experience pertaining to pools of homogeneous loan participation interests, all of which may be susceptible to change.

 

The appropriateness of the ACL is based on Management’s current judgments about the credit quality of the loan participation interests portfolio. These judgments consider on-going evaluations of the loan participation interests portfolio, including such factors as the differing economic risks associated with each loan participation interests category, the financial condition of specific borrowers, the level of delinquent loan participation interests, the value of any collateral and, where applicable, the existence of any guarantees or other documented support. Further, Management evaluates the impact of changes in interest rates and overall economic conditions on the ability of borrowers to meet their financial obligations when quantifying the exposure to credit losses and assessing the appropriateness of the ACL at each reporting date. In addition to general economic conditions and the other factors described above, additional factors also considered include the impact of declining residential real estate values and the diversification of commercial real estate loan participation interests. Also, the ACL assessment includes the on-going assessment of credit quality metrics, and a comparison of certain ACL benchmarks to current performance.

 

ALPL is transferred to HPCI either directly or through Holdings from the Bank on loan participation interests underlying the participation interests at the time the participation interests are acquired. This transfer of ALPL is reflected as ALPL acquired, rather than HPCI recording provision for credit losses. Based on Management’s quarterly evaluation of the factors previously mentioned, the ALPL may either be increased through a provision for credit losses, net of recoveries, and charged to earnings or lowered through a reduction in allowance for credit losses, net of recoveries, and credited to earnings. Credit losses are charged against the ALPL when Management believes the loan participation interest balance, or a portion thereof, is uncollectible.

 

The ALPL consists of two components: (1) the transaction reserve, which includes an allocation per ASC 310-10, specific reserves related to loan participation interests considered to be impaired, and loan participation interests involved in TDRs allocated per ASC 310-40, and (2) the general reserve. The transaction reserve component includes both (1) an estimate of loss based on pools of commercial and consumer loan participation interests with similar characteristics and (2) an estimate of loss based on an impairment review of each impaired CRE loan participation interest greater than $1.0 million. For the CRE portfolio, the estimate of loss based on pools of loan participation interests with similar characteristics is made by applying a PD factor and a LGD factor to each individual loan based on a continuously updated loan grade, using a standardized loan grading system. The PD and LGD factors are determined for each loan grade using statistical models based on historical performance data. The PD factor considers on-going reviews of the financial performance of the specific borrower, including cash flow, debt-service coverage ratio, earnings power, debt level, and equity position, in conjunction with an assessment of the borrower’s industry and future prospects. The LGD factor considers analysis of the type of collateral and the relative LTV ratio. These reserve factors are developed based on credit migration models that track historical movements of loan participation interests between loan ratings over time and a combination of long-term average loss experience of our own portfolio and external industry data using a 24-month emergence period.

 

In the case of more homogeneous portfolios, such as the consumer and residential real estate portfolio, the determination of the transaction reserve also incorporates PD and LGD factors, however, the estimate of loss is based on pools of loan participation interests with similar characteristics. The PD factor considers current credit scores unless the account is delinquent, in which case a higher PD factor is used. The credit score provides a basis of understanding the borrowers past and current payment performance, and this information is used to estimate expected losses over the subsequent 12-month period. The performance of first-lien loans ahead of junior-lien loans is available to use as part of the updated score process. The LGD factor considers analysis of the type of collateral and the relative LTV ratio. Credit scores, models, analyses, and other factors used to determine both the PD and LGD factors are updated frequently to capture the recent behavioral characteristics of the subject portfolios, as well as any changes in loss mitigation or credit origination strategies, and adjustments to the allowance factors are made as required. Models utilized in the ALPL estimation process are subject to the Bank’s model validation policies.

 

11
 

  

The general reserve consists of economic reserve and risk-profile reserve components. The economic reserve component considers the potential impact of changing market and economic conditions on portfolio performance. The risk-profile component considers items unique to our structure, policies, processes, and portfolio composition, as well as qualitative measurements and assessments of the portfolios including, but not limited to, management quality, concentrations, portfolio composition, industry comparisons, and internal review functions.

 

The estimate for the AULPC is determined using the same procedures and methodologies as used for the ALPL. The loss factors used in the AULPC are the same as the loss factors used in the ALPL while also considering a historical utilization of unused commitments.

 

The ACL is increased through a provision for credit losses that is charged to earnings, based on Management’s quarterly evaluation of the factors previously mentioned, and is reduced by charge-offs, net of recoveries. There were no material changes in assumptions or estimation techniques compared with prior periods that impacted the determination of the current period’s ALPL and AULPC.

 

The following table presents ALPL and AULPC activity by portfolio segment for the three-month periods ended March 31, 2013 and 2012:

 

    Commercial     Consumer and        
(dollar amounts in thousands)   Real Estate     Residential Real Estate     Total  
                 
Three-month period ended March 31, 2013                        
ALPL balance, beginning of period   $ 50,415     $ 9,036     $ 59,451  
ALPL for loan participation interests acquired     2,223       —       2,223  
Loan participation interest charge-offs     (1,083 )     (2,279 )     (3,362 )
Recoveries of loan participation interests previously charged-off     1,200       228       1,428  
(Reduction in) Provision for loan participation interest losses     (286 )     1,578       1,292  
ALPL balance, end of period   $ 52,469     $ 8,563     $ 61,032  
                         
AULPC balance, beginning of period   $ 1,057     $ —     $ 1,057  
Provision for unfunded loan participation commitment losses     (233 )     —       (233 )
AULPC balance, end of period   $ 824     $ —     $ 824  
                         
ACL balance, end of period   $ 53,293     $ 8,563     $ 61,856  

 

    Commercial     Consumer and        
(dollar amounts in thousands)   Real Estate     Residential Real Estate     Total  
                   
Three-month period ended March 31, 2012:                        
ALPL balance, beginning of period   $ 71,555     $ 12,217     $ 83,772  
ALPL for loan participation interests acquired     4,942       —       4,942  
Loan participation interest charge-offs     (3,587 )     (2,169 )     (5,756 )
Recoveries of loan participation interests previously charged-off     3,439       261       3,700  
(Reduction in) Provision for loan participation interest losses     (16,706 )     770       (15,936 )
ALPL balance, end of period   $ 59,643     $ 11,079     $ 70,722  
                         
AULPC balance, beginning of period   $ 1,035     $ —     $ 1,035  
Reduction in allowance for unfunded loan participation commitment losses     (190 )     —       (190 )
AULPC balance, end of period   $ 845     $ —     $ 845  
                         
ACL balance, end of period   $ 60,488     $ 11,079     $ 71,567  

  

12
 

 

Any loan participation interest in any portfolio may be charged-off prior to the policies described below if a loss confirming event has occurred. Loss confirming events include, but are not limited to, bankruptcy (unsecured), continued delinquency, foreclosure, or receipt of an asset valuation indicating a collateral deficiency and that asset is the sole source of repayment. Additionally, discharged, collateral dependent non-reaffirmed debt in Chapter 7 bankruptcy filings are charged-off to estimated collateral value, less anticipated selling costs.

 

CRE loan participation interests are either charged-off or written down to net realizable value at 90-days past due. First-lien consumer and residential real estate loan participation interests are charged-off to the estimated fair value of the collateral, less anticipated selling costs at 150-days past due. Junior-lien consumer and residential real estate loan participation interests are charged-off to the estimated fair value of the collateral, less anticipated selling costs at 120-days past due.

 

Credit Quality Indicators

 

To facilitate the monitoring of credit quality for CRE loan participation interests, and for purposes of determining an appropriate ACL level for these loan participation interests, the following categories of credit grades are utilized:

 

Pass = Higher quality loan participation interests that do not fit any of the other categories described below.

 

OLEM = The credit risk may be relatively minor yet represent a risk given certain specific circumstances. If the potential weaknesses are not monitored or mitigated, the asset may weaken or inadequately protect the Company’s position in the future. For these reasons, the loan participation interests are considered to be potential problem loan participation interests.

 

Substandard = Inadequately protected loan participation interests by the borrower’s ability to repay, equity, and/or the collateral pledged to secure the loan participation interest. These loan participation interests have identified weaknesses that could hinder normal repayment or collection of the debt. It is likely that the Company will sustain some loss if any identified weaknesses are not mitigated.

 

Doubtful = Loan participation interests that have all of the weaknesses inherent in those loan participation interests classified as Substandard, with the added elements of the full collection of the loan participation interest is improbable and that the possibility of loss is high.

 

The categories above, which are derived from standard regulatory rating definitions, are assigned upon initial approval of the loan and updated as appropriate.

 

Commercial loan participation interests categorized as OLEM, Substandard, or Doubtful are considered Criticized loan participation interests. Commercial loan participation interests categorized as Substandard or Doubtful are also considered Classified loan participation interests.

 

For all classes within the consumer and residential real estate portfolio, each loan participation interest is assigned a specific PD factor that is generally based on the borrower’s most recent credit bureau score (FICO), which is updated quarterly. A FICO credit bureau score is a credit score developed by Fair Isaac Corporation based on data provided by the credit bureaus. The FICO credit bureau score is widely accepted as the standard measure of consumer credit risk used by lenders, regulators, rating agencies, and consumers. The higher the FICO credit bureau score, the higher likelihood of repayment and, therefore, an indicator of higher credit quality.

 

The risk in the loan portfolio is assessed by utilizing numerous risk characteristics. The classifications described above, and presented in the table below, represent one of those characteristics that are closely monitored in the overall credit risk management process.

