|• FORM 10-Q • EXHIBIT 31.1 • EXHIBIT 31.2 • EXHIBIT 32.1 • EXHIBIT 32.2 • EXHIBIT 99.1 • XBRL INSTANCE DOCUMENT • XBRL TAXONOMY EXTENSION SCHEMA • XBRL TAXONOMY EXTENSION CALCULATION LINKBASE • XBRL TAXONOMY EXTENSION DEFINITION LINKBASE • XBRL TAXONOMY EXTENSION LABEL LINKBASE • XBRL TAXONOMY EXTENSION PRESENTATION LINKBASE|
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
QUARTERLY PERIOD ENDED June 30, 2012
Commission File Number 000-33243
Huntington Preferred Capital, Inc.
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):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
As of July 31, 2012, 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.
Glossary of Acronyms and Terms
The following listing provides a comprehensive reference of common acronyms and terms used throughout the document:
Part 1. FINANCIAL INFORMATION
Item 1. Financial Statements
Huntington Preferred Capital, Inc.
Condensed Balance Sheets
See notes to unaudited condensed financial statements.
Huntington Preferred Capital, Inc.
Condensed Statements of Comprehensive Income
(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.
Huntington Preferred Capital, Inc.
Condensed Statements of Changes in Shareholders' Equity
See notes to unaudited condensed financial statements.
Huntington Preferred Capital, Inc.
Condensed Statements of Cash Flows
See notes to unaudited condensed financial statements.
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 June 30, 2012, the Bank, on a consolidated basis with its subsidiaries, accounted for over 99% of Huntington’s consolidated total assets and 98% 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, 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 Securities and Exchange Commission (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 HPCI’s Annual Report on Form 10-K for the year ended December 31, 2011 (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. 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, is not subject to federal income taxes. All of HPCI’s common stock is owned by affiliates; therefore, net income per common share information is not presented.
ASU 2011-04 — Fair Value Measurement (Topic 820), Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The ASU amends Topic 820 to add both additional clarifications to existing fair value measurement and disclosure requirements and changes to existing principles and disclosure guidance. Clarifications were made to the relevancy of the highest and best use valuation concept, measurement of an instrument classified in an entity’s shareholder’s equity and disclosure of quantitative information about the unobservable inputs for level 3 fair value measurements. Changes to existing principles and disclosures included measurement of financial instruments managed within a portfolio, the application of premiums and discounts in fair value measurement, and additional disclosures related to fair value measurements. The updated guidance and requirements are effective for financial statements issued for the first interim or annual period beginning after December 15, 2011, and should be applied prospectively. The amendments did not have a material impact on HPCI’s Unaudited Condensed Financial Statements.
ASU 2011-05 — Other Comprehensive Income (Topic 220), Presentation of Comprehensive Income. The ASU amends Topic 220 to require an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. An entity is also required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. The amendments do not change items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income, only the format for presentation. The updated guidance and requirements are effective for financial statements issued for the fiscal years, and the interim periods within those years, beginning after December 15, 2011. The amendments should be applied retrospectively. The amendment did not have a material 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 June 30, 2012, and December 31, 2011, loan participation interests were comprised of the following:
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.
As defined by regulatory guidance, there were no underlying loans outstanding that would be considered a concentration of lending in any particular industry, group of industries, or business activity. Underlying loans were, however, generally collateralized by real estate. Loans made to borrowers in the five states of Ohio, Michigan, Indiana, Pennsylvania, and Kentucky comprised approximately 94% and 93% of the portfolio at June 30, 2012, and December 31, 2011, respectively.
Loan Participation Interest Purchases and Sales
The following table summarizes significant portfolio purchase activity during the three-month and six-month periods ended June 30, 2012 and 2011:
There were no significant portfolio loan participation interest sales during either the three-month or six-month periods ended June 30, 2012 and 2011.
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. 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 entirely against principal until the loan has been collected in full, after which time any additional cash receipts are recognized as interest income.
Regarding all classes within all portfolios, 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 June 30, 2012, and December 31, 2011:
The following table presents an aging analysis of loan participation interests, including past due loan participation interests, by loan class at June 30, 2012, and December 31, 2011: (1)
(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 directly 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 under ASC 310-10, specific reserves related to loan participation interests considered to be impaired, and loan participation interests involved in TDRs allocated under 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 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 second-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 needed.
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.
No substantial changes to any material aspect of the overall approach in the determination of either the ALPL or AULPC were made during the current quarter, and 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 and six-month periods ended June 30, 2012 and 2011:
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.
CRE loan participation interests are either charged-off or written down to net realizable value at 90-days past due. First-lien and 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 150-days past due and 120-days past due, respectively.
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 = Potentially weak loan participation interests. 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.
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 participation interest and subsequently 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 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 lower credit risk.
