SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
Commission file Number 000-33243
HUNTINGTON PREFERRED CAPITAL, INC.
(Exact name of registrant as specified in its charter)
OHIO 31-1356967
---- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
HUNTINGTON CENTER, 41 S. HIGH STREET, COLUMBUS, OH 43287
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (614) 480-8300
--------------
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
NONCUMULATIVE EXCHANGEABLE PREFERRED SECURITIES, CLASS C (LIQUIDATION AMOUNT
----------------------------------------------------------------------------
$25.00 EACH)
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(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. [X] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). [ ] Yes [X] No
All common stock is held by affiliates of the registrant as of December 31,
2002. As of March 28, 2003, 14,000,000 shares of common stock without par value
were outstanding. The aggregate market value of the common stock held by
non-affiliates of the registrant as of the close of business on June 28, 2002:
$0.00
Documents Incorporated By Reference
Part III of this Form 10-K incorporates by reference certain information
from the registrant's definitive Information Statement for the 2003 Annual
Shareholders' Meeting.
HUNTINGTON PREFERRED CAPITAL, INC.
INDEX
Part I.
Item 1. Business 3
Item 2. Properties 18
Item 3. Legal Proceedings 18
Item 4. Submission of Matters to a Vote of Security Holders 18
Part II.
Item 5. Market for Registrant's Common Equity and Related Shareholder Matters 19
Item 6. Selected Financial Data 19
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 20
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 30
Item 8. Financial Statements and Supplementary Data 30
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 45
Part III.
Item 10. Directors and Executive Officers of the Registrant 45
Item 11. Executive Compensation 45
Item 12. Security Ownership of Certain Beneficial Owners and Management 45
Item 13. Certain Relationships and Related Transactions 45
Item 14. Controls and Procedures 45
Part IV.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 46
Signatures 47
Certifications 48-49
Exhibits 50-51
HUNTINGTON PREFERRED CAPITAL, INC.
Part I
ITEM 1: BUSINESS
GENERAL
Huntington Preferred Capital, Inc. (HPCI) is an Ohio company incorporated
in July 1992 under the name Airbase Realty, Inc. The name was changed to
Huntington Preferred Capital, Inc. in May 2001. HPCI's principal business
objective is to acquire, hold, and manage real estate assets and other
authorized investments that will generate net income for distribution to its
shareholders. Since May 1998, HPCI has been operating as a real estate
investment trust (REIT) for federal income tax purposes. HPCI has one wholly
owned subsidiary, HPCLI, Inc. (HPCLI), an Ohio corporation, which holds certain
non-interest-earning assets. At December 31, 2002, these assets amounted to
$37.3 million. The following chart outlines the relationship among affiliated
entities at December 31, 2002.
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| Huntington Bancshares Incorporated |
--------------------------------------------
|
------------------------------------|-----------------------
| | | |
| 100% Common | | |100% Common
- -------------------------------- | | -----------------------
| The Huntington | | | | HPC Holdings-II, |
| National Bank | | | | Inc. |
- -------------------------------- | | -----------------------
| | | 0.09% | |
| | 99.91% Common | Common | | 00% B Preferred
| ------------------- | |
| | | | Public & Private Preferred
| | | | | Shareholders
| | | | |
| ------------------------- | | |
| | Huntington Preferred | | 0.13% Common | | 10.9% A Preferred
| |Capital Holdings, Inc. | | | | 100% C Preferred
| ------------------------- | | |
| | | | |
| 10% Common | 100% Common | | |
| | | | |
| ------------------------- | | |
| |HPC Holdings-III, Inc. | | | |
| ------------------------- | | |
| | | | |
| 90% Common | 67.37% Common | | |
| | 89.1% A Preferred | | |
| | 100% D Preferred* | | |
| | | | |
- -------------------------- | | | |
| Huntington Preferred | | | | |
| Capital II, Inc. | | | | |
- -------------------------- | | | |
| | | | |
| 32.5% Common | | | |
---------------------------------------------------------------------------------------
-----------------------
|Huntington Preferred |
| Capital, Inc. |
-----------------------
|
| 100% Common
-----------------------
| HPCLI, Inc. |
-----------------------
- --------
*HPCH-III may sell to third party investors at some future date.
3
HPCI is a subsidiary of HPC Holdings-III, Inc. (HPCH-III), a Nevada corporation.
HPCH-III is a subsidiary of Huntington Preferred Capital Holdings, Inc.
(Holdings), an Indiana corporation that is consolidated as a subsidiary of The
Huntington National Bank (the Bank). The Bank is an interstate national banking
association organized under the laws of the United States and headquartered in
Columbus, Ohio. The Bank is the only bank subsidiary of Huntington Bancshares
Incorporated (Huntington). The Bank owns 99.91% of the outstanding shares of
Holdings and Huntington owns the remaining 0.09%. HPCH-III owns 67.37% of HPCI's
common shares, 89.1% of HPCI's Class A preferred securities, and 100% of HPCI's
Class D preferred securities. Huntington Preferred Capital II, Inc. (HPCII) owns
32.5% of HPCI's common shares while Huntington owns the remaining portion. The
remaining portion of HPCI's Class A preferred securities are restricted and
owned by past and present employees of Huntington. HPCI's Class B preferred
securities are owned by HPC Holdings-II, Inc., a non-bank subsidiary of
Huntington. All of HPCI's Class C preferred securities were sold to Holdings,
which were subsequently sold by Holdings to the public in an underwritten public
offering that closed on November 7, 2001.
HPCI's Class B, Class C, and Class D preferred securities will be exchanged,
without any approval or action on the part of the security holders, for Class B,
Class C, and Class D preferred securities of the Bank, if such an exchange is
directed by the Office of the Comptroller of the Currency (OCC) in the event the
Bank becomes, or may in the near term become, undercapitalized or if the Bank is
placed in conservatorship or receivership. The preferred securities of the Bank
have substantially equivalent terms as to dividends, liquidation preference, and
redemption as to the preferred securities of HPCI. At December 31, 2002, the
Bank's net loans and total deposits were $20.5 billion and $18.1 billion,
respectively, compared with Huntington's net loans of $20.6 billion and total
deposits of $17.5 billion. Total assets for Huntington were $27.6 billion
compared with $27.5 billion for the Bank at the end of 2002. Net income for 2002
was $356.0 million for the Bank versus $363.2 million for Huntington. The Bank's
financial condition, results of operations, and cash flows approximate those of
Huntington. The financial statements of Huntington are available to the public
over the Internet at the web site of the Securities and Exchange Commission
(SEC) at http://www.sec.gov or at the SEC's public reference rooms at 450 Fifth
Street, N.W., Washington, D.C. 20549.
On February 15, 2002, the Bank sold its Florida retail and commercial operations
as part of a comprehensive strategic and financial restructuring plan designed
to refocus its operations on core activities in the Midwest. At the end of 2001,
in anticipation of the sale by the Bank, HPCI completed its distribution of
participation interests in Florida-related loans to its common shareholders,
Holdings and Huntington. This distribution approximated $1.3 billion and
consisted of cash and the net book value of participation interests in loans
that were included in the sale, including the related accrued interest and
allowance for loan losses, representing approximately 17% of HPCI's total assets
at December 31, 2001.
GENERAL DESCRIPTION OF ASSETS
The Internal Revenue Code requires a REIT to invest at least 75% of the total
value of its assets in real estate assets, which includes residential real
estate loans and commercial real estate loans, including participation interests
in residential or commercial real estate loans, mortgage-backed securities
eligible to be held by REITs, cash, cash equivalents which includes receivables,
government securities, and other real estate assets (REIT Qualified Assets).
REITs may invest up to 25% of the value of its total assets in
non-mortgage-related securities as defined in the Investment Company Act. Under
the Investment Company Act, the term "security" is defined broadly to include,
among other things, any note, stock, treasury stock, debenture, evidence of
indebtedness, or certificate of interest or participation in any profit sharing
agreement or a group or index of securities. The Internal Revenue Code also
requires that the value of any one issuer's securities, other than those
securities included in the 75% test, may not exceed 5% by value of the total
assets of the REIT. In addition, under the Internal Revenue Code, the REIT may
not own more than 10% of the voting securities nor more than 10% of the value of
the outstanding securities of any one issuer, other than those securities
included in the 75% test and the securities of wholly-owned, qualified REIT
subsidiaries.
4
As of December 31, 2002, 89.3% of HPCI's assets were invested in REIT Qualifying
Assets and 10.7% were invested in commercial and consumer loans and other assets
that were not REIT Qualifying Assets. HPCI's assets consisted of the following
at December 31, 2002:
- ------------------------------------------------------------------------------------------
Percentage
of Total
(in thousands of dollars) Amount Assets
- ------------------------------------------------------------------------------------------
Loan participation interests:
Commercial real estate $3,922,467 71.1%
Commercial 344,858 6.3%
Consumer secured by real property 541,450 9.8%
Residential real estate 153,808 2.8%
Consumer not secured by real property 70,907 1.3%
Allowance for loan losses (140,353) -2.5%
Non-interest bearing deposits with The Huntington National Bank 534,254 9.7%
Other assets 89,630 1.5%
HPCI did not hold any securities nor intend to hold securities in any one issuer
that exceed 5% of its total assets or more than 10% of the voting securities of
any one issuer other than its permitted investment in its wholly owned
subsidiary, HPCLI.
Commercial and Commercial Real Estate Loans. HPCI owns participation interests
in unsecured commercial loans and commercial loans secured by non-real property
such as industrial equipment, aircraft, livestock, furniture and fixtures, and
inventory. Participation interests acquired in commercial real estate loans are
secured by real property such as office buildings, multi-family properties of
five units or more, industrial, warehouse, and self-storage properties, office
and industrial condominiums, retail space, strip shopping centers, mixed use
commercial properties, mobile home parks, nursing homes, hotels and motels,
churches, and farms. Commercial and commercial real estate loans may not be
fully amortizing. This means that the loans may have a significant principal
balance or "balloon" payment due on maturity. Additionally, there is no
requirement regarding the percentage of any commercial or commercial real estate
property that must be leased at the time HPCI acquires a participation interest
in a commercial or commercial real estate loan secured by such property nor are
commercial loans required to have third party guarantees.
The credit quality of a commercial or commercial real estate loan may depend on,
among other factors, the existence and structure of underlying leases; the
physical condition of the property, including whether any maintenance has been
deferred; the creditworthiness of tenants; the historical and anticipated level
of vacancies; rents on the property and on other comparable properties located
in the same region; potential or existing environmental risks; the availability
of credit to refinance the loan at or prior to maturity; and, the local and
regional economic climate in general. Foreclosures of defaulted commercial or
commercial real estate loans generally are subject to a number of complicating
factors, including environmental considerations, which are not generally present
in foreclosures of residential real estate loans.
At December 31, 2002, $3.3 billion, or 65%, of the commercial and commercial
real estate loans underlying HPCI's participation interests in such loans were
secured by a first mortgage or first lien and most bear variable or floating
interest rates. At this same date, HPCI's participation interests in commercial
loans that are unsecured was $146.9 million, or 3.4% of the total commercial and
commercial real estate loan participations.
Consumer Loans. HPCI owns participation interests in consumer loans secured by
automobiles, trucks, equipment, or a first or junior mortgage primarily on the
borrower's primary residence. Many of these mortgage loans were made for reasons
such as home improvements, acquisition of furniture and fixtures, and debt
consolidation. These loans are predominately repaid on an installment basis and
income is accrued based on the outstanding balance of the loan over terms that
range from 6 to 360 months. Of the loans underlying the consumer loan
participations, most bear interest at fixed rates.
Residential Real Estate Loans. HPCI owns participation interests in adjustable
rate, fixed rate, conforming, and nonconforming residential real estate loans.
Conforming residential real estate loans comply with the requirements for
inclusion in a loan guarantee or purchase program sponsored by either the FHLMC
or FNMA. Under current regulations, the maximum principal balance allowed on
conforming residential real estate loans ranges from
5
$322,700 for one-unit residential loans to $620,500 for four-unit residential
loans. Nonconforming residential real estate loans are residential real estate
loans that do not qualify in one or more respects for purchase by FNMA or FHLMC
under their standard programs. A majority of the nonconforming residential real
estate loans underlying the participation interests acquired by HPCI to date are
nonconforming because they have original principal balances which exceeded the
requirements for FHLMC or FNMA programs, the original terms are shorter than the
minimum requirements for FHLMC or FNMA programs at the time of origination, the
original balances are less than the minimum requirements for FHLMC or FNMA
programs, or generally because they vary in certain other respects from the
requirements of such programs other than the requirements relating to
creditworthiness of the mortgagors.
Each residential real estate loan is evidenced by a promissory note secured by a
mortgage or deed of trust or other similar security instrument creating a first
or second lien on single-family residential properties. Residential real estate
properties underlying residential real estate loans consist of individual
dwelling units, individual condominium units, two- to four-family dwelling
units, and townhouses.
Geographic Distribution. The following table shows the geographic location of
the properties securing the loans underlying HPCI's loan participations at
December 31, 2002:
- -----------------------------------------------------------------------------------
Percentage by
Aggregate Aggregate
Number Principal Principal
State (in thousands of dollars) of Loans Balance Balance
- -----------------------------------------------------------------------------------
Ohio 25,325 $ 2,769,144 55.0%
Michigan 11,705 1,458,357 29.0%
Indiana 3,481 343,007 6.8%
Kentucky 2,051 252,703 5.0%
- -----------------------------------------------------------------------------------
42,562 4,823,211 95.8%
All other locations 1,179 210,279 4.2%
- -----------------------------------------------------------------------------------
Total loan participation interests 43,741 $ 5,033,490 100.0%
===================================================================================
Principal Balances. The following table shows data with respect to the principal
balance of the loans underlying HPCI's loan participations at December 31, 2002:
- --------------------------------------------------------------------------------------
Percentage by
Aggregate Aggregate
Number Principal Principal
Size (in thousands of dollars) of Loans Balance Balance
- --------------------------------------------------------------------------------------
Less than $50,000 33,625 $ 539,941 10.7%
Greater than $50,000 to $100,000 3,967 273,254 5.4%
Greater than $100,000 to $250,000 2,882 457,333 9.1%
Greater than $250,000 to $500,000 1,489 523,769 10.4%
Greater than $500,000 to $1,000,000 867 606,783 12.1%
Greater than $1,000,000 to $3,000,000 668 1,096,893 21.8%
Greater than $3,000,000 to $5,000,000 134 496,590 9.9%
Greater than $5,000,000 to $10,000,000 88 604,254 12.0%
Greater than $10,000,000 21 434,673 8.6%
- --------------------------------------------------------------------------------------
Total loan participation interests 43,741 $ 5,033,490 100.0%
======================================================================================
6
Interest Rate. Some of the loans underlying HPCI's loan participations bear
interest at fixed rates and some bear interest at variable rates based on
indices such as LIBOR and the prime rate. The following table shows data with
respect to interest rates of the loans underlying HPCI's loan participations at
December 31, 2002:
- -------------------------------------------------------------------------------------------------------------------
Fixed Rate Variable Rate
------------------------------------------ -------------------------------------------
Percentage by Percentage by
Aggregate Aggregate Aggregate Aggregate
(in thousands of Number Principal Principal Number Principal Principal
dollars) of Loans Balance Balance of Loans Balance Balance
- -------------------------------------------------------------------------------------------------------------------
under 5.00% 149 $ 26,584 2.2% 2,655 $ 2,622,152 68.9%
5.00% to 5.99% 322 32,233 2.6% 1,794 370,021 9.7%
6.00% to 6.99% 1,826 157,548 12.8% 1,213 269,314 7.1%
7.00% to 7.99% 5,598 375,074 30.5% 1,238 329,605 8.7%
8.00% to 8.99% 7,441 278,448 22.7% 788 159,784 4.2%
9.00% to 9.99% 6,537 173,596 14.1% 390 49,590 1.3%
10.00% to 10.99% 3,638 87,328 7.1% 34 3,709 0.1%
11.00% to 11.99% 1,407 32,037 2.6% 3 28 0.0%
12.00% and over 8,705 66,202 5.4% 3 237 0.0%
- -------------------------------------------------------------------------------------------------------------------
Total 35,623 $ 1,229,050 100.0% 8,118 $ 3,804,440 100.0%
===================================================================================================================
Loan Delinquencies. The following table provides delinquency information for the
loans underlying HPCI's loan participations at December 31, 2002.