 

The following table presents loan participation interest balances by credit quality indicator as of March 31, 2013 and December 31, 2012:

 

13
 

 

    March 31, 2013  
    Credit Risk Profile by UCS classification  
(dollar amounts in thousands)   Pass     OLEM     Substandard     Doubtful     Total  
Commercial real estate:                                        
Industrial and warehouse   $ 616,708     $ 11,464     $ 13,610     $ —     $ 641,782  
Retail properties     524,195       11,302       7,969       —       543,466  
Office     427,182       6,723       9,029       —       442,934  
Multi family     270,846       7,955       2,927       —       281,728  
Other commercial real estate     834,572       5,292       16,446       —       856,310  
Total commercial real estate   $ 2,673,503     $ 42,736     $ 49,981     $ —     $ 2,766,220  

 

    Credit Risk Profile by FICO score (1)  
    750+     650-749     <650     Total  
Consumer and residential real estate:                                
Secured by first-lien   $ 159,191     $ 125,422     $ 56,562     $ 341,175  
Secured by junior-lien     24,386       30,315       22,778       77,479  
Total consumer and residential real estate   $ 183,577     $ 155,737     $ 79,340     $ 418,654  

  

    December 31, 2012  
    Credit Risk Profile by UCS classification  
(dollar amounts in thousands)   Pass     OLEM     Substandard     Doubtful     Total  
Commercial real estate:                                        
Industrial and warehouse   $ 646,537     $ 13,660     $ 16,302     $ —     $ 676,499  
Retail properties     558,396       9,927       7,325       —       575,648  
Office     450,862       4,872       15,642       —       471,376  
Multi family     298,039       1,178       3,001       —       302,218  
Other commercial real estate     826,403       7,133       16,593       —       850,129  
Total commercial real estate   $ 2,780,237     $ 36,770     $ 58,863     $ —     $ 2,875,870  

  

    Credit Risk Profile by FICO score (1)  
    750+     650-749     <650     Total  
Consumer and residential real estate:                                
Secured by first-lien   $ 175,314     $ 120,661     $ 58,949     $ 354,924  
Secured by junior-lien     28,488       31,805       23,856       84,149  
Total consumer and residential real estate   $ 203,802     $ 152,466     $ 82,805     $ 439,073  

 

(1) Reflects currently updated customer credit scores.

 

Impaired Loan Participation Interests

 

For all classes within the CRE portfolio, all loan participation interests with an outstanding balance of greater than $1.0 million are considered for individual impairment evaluation on a quarterly basis. Generally, consumer loan participation interests within any class are not individually evaluated on a regular basis for impairment. Additionally, all TDRs, regardless of the outstanding balance amount, are also considered impaired.

 

Once a loan participation interest has been identified for an assessment of impairment, the loan participation interest is considered impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. This determination requires significant judgment and use of estimates, and the eventual outcome may differ significantly from those estimates.

 

14
 

 

When a loan participation interest in any class has been determined to be impaired, t he amount of the impairment is measured using the present value of expected future cash flows discounted at the loan participation interest’s effective interest rate or, as a practical expedient, the observable market price of the loan participation interest, or the fair value of the collateral if the loan participation interest is collateral-dependent. When the present value of expected future cash flows is used, the effective interest rate is the original contractual interest rate of the loan participation interest adjusted for any premium or discount. When the contractual interest rate is variable, the effective interest rate of the loan participation interest changes over time. A specific reserve is established as a component of the ALPL when a loan participation interest has been determined to be impaired. Subsequent to the initial measurement of impairment, if there is a significant change to the impaired loan participation interest's expected future cash flows, or if actual cash flows are significantly different from the cash flows previously estimated, the impairment is recalculated and the specific reserve is appropriately adjusted. Similarly, if impairment is measured based on the observable market price of an impaired loan participation interest or the fair value of the collateral, less costs to sell, of an impaired collateral-dependent loan participation interest, the specific reserve is adjusted.

 

When a loan participation interest within any class is impaired, interest income is discontinued unless the receipt of principal and interest is no longer in doubt. Interest income on TDRs is accrued when all principal and interest is expected to be collected under the post-modification terms. Cash receipts received on nonaccrual impaired loan participation interests within any class are generally applied entirely against principal until the loan participation interest has been collected in full, after which time any additional cash receipts are recognized as interest income. Cash receipts received on accruing impaired loan participation interests within any class are applied in the same manner as accruing loan participation interests that are not considered impaired.

 

The following tables present the balance of the ALPL attributable to loans by portfolio segment individually and collectively evaluated for impairment and the related loan participation interest balance at March 31, 2013 and December 31, 2012: (1)

 

          Consumer and        
    Commercial     Residential        
    Real Estate     Real Estate     Total  
                   
ALPL at March 31, 2013:                        
(dollar amounts in thousands)                        
                         
Portion of ALPL balance:                        
                         
Attributable to loan participation interests individually evaluated for impairment   $ 1,256     $ 774     $ 2,030  
Attributable to loan participation interests collectively evaluated for impairment     51,213       7,789       59,002  
Total ALPL balance   $ 52,469     $ 8,563     $ 61,032  
                         
Loan Participation Interests Ending Balance at March 31, 2013:                        
                         
Portion of loan participation interest ending balance:                        
                         
Individually evaluated for impairment   $ 8,712     $ 31,171     $ 39,883  
Collectively evaluated for impairment     2,757,508       387,483       3,144,991  
Total loan participation interests evaluated for impairment   $ 2,766,220     $ 418,654     $ 3,184,874  
                         
ALPL at December 31, 2012:                        
                         
Portion of ALPL balance:                        
                         
Attributable to loan participation interests individually evaluated for impairment   $ 1,195     $ 640     $ 1,835  
Attributable to loan participation interests collectively evaluated for impairment     49,220       8,396       57,616  
Total ALPL balance   $ 50,415     $ 9,036     $ 59,451  
                         
Loan Participation Interests Ending Balance at December 31, 2012:                        
                         
Portion of loan participation interest ending balance:                        
                         
Individually evaluated for impairment   $ 18,086     $ 30,275     $ 48,361  
Collectively evaluated for impairment     2,857,784       408,798       3,266,582  
Total loan participation interests evaluated for impairment   $ 2,875,870     $ 439,073     $ 3,314,943  

  

(1) No loans with deteriorated credit quality, as defined by ASC 310-30, have been acquired.

 

15
 

 

The following tables present, by class, the ending, unpaid principal balance, and the related ALPL, along with the average balance and interest income recognized only for loan participation interests individually evaluated for impairment at March 31, 2013 and December 31, 2012: (1), (2)

 

(dollar amounts in thousands)                     Three Months Ended  
    March 31, 2013     March 31, 2013  
          Unpaid                 Interest  
    Ending     Principal     Related     Average     Income  
    Balance     Balance (4)     Allowance     Balance     Recognized  
                               
With no related allowance recorded:                                        
Commercial real estate:                                        
Industrial and warehouse   $ —     $ —     $ —     $ —     $ —  
Retail properties     —       —       —       2,224       —  
Office     —       —       —       1,884       —  
Multi family     —       —       —       —       —  
Other commercial real estate     —       —       —       —       —  
Total commercial real estate   $ —     $ —     $ —     $ 4,108     $ —  
                                         
Consumer and residential real estate:                                        
Secured by first-lien   $ —     $ —     $ —     $ —     $ —  
Secured by junior-lien     —       —       —       —       —  
Total consumer and residential real estate   $ —     $ —     $ —     $ —     $ —  
                                         
With an allowance recorded:                                        
Commercial real estate: (3)                                        
Industrial and warehouse   $ —     $ —     $ —     $ —     $ —  
Retail properties     —       —       —       —       —  
Office     5,184       8,276       443       5,205       —  
Multi family     936       936       113       939       6  
Other commercial real estate     2,592       5,006       700       2,644       —  
Total commercial real estate   $ 8,712     $ 14,218     $ 1,256     $ 8,788     $ 6  
                                         
Consumer and residential real estate:                                        
Secured by first-lien   $ 27,741     $ 30,575     $ 511     $ 27,230     $ 262  
Secured by junior-lien     3,430       4,938       263       3,493       40  
Total consumer and residential real estate   $ 31,171     $ 35,513     $ 774     $ 30,723     $ 302  
16
 

 

(dollar amounts in thousands)                  
    December 31, 2012  
    Ending     Unpaid Principal     Related  
    Balance     Balance (4)     Allowance  
                   
With no related allowance recorded:                        
Commercial real estate:                        
Industrial and warehouse   $ —     $ —     $ —  
Retail properties     3,334       4,139       —  
Office     5,847       5,848       —  
Multi family     —       —       —  
Other commercial real estate     —       —       —  
Total commercial real estate   $ 9,181     $ 9,987     $ —  
                         
Consumer and residential real estate:                        
Secured by first-lien   $ —     $ —     $ —  
Secured by junior-lien     —       —       —  
Total consumer and residential real estate   $ —     $ —     $ —  
                         
With an allowance recorded:                        
Commercial real estate:                        
Industrial and warehouse   $ —     $ —     $ —  
Retail properties     —       —       —  
Office     5,266       8,332       480  
Multi family     944       944       114  
Other commercial real estate     2,695       5,108       601  
Total commercial real estate   $ 8,905     $ 14,384     $ 1,195  
                         
Consumer and residential real estate:                        
Secured by first-lien   $ 26,719     $ 29,346     $ 350  
Secured by junior-lien     3,556       4,879       290  
Total consumer and residential real estate   $ 30,275     $ 34,225     $ 640  

 

(1) These tables do not include loan participation interests which are fully charged-off.  
(2) All consumer and residential real estate impaired loan participation interests are considered impaired due to their status as a TDR.  
(3) At March 31, 2013, $63 thousand of the $8,712 thousand of commercial real estate loan participation interests with an allowance recorded were considered impaired due to their status as a TDR.  At December 31, 2012, $167 thousand of the $8,905 thousand of commercial real estate loan participation interests with an allowance recorded were considered impaired due to their status as a TDR.  
(4) The differences between the ending balance and unpaid principal balance amounts represent partial charge-offs.  

 

TDR Loan Participation Interests

 

TDRs are modified loan participation interests where a concession was provided to a borrower experiencing financial difficulties. Loan participation interest modifications are considered TDRs when the concessions provided are not available to the borrower through either the Bank’s normal channels or other sources. However, not all loan participation interest modifications are TDRs.

 

TDR Concession Types

 

The Bank’s standards relating to loan modifications consider, among other factors, minimum verified income requirements, cash flow analysis, and collateral valuations. Each potential loan modification is reviewed individually and the terms of the loan are modified to meet a borrower’s specific circumstances at a point in time. Commercial TDRs are reviewed and approved by the Bank’s Special Assets Division. The types of concessions provided to borrowers include:

 

17
 

 

· Interest rate reduction: A reduction of the stated interest rate to a nonmarket rate for the remaining original life of the debt.