The following table presents loan participation interest balances by credit quality indicator as of June 30, 2012, and December 31, 2011:
(1) Reflects currently updated customer credit scores.
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.
When a loan participation interest in any class has been determined to be impaired, the 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 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 June 30, 2012, and December 31, 2011: (1)
(1) No loans with deteriorated credit quality, as defined by ASC 310-30, have been acquired.
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 June 30, 2012, and December 31, 2011: (1), (2), (5)
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. All loan modifications, including those classified as TDRs, are reviewed and approved by the Bank’s Special Assets Division. The types of concessions provided to borrowers include:
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 and six-month periods ended June 30, 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 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.
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 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.
TDR concessions and classification may reduce the ALPL within certain classes, specifically the CRE portfolio. The reduction is derived from the type of concessions given to the borrowers and the resulting application of the transaction reserve calculation within the ALPL. TDRs may include multiple concessions and the disclosure classifications are based on the primary concession provided to the borrower. The majority of our concessions for CRE loan participations during the period are situations in which the maturity date is extended which is normally coupled with an increase in the interest rate (in these cases, the primary concession is the maturity date extension).
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 transaction reserve is measured based on the estimation of the probable discounted future cash flows expected to be collected on the modified loan in accordance with ASC 310-10. The resulting TDR ALPL calculation often results in a minimal or zero ALPL amount because (1) it is probable all cash flows will be collected and, (2) due to the rate increase, the discounting of the cash flows on the modified loan participation interest, using the pre-modification interest rate, exceeds the carrying value of the loan participation interest.
However, TDR concessions and classification may increase the ALPL to certain loan participation interests, such as consumer and residential real estate loans. The concessions made to these loan participation interests 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 probable discounted cash flows expected to be collected on the modified loan in accordance with ASC 310-10. The resulting TDR ALPL calculation often results in a higher ALPL amount because (1) it may not be probable all cash flows will be collected and, (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 it is not probable that all cash flows will be collected.
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 net change in ALPL resulting from the TDR modification for the three-month and six-month periods ended June 30, 2012:
All classes within the CRE portfolios are considered as payment redefaulted at 90-days past due. First-lien and junior-lien consumer and residential real estate loan participation interests are considered as payment redefaulted at 150-days past due and 120-days past due, respectively.
During the three-month and six-month periods ended June 30, 2012, there were no TDRs in any class of any portfolio with payment redefaults which had been modified within the previous twelve months.
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 $1.6 million and $1.8 million for the three-month periods ended June 30, 2012 and 2011, respectively. For the six-month periods ended June 30, 2012 and 2011, the costs were $3.2 million and $3.5 million, respectively.
In 2012 and 2011, the annual servicing rates the Bank charged with respect to outstanding principal balances were:
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 June 30, 2012 and 2011, and are included in other noninterest expense. Personnel costs for each of the respective six-month periods, was $0.2 million.
The following table represents the ownership of HPCI’s outstanding common and preferred securities as of June 30, 2012:
As of June 30, 2012, 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 June 30, 2012, HPCI board members and executive officers beneficially owned, in the aggregate, a total of 7,471 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 then 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, with prior consent of the OCC.
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 $25.8 million and $40.4 million at June 30, 2012 and December 31, 2011, respectively. 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 June 30, 2012, HPCI identified the following loan participation interests where the carrying value exceeded the fair value of the underlying collateral for the loan. The fair value impairment for the six-month period ended June 30, 2012, was recorded within the provision for credit losses.
There were no changes in the valuation techniques or related inputs used to measure similar assets in prior periods.
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 June 30, 2012 and December 31, 2011 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 June 30, 2012, the net carrying amount of $3.4 billion corresponded to a fair value of $3.0 billion. As of December 31, 2011, the net carrying value of $3.5 billion corresponded to a fair value of $3.2 billion. All amounts at June 30, 2012 and December 31, 2011 are classified as Level 3 in the valuation hierarchy. At June 30, 2012, the valuation of the loan portfolio reflected discounts that HPCI believed are consistent with transactions occurring in the marketplace.
Note 6 - Commitments and Contingencies
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, limited to $3.9 billion as of June 30, 2012, based on the Bank’s holdings of FHLB stock. As of this same date, the Bank had exposure of $0.8 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 $1.0 billion as of June 30, 2012, 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 $0.3 billion at June 30, 2012. In 2012, 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 and $0.4 million for the three-month periods ended June 30, 2012 and 2011, respectively, as compensation for making such assets available to the Bank. The amounts paid to HPCI for the six-month periods ended June 30, 2012 and 2011 were $0.6 million and $0.8 million, respectively.
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 June 30, 2012 and December 31, 2011, HPCI’s unfunded loan participation interest commitments totaled $221.5 million and $233.4 million, respectively.