- -------------------------------------------------------------------------------------------------------------------
Fixed Rate Variable Rate
------------------------------------------ -------------------------------------------
Percentage by Percentage by
Aggregate Aggregate Aggregate Aggregate
(in thousands of Number Principal Principal Number Principal Principal
dollars) of Loans Balance Balance of Loans Balance Balance
- -------------------------------------------------------------------------------------------------------------------
Current 27,167 $ 1,053,865 85.7% 7,253 $ 3,500,150 92.0%
1 to 30 days 5,801 119,943 9.8% 559 212,327 5.6%
31 to 60 days 1,537 24,490 2.0% 111 27,996 0.7%
61 to 90 days 467 9,622 0.8% 30 19,414 0.5%
over 90 days 651 21,130 1.7% 165 44,553 1.2%
- -------------------------------------------------------------------------------------------------------------------
Total 35,623 $ 1,229,050 100.0% 8,118 $ 3,804,440 100.0%
===================================================================================================================
Other Assets. Non-interest bearing balances with The Huntington National Bank
represent cash received by the Bank from borrowers for the payment of principal
and interest on the underlying loans deposited in a demand deposit account of
the Bank. Interest bearing deposits in the Bank consist of available funds
invested nightly in an investment product that provides HPCI with a market
return for overnight funds. These funds are available for the acquisition of
additional participation interests. Due from Holdings and the Bank represents
unsettled cash transactions involving HPCI's participation interests in loans
that occur in the ordinary course of business. Other assets include premises and
equipment related to real property located in Indiana and also accrued interest
on the loans underlying its loan participation interests, which is calculated by
the Bank's loan accounting systems.
DIVIDEND POLICY AND RESTRICTIONS
HPCI expects to pay an aggregate amount of dividends with respect to the
outstanding shares of its capital stock equal to substantially all of its REIT
taxable income, which excludes capital gains. In order to remain qualified as a
REIT, HPCI must distribute annually at least 90% of its REIT taxable income to
shareholders. Dividends are declared at the discretion of the board of directors
after considering its distributable funds, financial condition, and capital
needs, the impact of current and pending legislation and regulations, economic
conditions, tax considerations, its continued qualification as a REIT, and other
factors. Although there can be no assurances, HPCI expects that both its cash
available for distribution and its REIT taxable income will be in excess of
amounts needed to pay dividends on the preferred securities in the foreseeable
future because substantially all of HPCI's real estate assets and other
authorized investments are interest-bearing; all outstanding preferred
securities represent in the aggregate only approximately 15% of HPCI's
capitalization; HPCI does not anticipate incurring any indebtedness
7
other than permitted indebtedness, which includes acting as a co-borrower or
guarantor of certain obligations of the Bank that HPCI does not anticipate will
involve a pledge of more than 25% of its assets; and, HPCI expects its
interest-earning assets will continue to exceed the liquidation preference of
its preferred securities.
Payment of dividends on the preferred securities could also be subject to
regulatory limitations if the Bank becomes "undercapitalized" for purposes of
regulations issued by the OCC. Under these regulations, the Bank will be deemed
"undercapitalized" if it has a total risk-based capital ratio of less than 8.0%;
a Tier 1 risk-based capital ratio of less than 4.0%; and a leverage ratio of
less than 4.0% or less than 3% if the institution has been awarded the highest
supervisory rating. At December 31, 2002, the Bank's total risk-based capital
ratio was 10.24%, its Tier 1 risk-based capital ratio was 6.40%, and its
leverage ratio was 6.62%. The Bank currently intends to maintain its capital
ratios in excess of the "well-capitalized" levels under these regulations.
However, there can be no assurance that the Bank will be able to maintain its
capital in excess of the "well-capitalized" levels. The exercise of the OCC's
power to restrict dividends on preferred securities would, however, also have
the effect of restricting the payment of dividends on common shares. The
inability to pay dividends on common shares would prevent HPCI from meeting the
statutory requirement for a REIT to distribute 90% of its taxable income and,
therefore, would cause HPCI to fail to qualify for the favorable tax treatment
accorded to REITs.
CONFLICT OF INTERESTS AND RELATED POLICIES
The Bank continues to control 98.6% of the voting power of HPCI's outstanding
securities. Accordingly, the Bank will continue to have the right to elect all
of HPCI's directors, including its independent directors, unless HPCI fails to
pay dividends on its Class C and Class D preferred securities. In addition, all
of HPCI's officers and five of its nine directors are also officers of
Huntington or the Bank. Because of the nature of HPCI's relationship with
Holdings, HPCII, HPCH-III, and the Bank, conflicts of interest have arisen and
may arise in the future with respect to certain transactions, including without
limitation, HPCI's acquisition of assets from the Bank and its affiliates,
HPCI's disposition of assets to the Bank, servicing of the loans underlying
HPCI's participation interests, particularly with respect to loans placed on
nonaccrual status, as well as the modification of the participation agreement
between the Bank and Holdings and the subparticipation agreement between
Holdings and HPCI. Any future modification of these agreements will require the
approval of a majority of HPCI's independent directors. HPCI's board of
directors also has broad discretion to revise its investment and operating
strategy without shareholder approval.
It is the intention of HPCI and the Bank that any agreements and transactions
between them be fair to all parties and consistent with market terms for such
types of transactions. The requirement in HPCI's articles of incorporation that
certain actions be approved by a majority of HPCI's independent directors also
is intended to ensure fair dealings among HPCI, Holdings, and the Bank. HPCI's
independent directors serve on its audit committee and review material
agreements and significant transactions among HPCI, Holdings, the Bank, and
their respective affiliates.
There are no provisions in HPCI's articles of incorporation limiting any of its
officers, directors, shareholders, or affiliates from having any direct or
indirect pecuniary interest in any asset to be acquired or disposed of by HPCI
or in any transaction in which it has an interest or from engaging in acquiring,
holding, and managing its assets. It is expected that the Bank will have direct
interests in transactions with HPCI including, without limitation, the sale of
assets to HPCI; however, it is not anticipated that any of HPCI's officers or
directors will have any interests in such assets, other than as borrowers or
guarantors of loans underlying HPCI's participation interests, in which case
such loans would be on substantially the same terms, including interest rates
and collateral on loans, as those prevailing at the time for comparable
transaction with others and would not involve more than the normal risk of
collectibility or present other unfavorable features. At December 31, 2002,
there were no direct or indirect pecuniary interests in any asset of HPCI by any
of its officers or directors.
OTHER MANAGEMENT POLICIES AND PROGRAMS
General. In administering HPCI's participation interests and other authorized
investments, the Bank has a high degree of autonomy. HPCI, however, has certain
policies to guide its administration with respect to the Bank's underwriting
standards, the acquisition and disposition of assets, credit risk management,
and certain other activities. These policies, which are discussed below, may be
amended or revised from time to time at the discretion of HPCI's board of
directors, subject in certain circumstances to the approval of a majority of
HPCI's independent directors, but without a vote of its shareholders.
Underwriting Standards. The Bank has represented to Holdings, and Holdings has
represented to HPCI, that most of the loans underlying HPCI's participation
interests were originated generally in accordance with underwriting policies
customarily employed by the Bank during the period in which the loans were
originated. The Bank
8
emphasizes "in-market" lending, which means lending to borrowers that are
located where the Bank or its affiliates have branches or loan origination
offices. The Bank avoids transactions perceived to have unacceptably high risk,
as well as excessive industry and other concentrations.
Some of the loans, however, were acquired by the Bank in connection with the
acquisition of other financial institutions. Prior to acquiring any financial
institution, the Bank performed a number of due diligence procedures to, among
other things, assess the overall quality of the target institution's loan
portfolio. These procedures included the examination of underwriting standards
used in the origination of loan products by the target institution, the review
of loan documents and the contents of selected loan files, and the verification
of the past due status and payment histories of selected borrowers. Through its
due diligence procedures, the Bank obtained a sufficient level of comfort
pertaining to the underwriting standards used by the target institution and
their influence on the quality of the portfolio. Even though the Bank did not
and does not warrant those standards, the Bank found them acceptable in
comparison to HPCI's underwriting standards in cases where the Bank had made a
favorable decision to acquire the institution as a whole.
Asset Acquisition and Disposition Policies. It is HPCI's policy to purchase from
the Bank participation interests generally in loans that:
- are performing, meaning they have no more than two payments past due,
- are in accruing status,
- are not made to related parties of HPCI or the Bank,
- are secured by real property such that they are REIT qualifying, and
- have not been previously sold, securitized, or charged-off either in
whole or in part.
HPCI's policy also allows for investment in assets that are not REIT-Qualified
Assets up to but not exceeding the statutory limitations imposed on
organizations that qualify as REITs. In the past, Holdings has purchased from
the Bank and sold to HPCI participation interests in loans not secured by real
property because of available proceeds from loan repayments and pay-offs.
Management, under this policy, also has the discretion to purchase other assets
to maximize its return to shareholders.
It is anticipated that from time to time HPCI will receive participation
interests in additional real estate loans from the Bank on a basis consistent
with secondary market standards pursuant to the loan participation and
subparticipation agreements, out of proceeds received in connection with the
repayment or disposition of loan participation interests in HPCI's portfolio.
Although HPCI is permitted to do so, it has no present plans or intentions to
purchase loans or loan participation interests from unaffiliated third parties.
It is currently anticipated that participation interests in additional loans
acquired by HPCI will be of the types described above under the heading "General
Description of Assets," although HPCI is not precluded from purchasing
additional types of loans or loan participation interests.
HPCI may continue to acquire from time to time limited amounts of participation
interests in loans that are not commercial or residential loans, such as
automobile loans and equipment loans, or other authorized investments. Although
currently there is no intention to acquire any mortgage-backed securities
representing interests in or obligations backed by pools of mortgage loans that
will be secured by single-family residential, multi-family, or commercial real
estate properties located throughout the United States, HPCI is not restricted
from doing so. HPCI does not intend to acquire any interest-only or
principal-only mortgage-backed securities. HPCI also will not be precluded from
investing in mortgage-backed securities when the Bank is the sponsor or issuer.
At December 31, 2002, HPCI did not hold any mortgage-backed securities.
HPCI currently anticipates that it will not acquire the right to service any
loan underlying a participation interest that it acquires in the future and that
the Bank will act as servicer of any such additional loans. HPCI anticipates
that any servicing arrangement that it enters into in the future with the Bank
will contain fees and other terms that would be substantially equivalent to or
more favorable to HPCI than those that would be contained in servicing
arrangements entered into with third parties unaffiliated with HPCI.
HPCI's current policy is not to acquire any participation interest in any
commercial real estate loan that constitutes more than 5.0% of the total book
value of HPCI's real estate assets at the time of acquisition. In addition,
HPCI's current policy prohibits the acquisition of any loan or any interest in a
loan other than an interest resulting from the acquisition of mortgage-backed
securities, which loan is collateralized by real estate located in West Virginia
or that is made to a municipality or other tax-exempt entity.
9
HPCI's current policy is to reinvest the proceeds of its assets in other
interest-earning assets such that its Funds from Operations (FFO), which
represents cash flows from operations, over any period of four fiscal quarters
will be anticipated to equal or exceed 150% of the amount that would be required
to pay full annual dividends on the Class A, Class C, and Class D preferred
securities, except as may be necessary to maintain its status as a REIT. HPCI's
articles of incorporation provide that it cannot amend or change this policy
with respect to the reinvestment of proceeds without the consent or affirmative
vote of the holders of at least two-thirds of the Class C preferred securities
and two thirds of the Class D preferred securities, voting as separate classes.
Credit Risk Management Policies. It is expected that participation interests in
each commercial or residential real estate loan acquired in the future will
represent a first lien position and will be originated by the Bank, one of its
affiliates, or an unaffiliated third party in the ordinary course of its real
estate lending activities based on the underwriting standards generally applied
by or substantially similar to those applied by the Bank at the time of
origination for its own account. It is also expect that all loans will be
serviced by or through the Bank pursuant to the participation agreement and
subparticipation agreement, which require servicing in conformity with any loan
servicing guidelines promulgated by HPCI and, in the case of residential real
estate loans, with FNMA and FHLMC guidelines and procedures.
Other Policies. HPCI intends to operate in a manner that will not subject it to
regulation under the Investment Company Act. Unless otherwise approved by its
board of directors, HPCI does not intend to:
- invest in the securities of other issuers for the purpose of
exercising control over such issuers;
- underwrite securities of other issuers;
- actively trade in loans or other investments;
- offer securities in exchange for property; or
- make loans to third parties, including, its officers, directors, or
other affiliates.
The Investment Company Act exempts entities that, directly or through
majority-owned subsidiaries, are "primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on and interests in
real estate" (Qualifying Interests). Under current interpretations by the staff
of the SEC, in order to qualify for this exemption, HPCI, among other things,
must maintain at least 55% of its assets in Qualifying Interests and also may be
required to maintain an additional 25% in either Qualifying Interests or other
real estate-related assets. The assets that HPCI may acquire therefore may be
limited by the provisions of the Investment Company Act. HPCI intends to operate
its business in a manner that will maintain its exemption under the Investment
Company Act.
HPCI has no present intention of repurchasing any of its capital securities, and
any such action would be taken only in conformity with applicable federal and
state laws and regulations and the requirements for qualifying as a REIT.
HPCI intends to distribute to its shareholders, in accordance with the
Securities and Exchange Act of 1934, as amended, annual reports containing
financial statements prepared in accordance with generally accepted accounting
principles in the United States and certified by its independent auditors.
HPCI's articles of incorporation provide that it will maintain its status as a
reporting company under the Exchange Act for so long as any of the Class C
preferred securities are outstanding and held by unaffiliated shareholders.
HPCI currently makes investments and operates its business in such a manner
consistent with the requirements of the Internal Revenue Code to qualify as a
REIT. However, future economic, market, legal, tax, or other considerations may
cause its board of directors, subject to approval by a majority of its
independent directors, to determine that it is in HPCI's best interest and the
best interest of its shareholders to revoke HPCI's REIT status. The Internal
Revenue Code prohibits HPCI from electing REIT status for the five taxable years
following the year of such revocation.
EMPLOYEES
At December 31, 2002, HPCI had five executive officers and two additional
officers, but no other employees. Day-to-day activities and the servicing of the
loans underlying HPCI's participation interests are administered by the Bank.
All of HPCI's officers are also officers or employees of Huntington, the Bank,
and/or Holdings. HPCI maintains corporate records and audited financial
statements that are separate from those of Huntington, the Bank, and Holdings.