 

· Amortization or maturity date change beyond what the collateral supports, including any of the following:

 

(1) Lengthens the amortization period of the amortized principal beyond market terms. This concession reduces the minimum monthly payment and increases the amount of the balloon payment at the end of the term of the loan. Principal is generally not forgiven.
(2) Reduces the amount of loan principal to be amortized. This concession also reduces the minimum monthly payment and increases the amount of the balloon payment at the end of the term of the loan. Principal is generally not forgiven.
(3) Extends the maturity date or dates of the debt beyond what the collateral supports. This concession generally applies to loans without a balloon payment at the end of the term of the loan.

 

· Chapter 7 bankruptcy: A bankruptcy court’s discharge of a borrower’s debt is considered a concession when the borrower does not reaffirm the discharged debt.

 

· Other: A concession that is not categorized as one of the concessions described above. These concessions include, but are not limited to: principal forgiveness, collateral concessions, covenant concessions, and reduction of accrued interest.

 

Principal forgiveness may result from any TDR modification of any concession type. However, the aggregate amount of principal forgiven as a result of loans modified as TDRs during the three-month periods ended March 31, 2013 and 2012, was not significant.

 

TDRs by Loan Participation Interest Type

 

The following is a description of TDRs by loan participation interest type:

 

Commercial real estate loan participation interest TDRs – CRE accruing TDRs often result from loan participation interests receiving a concession with terms that are not considered a market transaction to the Bank. The TDR remains in accruing status as long as the customer is less than 90-days past due on payments per the restructured loan participation interest terms and no loss is expected.

 

CRE nonaccrual TDRs result from either: (1) an accruing CRE TDR being placed on nonaccrual status, or (2) a workout where an existing CRE NAL is restructured and a concession was given. At times, these workouts restructure the NAL so that two or more new notes are created. The primary note is underwritten based upon the Bank’s normal underwriting standards and is sized so projected cash flows are sufficient to repay contractual principal and interest. The terms on the secondary note(s) vary by situation, and may include notes that defer principal and interest payments until after the primary note is repaid. Creating two or more notes often allows the borrower to continue a project or weather a temporary economic downturn and allows the Bank to right-size a loan based upon the current expectations for a borrower’s or project’s performance.

 

Our strategy involving TDR borrowers includes working with these borrowers to allow them to refinance elsewhere as well as allow them time to improve their financial position and remain our customer through refinancing their notes according to market terms and conditions in the future. A refinancing or modification of a loan occurs when either the loan matures according to the terms of the TDR-modified agreement or the borrower requests a change to the loan agreements. At that time, the loan is evaluated to determine if it is creditworthy. It is subjected to the Bank’s normal underwriting standards and process for similar credit extensions, both new and existing.

 

In accordance with ASC 310-20-35, the refinanced note is evaluated to determine if it is considered a new loan or a continuation of the prior loan. A new loan is considered for removal of the TDR designation, whereas a continuation of the prior note requires a continuation of the TDR designation. In order for the TDR designation to be removed, the borrower must no longer be experiencing financial difficulties and the terms of the refinanced loan must not represent a concession.

 

Consumer and residential real estate loan participation interest TDRs – Consumer and residential real estate TDRs represent loan modifications associated with traditional first-lien mortgage loans, as well as first-lien and junior-lien home equity loans, in which a concession has been provided to the borrower. The primary concessions given to these borrowers are amortization or maturity date changes and interest rate reductions. Consumer and residential real estate loans identified as TDRs include borrowers unable to refinance their mortgages through the Bank’s normal mortgage origination channels or through other independent sources. Some, but not all, of the loans may be delinquent at the time of modification.

 

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TDR Impact on Credit Quality

 

The ALPL is largely driven by updated risk ratings assigned to CRE loan participation interests, updated borrower credit scores on consumer and residential real estate, and borrower delinquency history in both portfolios. These updated risk ratings and credit scores consider the default history of the borrower, including payment redefaults. As such, the provision for credit losses is impacted primarily by changes in borrower payment performance rather than the TDR classification. TDRs can be classified as either accrual or nonaccrual loan participation interests. Nonaccrual TDRs are included in NPAs whereas accruing TDRs are excluded from NPAs as it is probable that all contractual principal and interest due under the restructured terms will be collected.

 

TDRs may include multiple concessions and the disclosure classifications are presented based on the primary concession provided to the borrower. The majority of concessions for the CRE portfolio are the extension of the maturity date coupled with an increase in the interest rate. In these instances, the primary concession is the maturity date extension.

 

TDR concessions may also result in the reduction of the ALPL within the CRE portfolio. This reduction is from payments and the resulting application of the reserve calculation within the ALPL.  The transaction reserve for non-TDR loans is calculated based upon several estimated probability factors, such as PD and LGD, both of which were previously discussed above.  Upon the occurrence of a TDR in the CRE portfolio, the reserve is measured based on discounted expected cash flows or collateral value, less selling costs, of the modified loan in accordance with ASC 310-10.  The resulting TDR ALPL calculation often results in a lower ALPL amount because: (1) the discounted expected cash flows or collateral value indicate a lower estimated loss, (2) if the modification includes a rate increase, the discounting of cash flows or the collateral value, less selling costs, on the modified loan, using the pre-modification interest rate, exceeds the carrying value of the loan, or (3) payments may occur as part of the modification. The ALPL for CRE loans may increase as a result of the modification, as the discounted cash flow analysis may indicate additional reserves are required.

 

TDR concessions on consumer and residential real estate loans may increase the ALPL.  The concessions made to these borrowers often include interest rate reductions and, therefore, the TDR ALPL calculation results in a greater ALPL compared with the non-TDR calculation as the reserve is measured based on the estimation of the discounted expected cash flows or collateral value, less selling costs, on the modified loan in accordance with ASC 310-10. The resulting TDR ALPL calculation often results in a higher ALPL amount because (1) the discounted expected cash flows or collateral value, less selling costs, indicate a higher estimated loss or, (2) due to the rate decrease, the discounting of the cash flows on the modified loan participation interest, using the pre-modification interest rate, indicates a reduction in the expected cash flows or collateral value, less selling costs. In certain instances, the ALPL may decrease as a result of payments made in connection with the modification.

 

Commercial real estate loan participation interest TDRs – In instances where the Bank substantiates that it will collect the outstanding balance in full, the note is considered for return to accrual status upon the borrower sustaining sufficient cash flows for a six-month period of time. This six-month period could extend before or after the restructure date. If a charge-off was taken as part of the restructuring, any interest or principal payments received on that note are applied to first reduce the outstanding book balance and then to recoveries of charged-off principal, unpaid interest, and/or fee expenses.

 

Consumer and residential real estate loan participation interest TDRs – Modified loans identified as TDRs are aggregated into pools for analysis. Cash flows and weighted average interest rates are used to calculate impairment at the pooled-loan level. Once the loans are aggregated into the pool, they continue to be classified as TDRs until contractually repaid or charged-off.

 

The following table presents, by class and the reason for the modification, the number of contracts, post-modification outstanding balance, and the financial effects of the modification for the three-month periods ended March 31, 2013 and 2012:

  

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    New Troubled Debt Restructurings During The Three-Month Period Ended (1), (2)  
    March 31, 2013     March 31, 2012  
          Post-modification                 Post-modification        
(dollar amounts in thousands)   Number of     Outstanding     Financial effects     Number of     Outstanding     Financial effects  
    Contracts     Balance     of modification (3)     Contracts     Balance     of modification (3)  
                                     
CRE - Retail properties:                                                
                                                 
Interest rate reduction     —     $ —     $ —       1     $ 892     $ (2 )
Amortization or maturity date change     —       —       —       —       —       —  
Other     —       —       —       —       —       —  
Total CRE - Retail properties     —     $ —     $ —       1     $ 892     $ (2 )
                                                 
Consumer and residential real estate secured by first-lien:                                                
                                                 
Interest rate reduction     5     $ 573     $ 100       38     $ 4,729     $ 765  
Amortization or maturity date change     1       75       (8 )     3       384       (1 )
Chapter 7 bankruptcy     18       1,192       (27 )     —       —       —  
Other     —       —       —       —       —       —  
Total consumer and residential real estate secured by first-lien     24     $ 1,840     $ 65       41     $ 5,113     $ 764  
                                                 
Consumer and residential real estate secured by junior-lien:                                                
                                                 
Interest rate reduction     —     $ —     $ —       3     $ 63     $ 3  
Amortization or maturity date change     2       12       —       2       47       (2 )
Chapter 7 bankruptcy     18       103       (21 )     —       —       —  
Other     —       —       —       —       —       —  
Total consumer and residential real estate secured by junior-lien     20     $ 115     $ (21 )     5     $ 110     $ 1  
                                                 
Total new troubled debt restructurings     44     $ 1,955     $ 44       47     $ 6,115     $ 763  

 

(1) TDRs may include multiple concessions and the disclosure classifications are based on the primary concession provided to the borrower.
(2) For the three-month periods ended March 31, 2013 and 2012, there were no new troubled debt restructurings for the following classes: C&I - owner occupied, C&I - nonowner occupied, CRE - multi family, CRE - office, CRE - industrial and warehouse, and CRE - other CRE.
(3) Amounts represent the financial impact via provision for loan participation interest losses as a result of the modification.

 

Any loan participation interest within any portfolio or class is considered as payment redefaulted at 90-days past due.

 

During the three-month periods ended March 31, 2013 and 2012, there were no TDRs in any class of any portfolio that redefaulted within one year of modification.

 

Note 4 - Related Party Transactions

 

The Bank is required, under the Agreements, to service HPCI’s loan participation interest portfolio in a manner substantially the same as for similar work for transactions on its own behalf. The Bank collects and remits principal and interest payments, maintains perfected collateral positions, and submits and pursues insurance claims. In addition, the Bank provides accounting and reporting services to HPCI. The Bank is required to adhere to HPCI’s policies relating to the relationship between HPCI and the Bank and to pay all expenses related to the performance of the Bank’s duties under the participation and subparticipation agreements. All of these participation interests to date were acquired directly or indirectly from the Bank.