Based on a regulatory dividend limitation the Bank could not have declared and paid a dividend at June 30, 2012, 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. The OCC has approved the payment of HPCI's dividends on its preferred securities throughout 2011 and through the 2012 third quarter. For the foreseeable future, management intends to request approval for any future dividend; however, there can be no assurance that the OCC will approve 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.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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 Form 10-K should be read in conjunction with this interim MD&A.
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, and timing of governmental actions and reforms, including the Dodd-Frank Act, as well as future regulations which will be adopted by the relevant regulatory agencies, including the newly created CFPB, to implement the Dodd-Frank Act’s provisions. Additional factors that could cause results to differ materially from those described above can be found in our 2011 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.
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 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 2011 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.
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 2011 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 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 June 30, 2012, 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 2011, 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 June 30, 2012, 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 $18.6 million, or 72%, increase in net income for the 2012 second quarter, compared with same period in 2011, was primarily the result of lower provision expense as the current quarter recorded a reduction in allowance for credit losses of $11.3 million compared to provision for credit losses of $9.3 million in the year-ago quarter.
Table 1 - Selected Quarterly Income Statement Data
(1)All of HPCI's common stock is owned by HPCII and Holdings and, therefore, net income per share is not presented.
The following table details the results of operations for the six-month periods ended June 30, 2012 and 2011. The $17.3 million increase in net income for the first six-month period of 2012, compared to the same period in 2011, was primarily the result of a $20.3 million increase of the reduction in allowance for credit losses, partially offset by lower interest income.
Table 2 - Selected Year to Date Income Statement Data
(1)All of HPCI's common stock is owned by HPCII and Holdings therefore net income per share is not presented.
Interest and Fee Income
Our primary source of revenue is interest and fee income on our participation interests in loans. At June 30, 2012 and 2011, 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 and six-month periods ended June 30, 2012 and 2011:
Table 3 - Quarterly Interest and Fee Income
(1)Income includes interest and fees.
(2)For the purposes of this analysis, average balances include nonaccrual loans.
Table 4 - Year-To-Date Interest and Fee Income
(1)Income includes interest and fees.
(2)For the purposes of this analysis, average balances include nonaccrual loans.
Interest and fee income was $34.5 million for the 2012 second quarter compared with $36.5 million for the year ago quarter. As shown in Table 3, the decrease in interest and fee income was primarily the result of a decrease in yields on loan participation interests. In the 2012 second quarter, the loan yield decreased 16 basis points to 3.97%, while average loan participation interest balances decreased $55.8 million, or 2% compared to the year-ago quarter.
For the six-months ended June 30, 2012 and 2011, interest and fee income was $70.1 million and $73.2 million, respectively. As shown in Table 4, the decrease in interest and fee income was primarily the result of a decrease in yields on loan participation interests. In the first six-month period of 2012, the loan yield decreased 19 basis points to 4.00% compared to the year-ago period, while average loan participation interest balances were essentially unchanged.
At June 30, 2012, and December 31, 2011, approximately 78% and 75%, 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 HPCI having to record a provision expense for ALPL. 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.
Such adjustments in the 2012 second quarter resulted in a reduction in allowance for credit losses of $11.3 million compared to a provision for credit losses of $9.3 million in the year-ago quarter. On a year-to-date basis, the first six-month period of 2012 recorded a reduction in allowance for credit losses of $27.4 million compared to a reduction in allowance for credit losses of $7.1 million in the comparable year-ago period. See ACL discussion within the Credit Quality section.
Noninterest Income and Noninterest Expense
Noninterest income for the 2012 second quarter was $0.3 million compared with $0.4 million in the year-ago quarter. Noninterest income for the first six-month period of 2012 was $0.7 million, compared with $0.9 million in the year-ago period. Noninterest income includes fees from the Bank for use of our assets as collateral for the Bank’s advances from the FHLB. For the 2012 second quarter, these fees totaled $0.3 million, compared with $0.4 million for the prior year quarter. For the first six-month period of 2012 and 2011, these fees totaled $0.6 million and $0.8 million, respectively. 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 2012 second quarter was $1.8 million compared with $1.9 million in the year-ago quarter. For the six-month periods ended June 30, 2012 and 2011, noninterest expense was $3.6 million and $3.9 million, respectively. The predominant component of noninterest expense is the fee paid to the Bank for servicing the loans underlying the participation interests. For the 2012 second quarter, servicing costs amounted to $1.6 million, compared with $1.8 million for the year-ago quarter. The servicing costs for the six-month periods ended June 30, 2012 and 2011, totaled $3.2 million and $3.5 million, respectively. The decrease in the servicing costs from the comparable periods reflected lower residential real estate and consumer loan balances which have higher servicing costs. The annual servicing rates the Bank charged with respect to outstanding principal balances in 2012 and 2011 were:
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 the 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.