10
Although there are no restrictions or limitations contained in HPCI's articles
of incorporation or bylaws, HPCI does not anticipate that its officers or
directors will have any direct or indirect pecuniary interest in any asset to be
acquired or disposed of by HPCI or in any transaction in which HPCI has an
interest or will engage in acquiring, holding, and managing assets, other than
as borrowers or guarantors of loans underlying HPCI's participation interests,
in which case such loans would be on substantially the same terms, including
interest rates and collateral on loans, as those prevailing at the time for
comparable transaction with others and would not involve more than the normal
risk of collectibility or present other unfavorable features.
SERVICING
The loans underlying HPCI's participation interests are serviced by the Bank
pursuant to the terms of the participation agreement between the Bank and
Holdings and the subparticipation agreement between Holdings and HPCI. The Bank
has delegated servicing responsibility of the residential real estate loans to
The Huntington Mortgage Company (HMC), a wholly-owned subsidiary of the Bank.
Beginning in 2003, HMC will operate as a division of the Bank as a result of the
merger of HMC into the Bank at the end of 2002.
The participation and subparticipation agreements require the Bank to service
the loans underlying HPCI's participation interests in a manner substantially
the same as for similar work performed by the Bank for transactions on its own
behalf. The Bank or its affiliates collect and remit principal and interest
payments, maintain perfected collateral positions, and submit and pursue
insurance claims. The Bank and its affiliates also provide accounting and
reporting services required by HPCI for its participation interests. HPCI may
direct the Bank to dispose of any loans that become classified, are placed in a
non-performing status, or are renegotiated due to the financial deterioration of
the borrower. The Bank is required to pay all expenses related to the
performance of its duties under the participation and subparticipation
agreements, including any payment to its affiliates for servicing the loans. The
Bank or its affiliates may institute foreclosure proceedings at the direction of
HPCI, exercise any power of sale contained in any mortgage or deed of trust,
obtain a deed in lieu of foreclosure, or otherwise acquire title to a mortgaged
property underlying a real estate loan by operation of law or otherwise in
accordance with the terms of the participation and subparticipation agreement.
Under the participation and subparticipation agreements, the Bank has the right
in its discretion to give consents, waivers, and modifications of the loan
documents to the same extent as if the loans were wholly owned by the Bank;
provided, however, without the written consent of Holdings, the Bank may not
waive any payment default, extend the maturity of the loans, reduce the rate or
rates of interest with respect to the loans, forgive or reduce the principal sum
of the loans, increase the lending formula or advance rates, or amend or modify
the financial covenants contained in the loan documents in any way that would
make such financial covenants less restrictive.
The Bank has the right to accept payment or prepayment of the whole principal
sum and accrued interest in accordance with the terms of the loans, waive
prepayment charges in accordance with the Bank's policy for loans in which no
participation interest has been granted, and accept additional security for the
loans. No specific term is specified in the participation agreement and
subparticipation agreement; the agreements may be terminated by mutual agreement
of the parties at any time, without penalty. Due to the relationship among HPCI,
Holdings, and the Bank, it is not anticipated that these agreements will be
terminated by any party in the foreseeable future.
The Bank, in its role as servicer under the terms of the loan participation
agreement, receives a loan servicing fee designed as a reimbursement for costs
incurred to service the underlying loan. The amount and terms of the fee are
determined by mutual agreement of the Bank, Holdings, and HPCI from time to time
during the term of the participation agreement and subparticipation agreement.
Periodically, a review and analysis of loan servicing operations is conducted by
the Bank. As a result, among other things, the cost to service an individual
loan is calculated and is used as a basis to determine fair compensation for
services rendered. The loan servicing fee is subject to adjustment annually
based upon the Bank's review and analysis at the end of each calendar year
during the term of the participation agreement.
HPCI paid servicing fees of $6.7 million for the year ended December 31, 2002,
$8.3 million for the year ended December 31, 2001, and $7.8 million for the year
ended December 31, 2000. In 2002, the annual servicing fee with respect to the
commercial real estate, commercial, and consumer loans was equal to the
outstanding principal balance of each loan multiplied to a fee of 0.125% and the
annual servicing fee with respect to residential real estate loans is equal to
0.282% of the interest income collected. Neither the participation agreement nor
the subparticipation agreement limits or caps the servicing fees that are paid
to the Bank.
11
COMPETITION
Competition in the form of price and service from other banks and financial
companies such as savings and loans, credit unions, finance companies, and
brokerage firms is intense in most of the markets served by Huntington and its
subsidiaries. Mergers between and the expansion of financial institutions both
within and outside Ohio have provided significant competitive pressure in major
markets. Since 1995, when federal interstate banking legislation became
effective that made it permissible for bank holding companies in any state to
acquire banks in any other state, and for banks to establish interstate branches
(subject to certain limitations by individual states), actual or potential
competition in each of Huntington's markets has been intensified. Internet
banking also competes with Huntington's business. This competition impacts
Huntington's ability to attract new business, particularly in the form of loans
secured by real estate, and, therefore, also affects HPCI's availability to
invest in participation interests in such loans.
REGULATORY MATTERS
HPCI is an indirect subsidiary of the Bank and therefore, regulatory authorities
have the right to examine HPCI and its activities and, under certain
circumstances, to impose restrictions on the Bank or HPCI. The Bank is subject
to examination and supervision by the OCC. In addition to the impact of federal
and state regulation, the Bank is affected significantly by the actions of the
Federal Reserve Board as it attempts to control the money supply and credit
availability in order to influence the economy.
BUSINESS RISKS
HPCI, like all other companies, is subject to a number of risks, many of which
are outside of HPCI's control. HPCI's management strives to limit those risks
while maximizing profitability. Among the risks that HPCI assumes are: (1)
credit risk, which is the risk that underlying loan customers or other
counterparties will be unable to perform their contractual obligations, (2)
operational risk, which is the risk of loss resulting from the inadequate or
failed internal processes, people, and systems or from external events, and (3)
interest rate risk, which is the risk that interest income on HPCI's
participation interests will fall as interest rates fall. In addition to the
other information in this report, readers should carefully consider that the
following important factors, among others, could materially impact HPCI's
business, future results of operations, and future cash flows.
HPCI RELIES ON THE BANK'S CREDIT UNDERWRITING STANDARDS AND ON-GOING PROCESS OF
CREDIT ASSESSMENT; THERE CAN BE NO ASSURANCE THAT THE BANK'S STANDARDS AND
ASSESSMENTS WILL PROTECT HPCI FROM SIGNIFICANT CREDIT LOSSES ON LOANS UNDERLYING
ITS PARTICIPATION INTERESTS.
To date, HPCI has purchased, and intends to continue to purchase, all of its
participation interests in loans originated by or through the Bank and its
affiliates. After HPCI purchases the participation interests, the Bank continues
to service the underlying loans. Accordingly, in managing its credit risk, HPCI
relies on the Bank's credit underwriting standards and on-going process of
credit assessment. The Bank's exposure to credit risk is managed through the use
of consistent underwriting standards that emphasize "in-market" lending while
avoiding highly leveraged transactions as well as excessive industry and other
concentrations. The Bank's credit administration function employs risk
management techniques to ensure that underlying loans adhere to corporate policy
and problem loans underlying HPCI's participation interests are promptly
identified. There can be no assurance that the Bank's credit underwriting
standards and its on-going process of credit assessment will protect HPCI from
significant credit losses on loans underlying its participation interests.
THE LOANS UNDERLYING HPCI'S PARTICIPATION INTERESTS ARE CONCENTRATED IN FOUR
STATES, AND ADVERSE CONDITIONS IN THOSE STATES, IN PARTICULAR, COULD NEGATIVELY
IMPACT RESULT OF OPERATIONS AND ABILITY TO PAY DIVIDENDS.
At December 31, 2002, 95.8% of the properties underlying HPCI's loan
participation interests (as a percentage of loan principal balances) were
located in Ohio, Michigan, Indiana, and Kentucky. Because of the concentration
of its interests in those states, in the event of adverse economic conditions in
those states, HPCI would likely experience higher rates of loss and delinquency
on its loan participation interests than if the underlying loans were more
geographically diversified. Additionally, the loans underlying its loan
participation interests may be subject to a greater risk of default than other
comparable loans in the event of adverse economic, political, or business
developments or natural hazards that may affect Ohio, Michigan, Indiana, or
Kentucky and the ability of property owners in those states to make payments of
principal and interest on the underlying loans. In the event of any adverse
development or natural disaster, HPCI's results of operations and ability to pay
dividends on preferred and common securities could be adversely affected.
12
THE LOANS UNDERLYING PARTICIPATION INTERESTS ARE SUBJECT TO LOCAL ECONOMIC
CONDITIONS THAT COULD NEGATIVELY AFFECT THE VALUE OF THE COLLATERAL SECURING
SUCH LOANS AND/OR THE RESULTS OF HPCI'S OPERATIONS.
The value of the collateral underlying HPCI's loans and/or the results of its
operations could be affected by various conditions in the economy, all of which
are beyond HPCI's control. These include local and other economic conditions
affecting real estate and other collateral values; the continued financial
stability of a borrower and the borrower's ability to make loan principal and
interest payments, which may be adversely affected by job loss, recession,
divorce, illness, or personal bankruptcy. These also include the ability of
tenants to make lease payments; the ability of a property to attract and retain
tenants, which may be affected by conditions such as an oversupply of space or a
reduction in demand for rental space in the area, the attractiveness of
properties to tenants, competition from other available space, and the ability
of the owner to pay leasing commissions, provide adequate maintenance and
insurance, pay tenant improvement costs, and make other tenant concessions.
Furthermore, interest rate levels and the availability of credit to refinance
loans at or prior to maturity and increased operating costs, including energy
costs, real estate taxes, and costs of compliance with environmental controls
and regulations are also various conditions in the economy that effect the value
of the underlying collateral and the result of HPCI's operations.
HPCI'S ACQUISITION OF PARTICIPATION INTERESTS IN COMMERCIAL REAL ESTATE LOANS
SUBJECTS IT TO RISKS THAT ARE NOT PRESENT IN PARTICIPATION INTERESTS IN
RESIDENTIAL REAL ESTATE LOANS.
At December 31, 2002, 71.1% of HPCI's assets, as measured by aggregate
outstanding principal amount, consisted of participation interests in commercial
real estate loans. Commercial real estate loans generally tend to have shorter
maturities than residential real estate loans and may not be fully amortizing,
meaning that they may have a significant principal balance or "balloon" payment
due on maturity. Commercial real estate properties tend to be unique and are
more difficult to value than single-family residential real estate properties.
They are also subject to relatively greater environmental risks and to the
corresponding burdens and costs of compliance with environmental laws and
regulations. Due to these risks, HPCI may experience higher rates of default on
its participation interests in commercial real estate loans than if its
participation interests were more diversified and included a greater percentage
of underlying residential and other loans.
A DECLINE IN THE BANK'S CAPITAL LEVELS MAY RESULT IN PREFERRED SECURITIES BEING
SUBJECT TO A CONDITIONAL EXCHANGE INTO BANK PREFERRED SECURITIES AT A TIME WHEN
THE BANK'S FINANCIAL CONDITION IS DETERIORATING. CONSEQUENTLY, THE LIKELIHOOD OF
DIVIDEND PAYMENTS, AS WELL AS THE LIQUIDATION PREFERENCE, TAXATION, VOTING
RIGHTS, AND LIQUIDITY OF SECURITIES WOULD BE NEGATIVELY IMPACTED.
The returns from a shareholder's investment in HPCI's preferred securities will
be dependent to a significant extent on the performance and capital of the Bank.
A decline in the performance and capital levels of the Bank or the placement of
the Bank into conservatorship or receivership could result in the exchange, if
so directed by the OCC, of HPCI's preferred securities for Bank preferred
securities, without shareholder approval or any shareholder action. This would
represent an investment in the Bank and not in HPCI. Under these circumstances,
there would likely be a significant loss associated with this investment. Also,
since preferred shareholders of HPCI would become preferred shareholders of the
Bank at a time when the Bank's financial condition has deteriorated, it is
unlikely that the Bank would be in a financial position to make any dividend
payments on the Bank preferred securities.
In the event of a liquidation of the Bank, the claims of depositors and
creditors of the Bank would be entitled to priority in payment over the claims
of holders of equity interests such as the Bank preferred securities, and,
therefore, preferred shareholders likely would receive substantially less than
would have been received had the preferred securities not been exchanged for
Bank preferred securities.
The exchange of the preferred securities for Bank preferred securities would
most likely be a taxable event to shareholders under the Internal Revenue Code
and, in that event, shareholders would incur a gain or loss, as the case may be,
measured by the difference between the basis in the preferred securities and the
fair market value of the Bank preferred securities received in the exchange.
Although the terms of the Bank preferred securities are substantially similar to
the terms of HPCI's preferred securities, there are differences, such as the
Bank preferred securities do not have any voting rights or any right to elect
independent directors if dividends are missed. In addition, the Bank preferred
securities will not be listed on the NASDAQ Stock Market or any exchange and a
market for them may never develop.
13
BANK REGULATORS MAY LIMIT HPCI'S ABILITY TO IMPLEMENT ITS BUSINESS PLAN AND MAY
RESTRICT ITS ABILITY TO PAY DIVIDENDS.
Because HPCI is an indirect subsidiary of the Bank, regulatory authorities will
have the right to examine HPCI and its activities and, under certain
circumstances, to impose restrictions on the Bank or HPCI which could impact
HPCI's ability to conduct business pursuant to its business plan and which could
adversely effect its financial condition and results of operations.
If the OCC determines that the Bank's relationship with HPCI results in an
unsafe and unsound banking practice, the OCC and other regulators of the Bank
have the authority to restrict HPCI's ability to transfer assets, restrict its
ability to make distributions to shareholders or redeem preferred securities, or
to require the Bank to sever its relationship with HPCI or divest its ownership
in HPCI. Certain of these actions by the OCC would likely result in HPCI's
failure to qualify as a REIT.
Payment of dividends on the preferred securities could also be subject to
regulatory limitations if the Bank becomes "undercapitalized" for purposes of
regulations issued by the OCC. Under these regulations, the Bank will be deemed
"undercapitalized" if it has a total risk-based capital ratio of less than 8.0%;
a Tier 1 risk-based capital ratio of less than 4.0%; and a leverage ratio of
less than 4.0% or less than 3% if the institution has been awarded the highest
supervisory rating. At December 31, 2002, the Bank's total risk-based capital
ratio was 10.24%, its Tier 1 risk-based capital ratio was 6.40%, and its
leverage ratio was 6.62%. The Bank currently intends to maintain its capital
ratios in excess of the "well-capitalized" levels under these regulations.
However, there can be no assurance that the Bank will be able to maintain its
capital in excess of the "well-capitalized" levels. The exercise of the OCC's
power to restrict dividends on preferred securities would, however, also have
the effect of restricting the payment of dividends on common shares. The
inability to pay dividends on common shares would prevent HPCI from meeting the
statutory requirement for a REIT to distribute 90% of its taxable income and,
therefore, would cause HPCI to fail to qualify for the favorable tax treatment
accorded to REITs.