 

The Bank performs the servicing of the commercial real estate, consumer, and residential real estate loans underlying the participations held by HPCI in accordance with normal industry practice under the amended participation and subparticipation agreements. In its capacity as servicer, the Bank collects and holds the loan payments received on behalf of HPCI until the end of each month. Loan servicing costs totaled $1.5 million and $1.6 million for the three-month periods ended March 31, 2013 and 2012, respectively.

 

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In 2013 and 2012, the annual servicing rates the Bank charged with respect to outstanding principal balances were:

 

    January 1, 2012  
    through  
    March 31, 2013  
Commercial real estate     0.125 %
Consumer     0.650  
Residential real estate     0.267  

 

Pursuant to the Agreements, the amount and terms of the loan servicing fee between the Bank and HPCI are determined by mutual agreement from time-to-time during the terms of the Agreements. In lieu of paying higher servicing costs to the Bank with respect to CRE loans, HPCI has waived its right to receive any origination fees associated with participation interests in CRE loans. The Bank and HPCI performed a review of loan servicing fees in 2012, and have agreed to retain current servicing rates for all loan participation categories, including the continued waiver by HPCI of its right to origination fees, until such time as servicing fees are reviewed in 2013.

 

Huntington’s and the Bank’s personnel handle day-to-day operations of HPCI such as financial analysis and reporting, accounting, tax reporting, and other administrative functions. On a monthly basis, HPCI pays the Bank and Huntington for the cost related to the time spent by employees for performing these functions. These personnel costs totaled $0.1 million for each of the three-month periods ended March 31, 2013 and 2012, and are included in other noninterest expense.

 

The following table represents the ownership of HPCI’s outstanding common and preferred securities as of March 31, 2013:

 

    Number of                          
    Common     Number of Preferred Securities  
Shareholder:   Shares     Class A     Class B     Class C     Class E  
Held by related parties:                                        
HPCII     11,130,000       —       —       —       —  
Holdings     2,870,000       895       —       —       —  
Tower Hill Securities, Inc.     —       —       —       —       1,400,000  
HPC Holdings-II, Inc.     —       —       400,000       —       —  
Total held by related parties     14,000,000       895       400,000       —       1,400,000  
Other shareholders     —       105       —       2,000,000       —  
Total shares outstanding     14,000,000       1,000       400,000       2,000,000       1,400,000  

 

As of March 31, 2013, 10.5% of the Class A preferred securities were owned by current and past employees of Huntington and its subsidiaries in addition to the 89.5% owned by Holdings. 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 have purchased a portion of the Class C preferred securities. At March 31, 2013, HPCI board members and executive officers beneficially owned, in the aggregate, a total of 6,965 shares, or less than 1%, of the HPCI Class C preferred securities. All of the Class E preferred securities are owned by Tower Hill Securities, Inc.  In the event HPCI redeems its Class C or Class E preferred securities, holders of such securities will be entitled to receive $25.00 per share for Class C shares, $250.00 per share for Class E shares, plus any accrued and unpaid dividends on such shares. The redemption amount may be significantly lower than the current market price of the Class C preferred securities.

 

Both the Class C and Class E preferred securities are entitled to one-tenth of one vote per share on all matters submitted to HPCI shareholders.  If the Bank becomes under-capitalized, or is placed in conservatorship or receivership, the OCC may require the exchange of Class C and Class E Preferred securities for preferred securities of the Bank with substantially equivalent terms. The Class E preferred securities are currently redeemable and Class C preferred securities are redeemable at HPCI’s option on or after December 31, 2021, subject to the prior written approval of the OCC.  In the event HPCI redeems its Class C or Class E preferred securities, holders will be entitled to receive $25.00 per share for Class C shares, $250.00 per share for Class E shares, plus any accrued and unpaid dividends on such shares.  The redemption amount may be significantly different than the current market price of the Class C preferred securities. 

 

In addition, at any time following the occurrence of certain special events, including a regulatory capital event described in the paragraph below, HPCI will have the right to redeem the Class C preferred securities in whole, subject to the prior written approval of the OCC.  (Also see the Class C Preferred Securities section in Note 6.)

 

In June 2012, federal banking agencies, including the FRB, jointly published notices of proposed rulemaking, which would substantially amend the risk-based capital rules for banks. The proposed capital rules (Basel III NPR) are intended to implement the Basel III regulatory capital reforms, comply with changes required by the Dodd-Frank Act, and replace the existing Basel I-based capital requirements. Based on our interpretation of Basel III NPR as currently proposed, we believe the HPCI Class C preferred securities would no longer constitute Tier 1 capital for Huntington or the Bank. It is possible that, upon considering comments received on the NPRs, the FRB may not adopt the Basel III NPR as proposed, or may make additional changes to the applicable Tier 1 capital rules prior to final adoption. However, in the event the FRB’s applicable final rules regarding Tier 1 capital treatment are substantially similar to Basel III NPR as proposed, or otherwise result in the Class C preferred securities no longer constituting Tier 1 capital for the Bank and we receive an opinion of counsel to that effect, HPCI would be able to redeem the Class C preferred securities at the par value of $25 per share due to a regulatory capital event. There can be no assurance as to if or when HPCI would redeem the Class C preferred securities.

 

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As only related parties hold HPCI’s common stock, there is no established public trading market for this class of stock.

 

HPCI had a noninterest-bearing receivable due from the Bank of $60.3 million at March 31, 2013 and a noninterest-bearing payable due to the Bank of $62.9 million at December 31, 2012. The balances represent the net settlement amounts due to, or from, the Bank for the last month of the period’s activity. Principal and interest payments on loan participations remitted by customers are due from the Bank, while new loan participation purchases are due to the Bank. The amounts are settled with the Bank within the first few days of the following month.

 

HPCI has assets pledged in association with the Bank’s advances from the FHLB. For further information regarding this, see Note 6.

 

HPCI maintains and transacts all of its cash activity through the Bank. Typically, cash is invested with the Bank in an interest-bearing account. These interest-bearing balances are invested overnight or may be invested in Eurodollar deposits with the Bank for a term of not more than 30 days at market rates.

 

Note 5 - Fair Values of Assets and Liabilities

 

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Fair value measurements are classified within one of three levels in a valuation hierarchy based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:

 

Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

 

Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

 

Level 3 – inputs to the valuation methodology are unobservable and significant to the fair value measurement.

 

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Transfers in and out of Level 1, 2, or 3 are recorded at fair value at the beginning of the reporting period.

 

Certain assets and liabilities may be required to be measured at fair value on a nonrecurring basis in periods subsequent to their initial recognition. These assets and liabilities are not measured at fair value on an on-going basis; however, they are subject to fair value adjustments in certain circumstances, such as when there is evidence of impairment.

 

Periodically, HPCI records nonrecurring adjustments of collateral-dependent loan participation interests measured for impairment when establishing the ACL. Such amounts are generally based on the fair value of the underlying collateral supporting the loan. Appraisals are generally obtained to support the fair value of the collateral and incorporate measures such as recent sales prices for comparable properties and cost of construction. HPCI considers these fair values Level 3. In cases where the carrying value exceeds the fair value of the collateral less cost to sell, an impairment charge is recognized.

 

At March 31, 2013, HPCI identified the following loan participation interests that were measured at fair value on a nonrecurring basis. The fair value impairment for the three-month period ended March 31, 2013, was recorded within the provision for credit losses.

 

          Fair Value Measurements Using        
          Quoted Prices     Significant     Significant     Total  
          In Active     Other     Other     Gains/(Losses)  
          Markets for     Observable     Unobservable     For the Three  
    Fair Value at     Identical Assets     Inputs     Inputs     Months Ended  
(dollar amounts in thousands)   March 31, 2013     (Level 1)     (Level 2)     (Level 3)     March 31, 2013  
Loan participation interests   $ 9,031     $ —     $ —     $ 9,031     $ (493 )

 

There were no changes in the valuation techniques or related inputs used to measure similar assets in prior periods .

 

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Fair Value of Financial Instruments

 

The following methods and assumptions were used by HPCI to estimate the fair value of the classes of financial instruments:

 

Cash and interest-bearing deposits and due from The Huntington National Bank — The carrying value approximates fair value based on its highly liquid nature. All amounts at March 31, 2013 and December 31, 2012 are classified as Level 1 in the valuation hierarchy.

 

Loan participation interests — Underlying variable rate loans that reprice frequently are based on carrying amounts, as adjusted for estimated credit losses. The fair values for other loans are estimated using discounted cash flow analyses and employ interest rates currently being offered for loans with similar terms. The rates take into account the position of the yield curve, as well as an adjustment for prepayment risk, operating costs, and profit. This value is also reduced by an estimate of probable losses and the credit risk associated in the loan portfolio. As of March 31, 2013, the net carrying amount of $3.1 billion corresponded to a fair value of $2.8 billion. As of December 31, 2012, the net carrying value of $3.3 billion corresponded to a fair value of $2.9 billion. All amounts at March 31, 2013 and December 31, 2012 are classified as Level 3 in the valuation hierarchy. At March 31, 2013, the valuation of the loan portfolio reflected discounts that HPCI believed are consistent with transactions occurring in the marketplace.

 

Note 6 - Commitments and Contingencies

 

Class C Preferred Securities

 

In June 2012, federal banking agencies, including the FRB, jointly published notices of proposed rulemaking, which would substantially amend the risk-based capital rules for banks. The proposed capital rules (Basel III NPR) are intended to implement the Basel III regulatory capital reforms, comply with changes required by the Dodd-Frank Act, and replace the existing Basel I-based capital requirements. Based on our interpretation of the Basel III NPR as currently proposed, we believe the HPCI Class C preferred securities would no longer constitute Tier 1 capital for Huntington or the Bank. It is possible that, upon considering comments received on the NPRs, the FRB may not adopt the Basel III NPR as proposed, or may make additional changes to the applicable Tier 1 capital rules prior to final adoption. However, in the event the FRB’s applicable final rules regarding Tier 1 capital treatment are substantially similar to the Basel III NPR as proposed, or otherwise result in the Class C preferred securities no longer constituting Tier 1 capital for the Bank and we receive an opinion of counsel to that effect, HPCI would be able to redeem the Class C preferred securities at the par value of $25 per share due to a regulatory capital event. There can be no assurance as to if or when HPCI would redeem the Class C preferred securities.