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 income taxes for three-month and six-month periods of 2012 and 2011.
We are included in certain of Huntington’s consolidated state income and franchise tax returns. On March 8, 2012, our 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 consolidated state tax provision will be allocated to its separate subsidiary companies, including us, on the basis of separate return computations. Under its tax-sharing agreement with Huntington, we will provide and remit state taxes to or receive a state tax benefit from Huntington or the tax paying member. For the first six-month periods of 2012 and 2011, we had no state provision for income taxes.
RISK MANAGEMENT AND CAPITAL
Risk awareness, identification and assessment, reporting, and active management are key elements to 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 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.
(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 significant change in the economic conditions and the resulting changes in borrower behavior over the past several years resulted in the focusing of significant resources to the identification, monitoring, and managing of credit risk. 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 June 30, 2012, CRE loan participation interests were 89% of total loan participation interests compared with 88% at December 31, 2011. Total consumer and residential real estate loan participation interests were 11% of total loan participation interests at June 30, 2012, compared with 12% at December 31, 2011. The change in the portfolio mix over the past six months reflects not purchasing any new consumer and residential real estate loan participation interests during this period.
Commercial Real Estate Credit
CRE loan credit approvals are made by the Bank and are based on, among other factors, the financial strength of the borrower, assessment of the borrower’s management capabilities, appraised collateral value, industry sector trends, type of exposure, transaction structure, and the general economic outlook.
In commercial lending, on-going credit management is dependent on the type and nature of the loan. The Bank monitors all significant credit extensions on an on-going basis. All commercial credit extensions are assigned internal risk ratings reflecting the borrower’s PD and LGD (severity of loss). This two-dimensional rating methodology provides granularity in the portfolio management process. The PD is rated and applied at the borrower level. The LGD is rated and applied based on the type of credit extension and the quality and lien position associated with the underlying collateral. The internal risk ratings are assessed at origination and updated with each periodic monitoring event. There is also extensive macro portfolio management analysis on an on-going basis. The Bank continually reviews and adjusts the risk-rating criteria based on actual experience, which provides the current risk level in the portfolio, and is the basis for determining an appropriate ACL amount for the portfolio.
In addition to the initial credit analysis initiated during the approval process, the Bank’s Credit Review group performs testing to provide an independent review and assessment of the quality and / or risk of new loan originations. This group is part of the Bank’s Risk Management area, and conducts portfolio reviews on a risk-based cycle to evaluate individual loans, validate risk ratings, as well as test the consistency of credit processes.
The standardized loan grading system considers many components that directly correlate loan quality and likelihood of repayment, one of which is guarantor support. On an annual basis, or more frequently if warranted, we consider, among other things, the guarantor’s reputation and creditworthiness, along with various key financial metrics such as liquidity and net worth, assuming such information is available. Our assessment of the guarantor’s credit strength, or lack thereof, is reflected in the risk ratings for such loans. The risk ratings are directly tied to, and an integral component of, the ALPL methodology. When a loan participation interest goes to impaired status, viable guarantor support is considered in the determination of the recognition of loan participation interest loss. If the assessment of the guarantor’s credit strength yields an inherent capacity to perform, we will seek repayment from the guarantor as part of the collection process and have done so successfully. However, the repayment success from guarantors is not formally tracked.
Substantially all CRE loans categorized as Classified (see Note 3 of Notes to Unaudited Condensed Financial Statements) are managed by the Bank’s SAD. The SAD is a specialized credit group that handles the day-to-day management of workouts, commercial recoveries, and problem loan sales. Its responsibilities include developing action plans, assessing risk ratings, and determining the appropriateness of the allowance, the accrual status, and the ultimate collectability of the Classified loan participation interest portfolio.
The CRE portfolio is diversified by customer size, as well as geographically throughout the Bank’s footprint. 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 June 30, 2012, were as follows:
Table 5 - Commercial Real Estate Loan Participation Interests by Property Type and Borrower Location
As shown in the table above, we had $3.0 billion of CRE loan participation interests at June 30, 2012. 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
Consumer credit approvals by the Bank are based on, among other factors, the financial strength and payment history of the borrower, type of exposure, and the transaction structure. Consumer credit decisions are generally made in a centralized environment utilizing decision models.
The consumer and residential real estate portfolio is primarily located throughout the Bank’s geographic footprint. The continued stress on home prices has caused the performance in this portfolio to remain weaker than historical levels.
Credit quality performance during the first six-month period of 2012, reflected overall continued improvement. NPAs and commercial Criticized loan participation interests declined 46% and 130%, respectively, compared to December 31, 2011 and NCOs during the first six-month period of 2012 were lower than 2011 levels. Also, the ACL coverage ratio of NPAs increased to 223% at June 30, 2012, compared with 164% at December 31, 2011, and 160% at June 30, 2011.
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.
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.