Legal and regulatory limitations on the payment of dividends by the Bank could
also affect HPCI's ability to pay dividends to unaffiliated third parties,
including the preferred shareholders. Since HPCI, HPCII, HPCH-III, and Holdings
are members of the Bank's consolidated group, payment of common and preferred
dividends by the Bank and/or any member of its consolidated group to
unaffiliated third parties, including payment of dividends to the shareholders
of preferred securities, would require regulatory approval if aggregate
dividends on a consolidated basis exceed certain limitations. Regulatory
approval is required prior to the Bank's declaration of any dividends in excess
of available retained earnings. The amount of dividends that may be declared
without regulatory approval is further limited to the sum of net income for the
current year and retained net income for the preceding two years, less any
required transfers to surplus or common stock.
DIVIDENDS ARE NOT CUMULATIVE; PREFERRED SHAREHOLDERS ARE NOT ENTITLED TO RECEIVE
DIVIDENDS UNLESS DECLARED BY HPCI'S BOARD OF DIRECTORS.
Dividends on the preferred securities are not cumulative. Consequently, if the
board of directors does not declare a dividend on the preferred securities for
any quarterly period, including if prevented by bank regulators, preferred
shareholders will not be entitled to receive that dividend whether or not funds
are or subsequently become available. The board of directors may determine that
it would be in HPCI's best interests to pay less than the full amount of the
stated dividends on the preferred securities or no dividends for any quarter
even though funds are available. Factors that would generally be considered by
the board of directors in making this determination are the amount of
distributable funds, HPCI's financial condition and capital needs, the impact of
current and pending legislation and regulations, economic conditions, tax
considerations, and HPCI's continued qualification as a REIT. If full dividends
on the Class A, Class C, and Class D preferred securities have not been paid for
six full dividend periods, the holders of the Class C and Class D preferred
securities, voting together as one class, will have the right to elect two
independent directors in addition to those already on the board.
HPCI AND THE BANK MAINTAIN INTERNAL OPERATIONAL CONTROLS. IF HPCI'S AND/OR THE
BANK'S SYSTEMS OF INTERNAL CONTROLS SHOULD FAIL TO WORK AS EXPECTED, THEIR
SYSTEMS WERE TO BE USED IN AN UNAUTHORIZED MANNER, OR EMPLOYEES WERE TO SUBVERT
THE SYSTEMS OF INTERNAL CONTROLS, SIGNIFICANT LOSSES TO HPCI COULD OCCUR.
HPCI is exposed to numerous types of operational risk. Operational risk
generally refers to the risk of loss resulting from operations, including, but
not limited to, the risk of fraud by employees or persons outside HPCI and the
Bank, the execution of unauthorized transactions by employees, errors relating
to transaction processing and systems, and breaches of the internal control
system and compliance requirements. This risk of loss also includes the
potential
14
legal actions that could arise as a result of the operational deficiency or as a
result of noncompliance with applicable regulatory standards.
HPCI, directly and through the Bank, establishes and maintains systems of
internal operational controls that provide management with timely and accurate
information about its level of operational risk. While not foolproof, these
systems have been designed to manage operational risk at appropriate, cost
effective levels. The Bank and HPCI have also established procedures that are
designed to ensure that policies relating to conduct, ethics, and business
practices are followed. From time to time, HPCI experiences losses from
operational risk, including the effects of operational errors.
Management believes that HPCI's and the Bank's current systems of internal
controls are effective. While management continually monitors and improves their
systems of internal controls, data processing systems, and corporate-wide
processes and procedures, there can be no assurance that HPCI will not suffer
such losses in the future.
HPCI IS DEPENDENT IN VIRTUALLY EVERY PHASE OF ITS OPERATIONS ON THE DILIGENCE
AND SKILL OF THE OFFICERS AND EMPLOYEES OF THE BANK, AND ITS RELATIONSHIP WITH
THE BANK MAY CREATE POTENTIAL CONFLICTS OF INTEREST.
The Bank is involved in virtually every aspect of HPCI's existence. As of
December 31, 2002, all of its officers and five of its nine directors are also
officers or directors of the Bank or its affiliates. Officers that are common
with the Bank devote less than a majority of their time to managing HPCI's
business. The Bank has the right to elect all of HPCI's directors, including
independent directors, except under limited circumstances if it fails to pay
future dividends. The Bank and its affiliates have interests that are not
identical to HPCI's and, therefore, conflicts of interest could arise in the
future with respect to transactions between or among the Bank, Holdings, HPCII,
HPCH-III, and HPCI.
The Bank administers HPCI's day-to-day activities under the terms of
participation and subparticipation agreements. The parties to these agreements
are all affiliated and, accordingly, these agreements were not the result of
arms-length negotiations and may be modified at any time in the future. Although
the modification of the agreements requires the approval of a majority of
independent directors, the Bank, through its direct and indirect ownership of
HPCH-III's and HPCII's common stock and their ownership of HPCI's common stock,
controls the election of all of the directors, including independent directors.
Therefore, HPCI cannot assure shareholders modifications to the participation
and subparticipation agreements will be on terms as favorable to it as those
that could have been obtained from unaffiliated third parties.
Huntington, the owner of all the Bank's common shares, may have investment goals
and strategies that differ from those of the holders of HPCI's preferred
securities. In addition, neither Huntington nor the Bank has a policy addressing
the treatment of new business opportunities. Thus, new business opportunities
identified by Huntington or the Bank may be directed to affiliates other than
HPCI. HPCI's board of directors has broad discretion to revise its investment
and operating strategy without shareholder approval. The Bank, through its
direct and indirect ownership of HPCH-III's and HPCII's common stock and their
ownership of HPCI's common stock, controls the election of all of HPCI's
directors, including independent directors. Consequently, HPCI's investment and
operating strategies will largely be directed by Huntington and the Bank.
HPCI is dependent on the diligence and skill of the officers and employees of
the Bank for the selection and structuring of the loans underlying its
participation interests and other authorized investments. The Bank selected the
amount, type, and price of loan participation interests and other assets that
were acquired from the Bank and its affiliates. HPCI anticipates that it will
continue to acquire all or substantially all of its assets from the Bank or its
affiliates for the foreseeable future. Although these acquisitions are made
within investment policies, neither HPCI nor the Bank obtained any third-party
valuations. HPCI does not intend to do so in the future. Although HPCI has
policies to guide the acquisition and disposition of assets, these policies may
be revised or exceptions may be approved from time to time at the discretion of
the board of directors without a vote of shareholders. Changes in or exceptions
made to these policies could permit the acquisition of lower quality assets.
HPCI is dependent on the Bank and others for monitoring and servicing the loans
underlying its participation interests. Conflicts could arise as part of such
servicing, particularly with respect to loans that are placed on nonaccrual
status. While HPCI believes that the Bank will diligently pursue collection of
any non-performing assets, HPCI cannot assure shareholders that this will occur.
HPCI's ability to make timely payments of dividends on the preferred and common
securities will depend in part upon the Bank's prompt collection efforts on its
behalf. HPCI pays substantial servicing fees to the Bank. HPCI paid servicing
fees of $6.7 million in 2002, $8.3 million in 2001, and $7.8 million in 2000.
15
The Bank may seek to exercise its influence over HPCI's affairs so as to cause
the sale of its assets and their replacement by lesser quality assets acquired
from the Bank or elsewhere. This could adversely affect HPCI's business and its
ability to make timely payment of dividends on the preferred and common
securities.
HPCI'S ASSETS MAY BE USED TO SECURE CERTAIN OF THE BANK'S OBLIGATIONS THAT
WILL HAVE A PREFERENCE OVER THE HOLDERS OF HPCI'S PREFERRED SECURITIES.
The Bank is eligible to obtain advances from various federal and
government-sponsored agencies, such as the Federal Home Loan Bank of Cincinnati
(FHLBC). Any such agency that makes advances to the Bank where HPCI has acted as
a co-borrower or guarantor or has pledged its assets as collateral will have a
preference over the holders of HPCI's preferred securities. These holders would
receive their liquidation preference only to the extent there are assets
available after satisfaction of HPCI's indebtedness, if any. HPCI is not
required to obtain the consent of its shareholders in order to make such a
pledge or act as co-borrower or guarantor.
The Bank has obtained a line of credit from the FHLBC, which line was capped at
$1.3 billion as of December 31, 2002. As of that same date, the Bank had
borrowings of $1.0 billion under the facility. HPCI has entered into an
agreement with the Bank with respect to the pledge of HPCI's assets to
collateralize the Bank's borrowings from the FHLBC. The agreement provides that
the Bank will not place at risk HPCI's assets in excess of an aggregate amount
or percentage of such assets established from time to time by HPCI's board of
directors, including a majority of HPCI's independent directors. HPCI's board
has set this limit at $1 billion, which limit may be changed in the future by
the board of directors, including a majority of HPCI's independent directors. As
of December 31, 2002, HPCI's pledged collateral was limited to 1-4 family
residential mortgages and second mortgage loans, which aggregated $543 million
as of that same date. A default by the Bank on its obligations to the FHLBC
could adversely affect HPCI's business and its ability to make timely dividend
payments on preferred and common securities.
NEW, OR CHANGES IN EXISTING, TAX, ACCOUNTING, AND REGULATORY LAWS, REGULATIONS,
RULES, AND STANDARDS COULD SIGNIFICANTLY IMPACT STRATEGIC INITIATIVES, RESULTS
OF OPERATIONS, FINANCIAL CONDITION, AND ABILITY TO PAY DIVIDENDS.
Future governmental regulations could impose significant additional limitations
on HPCI's operations. These regulations, along with the currently existing tax,
accounting, securities, insurance, and monetary laws, regulations, rules,
standards, policies, and interpretations control the methods by which companies
conduct business, implement strategic initiatives and tax planning, and govern
financial reporting and disclosures. These laws, regulations, rules, standards,
policies, and interpretations are constantly evolving and may change
significantly over time. Events that may not have a direct impact on HPCI, such
as the bankruptcy of major U.S. companies, have resulted in legislators,
regulators, and authoritative bodies, such as the Financial Accounting Standards
Board, the Securities and Exchange Commission, and the Public Company Accounting
Oversight Board, to respond by adopting and/or proposing substantive revisions
to laws, regulations, rules, standards, policies, and interpretations. The
nature, extent, and timing of the adoption of significant new laws, changes in
existing laws, or repeal of existing laws may have a material impact on HPCI's
business, results of operations, and ability to pay dividends; however, it is
impossible to predict at this time the extent to which any such adoption,
change, or repeal would impact HPCI.
THE EXTENDED DISRUPTION OF HUNTINGTON'S VITAL INFRASTRUCTURE COULD NEGATIVELY
IMPACT HPCI'S BUSINESS, RESULTS OF OPERATIONS, FINANCIAL CONDITION, AND ABILITY
TO PAY DIVIDENDS.
HPCI's operations depend upon, among other things, Huntington's and the Bank's
infrastructure, including their equipment and facilities. Extended disruption of
vital infrastructure by fire, power loss, natural disaster, telecommunications
failure, computer hacking or viruses, terrorist activity or the domestic and
foreign response to such activity, or other events outside of Huntington's or
the Bank's control could have a material adverse impact on the financial
services industry as a whole and on HPCI's business, results of operations, cash
flows, financial condition, and ability to pay dividends in particular.
HPCI HAS NO CONTROL OVER CHANGES IN INTEREST RATES AND SUCH CHANGES COULD
NEGATIVELY IMPACT ITS FINANCIAL CONDITION, RESULTS OF OPERATIONS, AND ABILITY TO
PAY DIVIDENDS.
HPCI's income consists primarily of interest and fees on loans underlying its
participation interests. At December 31, 2002, 24% of the loans underlying its
participation interests, as measured by the aggregate outstanding principal
amount, bore interest at fixed rates and the remainder bore interest at
adjustable rates. Adjustable-rate loans decrease the risks associated with
changes in interest rates but involve other risks. As interest rates rise, the
payment by the borrower rises to the extent permitted by the terms of the loan,
and the increased payment increases the potential for
16
default. At the same time, the marketability of the underlying property may be
adversely affected by higher interest rates. In a declining interest rate
environment, there may be an increase in prepayments on the loans underlying
HPCI's participation interests as the borrowers refinance their mortgages at
lower interest rates. Under these circumstances, HPCI may find it more difficult
to acquire additional participation interests with rates sufficient to support
the payment of the dividends on the preferred securities. Because the rate at
which dividends are required to be paid on the Class A and C preferred
securities is fixed, there can be no assurance that a declining interest rate
environment would not adversely affect HPCI's ability to pay full, or even
partial, dividends on its preferred securities.
HPCI'S FINANCIAL STATEMENTS CONFORM WITH ACCOUNTING PRINCIPLES GENERALLY
ACCEPTED IN THE UNITED STATES, WHICH REQUIRE MANAGEMENT TO MAKE ESTIMATES AND
ASSUMPTIONS THAT AFFECT AMOUNTS REPORTED IN THE FINANCIAL STATEMENTS. ACTUAL
RESULTS COULD DIFFER FROM THOSE ESTIMATES.
HPCI's financial statements include estimates related to accruals of income and
expenses. These estimates are based on information available at the time the
estimates are made. Factors involved in these estimates could change in the
future leading to a change of those estimates, which could be material to HPCI's
results of operations or financial condition.
HPCI COULD SUFFER ADVERSE TAX CONSEQUENCES IF IT FAILED TO QUALIFY AS A REIT.
No assurance can be given that HPCI will be able to continue to operate in such
a manner so as to remain qualified as a REIT. Qualification as a REIT involves
the application of highly technical and complex tax law provisions for which
there are only limited judicial or administrative interpretations and involves
the determination of various factual matters and circumstances not entirely
within its control. No assurance can be given that new legislation or new
regulations, administrative interpretations, or court decisions will not
significantly change the tax laws in the future with respect to qualification as
a REIT or the federal income tax consequences of such qualification in a way
that would materially and adversely affect HPCI's ability to operate. Any such
new legislation, regulation, interpretation, or decision could be the basis of a
tax event that would permit HPCI to redeem all or any preferred securities. If
HPCI were to fail to qualify as a REIT, the dividends on preferred securities,
would not be deductible for federal income tax purposes. HPCI would face a tax
liability that could consequently result in a reduction in HPCI's net earnings
after taxes. A reduction in net earnings after taxes could adversely affect its
ability to add interest-earning assets to its portfolio and pay dividends to its
preferred security holders.
If in any taxable year HPCI fails to qualify as a REIT, unless it is entitled to
relief under certain statutory provisions, it would also be disqualified from
treatment as a REIT for the five taxable years following the year its
qualification was lost. As a result, the amount of funds available for
distribution to shareholders would be reduced for the year or years involved.
As a REIT, HPCI generally will be required each year to distribute as dividends
to its shareholders at least 90% of REIT taxable income, excluding capital
gains. Failure to comply with this requirement would result in earnings being
subject to tax at regular corporate rates. In addition, HPCI would be subject to
a 4% nondeductible excise tax on the amount by which certain distributions
considered as paid with respect to any calendar year are less than the sum of
85% of ordinary income for the calendar year, 95% of capital gains net income
for the calendar year, and 100% of undistributed taxable income from prior
periods. Qualification as a REIT also involves application of other specific
provisions of the Internal Revenue Code. Two specific provisions are an income
test and an asset test. At least 75% of HPCI's gross income, excluding gross
income from prohibited transactions, for each taxable year must be derived
directly or indirectly from investments relating to real property or mortgages
on real property. Additionally, at least 75% of HPCI's total assets must be
represented by real estate assets. At December 31, 2002, HPCI had qualifying
income and qualifying assets that exceeded 75%.