 

Pledged Assets

 

The Bank is eligible to obtain collateralized advances from various federal and government-sponsored agencies such as the FHLB. 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 all or a portion of 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 the FHLB 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.

 

Currently, HPCI’s assets have been used to collateralize only one such facility. The Bank has a line of credit from the FHLB with a maximum borrowing capacity of $4.1 billion as of March 31, 2013, based on the Bank’s holdings of FHLB stock. As of this same date, the Bank had outstanding borrowings of $0.2 billion under the facility.

 

HPCI has entered into an Amended and Restated Agreement with the Bank with respect to the pledge of HPCI’s assets to collateralize the Bank’s borrowings from the FHLB. The agreement provides that the Bank will not place at risk HPCI’s assets in excess of an aggregate dollar amount or aggregate percentage of such assets established from time-to-time by HPCI’s board of directors, including a majority of HPCI’s independent directors. The pledge limit was established by HPCI’s board at 25% of total assets, or approximately $0.9 billion as of March 31, 2013, as reflected in HPCI’s month-end management report. This pledge limit may be changed in the future by the board of directors, including a majority of HPCI’s independent directors. The amount of HPCI’s participation interests pledged was $0.4 billion at March 31, 2013. In 2013, the loans pledged consisted of the 1-4 family residential mortgage loans. The agreement also provides that the Bank will pay HPCI a monthly fee based upon the total loans pledged by HPCI. The Bank paid HPCI a total of $0.3 million for each of the three-month periods ended March 31, 2013 and 2012, as compensation for making such assets available to the Bank.

 

23
 

 

Under the terms of the participation and subparticipation agreements, HPCI is obligated to make funds or credit available to the Bank, either directly or indirectly through Holdings so that the Bank may extend credit to any borrowers, or pay letters-of-credit issued for the account of any borrowers, to the extent provided in the loan agreements underlying HPCI’s participation interests. As of March 31, 2013 and December 31, 2012, HPCI’s unfunded loan participation interest commitments totaled $219.4 million and $273.4 million, respectively.

 

Dividends

 

Based on a regulatory dividend limitation, the Bank could not have declared and paid a dividend at March 31, 2013 without regulatory approval due to the deficit position of its undivided profits. As a subsidiary of the Bank, HPCI is also restricted from declaring or paying dividends to non-bank subsidiaries or outside shareholders without regulatory approval. There can be no assurance that regulatory approval will be granted for future dividends.

 

Note 7 - 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.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

INTRODUCTION

 

We are an Ohio corporation operating as a REIT for federal income tax purposes. Our principal business objective is to acquire, hold, and manage mortgage assets and other authorized investments that will generate net income for distribution to our shareholders.

 

We are a party to a Third Amended and Restated Loan Subparticipation Agreement with Holdings and a Second Amended and Restated Loan Participation Agreement with the Bank. The Bank is required, under the Agreements, to service our loan portfolio in a manner substantially the same as for similar work for transactions on our own behalf. The Bank collects and remits principal and interest payments, maintains perfected collateral positions, and submits and pursues insurance claims. In addition, the Bank provides to us accounting and reporting services as required. The Bank is required to adhere to our policies relating to the relationship between us and the Bank and to pay all expenses related to the performance of the Bank’s duties under the participation and subparticipation agreements. All of our participation interests to date were acquired directly or indirectly from the Bank.

 

The following discussion and analysis provides information we believe is necessary for understanding the financial condition, changes in financial condition, results of operations, and cash flows and should be read in conjunction with the financial statements, notes, and other information contained in this report. The MD&A appearing in our 2012 Form 10-K should be read in conjunction with this interim MD&A.

 

Forward-looking Statements

 

This report, including MD&A, contains certain forward-looking statements, including certain plans, expectations, goals, projections, and statements, which are subject to numerous assumptions, risks, and uncertainties. Statements that do not describe historical or current facts, including statements about beliefs and expectations, are forward-looking statements. The forward-looking statements are intended to be subject to the safe harbor provided by Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934, and the Private Securities Litigation Reform Act of 1995.

 

Actual results could differ materially from those contained or implied by such statements for a variety of factors including: (1) worsening of credit quality performance due to a number of factors such as the underlying value of the collateral could prove less valuable than otherwise assumed and assumed cash flows may be worse than expected; (2) changes in economic conditions; (3) movements in interest rates; (4) competitive pressures on the Bank’s product pricing and services; (5) success, impact, and timing of the Bank’s business strategies; (6) changes in accounting policies and principles and the accuracy of our assumptions and estimates used to prepare our financial statements; (7) extended disruption of vital infrastructure; and (8) the nature, extent, timing and results of governmental actions, examinations, reviews, reforms, and regulations including those related to the Dodd-Frank Wall Street Reform and Consumer Protection Act, OCC, Federal Reserve, and CFPB. Additional factors that could cause results to differ materially from those described above can be found in our 2012 Form 10-K, and documents subsequently filed by us with the SEC.

 

All forward-looking statements speak only as of the date they are made and are based on information available at that time. We assume no obligation to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements were made or to reflect the occurrence of unanticipated events except as required by federal securities laws. As forward-looking statements involve significant risks and uncertainties, caution should be exercised against placing undue reliance on such statements.

 

Risk Factors

 

We are subject to a number of risks that may adversely affect our financial condition or results of operation, many of which are outside of our direct control, though efforts are made to manage those risks while optimizing returns. Credit risk related to retail properties is of particular concern in the current economy. See Credit Risk section of this report. Additionally, more information on risk is set forth under the heading “Risk Factors” included in Item 1A of our 2012 Form 10-K, and subsequent filings with the SEC.

 

Critical Accounting Policies and Use of Significant Estimates

 

Our financial statements are prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires Management to establish critical accounting policies and make accounting estimates, assumptions, and judgments that affect amounts recorded and reported in our financial statements. Note 1 to the Financial Statements included in our 2012 Form 10-K as supplemented by this report lists significant accounting policies used by Management in the development and presentation of our financial statements. This MD&A, 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 us and our financial position, results of operations, and cash flows.

 

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An accounting estimate requires assumptions about uncertain matters that could have a material effect on the financial statements if a different amount within a range of estimates was used or if estimates changed from period-to-period. Estimates are made under facts and circumstances at a point in time and changes in those facts and circumstances could produce actual results that significantly differ from when those estimates were made.

 

Our most significant accounting estimates relate to our ACL. This significant accounting estimate and related application is discussed in our 2012 Form 10-K. The related fair value measurement on a nonrecurring basis can be found in Note 5 of Notes to the Unaudited Condensed Financial Statements.

 

QUALIFICATION TESTS

 

Qualification as a REIT involves application of specific provisions of the IRC relating to various asset tests. A REIT must satisfy six asset tests quarterly: (1) 75% 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% of the value of the REIT's total assets may consist of securities, other than those includible under the 75% test; (3) not more than 5% of the value of its total assets may consist of securities of any one issuer, other than those securities includible under the 75% test or securities of taxable REIT subsidiaries; (4) not more than 10% of the outstanding voting power of any one issuer may be held, other than those securities includible under the 75% test or securities of taxable REIT subsidiaries; (5) not more than 10% of the total value of the outstanding securities of any one issuer may be held, other than those securities includible under the 75% 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% of its total assets. At March 31, 2013, we met all of the quarterly asset tests.

 

Also, a REIT must annually satisfy two gross income tests: (1) 75% of its gross income must be from qualifying income closely connected with real estate activities; and (2) 95% of its gross income must be derived from sources qualifying for the 75% test plus dividends, interest, and gains from the sale of securities. In addition, a REIT must distribute 90% of the REIT’s taxable income for the taxable year, excluding any net capital gains, to maintain its nontaxable status for federal income tax purposes. For the tax year 2012, we met all annual income and distribution tests.

 

We operate in a manner that will not cause us to be deemed an investment company under the Investment Company Act. The Investment Company Act exempts from registration as an investment company an 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, we must invest at least 55% of our assets in Qualifying Interests and an additional 25% of our assets in real estate-related assets, although this percentage may be reduced to the extent that more than 55% of our assets are invested in Qualifying Interests. The assets in which we may invest under the IRC therefore may be further limited by the provisions of the Investment Company Act and positions taken by the SEC staff. At March 31, 2013, we were exempt from registration as an investment company under the Investment Company Act, and we intend to operate our business in a manner that will maintain this exemption.

 

RESULTS OF OPERATIONS

 

Our income is primarily derived from our participation in loans acquired from the Bank and Holdings. Income varies based on the level of these assets and their respective interest rates. The cash flows from these assets are used to satisfy our preferred dividend obligations. The preferred stock is considered equity and, therefore, the dividends are not reflected as interest expense.

 

The following table details the results of operations for the last five quarters. The $21.8 million, or 43% decrease in net income for the 2013 first quarter, compared with same period in 2012, was primarily the result of higher provision for credit losses. A provision for credit losses of $1.1 million was recorded in the current quarter compared to a reduction in allowance for credit losses of $16.1 million in the year-ago quarter.

 

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Table 1 - Selected Quarterly Income Statement Data

 

    2013     2012     1Q13 vs. 1Q12  
(dollar amounts in thousands)   First     Fourth     Third     Second     First     $ Chg     % Chg  
Interest and fee income                                                        
Interest on loan participation interests:                                                        
Commercial real estate   $ 24,686     $ 26,157     $ 27,517     $ 27,875     $ 28,583     $ (3,897 )     (14 )%
Consumer and residential real estate     5,976       5,873       5,691       6,171       6,625       (649 )     (10 )
Total loan participation interest income     30,662       32,030       33,208       34,046       35,208       (4,546 )     (13 )
Fees from loan participation interests     334       155       196       209       245       89       36  
Interest on deposits with the Bank     124       389       327       260       174       (50 )     (29 )
Total interest and fee income     31,120       32,574       33,731       34,515       35,627       (4,507 )     (13 )
Provision (reduction in allowance) for credit losses     1,059       (1,637 )     5,117       (11,257 )     (16,126 )     17,185       N.R.  
Interest income after provision (reduction in allowance) for credit losses     30,061       34,211       28,614       45,772       51,753       (21,692 )     (42 )
Noninterest income:                                                        
Rental income     18       18       18       18       18       —       —  
Collateral fees     294       271       291       299       326       (32 )     (10 )
Total noninterest income     312       289       309       317       344       (32 )     (9 )
                                                         
Noninterest expense:                                                        
Servicing costs     1,471       1,466       1,528       1,579       1,645       (174 )     (11 )
Franchise tax     196       187       555       —       —       196       N.R.  
Other     186       239       240       189       159       27       17  
Total noninterest expense     1,853       1,892       2,323       1,768       1,804       49       3  
Income before provision for income taxes   $ 28,520     $ 32,608     $ 26,600     $ 44,321     $ 50,293     $ (21,773 )     (43 )%
Provision (reduction in allowance) for income taxes     40       (143 )     182       —       —       40       N.R.  
Net income   $ 28,480     $ 32,751     $ 26,418     $ 44,321     $ 50,293     $ (21,813 )     (43 )
Dividends declared on preferred shares     3,058       3,071       3,272       3,284       3,578       520       (15 )
Net income applicable to common shares (1)   $ 25,422     $ 29,680     $ 23,146     $ 41,037     $ 46,715     $ (21,293 )     (46 )%

 

(1) All of HPCI's common stock is owned by HPCII and Holdings and, therefore, net income per share is not presented.

N.R. - Not relevant, as denominator of calculation is a loss in prior period compared with income in current period.

 

Interest and Fee Income

 

Our primary source of revenue is interest and fee income on our participation interests in loans. At March 31, 2013 and 2012, we did not have any interest-bearing liabilities or related interest expense. Interest income is impacted by changes in the levels of interest rates and earning assets. The yield on earning assets is the percentage of interest income to average earning assets.

 

The tables below show our average balances, interest and fee income, and yields for the three-month periods ended March 31, 2013 and 2012:

 

Table 2 - Quarterly Interest and Fee Income

 

    Three Months Ended March 31,  
    2013     2012  
(dollar amounts in millions)   Average
Balance 		    Income (1)     Yield     Average
Balance 		    Income (1)     Yield  
Loan participation interests:(2)                                                
Commercial real estate   $ 2,816.8     $ 25.0       3.60 %   $ 3,125.4     $ 28.8       3.71 %
Consumer and residential real estate     430.1       6.0       5.64       421.0       6.6       6.35  
Total loan participation interests     3,246.9       31.0       3.87       3,546.4       35.4       4.02  
Interest-bearing deposits in the Bank     199.0       0.1       0.25       275.2       0.2       0.25  
Total   $ 3,445.9     $ 31.1       3.66 %   $ 3,821.6     $ 35.6       3.75 %

(1) Income includes interest and fees.

(2) For the purposes of this analysis, average balances include nonaccrual loans.

 

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Interest and fee income was $31.1 million for the 2013 first quarter compared with $35.6 million for the year ago quarter. As shown in Table 2, the decrease in interest and fee income was primarily due to a decrease in yields on loan participation interests and lower average loan participation interest balances. In the 2013 first quarter, the loan yield decreased 15 basis points to 3.87%, while average loan participation interest balances decreased $299.5 million, or 8% compared to the year-ago quarter.

 

At March 31, 2013 and December 31, 2012, approximately 76%, respectively, of the portfolio was comprised of variable interest rate loan participations.

 

Provision (reduction in allowance) for credit losses

 

The provision (reduction in allowance) for credit losses is the charge (credit) to earnings necessary to maintain the ACL at a level appropriate to absorb our estimate of inherent probable losses in the loan portfolio. Loan participations are acquired net of related ALPL. As a result, this ALPL is transferred to HPCI from the Bank and is reflected as ALPL acquired, rather than us recording provision for credit losses. If credit quality deteriorates more than implied by the ALPL acquired, a provision to the ALPL is made. If credit quality performance is better than implied by the ALPL acquired, an ALPL reduction is recorded. As loan participations mature, refinance, or other such actions occur, any allowance not absorbed by loan losses is released through the reduction in ALPL.

 

The provision for credit losses was $1.1 million for the three-month period ended March 31, 2013 compared to a reduction in allowance for credit losses of $16.1 million for the three-month period ended March 31, 2012. The reduction in allowance for credit losses in the year-ago quarter reflected significant credit quality improvement in the underlying portfolio. Credit quality in the 2013 first quarter also improved although at a more moderated level compared to the 2012 first quarter.

 

Given the relatively absolute low level of the provision for credit losses and the uncertain and uneven nature of the economic recovery, some degree of volatility on a quarter-to-quarter basis is expected. See ACL discussion within the Credit Quality section.

  

Noninterest Income and Noninterest Expense

 

Noninterest income for the 2013 first quarter and the year-ago quarter was $0.3 million. Noninterest income includes fees from the Bank for use of our assets as collateral for the Bank’s advances from the FHLB. For the 2013 first quarter and the year-ago quarter these fees totaled $0.3 million. See Note 6 to the Unaudited Condensed Financial Statements included in this report for more information regarding the use of our assets as collateral for the Bank’s advances from the FHLB.

 

Noninterest expense for the 2013 first quarter was $1.9 million compared with $1.8 million in the year-ago quarter. HPCI is included in certain of Huntington’s unitary franchise tax returns. On March 8, 2012, HPCI’s board of directors adopted Huntington’s Policy Statement on Intercorporate State Tax Allocation, dated January 1, 2012. As a result, beginning in 2012, Huntington’s unitary franchise tax provision is allocated to each member of the unitary filing group based upon the filing group’s effective tax rate. Under the intercompany state tax allocation agreement with Huntington, we will provide and remit state franchise tax to or receive a state franchise tax benefit from the tax paying member. The franchise tax for the three month ended period March 31, 2013 was $196 thousand. The predominant component of noninterest expense is the fee paid to the Bank for servicing the loans underlying the participation interest. For the 2013 first quarter , servicing costs amounted to $1.5 million, compared with $1.6 million for the year-ago quarter. The decrease in the servicing costs from the comparable periods reflected lower loan participation interests balances. The annual servicing rates the Bank charged with respect to outstanding principal balances in 2013 and 2012 were:

 

    January 1, 2012  
    through  
    March 31, 2013  
Commercial and commercial real estate     0.125 %
Consumer     0.650  
Residential real estate     0.267  

 

Pursuant to the Agreements, the amount and terms of the loan-servicing fee between the Bank and us are determined by mutual agreement from time to time during the terms of the Agreements. In lieu of paying higher servicing costs to the Bank with respect to CRE loans, we waive our right to receive any origination fees associated with participation interests in CRE loans. We, along with t he Bank, performed a review of loan servicing fees in 2012, and agreed to retain current servicing rates for all loan participation categories, including the continued waiver by us of our right to origination fees, until such time as servicing fees are reviewed in 2013.

 

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Provision for Income Taxes

   

We have elected to be treated as a REIT for federal income tax purposes and intend to maintain compliance with the provisions of the IRC and, therefore, are not subject to federal income taxes. Thus, we had no provision for federal income taxes for the three-month periods ended March 31, 2013 and 2012.

 

HPCI is included in certain of Huntington’s unitary and combined state income tax returns. Huntington’s unitary and combined state income tax provision is allocated to each member of the unitary and combined filing group’s based upon the filing group’s effective tax rate. Under the intercompany state tax allocation agreement with Huntington, we will provide and remit state income taxes to or receive a state income tax benefit from the tax paying member. For the three-month period ended March 31, 2013, provision for state income taxes was $40 thousand. For the three-month period ended March 31, 2012, there was no provision for state income taxes.

 

RISK MANAGEMENT AND CAPITAL

 

Risk awareness, identification and assessment, reporting, and active management are key elements in overall risk management. The Bank manages risk to an aggregate moderate-to-low risk profile strategy through a control framework and by monitoring and responding to identified potential risks. Controls include, among others, effective segregation of duties, access, authorization and reconciliation procedures, as well as staff education and a disciplined assessment process. Management relies on the Bank’s credit management controls, processes, and procedures in evaluating and responding to risk within the loan participation interest portfolio.

 

Credit Risk

(This section should be read in conjunction with Note 3 of Notes to the Unaudited Condensed Financial Statements.)

 

Credit risk is the risk of financial loss if a counterparty is not able to meet the agreed upon terms of the financial obligation. The identification, monitoring, and managing of credit risk continues to be a primary focus. In addition to the traditional credit risk mitigation strategies of credit policies and processes, market risk management activities, and portfolio diversification, additional quantitative measurement capabilities were implemented that utilize external data sources, enhanced use of modeling technology, and internal stress testing processes.

 

Under the Agreements, the Bank may, in accordance with our guidelines, dispose of any underlying loan participation interest that is rated as Substandard or lower, is placed in a nonaccrual status, or is renegotiated due to the financial deterioration of the borrower. The Bank may, in accordance with our guidelines, institute foreclosure proceedings, 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 Agreements. Prior to completion of foreclosure or liquidation, the loan participation interest is sold to the Bank at fair market value. The Bank then incurs all costs associated with repossession and foreclosure.

 

Loan Participation Interest Credit Exposure Mix

 

At March 31, 2013, CRE loan participation interests were 87% of total loan participation interests, unchanged compared with December 31, 2012 . Total consumer and residential real estate loan participation interests were 13% of total loan participation interests at March 31, 2013 , also unchanged compared with December 31, 2012 .

 

Commercial Real Estate Credit

 

Refer to the “Commercial Real Estate Credit” section of our 2012 Form 10-K for our commercial credit underwriting and on-going credit management processes.