Although HPCI intends to operate in a manner designed to qualify as a REIT,
future economic, market, legal, tax, or other considerations may cause it to
determine that it is in its best interests and the best interests of holders of
common and preferred securities to revoke the REIT election. As long as any
class of preferred securities are outstanding, any such determination may be
made without shareholder approval, but will require the approval of a majority
of independent directors.
17
ENVIRONMENTAL LIABILITIES ASSOCIATED WITH REAL PROPERTY SECURING LOANS
UNDERLYING HPCI'S PARTICIPATION INTERESTS COULD REDUCE THE FAIR MARKET VALUE OF
ITS PARTICIPATION INTERESTS AND MAKE THE PROPERTY MORE DIFFICULT TO SELL.
In its capacity as servicer, the Bank at the direction of HPCI may be forced to
foreclose on a defaulted commercial real estate loan and/or a residential real
estate loan to recover its investment in the real estate loan. The Bank may be
subject to environmental liabilities in connection with the underlying real
property, which could exceed the value of the real property. Although the Bank
exercises due diligence to discover potential environmental liabilities prior to
the acquisition of any property through foreclosure, hazardous substances or
wastes, contaminants, pollutants, or their sources may be discovered on
properties during the Bank's ownership or after a sale to a third party. Even
though HPCI may sell to the Bank, at fair value, the participation interest in
any loan at the time the real property securing that loan becomes foreclosed
property, the discovery of these liabilities, any associated costs for removal
of hazardous substances, wastes, contaminants, or pollutants, and the difficulty
in selling the underlying real estate, could have a material adverse effect on
the fair value of that loan and therefore HPCI may not recover any or all of its
investment in the underlying loan.
HPCI MAY REDEEM THE CLASS C AND CLASS D PREFERRED SECURITIES UPON THE OCCURRENCE
OF CERTAIN SPECIAL EVENTS.
At any time following the occurrence of certain special events, HPCI will have
the right to redeem the Class C and Class D preferred securities in whole,
subject to the prior written approval of the OCC. The occurrence of such an
event will not, however, give a preferred shareholder any right to request that
such Class C or Class D preferred securities be redeemed. A special event
includes:
- a tax event which occurs when HPCI receives an opinion of counsel to
the effect that, as a result of a judicial decision or administrative
pronouncement, ruling, or other action or as a result of certain
changes in the tax laws, regulations, or related interpretations,
there is a significant risk that dividends with respect to HPCI's
capital stock will not be fully deductible by HPCI or it will be
subject to a significant amount of additional taxes or governmental
charges;
- an investment company event which occurs when HPCI receives an opinion
of counsel to the effect that, as a result of certain changes in the
applicable laws, regulations, or related interpretations, there is a
significant risk that HPCI will be considered an investment company
under the Investment Company Act of 1940; and
- a regulatory capital event which occurs when, as a result of certain
changes in the applicable laws, regulations, or related
interpretations, there is a significant risk that HPCI's Class C
preferred securities will no longer constitute Tier 1 capital of the
Bank (other than as a result of limitations on the portion of Tier 1
capital that may consist of minority interests in subsidiaries of the
Bank).
GUIDE 3 INFORMATION
Information required by Industry Guide 3 relating to statistical disclosure by
real estate investment trusts is set forth in Items 7 and 8.
ITEM 2: PROPERTIES
HPCI does not own any material physical property or real estate.
ITEM 3: LEGAL PROCEEDINGS
HPCI is not the subject of any material litigation. HPCI is not currently
involved in nor, to management's knowledge, is currently threatened with any
material litigation with respect to the loans underlying its participation
interests other than routine litigation arising in the ordinary course of
business.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the period
covered by this report.
18
Part II
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
There is no established public trading market for HPCI's common stock. As of
March 28, 2003, there were three common shareholders of record, all of which are
affiliates of the Bank. During 2002, 2001, and 2000, dividends of $382.8
million, $539.2 million, and $458.3 million were paid to common shareholders,
respectively, all of which were declared in December of each year.
Information regarding restrictions on dividends, as required by this item, is
set forth in Item 1 "Dividend Policy and Restrictions". No HPCI securities were
issued under compensation plans.
ITEM 6. SELECTED FINANCIAL DATA
The data presented below represents selected financial data relative to HPCI
for, and as of the end of, the years ended December 31, 2002, 2001, 2000, 1999,
and 1998 (in thousands of dollars):
- --------------------------------------------------------------------------------------------------------------
2002 2001 2000 1999 1998
- --------------------------------------------------------------------------------------------------------------
STATEMENTS OF INCOME:
Interest and fee income $ 347,754 $ 526,445 $ 549,718 $ 497,527 $ 298,420
Provision for loan losses (161) 48,510 2,293 --- ---
Non-interest income 6,759 1,646 --- --- ---
Non-interest expense 13,282 10,015 7,983 8,234 4,551
Net income before
preferred dividends 341,437 469,540 539,442 489,293 293,869
Dividends on preferred stock 23,814 21,827 80 80 ---
Net income applicable
to common shares 317,623 447,713 539,362 489,213 293,869
Dividends on common stock 382,840 539,170 458,335 413,760 293,869
Average yield on earning assets 5.82% 7.46% 8.28% 7.84% 8.48%
BALANCE SHEETS:
Loan participation interests, net
of allowance for loan losses $ 4,893,137 $ 5,203,286 $ 5,744,822 $ 5,939,286 $ 5,850,857
All other assets 623,884 745,473 1,153,451 280,076 150,041
Total assets 5,517,021 5,948,759 6,898,273 6,219,362 6,000,898
Total shareholders' equity 5,516,351 5,948,728 6,898,273 6,218,632 5,868,373
All of HPCI's common stock is owned by Huntington, HPCII, and HPCH-III and
therefore, earnings per common share information is not presented. At the end of
all years presented, HPCI did not have any long-term liabilities.
19
ITEM 7. MANAGEMENTS'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
INTRODUCTION
Huntington Preferred Capital, Inc. (HPCI or "the company") was incorporated in
Ohio in July 1992 under the name Airbase Realty, Inc. The company changed its
name to Huntington Preferred Capital, Inc. in May 2001. The company'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. Since May 1998, the company has been operating as a real estate
investment trust (REIT) for federal income tax purposes.
The company is a subsidiary of HPC Holdings-III, Inc. (HPCH-III), which is a
subsidiary of Huntington Preferred Capital Holdings, Inc. (Holdings). Holdings
is owned by The Huntington National Bank (the Bank) and Huntington Bancshares
Incorporated (Huntington). All of HPCI's day-to-day activities and the servicing
of the loans underlying its participation interests are administered by the
Bank. HPCI has one wholly-owned subsidiary, HPCLI, Inc. (HPCLI).
A participation agreement between the Bank and Holdings and a subparticipation
agreement between Holdings and HPCI require the Bank to service HPCI's loan
portfolio in a manner substantially the same as for similar work performed by
the Bank for transactions on its own behalf. The Bank collects and remits
principal and interest payments, maintains perfected collateral positions, and
submits and pursues insurance claims. The Bank and Huntington also provide to
HPCI accounting and reporting services as required. The Bank is required to pay
all expenses related to the performance of its duties under the participation
and subparticipation agreements. These participation interests were all acquired
from Holdings and Holdings acquired them from the Bank.
FORWARD-LOOKING STATEMENTS
This report, including management's discussion and analysis of financial
condition and results of operations, contains forward-looking statements about
HPCI, including descriptions of products or services, plans, or objectives of
its management for future operations, and forecasts of its revenues, earnings,
or other measures of economic performance. Forward-looking statements can be
identified by the fact that they do not relate strictly to historical or current
facts.
By their nature, forward-looking statements are subject to numerous assumptions,
risks, and uncertainties. A number of factors, including but not limited to,
those set forth under the heading "Business Risks" included in Item 1 of this
report and other factors described from time to time in HPCI's other filings
with the Securities and Exchange Commission, could cause actual conditions,
events, or results to differ significantly from those described in the
forward-looking statements.
Forward-looking statements speak only as of the date they are made. HPCI does
not update forward-looking statements to reflect circumstances or events that
occur after the date the forward-looking statements are made or to reflect the
occurrence of unanticipated events.
The following discussion and analysis, the purpose of which is to provide
investors and others with information that the company's management believes to
be necessary for an understanding of its financial condition, changes in
financial condition, and results of operations, should be read in conjunction
with the financial statements, notes, and other information contained in this
document.
CRITICAL ACCOUNTING POLICIES
Note 1 to HPCI's consolidated financial statements lists significant accounting
policies used in the development and presentation of its financial statements.
This discussion and analysis, the significant accounting policies, and other
financial statement disclosures identify and address key variables and other
qualitative and quantitative factors that are necessary for an understanding and
evaluation of HPCI, its financial position, results of operations, and cash
flows.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States (GAAP) requires HPCI's management to
establish critical accounting policies and make accounting estimates,
assumptions, and judgments that affect amounts recorded and reported in its
financial statements. An accounting estimate requires assumptions about
uncertain matters that could have a material effect on the financial statements
of HPCI if a different amount within a range of estimates were used or if
estimates changed from period
20
to period. Readers of this report should understand that estimates are made
under facts and circumstances at a point in time and changes in those facts and
circumstances could produce actual results that differ from when those estimates
were made. A material estimate that is particularly susceptible to significant
change relates to the determination of the allowance for loan losses.
PREFERRED SECURITIES
In October 2001, HPCI issued to Holdings 2,000,000 shares of Class C preferred
securities and 14,000,000 shares of Class D preferred securities and received a
capital contribution of common equity in exchange for $452.6 million of gross
participation interests in certain loans, $86.5 million of related specific loan
loss reserves, $45.4 million of net leasehold improvements, and $3.5 million of
accrued interest. These participation interests were in commercial, commercial
real estate, and consumer loans and were acquired at fair market value. The
underlying consumer loans included a combination of automobile, truck, and
equipment loans. HPCI intends to hold these participation interests as long-term
investments. Approximately 24% of these participation interests were
non-performing in nature. The company transferred the leasehold improvements to
HPCLI in exchange for its common shares. Holdings subsequently sold all of the
Class C preferred securities in an underwritten public offering. HPCI did not
receive any of Holdings' proceeds from the sale. On December 27, 2002, Holdings
contributed its ownership in HPCI's Class A and Class D preferred securities to
Huntington Preferred Capital II, Inc. (HPCII), a subsidiary of HPCH-III.
DISTRIBUTION OF FLORIDA LOAN PARTICIPATION INTERESTS
On December 31, 2001, in anticipation of the eventual sale by the Bank to
SunTrust Banks, Inc. (SunTrust) of its Florida banking operations, which closed
on February 15, 2002, HPCI completed its $1.3 billion distribution to common
shareholders, Holdings and Huntington. This distribution consisted of cash and
the net book value of participation interests in loans that were included in the
sale to SunTrust, including the related accrued interest and allowance for loan
losses. This distribution represented approximately 17% of HPCI's total assets
as of December 31, 2001.
OVERVIEW
HPCI's income is primarily derived from its participation interests in loans
acquired from the Bank and Holdings. Income varies based on the level of these
assets and their relative interest rates. The cash flows from these assets are
used to satisfy HPCI's preferred dividend obligations. The preferred stock is
considered equity and therefore, the dividends are not reflected as interest
expense.
HPCI reported net income before preferred dividends of $341.4 million for 2002,
$469.5 million for 2001, and $539.4 million for 2000. Net income available to
common shareholders was $317.6 million, $447.7 million, and $539.4 million for
the same respective periods. Average assets approximated average shareholders'
equity (including preferred stock) and, therefore, return on average assets
(ROA) and return on average equity (ROE) were the same for all annual periods
presented. ROA and ROE were 5.65% for 2002, 6.67% for 2001, and 8.14% for 2000.
At December 31, 2002 and 2001, HPCI had total assets and total equity (including
preferred stock) of $5.5 billion and $5.9 billion, respectively. At the most
recent year end, an aggregate of $5.0 billion, or 91.2%, of total assets
consisted of 99% participation interests in loans. Before the allowance for loan
losses, participation interests in commercial and commercial real estate loans
were $4.3 billion, or 77.3% of total assets, $612.4 million, or 11.1%, in
consumer loans, and $153.8 million, or 2.8%, in residential real estate loans.
The consumer loan participations are comprised of interests in loans, most of
which are secured by real estate. The composition of real estate qualifying
assets increased during the recent twelve months from 88.2% at the end of 2001
to 89.3% at the end of 2002. The following table shows the composition of HPCI's
gross participation interests in loans at the end of the most recent five years:
- -------------------------------------------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------------------------------------------------
At December 31,
Commercial $ 344,858 $ 646,509 $ 614,956 $ 813,809 $1,110,669
Commercial real estate 3,922,467 3,678,061 3,894,527 3,688,669 3,226,583
Consumer 612,357 783,735 971,594 791,396 698,328
Residential real estate 153,808 270,671 355,571 749,563 903,076
- -------------------------------------------------------------------------------------------------------------------
Total $ 5,033,490 $5,378,976 $5,836,648 $6,043,437 $5,938,656
===================================================================================================================
21
Qualification as a REIT involves application of specific provisions of the
Internal Revenue Code. Two specific provisions are an income test and an asset
test. At least 75% of HPCI's gross income, excluding gross income from
prohibited transactions, for each taxable year must be derived directly or
indirectly from investments relating to real property or mortgages on real
property. Additionally, real estate assets must represent at least 75% of HPCI's
total assets. At December 31, 2002, HPCI had qualifying income and qualifying
assets that exceeded 75%. Typically, cash is invested with the Bank in an
interest bearing account, however, late in 2002, after a rapid build-up in cash
due to loan prepayments, management moved the cash to a non-interest bearing
account in order to maintain qualifying income levels and HPCI's REIT status. In
addition, management made the decision to lower its level of cash through a
return of capital to its common shareholders at the end of 2002.
Interest-bearing and non-interest bearing cash balances on deposit with the Bank
were $534.3 million and $364.9 million at December 31, 2002 and 2001,
respectively. Funds, when invested, are invested overnight or in Eurodollar
deposits with the Bank for a term of not more than 30 days.
Amounts due from the Bank and Holdings at December 31, 2002 and 2001, were $7.4
million and $293.8 million, respectively. These represent amounts due from or
due to the Bank and/or Holdings that arise in the ordinary course of business
for unsettled transactions involving participation interests, fees, and other
related costs.
Shareholders' equity (including preferred stock) declined from $5.9 billion at
December 31, 2001, to $5.5 billion at December 31, 2002. This reflected the
aggregate dividend payments on the common and preferred securities and the
return of capital to HPCI's common shareholders during the recent year offset by
the $341.4 million of net income in 2002.
RESULTS OF OPERATIONS
INTEREST AND FEE INCOME
HPCI's primary source of revenue is interest and fee income on its participation
interests in loans. At December 31, 2002, 2001, and 2000, HPCI did not have any
interest-bearing liabilities nor related interest expense. HPCI's capital
structure has provided funding for acquisition of participation interests and
the continued cash flows from its participation interests in loans provide
sufficient funding such that outside borrowings are not required. Interest
income is impacted by changes in the level of interest rates and earning assets.
The yield on earning assets is the percentage of interest income to average
earning assets.