 

The CRE portfolio is diversified by customer size, as well as geographically. No outstanding CRE loan participation interests comprised an industry or geographic concentration of lending. CRE loan participation interests outstanding by property type and borrower location at March 31, 2013 and December 31, 2012, were as follows:

 

Table 3 - Commercial Real Estate Loan Participation Interests by Property Type and Borrower Location

 

    March 31, 2013  
(dollar amounts in thousands)   Ohio     Michigan     Indiana     Pennsylvania     Kentucky     Other     Total Amount     %  
                                                 
Industrial and warehouse   $ 373,125     $ 188,905     $ 36,887     $ 10,260     $ 14,778     $ 17,827     $ 641,782       23 %
Retail properties     329,467       93,794       43,186       10,622       11,254       55,143       543,466       20  
Office     257,185       90,888       12,584       63,144       7,659       11,474       442,934       16  
Multi family     129,826       34,034       61,808       13,097       19,342       23,621       281,728       10  
Other commercial real estate     487,403       183,679       30,301       41,084       40,267       73,576       856,310       31  
Total   $ 1,577,006     $ 591,300     $ 184,766     $ 138,207     $ 93,300     $ 181,641     $ 2,766,220       100 %

 

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    December 31, 2012  
(dollar amounts in thousands)   Ohio     Michigan     Indiana     Pennsylvania     Kentucky     Other     Total Amount     %  
                                                 
Industrial and warehouse   $ 404,117     $ 187,959     $ 39,668     $ 12,815     $ 15,191     $ 16,750     $ 676,500       24 %
Retail properties     345,907       95,595       41,789       26,707       12,783       52,867       575,648       20  
Office     280,826       80,825       13,498       70,943       7,790       17,494       471,376       16  
Multi family     148,727       31,955       67,411       13,097       19,086       21,941       302,217       11  
Other commercial real estate     482,246       178,538       31,345       43,629       40,519       73,852       850,129       29  
Total   $ 1,661,823     $ 574,872     $ 193,711     $ 167,191     $ 95,369     $ 182,904     $ 2,875,870       100 %

 

CRE loan participation interests are diversified by customer size, as well as customer location throughout the Bank’s lending area of Ohio, Michigan, Indiana, Kentucky, and Pennsylvania.

 

Consumer and Residential Real Estate Credit

 

Refer to the “Consumer Credit” section of our 2012 Form 10-K for our consumer credit underwriting and on-going credit management processes.

 

Credit Quality

 

Credit quality performance during the first three-month period of 2013 was consistent with our expectations. NPAs declined 21% compared to December 31, 2012 and NCOs during the first three-month period of 2013 were lower than 2012 quarterly levels. Also, the ACL coverage ratio of NPAs increased to 219% at March 31, 2013, compared with 169% at December 31, 2012.

 

NPAs

 

NPAs consist of loan participation interests in underlying loans that are no longer accruing interest. Any loan participation interest in our portfolio may be placed on nonaccrual status prior to the policies described below when collection of principal or interest is in doubt. Also, when a loan with a discharged non-reaffirmed debt in a Chapter 7 bankruptcy filing is identified and the loan is determined to be collateral dependent, the consumer loan participation interest is placed on nonaccrual status.

 

Underlying CRE loan participation interests are placed on nonaccrual status at 90-days past due. Underlying first-lien loan participation interests in consumer and residential real estate loans are placed on nonaccrual status at 150-days past due. Junior-lien loan participation interests in consumer and residential real estate loans are placed on nonaccrual status at the earlier of 120-days past due or when the related first-lien loan has been identified as nonaccrual.

 

For all classes in all portfolios, when a loan is placed on nonaccrual status, any accrued interest income is reversed with current year accruals charged to interest income, and prior year amounts charged-off as a credit loss. When, in Management’s judgment, the borrower’s ability to make required principal and interest payments has resumed and collectability is no longer in doubt, the loan participation interest is returned to accrual status.

 

The following table shows NPAs at the end of the most recent five quarters:

 

Table 4 - Quarterly Nonperforming Assets

 

    2013     2012  
(dollar amounts in thousands)   March 31,     December 31,     September 30,     June 30,     March 31,  
                               
Participation interest in nonaccrual assets:                                        
Commercial real estate   $ 18,707     $ 27,901     $ 24,965     $ 22,764     $ 31,714  
Consumer and residential real estate     9,485       7,970       7,585       5,217       5,681  
Total nonperforming assets   $ 28,192     $ 35,871     $ 32,550     $ 27,981     $ 37,395  
Accruing loan participation interests past due 90 days or more   $ 1,233     $ 3,222     $ 2,767     $ 4,845     $ 2,318  
                                         
NPAs as a % of total loan participation interests     0.89 %     1.08 %     0.97 %     0.82 %     1.07 %
ALPL as a % of NPAs     216       166       191       220       189  
ACL as a % of NPAs     219       169       195       223       191  

 

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The $7.7 million, or 21%, decrease in total NPAs compared with December 31, 2012, was centered in the commercial real estate portfolio and primarily reflected payments and payoffs.

 

ACL

 

We maintain two reserves, both of which are available to absorb credit losses inherent in the loan participation interests portfolio: the ALPL and the AULPC. Together, these reserves constitute the total ACL. Additions to the ALPL and AULPC result primarily from the transfer of the ACL associated with purchased loan participation interests at Huntington’s carrying value between entities under common control.

 

The following table shows the activity in HPCI’s ALPL and AULPC for each of the last five quarters:

 

Table 5 - Allowance for Credit Loss Activity

 

    2013     2012  
(dollar amounts in thousands)   First     Fourth     Third     Second     First  
                               
ALPL balance, beginning of period   $ 59,451     $ 62,063     $ 61,509     $ 70,722     $ 83,772  
Allowance of loan participation interests acquired     2,223       3,190       5,787       6,675       4,942  
Net charge-offs:                                        
Commercial real estate     117       (3,035 )     (3,998 )     (2,970 )     (148 )
Consumer and residential real estate     (2,051 )     (1,395 )     (5,927 )     (1,609 )     (1,908 )
Total net charge-offs     (1,934 )     (4,430 )     (9,925 )     (4,579 )     (2,056 )
Provision (reduction in allowance) for loan participation interest losses     1,292       (1,372 )     4,692       (11,309 )     (15,936 )
ALPL balance, end of period   $ 61,032     $ 59,451     $ 62,063     $ 61,509     $ 70,722  
AULPC balance, beginning of period   $ 1,057     $ 1,322     $ 897     $ 845     $ 1,035  
Provision (reduction in allowance) for unfunded loan participation commitment losses     (233 )     (265 )     425       52       (190 )
AULPC balance, end of period   $ 824     $ 1,057     $ 1,322     $ 897     $ 845  
Total allowance for credit losses, end of period   $ 61,856     $ 60,508     $ 63,385     $ 62,406     $ 71,567  
                                         
ALPL as a % of total loan participation interests     1.92 %     1.79 %     1.85 %     1.79 %     2.03 %
ACL as a % of total loan participation interests     1.94       1.83       1.88       1.82       2.05  

 

The ACL increased $1.3 million to $61.9 million at March 31, 2013, compared with $60.5 million at December 31, 2012. Given the relatively absolute low level of the ACL, some degree of quarter-to-quarter volatility is expected. Management believes that our ACL is appropriate and its coverage level is reflective of the quality of the portfolio and the current operating environment.

 

NCOs

 

Any loan participation interest in any portfolio may be charged-off prior to the policies described below if a loss confirming event has occurred. Loss confirming events include, but are not limited to, bankruptcy (unsecured), continued delinquency, foreclosure, or receipt of an asset valuation indicating a collateral deficiency and that asset is the sole source of repayment. Additionally, discharged, collateral dependent non-reaffirmed debt in Chapter 7 bankruptcy filings will result in a charge-off to estimated collateral value, less selling costs.

 

CRE loan participation interests are either charged-off or written down to net realizable value at 90-days past due. First-lien consumer and residential real estate loan participation interests are charged-off to the estimated fair value of the collateral, less anticipated selling costs, at 150-days past due. Junior-lien consumer and residential real estate loan participation interests are charged-off to the estimated fair value of the collateral, less anticipated selling costs, at 120-days past due.

 

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The table below reflects NCO detail for each of the last five quarters:

 

Table 6 - Net Charge-offs (1)

 

    2013     2012  
(dollar amounts in thousands)   March 31,     December 31,     September 30,     June 30,     March 31,  
                                                             
Commercial real estate   $ (117 )     (0.02 )%   $ 3,035       0.41 %   $ 3,998       0.53 %   $ 2,970       0.39 %   $ 148       0.02 %
Consumer and residential real estate     2,051       1.91       1,395       1.52       5,927       6.46       1,609       1.64       1,908       1.81  
Total net charge-offs   $ 1,934       0.24 %   $ 4,430       0.54 %   $ 9,925       1.17 %   $ 4,579       0.53 %   $ 2,056       0.23 %

 

(1) Percentages represent the annualized percentage of related average loan participation interests.

 

2013 first quarter NCOs decreased $0.1 million, or 6%, compared to the year-ago quarter. Given the relatively low absolute level of NCOs and the uncertain and uneven nature of the economic recovery, some degree of volatility on a quarter-to-quarter basis is expected.

 

Market Risk

 

Market risk represents the risk of loss due to changes in market values of assets and liabilities. We incur market risk in the normal course of business through exposures to market interest rates as changes can have a significant impact on reported earnings. The interest rate risk process is designed to compare income simulations in market scenarios designed to alter the direction, magnitude, and speed of interest rate changes, as well as the slope of the yield curve. If there is a decline in market interest rates, we may experience a reduction in interest income from our loan participation interests and a corresponding decrease in funds available to be distributed to shareholders. When rates rise, we are exposed to declines in the economic value of equity since approximately 24% of our loan participation portfolio is fixed rate.

 

INCOME SIMULATION AND ECONOMIC VALUE ANALYSIS

 

Huntington conducts its monthly interest rate risk management on a centralized basis and does not manage our interest rate risk separately.

 

Huntington uses two approaches to model interest rate risk: Interest Sensitive Earnings at Risk (ISE analysis) and Economic Value of Equity (EVE analysis). Under ISE analysis, net interest income is modeled utilizing various assumptions for assets, liabilities, and derivative positions under various interest rate scenarios over a one year time horizon. Market implied forward rates and various likely and extreme interest rate scenarios are used for ISE analysis. These likely and extreme scenarios include rapid and gradual interest rate ramps, rate shocks and yield curve twists. Under EVE analysis, the economic value of financial assets, liabilities and off-balance sheet instruments, is derived through the discounting of cash flows based on actual rates at the end of the period. The economic value of equity is calculated as the difference between the estimated market value of assets and liabilities, net of the impact of off-balance sheet instruments.

 

The ISE analysis used in the following table reflects the analysis used monthly by management. It models gradual -25, +100 and +200 basis point parallel shifts in market interest rates over the next one-year period, beyond the interest rate change implied by the forward yield curve. Due to the current low level of interest rates, the analysis uses a declining interest rate scenario of 25 basis points.

 

The table below shows the results of these scenarios as of March 31, 2013:

 

Table 7 - Interest Income Sensitivity

 

    Change in Interest Income for a Given  
    Change in Interest Rates  
(dollar amounts in millions)   Over / (Under) Base Case Parallel Ramp  
Basis point change scenario     -25       +100        +200   
March 31, 2013                        
Net interest income   $ -1.7     $ 7.0     $ 14.0  
Percentage change     -1.8 %     7.4 %     14.9 %

 

(1) The gradual 25 basis point decline in market rates over the next 12-month period assumes market interest rates would reach a bottom and not fall below historical levels.

 

The EVE analysis used in the following table reflects the analysis used monthly by management. It models immediate -25, +100 and +200 basis point parallel shifts in market interest rates. The EVE at risk shows that as interest rates increase (decrease) immediately, the value of the net equity position will decrease (increase), due to the relatively long duration of loan participation interests. When interest rates rise, assets lose economic value; the longer the duration, the greater the value lost. The opposite is true when interest rates fall. Due to the current low level of interest rates, the analysis uses a declining interest rate scenario of 25 basis.

 

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The table below shows the results of these scenarios as of March 31, 2013:

 

Table 8 - Economic Value Sensitivity

 

    Change in Economic Value for a Given  
    Change in Interest Rates  
(dollar amounts in millions)   Over / (Under) Base Case Parallel Shocks  
Basis point change scenario     -25       +100        +200   
March 31, 2013                        
Fair value of loan participation interests   $ 4.0     $ -19.0     $ -40.9  
Percentage change     0.1 %     -0.6 %     -1.3 %

 

The 25 basis point decline in market rates over the next 12-month period assumes market interest rates would reach a bottom and not fall below historical levels.

 

Off-Balance Sheet Arrangements

 

Under the terms of the Agreements, we are obligated to make funds or credit available to the Bank, either directly or indirectly through Holdings so that the Bank may extend credit or pay letters-of-credit issued for the account of any borrowers, to the extent provided in the loan agreements underlying our participation interests. At March 31, 2013 and December 31, 2012, HPCI’s unfunded loan participation interest commitments totaled $219.4 million and $273.4 million, respectively. It is expected that the existing cash balances and cash flows generated by the existing portfolio will be sufficient to meet these obligations.

 

Liquidity And Capital Resources

 

The objective of our liquidity management is to ensure the availability of sufficient cash flows to fund our existing loan participation commitments, to acquire additional participation interests, and to pay operating expenses and dividends. Unfunded commitments and additional participation interests in loans are funded with the proceeds from repayment of principal balances by individual borrowers, utilization of existing cash and cash equivalent funds, and if necessary, new capital contributions. Payment of operating expenses and dividends will be funded through cash generated by operations.

 

In managing liquidity, we take into account forecasted principal and interest payments on loan participations as well as various legal limitations placed on a REIT. To the extent that additional funding is required, we may raise such funds through retention of cash flow, debt financings, additional equity offerings, or a combination of these methods. However, any cash flow retention must be consistent with the provisions of the IRC requiring the distribution by a REIT of at least 90% of its REIT taxable income, excluding capital gains, and must take into account taxes that would be imposed on undistributed income.

 

At March 31, 2013 and December 31, 2012, we maintained cash and interest-bearing balances with the Bank totaling $254.4 million and $719.2 million, respectively . During the 2013 first quarter, we paid common stock dividends and the return of capital to common shareholders totaling $500.0 million. We maintain and transact all of our cash activity with the Bank and may invest available funds in Eurodollar deposits with the Bank for a term of not more than 30 days at market rates.

 

At March 31, 2013 , we had no material liabilities or contractual obligations, other than unfunded loan participation interest commitments of $219.4 million, with a weighted average remaining maturity of 1.6 years. In addition to anticipated cash flows, we have cash and interest bearing balances with the bank totaling $254.4 million to supplement the funding of these liabilities and contractual commitments.

 

As of March 31, 2013 and December 31, 2012, shareholders’ equity was $3.4 billion.

 

Regulatory approval is required prior to the Bank’s declaration of any dividends in excess of available retained earnings. Based on a regulatory dividend limitation, the Bank could not have declared and paid a dividend at March 31, 2013 without regulatory approval. As a subsidiary of the Bank, HPCI is also restricted from declaring or paying dividends to non-bank subsidiaries or outside shareholders without regulatory approval. There can be no assurance that regulatory approval will be granted for future dividends.

 

Regulatory capital ratios are the primary metrics used by regulators in assessing the safety and soundness of banks. At March 31, 2013, Huntington and the Bank met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions. The capital ratios for Huntington and the Bank at the end of the most recent five quarters are as follows:

 

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Table 9 - Regulatory Capital Ratios

 

    2013     2012  
    March 31,     December 31,     September 30,     June 30,     March 31,  
Tier 1 leverage ratio (5.00% Well-capitalized)                                        
Huntington     10.57 %     10.36 %     10.29 %     10.34 %     10.55 %
Bank     9.38       9.05       8.68       8.42       8.24  
Tier 1 risk-based capital ratio (6.00% Well-capitalized)                                        
Huntington     12.16       12.02       11.88       11.93       12.22  
Bank     10.79       10.49       10.03       9.70       9.54  
Total risk-based capital ratio (10.00% Well-capitalized)                                        
Huntington     14.55       14.50       14.36       14.42       14.76  
Bank     12.77       12.78       12.52       12.41       12.49  

 

In June 2012, the FRB, OCC, and FDIC (collectively, the Agencies) each issued NPRs that would revise and replace the Agencies’ current capital rules to align with the BASEL III capital standards and meet certain requirements of the Dodd-Frank Act.  Certain requirements of the NPRs would establish more restrictive capital definitions, higher risk-weightings for certain asset classes, capital buffers and higher minimum capital ratios. The NPRs were in a comment period through October 22, 2012, and those comments are currently being evaluated by the Agencies. In late 2012, the Agencies announced that implementation of the BASEL III requirements would be delayed as certain aspects of the NPRs were to be enacted in 2013.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Quantitative and qualitative disclosures for the current period can be found in the Market Risk section of this report, which includes material changes in market risk exposures from disclosures presented in HPCI's Form 10-K.

 

Item 4. Controls and Procedures

 

HPCI maintains disclosure controls and procedures designed to ensure that the information disclosed in its filings with the Securities and Exchange Commission is recorded, processed, summarized, and reported appropriately and on a timely basis. HPCI's management, with the participation of its President (principal executive officer) and the Vice President (principal financial officer), evaluated the effectiveness of HPCI’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon such evaluation, HPCI's President and Vice President have concluded that, as of the end of such period, HPCI's disclosure controls and procedures are effective.

 

There have not been any changes in HPCI’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2013, to which this report relates, that have materially affected, or are reasonably likely to materially affect, HPCI's internal control over financial reporting.

 

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 1A: Risk Factors

 

Information required by this item is set forth in Part 1 Item 2- Management’s Discussion and Analysis of Financial Condition and Results of Operations of this report and incorporated herein by reference.

 

Item 6. Exhibits

 

This report incorporates by reference the documents listed below that HPCI has previously filed with the SEC. The SEC allows incorporation by reference in this document. The information incorporated by reference is considered to be a part of this document, except for any information that is superseded by information that is included directly in this document.

 

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This information may be read and copied at the Public Reference Room of the SEC at 100 F Street, N.E., Washington, D.C. 20549. The SEC also maintains an Internet web site that contains reports, proxy statements, and other information about issuers, like HPCI, who file electronically with the SEC. The address of the site is http://www.sec.gov . The reports and other information filed by HPCI with the SEC are also available at Huntington’s Internet web site. The address of the site is http://www.huntington.com . Except as specifically incorporated by reference into this Quarterly Report on Form 10-Q, information on those web sites is not part of this report. Reports, proxy statements, and other information about HPCI can also be inspected at the offices of the NASDAQ National Market at 33 Whitehall Street, New York, New York.

 

3.1. Second Amended and Restated Articles of Incorporation (previously filed as Exhibit 3.1 to Current Report on Form 8-K (File No. 000-33243), filed with the Securities and Exchange Commission on November 2, 2010, and incorporated herein by reference.)

 

3.2. Code of Regulations (previously filed as Exhibit 3(b) to the Registrant's Registration Statement of Form S-11 (File No. 333-61182), filed with the Securities and Exchange Commission on May 17, 2001, and incorporated herein by reference.)

 

4.1 Specimen of certificate representing Class C preferred securities, previously filed as Exhibit 4 to the Registrant's Amendment No. 1 to Registration Statement of Form S-11 (File No. 333-61182), filed with the Securities and Exchange Commission on May 31, 2001, and incorporated herein by reference.

 

31.1. Rule 13a – 14(a) Certification – President (chief executive officer).

 

31.2. Rule 13a – 14(a) Certification – Vice President (chief financial officer).

 

32.1. Section 1350 Certification – President (chief executive officer).

 

32.2. Section 1350 Certification – Vice President (chief financial officer).

 

99.1. Unaudited Condensed Consolidated Financial Statements of Huntington Bancshares Incorporated as of and for the three-month periods ended March 31, 2013 and 2012.

 

101** The following material from HPCI’s Form 10-Q Report for the quarterly period ended March 31, 2013, formatted in XBRL: (i) Unaudited Condensed Balance Sheets, (ii) Unaudited Condensed Statements of Comprehensive Income, (iii) Unaudited Condensed Statements of Changes in Shareholders’ Equity, (iv) Unaudited Condensed Statements of Cash Flows, and (v) the Notes to Unaudited Condensed Financial Statements.

 

** Furnished, not filed.  

  

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SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) 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, on the 13th day of May, 2013.

 

HUNTINGTON PREFERRED CAPITAL, INC.

(Registrant)

 

By: /s/ Donald R. Kimble   By: /s/ David S. Anderson
  Donald R. Kimble     David S. Anderson
  President and Director     Vice President and Director
  (Principal Executive Officer)     (Principal Financial and Accounting Officer)

  

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