Interest and fee income was $347.7 million for the recent twelve months compared
with $526.4 million for the twelve months ended December 31, 2001. Interest and
fee income was $549.7 million for 2000. The yield on earning assets contracted
to 5.82% in 2002 from 7.46% and 8.28% in 2001 and 2000, respectively. The yield
on participations in consumer loans increased to 10.60% in 2002 from 9.43% in
2001, which was indicative of the full-year impact from higher-yielding
participation interests in consumer loans acquired in the fourth quarter 2001 in
association with the issuance of the Class C and D preferred securities,
partially offset by the distribution of the Florida-related participations at
the end of 2001. In the table below, individual components include
participations in non-accrual loans and related interest received. The amount of
interest income that would have been recorded under original terms for
participations in loans classified as non-accrual was $8.6 million for the
twelve months ended December 31, 2002. Amounts actually received and recorded as
interest income for these participations totaled $3.5 million in 2002.
22
HPCI's average balances, interest and fee income, and yields are presented below
for the twelve-month periods ended December 31:
- -------------------------------------------------------------------------------------------------------------------
2002 2001
----------------------------------- ------------------------------------
AVERAGE AVERAGE
(in millions of dollars) BALANCE INCOME YIELD BALANCE INCOME YIELD
- -------------------------------------------------------------------------------------------------------------------
Loan participation interests:
Commercial $ 503.2 $ 24.9 4.95 % $ 560.1 $ 40.5 7.24 %
Commercial real estate 3,846.6 212.6 5.53 4,182.5 304.5 7.28
Consumer 697.5 74.0 10.60 1,068.0 100.8 9.43
Residential real estate 211.3 14.6 6.92 558.2 41.2 7.38
- -------------------------------------------------------------------------------------------------------------------
Total loan participations 5,258.6 326.1 6.20 6,368.8 487.0 7.65
- -------------------------------------------------------------------------------------------------------------------
Interest bearing deposits
in banks 716.6 12.3 1.72 692.8 27.9 4.02
Fees from loan participation
interests 9.3 11.5
- -------------------------------------------------------------------------------------------------------------------
Total $ 5,975.2 $ 347.7 5.82 % $ 7,061.6 $ 526.4 7.46 %
===================================================================================================================
- -------------------------------------------------------------------------------------------------------------------
2000
----------------------------------
AVERAGE
(in millions of dollars) BALANCE INCOME YIELD
- -------------------------------------------------------------------------------------------------------------------
Loan participation interests:
Commercial $ 721.9 $ 62.5 8.66 %
Commercial real estate 3,809.1 324.3 8.51
Consumer 865.8 78.3 9.04
Residential real estate 689.2 46.4 6.73
- -------------------------------------------------------------------------------------------------------------------
Total loan participations 6,086.0 511.5 8.40
- -------------------------------------------------------------------------------------------------------------------
Interest bearing deposits in banks 556.9 33.1 5.94
Fees from loan participation interests 5.1
- -------------------------------------------------------------------------------------------------------------------
Total $6,642.9 $ 549.7 8.28 %
===================================================================================================================
The declines in interest and fee income experienced during 2002 were due to
declines in interest rates and lower earning assets. The declines in the yields
earned on participation interests in both 2002 and 2001 were indicative of the
changes in the interest rate environment during the periods. The rate earned on
participation interests declined 145 basis points in 2002 from 2001 while the
rate earned on participation interests in 2001 declined 75 basis points from
2000 but was offset slightly by higher fees in 2001.
The table below shows changes in interest and fee income for the twelve months
ended December 31 due to volume and rate variances for each category of earning
assets. The change in interest and fees not solely due to changes in volume or
rates has been allocated in proportion to the absolute dollar amounts of the
change in volume and rate.
- -----------------------------------------------------------------------------------------------------------------------------
2002 2001
- -----------------------------------------------------------------------------------------------------------------------------
Increase (Decrease) From Increase (Decrease) From
Previous Year Due To: Previous Year Due To:
- -----------------------------------------------------------------------------------------------------------------------------
(in millions of dollars) Volume Yield Total Volume Yield Total
- -----------------------------------------------------------------------------------------------------------------------------
Interest bearing deposits in
The Huntington National Bank $ 0.9 $(16.5) $ (15.6) $ 7.0 $ (12.2) $ (5.2)
Loan participation interests:
Commercial (3.9) (11.8) (15.7) (12.9) (8.7) (21.6)
Commercial real estate (23.6) (69.1) (92.7) 30.3 (45.7) (15.4)
Consumer (38.8) 11.3 (27.5) 19.3 4.4 23.7
Residential real estate (24.8) (2.4) (27.2) (9.6) 4.8 (4.8)
- -----------------------------------------------------------------------------------------------------------------------------
TOTAL EARNING ASSETS (90.2) (88.5) (178.7) 34.1 (57.4) (23.3)
- -----------------------------------------------------------------------------------------------------------------------------
TOTAL INTEREST-BEARING LIABILITIES --- --- --- --- --- ---
- -----------------------------------------------------------------------------------------------------------------------------
INTEREST AND FEE INCOME $(90.2) $(88.5) $(178.7) $ 34.1 $ (57.4) $ (23.3)
=============================================================================================================================
23
PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES
The provision for loan losses is the charge to earnings necessary to maintain
the allowance for loan losses (ALL) at a level adequate to absorb management's
estimate of inherent losses in the loan portfolio. The provision for loan losses
was a credit of $0.2 million for 2002, versus an expense of $48.5 million and
$2.3 million for the years ended December 31, 2001 and 2000, respectively. The
decline in provision expense in 2002 from 2001 was indicative of management's
judgment regarding the adequacy of the allowance for loan losses at December 31,
2002.
The ALL was $140.4 million at December 31, 2002, down from $175.7 million at the
end of 2001. This represents 2.79% and 3.27% of total loan participations at the
end of 2002 and 2001, respectively. Non-performing loans were covered by the ALL
1.45 times at the end of 2002 compared with 0.9 times at the end of the prior
year. Additional information regarding the ALL and asset quality appears in the
"Credit Quality" section. The following table shows the activity in HPCI's ALL.
- -----------------------------------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001 2000 1999 1998
- -----------------------------------------------------------------------------------------------------------
BALANCE, BEGINNING OF YEAR $ 175,690 $ 91,826 $104,151 $ 87,799 $ ---
Allowance of loan participations 37,020 113,291 (9,434) 25,988 88,789
acquired, net
Distribution of participations in
Florida-related loans --- (18,604) --- --- ---
Net loan losses
Commercial (29,686) (32,959) (1,274) (1,203) (58)
Commercial real estate (21,599) (7,574) (1,321) (2,760) (401)
Consumer (20,911) (18,800) (2,589) (5,673) (531)
Residential real estate --- --- --- --- ---
Provision (credit) for loan losses (161) 48,510 2,293 --- ---
- -----------------------------------------------------------------------------------------------------------
BALANCE, END OF YEAR $ 140,353 $ 175,690 $ 91,826 $104,151 $87,799
===========================================================================================================
Total net charge-offs were 1.37% in 2002, up from 0.93% and 0.09% of average
loan participations in 2001 and 2000, respectively. Net charge-offs related to
participations in commercial loans were 5.9% in both of the recent two years
versus 0.18% in 2000. Net charge-offs related to consumer loans were up to 3.00%
in 2002 from 1.76% in 2001 and 0.30% in 2000. Net charge-offs were 0.56%, 0.18%,
and 0.03% for participations in commercial real estate loans in 2002, 2001, and
2000, respectively. The higher charge-off ratios in 2002 were the result of
participation interests in lower-quality underlying loans acquired in
association with the issuance of the Class C and D preferred securities in the
fourth quarter of 2001.
An ALL is transferred to HPCI from the Bank to Holdings and then from Holdings
on loans underlying the participations at the time the participations are
acquired. Prior to the fourth quarter of 2001, HPCI had been transferring a
portion of the ALL related to loan paydowns and other similar transactions
underlying the participation interests back to the Bank through Holdings.
Subsequently, with concerns over the general economy and the deteriorating
credit quality in the loan participation portfolio, HPCI ceased transferring the
allowance for such transactions.
It is HPCI's policy to perform a detailed analysis as of the end of each period
to estimate the level of the ALL. HPCI, through reliance on methods utilized by
Huntington, allocates the ALL to each loan participation category based on an
expected loss ratio determined by continuous assessment of credit quality based
on portfolio risk characteristics and other relevant factors such as historical
performance, internal controls, and impacts from mergers and acquisitions. For
the commercial and commercial real estate loan participations, expected loss
factors are assigned by credit grade at the individual underlying loan level at
the time the loan is originated by the Bank. On a periodic basis, management
reevaluates these credit grades. The aggregation of these factors represents
management's estimate of the inherent loss. The portion of the allowance
allocated to the more homogeneous underlying consumer loan participations is
determined by developing expected loss ratios based on the risk characteristics
of the various portfolio segments and giving consideration to existing economic
conditions and trends.
24
- -----------------------------------------------------------------------------------------------------------------------------
2002 2001 2000 1999 1998
- -----------------------------------------------------------------------------------------------------------------------------
% OF % OF % OF % OF % OF
LOAN LOAN LOAN LOAN LOAN
PART. PART. PART. PART. PART.
(in thousands TO TO TO TO TO
of dollars) ALL TOTAL ALL TOTAL ALL TOTAL ALL TOTAL ALL TOTAL
- -----------------------------------------------------------------------------------------------------------------------------
Commercial $75,264 6.9% $103,119 12.0% $38,327 10.5% $38,270 13.5% $27,521 18.7%
Consumer 9,979 12.2% 17,030 14.6% 25,793 16.6% 31,693 13.1% 34,916 11.8%
Real estate
Residential 2,883 3.1% 1,766 5.0% 1,305 6.1% 1,936 12.4% 1,630 15.2%
Commercial 26,605 77.8% 33,886 68.4% 12,381 66.8% 12,923 61.0% 11,797 54.3%
- -----------------------------------------------------------------------------------------------------------------------------
Total Allocated 114,731 100.0% 155,801 100.0% 77,806 100.0% 84,822 100.0% 75,864 100.0%
Total Unallocated 25,622 --- 19,889 --- 14,020 --- 19,329 --- 11,935 ---
- -----------------------------------------------------------------------------------------------------------------------------
Total $140,353 100.0% $175,690 100.0% $91,826 100.0% $104,151 100.0% $87,799 100.0%
=============================================================================================================================
% of Loan Part. 2.79% 3.27% 1.57% 1.72% 1.48%
=============================================================================================================================
Expected loss ratios incorporate factors such as trends in past due and
non-accrual amounts, recent underlying loan loss experience, current economic
conditions, risk characteristics, and concentrations of various underlying loan
categories. Actual loss ratios experienced in the future, however, could vary
from those expected as an underlying loan's performance is a function of not
only economic factors but also other factors unique to each customer. Actual
loss ratios experienced in the future, could vary from those expected, as
performance is a function of factors unique to each customer as well as general
economic conditions. To ensure adequacy to a higher degree of confidence, a
portion of the ALL is considered unallocated. Due to the increase in
uncertainties in the general economic outlook and world events that could impact
customers underlying HPCI's participation interests, the unallocated portion of
the ALL increased at the end of 2002. While amounts are allocated to various
portfolio segments, the total ALL, excluding impairment reserves prescribed
under provisions of Statement of Financial Accounting Standard No. 114, is
available to absorb losses from any segment of the loan participation portfolio.
NON-INTEREST INCOME AND NON-INTEREST EXPENSE
Non-interest income was $6.8 million in 2002 and $1.6 million in 2001. This
primarily represents rental income received from the Bank related to land and
land improvements, and buildings acquired in 2000, and leasehold improvements
ultimately acquired by HPCLI in the fourth quarter of 2001. In 2002, HPCI begain
receiving fees from the Bank for use of its assets as collateral for the Bank's
advances from the Federal Home Loan Bank of Cincinnati (FHLBC). These fees
totaled $641,000 in 2002. See Note 10 to the consolidated financial statements
for more information regarding use of HPCI's assets as collateral for the Bank's
advances from the FHLBC.
Non-interest expense was $13.3 million in 2002 compared with $10.0 million in
2001. Non-interest expense for 2000 was $8.0 million. Non-interest expense
includes fees paid monthly to the Bank for servicing the loans underlying the
participation interests, and other costs such as depreciation and amortization
on premises and equipment and professional service fees. On an annual basis, the
service fee with respect to the commercial real estate, commercial, and consumer
loans is equal to the outstanding principal balance of each loan multiplied by a
fee of 0.125% and the service fee for residential real estate loans is equal to
0.282% of the interest income collected. HPCI paid servicing fees of $6.7
million for the year ended December 31, 2002, $8.3 million and $7.8 million for
the years ended December 31, 2001 and 2000, respectively. The increase in
non-interest expense for 2002 was due largely to higher depreciation and
amortization on premises and equipment, which amounted to $5.8 million, but was
offset by lower servicing fees paid on its loan participation portfolio. The
increase in non-interest expense in 2001 was primarily due to depreciation and
amortization of $1.5 million recorded on the assets acquired.
INCOME TAXES
HPCI has elected to be treated as a REIT for Federal income tax purposes and
intends to maintain compliance with the provisions of the Code and, therefore,
is not subject to income taxes. HPCI's subsidiary, HPCLI, elected to be treated
as a taxable REIT subsidiary and, therefore, a separate provision related to its
income taxes is included in the accompanying consolidated financial statements.
25
INTEREST RATE RISK MANAGEMENT
HPCI's income consists primarily of interest income on participation interests
in commercial, consumer, residential real estate, and commercial real estate
loans. If there is a decline in market interest rates, the company may
experience a reduction in interest income on its participation interests and a
corresponding decrease in funds available to be distributed to shareholders. The
reduction in interest income may result from downward adjustments of the indices
upon which the interest rates on underlying variable rate loans are based and
from prepayments of underlying loans with fixed interest rates as well as
reinvestment in lower-earning assets.
Huntington conducts its interest rate risk management on a centralized basis and
does not manage HPCI's interest rate risk seperately. A key element used in
Huntington's interest rate risk management is an income simulation model, which
includes, among other things, assumptions for loan prepayments on the existing
portfolio and new loan volumes. Using that model for HPCI as of December 31,
2002, and assuming no new loan participation volumes, interest income for the
next 12 month period would be expected to increase by 7.7% if rates rose 200
basis points gradually and with a parallel shift of the yield curve above the
forward rates implied in the December 31, 2002 yield curve. Interest income
would be expected to decline 7.0% in the event of a gradual 200 basis point
decline in rates from the forward rates implied in the December yield curve.
CREDIT QUALITY
HPCI's exposure to credit risk is managed by personnel of the Bank through its
use of consistent underwriting standards that emphasize "in-market" lending
while avoiding highly leveraged transactions as well as excessive industry and
other concentrations. The Bank's credit administration function employs risk
management techniques to ensure that loans adhere to corporate policy and
problem loans are promptly identified. These procedures provide executive
management of the Bank and HPCI with the information necessary to implement
policy adjustments where necessary, and to take corrective actions on a
proactive basis. These procedures also include evaluating the adequacy of the
ALL, which includes an analysis of specific credits and the application of
relevant reserve factors that represent relative risk, based on portfolio
trends, current and historic loss experience, and prevailing economic
conditions, to specific portfolio segments.
Concentration of credit risk generally arises with respect to participation
interests when a number of underlying loans have borrowers engaged in similar
business activities or activities in the same geographical region. Concentration
of credit risk indicates the relative sensitivity of performance to both
positive and negative developments affecting a particular industry. Borrowers
obligated in loans underlying HPCI's participation interests, however, do not
represent a particular concentration of similar business activity. HPCI's
balance sheet exposure to geographic concentrations directly affects the credit
risk of the underlying loans within the participation interests. The majority of
the loans underlying the participation interests are located in Ohio, Michigan,
Indiana, and Kentucky. At December 31, 2002, 95.8% of the underlying loans in
all participation interests consisted of loans located in these four states.
Consequently, the portfolio may experience a higher default rate in the event of
adverse economic, political, or business developments or natural hazards in
these states and may affect the ability of borrowers to make payments of
principal and interest on the underlying loans.
- --------------------------------------------------------------------------------------------------------------------------------
NON-PERFORMING ASSETS AT DECEMBER 31,
----------------------------------------------------------------------
(in thousands of dollars) 2002 2001 2000 1999 1998
- --------------------------------------------------------------------------------------------------------------------------------
Participation interests in non-accrual loans
Commercial $ 57,112 $ 156,874 $ 16,025 $ 14,684 $ 4,880
Commercial Real Estate 32,979 32,492 19,638 23,465 10,918
Residential Real Estate 6,455 8,232 6,271 320 1,247
- --------------------------------------------------------------------------------------------------------------------------------
TOTAL NON-PERFORMING ASSETS $ 96,546 $ 197,598 $ 41,934 $ 38,469 $ 17,045
================================================================================================================================
NON-PERFORMING ASSETS AS A % OF TOTAL
PARTICIPATION INTERESTS 1.92% 3.67% 0.72% 0.64% 0.29%
ALLOWANCE FOR LOAN LOSSES AS A % OF NON-
PERFORMING ASSETS 145.37% 88.91% 218.98% 270.74% 515.10%
Non-performing assets (NPAs), consist of participation interests in underlying
loans that are no longer accruing interest. Underlying commercial and commercial
real estate loans are placed on non-accrual status and stop accruing interest
when collection of principal or interest is in doubt or generally when the
underlying loan is 90 days past due. Underlying residential real estate loans
are placed on non-accrual status within 180 days past due as to principal and
210 days past due as to interest. When interest accruals are suspended, accrued
interest income is reversed with
26
current year accruals charged to earnings and prior year amounts generally
charged off as a credit loss. Consumer loans are not placed on non-accrual
status; rather they are charged off in accordance with regulatory statutes
governing the Bank, which is generally no more than 120 days.
Total NPAs declined to $96.5 million at the end of 2002 from $197.6 million at
December 31, 2001, representing 1.92% and 3.67% of total participation
interests. The decrease was due in large part to credit losses of $51.3 million
taken in 2002 along with payment activity. The amount of participation interests
in non-performing Florida-related loans distributed in 2001 approximated $4.6
million.
Underlying loans past due ninety days or more but continuing to accrue interest
were $26.1 million at the end of 2002 and $24.3 million at December 31, 2001.
Under the participation and subparticipation agreements, HPCI may direct the
Bank to dispose of any underlying loan that becomes classified, is placed in a
non-performing status, or is renegotiated due to the financial deterioration of
the borrower. The Bank may institute foreclosure proceedings at the discretion
of HPCI, exercise any power of sale contained in any mortgage or deed of trust,
obtain a deed in lieu of foreclosure, or otherwise acquire title to a property
underlying a mortgage loan by operation of law or otherwise in accordance with
the terms of the participation and subparticipation agreement. Any participation
interest in a loan is sold to the Bank at fair market value where the security
is either repossessed or goes into foreclosure proceedings. The Bank then incurs
all costs associated with repossession and foreclosure.
LIQUIDITY AND CAPITAL RESOURCES
The objective of HPCI's liquidity management is to ensure the availability of
sufficient cash flows to meet all of its financial commitments and to capitalize
on opportunities for business expansion. In managing liquidity, management takes
into account various legal limitations placed on a REIT.
HPCI's principal liquidity needs are to pay operating expenses and dividends and
acquire additional participation interests as the underlying loans in its
portfolio paydown or mature. Operating expenses and dividends are expected to be
funded through cash generated by operations, while the acquisition of additional
participation interests in loans is intended to be funded with the proceeds
obtained from repayment of principal balances by individual borrowers. HPCI
intends to pay dividends on its preferred stock and common stock in amounts
necessary to continue to preserve its status as a REIT under the Internal
Revenue Code.
As mentioned previously, HPCI issued to Holdings Class C and D preferred
securities and received a capital contribution of common equity in exchange for
the fair market value of participation interests in certain loans and leasehold
improvements in 2001, which approximated $400 million. The company transferred
the leasehold improvements to HPCLI in exchange for its common shares. Holdings
subsequently sold all of the Class C preferred securities in an underwritten
public offering. HPCI did not receive any of Holdings' proceeds from the sale.
On December 31, 2001, HPCI distributed its participation interests in
Florida-related loans to its common shareholders, Holdings and Huntington, in
anticipation of the eventual sale of the Florida operations by the Bank that
closed on February 15, 2002. This distribution, which approximated $1.3 billion,
consisted of cash and the net book value of participation interests in loans.
At December 31, 2002 and 2001, HPCI maintained interest bearing and non-interest
bearing cash balances with the Bank totaling $543.3 million and $364.9 million,
respectively. HPCI maintains and transacts all of its cash activity with the
Bank and invests available funds in Eurodollar deposits with the Bank for a term
of not more than 30 days.
To the extent that the board of directors determines that additional funding is
required, management may raise such funds through additional equity offerings,
debt financings, or retention of cash flow, or a combination of these methods.
However, any cash flow retention must be consistent with the provisions of the
Internal Revenue Code requiring the distribution by a REIT of at least 90% of
its REIT taxable income, excluding capital gains, and must take into account
taxes that would be imposed on undistributed income. Management does not
anticipate that additional funding will be required for at least the next twelve
months.
27
RESULTS FOR THE FOURTH QUARTER
Net income for the fourth quarter 2002 was $99.9 million, up from $85.2 million
for the third quarter 2002 and $89.1 million for the last quarter 2001. After
the declaration and payment of preferred stock dividends of $5.7 million, net
income applicable to common shares for the fourth quarter 2002 was $94.2
million. This compares with $79.4 million for the third quarter 2002 and $82.4
million for the last quarter of 2001 after applicable preferred dividends. Lower
interest rates and earning assets directly impacted the performance of the
company in the recent quarter, which was offset by improvements in credit
quality.
It is HPCI's policy to perform a detailed analysis as of the end of each period
to estimate the level of the ALL. As a result of that analysis in the fourth
quarter 2002, management reduced the ALL by $20 million with a credit to the
provision for loan losses. This reduction was partially based on charge-offs of
commercial loans during the second half of 2002 that were lower than the
previous estimated losses. Additionally, the reduction was in response to an
overall improvement in the credit quality of the loan participations owned by
HPCI. Without the credit to provision for loan losses in the fourth quarter
2002, net income would have been $79.9 million, or 6% lower than the third
quarter 2002 and 10% lower than the same period a year ago, which reflected the
lower interest rate environment.
Interest income for the recent quarter was $76.3 million, which was down from
$80.5 million and $115.2 million for the three months ended September 30, 2002
and December 31, 2001, respectively. The yield on earning assets declined to
5.46% from 5.61% and 6.55% for the same respective quarterly periods.
Total assets declined to $5.5 billion at the end of 2002, down from $6.2 billion
at September 30, 2002 and $5.9 billion at December 31, 2001. HPCI paid its
fourth quarter preferred dividends and paid dividends and returned capital to
its common shareholders. These distributions exceeded $750 million in cash paid
on December 31, 2002.
The allowance for loan losses decreased to 2.79% of total loan participation
interests at December 31, 2002 from 3.22% at the end of the preceding quarter.
Net charge-offs in the fourth quarter 2002 were $12.9 million, versus $9.9
million for the third quarter and $38.9 million for the last quarter of the
prior year. This represents 0.99%, 0.75%, and 2.31% of average loan
participations for the same respective quarterly periods. The increase in the
recent quarter was due to the general decline in economic conditions. HPCI's
management expects favorable trends in credit quality and net charge-offs
entering 2003 assuming no further deterioration in the economy.
HPCLI received from the Bank rent of $1.5 million in the recent three months,
which is reflected in non-interest income, compared with $1.5 million for the
third quarter of 2002 and $1.6 million for the year-ago fourth quarter.
Non-interest expense included depreciation and amortization expense for all
premises and equipment, which amounted to $1.4 million for the fourth quarter
2002, compared with $1.4 million for the preceding three months and $1.5 million
for the last quarter of 2001. Management fees for the fourth quarter 2002 paid
by HPCI were $1.6 million, compared with $1.6 million for the third quarter of
2002 and $2.2 million for the last quarter of the prior year. HPCLI is a taxable
REIT subsidiary and therefore, a provision of $25,000 for income taxes applied
to its taxable income is reflected in the fourth quarter 2002 results. A
provision of $22,000 and $26,000 was recorded in the third quarter of 2002 and
the fourth quarter of 2001.
28
- -------------------------------------------------------------------------------
QUARTERLY STATEMENTS OF INCOME
- -------------------------------------------------------------------------------
2002 2001
----------------------------------- ------------------------------------
(in thousands of dollars) FOURTH THIRD SECOND FIRST FOURTH THIRD SECOND FIRST
- ---------------------------------------------------------------------------------------------------------------------------
Interest and fee income (1)
Interest on loan participation interests
Commercial $ 5,734 $ 5,421 $ 6,440 $ 7,309 $ 9,489 $ 8,881 $ 10,211 $ 11,962
Commercial real estate 50,951 53,512 54,290 53,880 68,082 75,875 78,247 82,376
Consumer 16,838 18,198 18,882 20,044 28,349 25,102 24,189 23,127
Residential real estate 2,807 3,403 3,851 4,560 9,259 10,438 12,232 9,272
- -----------------------------------------------------------------------------------------------------------------------------
76,330 80,534 83,463 85,793 115,179 120,296 124,879 126,737
- -----------------------------------------------------------------------------------------------------------------------------
Fees from loan participation interests 1,988 2,135 2,737 2,441 3,034 3,703 3,030 1,729
Interest bearing deposits in banks 3,138 4,033 3,284 1,878 4,432 6,115 5,041 12,270
- -----------------------------------------------------------------------------------------------------------------------------
TOTAL INTEREST AND FEE INCOME 81,456 86,702 89,484 90,112 122,645 130,114 132,950 140,736
- -----------------------------------------------------------------------------------------------------------------------------
Provision (credit) for loan losses (20,000) -- 3,000 16,839 31,404 6,428 6,751 3,927
- -----------------------------------------------------------------------------------------------------------------------------
NET INTEREST INCOME
AFTER PROVISION FOR LOAN LOSSES 101,456 86,702 86,484 73,273 91,241 123,686 126,199 136,809
- -----------------------------------------------------------------------------------------------------------------------------
Non-interest income
Rental income 1,520 1,530 1,533 1,535 1,603 15 14 14
Collateral fees 177 191 273 -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------
1,697 1,721 1,806 1,535 1,603 15 14 14
- -----------------------------------------------------------------------------------------------------------------------------
Non-interest expense
Management fees 1,647 1,623 1,715 1,729 2,155 2,056 2,110 1,973
Depreciation and amortization 1,437 1,428 1,450 1,452 1,517 4 4 4
Other 150 101 92 458 54 42 42 54
- -----------------------------------------------------------------------------------------------------------------------------
3,234 3,152 3,257 3,639 3,726 2,102 2,156 2,031
- -----------------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 99,919 85,271 85,033 71,169 89,118 121,599 124,057 134,792
Income taxes 25 22 25 (117) 26 -- -- --
- -----------------------------------------------------------------------------------------------------------------------------
NET INCOME BEFORE PREFERRED DIVIDENDS 99,894 85,249 85,008 71,286 89,092 121,599 124,057 134,792
DIVIDENDS ON PREFERRED STOCK 5,709 5,892 6,231 5,982 6,737 15,090 -- --
- -----------------------------------------------------------------------------------------------------------------------------
NET INCOME APPLICABLE TO
COMMON SHARES (2) $ 94,185 $79,357 $78,777 $ 65,304 $ 82,355 $106,509 $124,057 $134,792
=============================================================================================================================
(1) On December 31, 2001, in anticipation of the eventual sale by the Bank of
its Florida banking operations to SunTrust Banks, Inc. (SunTrust), which
closed on February 15, 2002, HPCI distributed participation interests in
Florida-related loans to its common shareholders, Holdings and Huntington.
This distribution approximated $1.3 billion and consisted of cash and the
net book value of participation interests in loans, net of $18.6 million
of ALL, which were included in the sale to SunTrust, including the related
accrued interest. This distribution represented approximately 17% of
HPCI's total assets as of December 31, 2001.
(2) All of HPCI's common stock is owned by Huntington, HPCII, and HPCH-III and
therefore, earnings per common share information is not presented.
29
ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The tables below represents the remaining maturity of HPCI's interest-earning
assets at December 31, 2002. In addition, variable-rate interest-earning assets
by repricing frequency is presented below. Assets that immediately reprice are
placed in the overnight column.
- -----------------------------------------------------------------------------------------------------------------------
WITHIN ONE ONE TO THREE THREE TO FIVE OVER FIVE
(in thousands) OVERNIGHT YEAR YEARS YEARS YEARS TOTAL
- -----------------------------------------------------------------------------------------------------------------------
Interest bearing
deposits $ --- $ --- $ --- $ --- $ --- $ ---
Loan participations:
Fixed rate --- 115,426 229,097 211,274 673,253 1,229,050
Variable rate --- 1,182,720 889,445 622,628 1,109,647 3,804,440
- -----------------------------------------------------------------------------------------------------------------------
Total maturities $ --- $ 1,298,146 $ 1,118,542 $ 833,902 $ 1,782,900 $ 5,033,490
=======================================================================================================================
Repricing frequency $ 1,791,646 $ 1,389,369 $ 370,046 $ 220,032 $ 33,347 $ 3,804,440
=======================================================================================================================
Interest rate risk is HPCI's primary market risk. As indicated earlier, HPCI's
income consists primarily of interest income from participation interests in
commercial, consumer, residential mortgage, and commercial mortgage loans. If
there is a decline in market interest rates resulting from downward adjustments
in the indices upon which the interest rates on loans are based, HPCI may
experience a reduction in interest income and a corresponding decrease in funds
available for distribution to shareholders. A decline in interest income can
also be realized from prepayments, including pay-offs, of loans with fixed
interest rates, resulting in reinvestment of proceeds in lower-yielding
participation interests. The borrower has the ability to prepay a loan with or
without premium or penalty depending on the provisions found in the underlying
loan agreements. The level of underlying loan prepayments is influenced by
several factors, including the interest rate environment, the real estate market
in particular geographic areas, the timing of transactions, and circumstances
related to individual borrowers and loans.
At December 31, 2002, approximately 24% of the loans underlying the
participation portfolio carried fixed interest rates. Such loans tend to
increase interest rate risk. At this same date, HPCI did not have any
interest-rate-sensitive liabilities.
Analysis of HPCI's interest earning assets is performed in conjunction with, and
is part of, Huntington's overall interest rate management process. A key element
used in Huntington's process is the use of an income simulation model, which
includes, among other things, assumptions for prepayments. Based on the most
recent simulation performed at December 31, 2002, HPCI's experience and
management's estimates, the results of the company's sensitivity analysis
indicated that 12-month net interest income would be expected to increase by
approximately 7.7% if rates rose 200 basis points above December 31, 2002
implied forward expectations and would drop an estimated 7.0%, in the event of a
gradual 200 basis point decline from December 31, 2002 implied forward
expectations.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following consolidated financial statements of HPCI at December 31, 2002 and
2001 and for the years ended December 31, 2002, 2001, and 2000 are included in
this report at the pages indicated. Quarterly statements of income are found on
page 29 of this report.
Page
----
Report of Management 31
Independent Auditors' Report 32
Consolidated Balance Sheets 33
Consolidated Statements of Income 34
Consolidated Statements of Changes in Shareholders' Equity 35
Consolidated Statements of Cash Flows 36
Notes to Consolidated Financial Statements 37
30
REPORT OF MANAGEMENT
The management of HPCI is responsible for the financial information and
representations contained in the consolidated financial statements and other
sections of this report. The consolidated financial statements have been
prepared in conformity with accounting principles generally accepted in the
United States. In all material respects, they reflect the substance of
transactions that should be included based on informed judgments, estimates, and
currently available information.
HPCI utilizes accounting and other control systems maintained by Huntington
Bancshares Incorporated (Huntington) that, in the opinion of management, provide
reasonable assurance that (1) transactions are properly authorized, (2) that the
assets are properly safeguarded, and (3) transactions are properly recorded and
reported to permit the preparation of the financial statements in conformity
with accounting principles generally accepted in the United States. The systems
of internal accounting controls include the careful selection and training of
qualified personnel, appropriate segregation of responsibilities, communication
of written policies and procedures, and a broad program of internal audits. The
costs of the controls are balanced against the expected benefits. During 2002,
the Audit Committee of the Board of Directors met with management, Huntington's
internal auditors, and the independent auditors, Ernst & Young LLP, to review
the scope of the audits and to discuss the evaluation of internal accounting
controls and financial reporting matters. The independent and internal auditors
have free access to and meet confidentially with the Audit Committee to discuss
appropriate matters. Also during 2002, HPCI formed a Disclosure Review
Committee. This committee's purpose is to design and maintain disclosure
controls and procedures to ensure that material information relating to the
financial and operating condition of HPCI is properly reported to its chief
executive officer or president, chief financial officer or principal accounting
officer, internal auditors, and the Audit Committee of the Board of Directors in
connection with the preparation and filing of periodic reports and the
certification of those reports by the chief executive officer or president and
the chief financial officer or principal accounting officer.
The independent auditors are responsible for expressing an informed
judgment as to whether the consolidated financial statements present fairly, in
accordance with accounting principles generally accepted in the United States,
the financial position, results of operations and cash flows of HPCI. They
obtained an understanding of HPCI's internal accounting controls and conducted
such tests and related procedures as they deemed necessary to provide reasonable
assurance, giving due consideration to materiality, that the consolidated
financial statements contain neither misleading nor erroneous data.
/s/ Michael J. McMennamin /s/ John D. Van Fleet
- --------------------------------- -------------------------------------
Michael J. McMennamin John D. Van Fleet
President Vice President
31
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
To the Board of Directors and Shareholders
Huntington Preferred Capital, Inc. and Subsidiary
We have audited the accompanying consolidated balance sheets of Huntington
Preferred Capital, Inc. and Subsidiary as of December 31, 2002 and 2001, and the
related consolidated statements of income, changes in shareholders' equity, and
cash flows for each of the three years in the period ended December 31, 2002.
These financial statements are the responsibility of the company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Huntington
Preferred Capital, Inc. and Subsidiary at December 31, 2002 and 2001, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2002, in conformity with accounting
principles generally accepted in the United States.
/s/ ERNST & YOUNG LLP
Columbus, Ohio
February 28, 2003
32
- ----------------------------------------------------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
- ----------------------------------------------------------------------------------------------------------------------------
DECEMBER 31,
---------------------------------------
(in thousands of dollars, except share data) 2002 2001
- ----------------------------------------------------------------------------------------------------------------------------
ASSETS
Non-interest bearing balances with The Huntington National Bank $ 534,254 $ ---
Interest bearing balances with The Huntington National Bank --- 364,912
Due from Huntington Preferred Capital Holdings, Inc. and The
Huntington National Bank 7,440 293,809
Loan participation interests
Commercial 344,858 646,509
Commercial real estate 3,922,467 3,678,061
Consumer 612,357 783,735
Residential real estate 153,808 270,671
- ----------------------------------------------------------------------------------------------------------------------------
5,033,490 5,378,976
Less allowance for loan losses 140,353 175,690
- ----------------------------------------------------------------------------------------------------------------------------
Net loan participation interests 4,893,137 5,203,286
- ----------------------------------------------------------------------------------------------------------------------------
Premises and equipment 38,088 44,641
Accrued income and other assets 44,102 42,111
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 5,517,021 $5,948,759
============================================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Accounts payable and other liabilities $ 670 $ 31
- ----------------------------------------------------------------------------------------------------------------------------
Total Liabilities 670 31
- ----------------------------------------------------------------------------------------------------------------------------
SHAREHOLDERS' EQUITY
Preferred stock, Class A, 8.000% noncumulative, non- exchangeable; $1,000
par and liquidation value per share;
1,000 shares authorized, issued and outstanding in 2002 and 2001 1,000 1,000
Preferred stock, Class B, variable-rate noncumulative and
conditionally exchangeable; $1,000 par and liquidation
value per share; authorized 500,000 shares; 400,000 shares
issued and outstanding in 2002 and 2001 400,000 400,000
Preferred stock, Class C, 7.875% noncumulative and
conditionally exchangeable; $25 par and liquidation
value; authorized 2,000,000 shares; 2,000,000 shares issued and
outstanding in 2002 and 2001 50,000 50,000
Preferred stock, Class D, variable-rate noncumulative and
conditionally exchangeable; $25 par and liquidation
value; authorized 14,000,000 shares; 14,000,000 shares issued
and outstanding in 2002 and 2001 350,000 350,000
Preferred stock, $25 par value, 10,000,000 shares
authorized; no shares issued or outstanding in 2001 and 2000 --- ---
Common stock - without par value; shares authorized, issued, and
outstanding: 14,000,000 in 2002 and 2001 4,715,351 5,082,511
Retained earnings --- 65,217
- ----------------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 5,516,351 5,948,728
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 5,517,021 $5,948,759
============================================================================================================================
See notes to consolidated financial statements.
33
- ----------------------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
- ----------------------------------------------------------------------------------------------------------------------
TWELVE MONTHS ENDED DECEMBER 31,
-------------------------------------------------------
(in thousands of dollars) 2002 2001 2000
- ----------------------------------------------------------------------------------------------------------------------
Interest and fee income
Interest on loan participation interests
Commercial $ 24,904 $ 40,543 $ 62,488
Commercial real estate 212,633 304,580 324,244
Consumer 73,962 100,767 78,327
Residential real estate 14,621 41,201 46,421
- ----------------------------------------------------------------------------------------------------------------------
326,120 487,091 511,480
- ----------------------------------------------------------------------------------------------------------------------
Fees from loan participation interests 9,301 11,496 5,143
Interest bearing deposits in banks 12,333 27,858 33,095
- ----------------------------------------------------------------------------------------------------------------------
TOTAL INTEREST AND FEE INCOME 347,754 526,445 549,718
- ----------------------------------------------------------------------------------------------------------------------
Provision (credit) for loan losses (161) 48,510 2,293
- ----------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
AFTER PROVISION FOR LOAN LOSSES 347,915 477,935 547,425
- ----------------------------------------------------------------------------------------------------------------------
Non-interest income 6,759 1,646 ---
Non-interest expense 13,282 10,015 7,983
- ----------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 341,392 469,566 539,442
Income taxes (45) 26 ---
- ----------------------------------------------------------------------------------------------------------------------
NET INCOME BEFORE PREFERRED DIVIDENDS 341,437 469,540 539,442
DIVIDENDS ON PREFERRED STOCK 23,814 21,827 80
- ----------------------------------------------------------------------------------------------------------------------
NET INCOME APPLICABLE TO COMMON SHARES $ 317,623 $ 447,713 $ 539,362
======================================================================================================================
</Table>
See notes to consolidated financial statements.
34
- ------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
- ------------------------------------------------------------------------------------------------------
PREFERRED, CLASS A PREFERRED, CLASS B PREFERRED, CLASS C
------------------ ------------------ -------------------
(in thousands, except per share data) SHARES STOCK SHARES STOCK SHARES STOCK
- ------------------------------------------------------------------------------------------------------
Balance, January 1, 2000 1 $ 1,000 -- $ -- -- $ --
Comprehensive Income:
Net income
Total comprehensive income
Issuance of Class B preferred stock 400 400,000
- -----------------------------------------------------------------------------------------------------
Balance, December 31, 2000 1 1,000 400 400,000 -- --
- -----------------------------------------------------------------------------------------------------
Comprehensive Income:
Net income
Total comprehensive income
Issuance of Class C preferred stock 2,000 50,000
- -----------------------------------------------------------------------------------------------------
Balance, December 31, 2001 1 1,000 400 400,000 2,000 50,000
- -----------------------------------------------------------------------------------------------------
Comprehensive Income:
Net income
Total comprehensive income
- -----------------------------------------------------------------------------------------------------
Balance, December 31, 2002 1 $ 1,000 400 $400,000 2,000 $ 50,000
=====================================================================================================
PREFERRED, CLASS D PREFERRED
------------------------ --------------------
(in thousands, except per share data) SHARES STOCK SHARES STOCK
- ----------------------------------------------------------------------------------------------------------------------------------
Balance, January 1, 2000 --- $ --- --- $ ---
Comprehensive Income:
Net income
Total comprehensive income
Issuance of Class B preferred stock
Dividends declared on Class A preferred stock ($80.00 per share)
Dividends declared on common stock
Capital contribution in consideration for the acquisition of
loan participations, net
- ----------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2000 --- --- --- ---
- ----------------------------------------------------------------------------------------------------------------------------------
Comprehensive Income:
Net income
Total comprehensive income
Issuance of Class C preferred stock
Issuance of Class D preferred stock 14,000 350,000
Dividends declared on Class A preferred stock ($80.00 per share)
Dividends declared on Class B preferred stock ($44.225 per share)
Dividends declared on Class C preferred stock ($0.4265625 per share)
Dividends declared on Class D preferred stock ($0.22885 per share)
Dividends declared on common stock
Common shares issued in 18,666.66667-to-1 stock split
Distribution of participation interests in Florida loans
Capital contribution in consideration for the acquisition of
loan participations, net
- ----------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2001 14,000 350,000 --- ---
- ----------------------------------------------------------------------------------------------------------------------------------
Comprehensive Income:
Net income
Total comprehensive income
Dividends declared on Class A preferred stock ($80.00 per share)
Dividends declared on Class B preferred stock ($18.814075 per share)
Dividends declared on Class C preferred stock ($1.9685 per share)
Dividends declared on Class D preferred stock ($0.8766 per share)
Dividends declared on common stock
Return of capital
- ----------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2002 14,000 $350,000 --- $ ---
==================================================================================================================================
See notes to consolidated financial statements.
COMMON
----------------------- RETAINED
(in thousands, except per share data) SHARES STOCK EARNINGS TOTAL
- --------------------------------------------------------------------------------------------------------------------------------
Balance, January 1, 2000 1 $ 6,143,103 $ 74,529 $ 6,218,632
Comprehensive Income:
Net income 539,442 539,442
-------------
Total comprehensive income 539,442
-------------
Issuance of Class B preferred stock 400,000
Dividends declared on Class A preferred stock ($80.00 per share) (80) (80)
Dividends declared on common stock (458,335) (458,335)
Capital contribution in consideration for the acquisition of
loan participations, net 198,614 198,614
- --------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2000 1 6,341,717 155,556 6,898,273
- --------------------------------------------------------------------------------------------------------------------------------
Comprehensive Income:
Net income 469,540 469,540
-------------
Total comprehensive income 469,540
-------------
Issuance of Class C preferred stock 50,000
Issuance of Class D preferred stock 350,000
Dividends declared on Class A preferred stock ($80.00 per share) (80) (80)
Dividends declared on Class B preferred stock ($44.225 per share) (17,690) (17,690)
Dividends declared on Class C preferred stock ($0.4265625 per share) (853) (853)
Dividends declared on Class D preferred stock ($0.22885 per share) (3,204) (3,204)
Dividends declared on common stock (1,118) (538,052) (539,170)
Common shares issued in 18,666.66667-to-1 stock split 13,999 ---
Distribution of participation interests in Florida loans (1,273,059) (1,273,059)
Capital contribution in consideration for the acquisition of
loan participations, net 14,971 14,971
- --------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2001 14,000 5,082,511 65,217 5,948,728
- --------------------------------------------------------------------------------------------------------------------------------
Comprehensive Income:
Net income 341,437 341,437
-------------
Total comprehensive income 341,437
-------------
Dividends declared on Class A preferred stock ($80.00 per share) (80) (80)
Dividends declared on Class B preferred stock ($18.814075 per share) (7,525) (7,525)
Dividends declared on Class C preferred stock ($1.9685 per share) (3,937) (3,937)
Dividends declared on Class D preferred stock ($0.8766 per share) (12,272) (12,272)
Dividends declared on common stock (382,840) (382,840)
Return of capital (367,160) (367,160)
- --------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2002 14,000 $4,715,351 $ --- $ 5,516,351
================================================================================================================================
35
- -----------------------------------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
- -----------------------------------------------------------------------------------------------------------------------------------
TWELVE MONTHS ENDED DECEMBER 31,
----------------------------------------------------------
(in thousands of dollars) 2002 2001 2000
- -----------------------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net Income $341,437 $ 469,540 $539,442
Adjustments to reconcile net income to net
cash provided by operating activities:
Provision (credit) for loan losses (161) 48,510 2,293
Depreciation and amortization 5,767 1,529 ---
Loss on sale of fixed assets 483 --- ---
Decrease in accrued interest and other assets 2,384 15,328 118
Decrease (increase) in due from/to Huntington
Preferred Capital Holdings, Inc. and The
Huntington National Bank 286,369 (69,258) (218,957)
Increase in accounts payable and other
liabilities 639 31 ---
- -----------------------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES 636,918 465,680 322,896
- -----------------------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Decrease (increase) in interest bearing deposits
in The Huntington National Bank 364,912 453,960 (751,801)
Participation interests acquired (4,868,942) (5,909,528) (6,747,027)
Sales and repayments on loans underlying
participation interests 5,174,877 5,491,976 7,128,615
Proceeds from the sale of fixed assets 303 --- ---
Purchase of premises and equipment --- (797) ---
- -----------------------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES 671,150 35,611 (370,213)
- -----------------------------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Proceeds from issuance of Class B preferred
stock --- --- 400,000
Dividends paid on common stock (382,840) (539,170) (458,335)
Dividends paid on preferred stock (23,814) (21,827) (80)
Return of capital to common shareholders (367,160) (1,697) ---
- -----------------------------------------------------------------------------------------------------------------------------------
NET CASH USED FOR FINANCING ACTIVITIES (773,814) (562,694) (58,415)
- -----------------------------------------------------------------------------------------------------------------------------------
CHANGE IN CASH IN THE BANK 534,254 (61,403) (105,732)
CASH IN THE BANK:
AT BEGINNING OF PERIOD --- 61,403 167,135
- -----------------------------------------------------------------------------------------------------------------------------------
AT END OF PERIOD $534,254 $ --- $ 61,403
===================================================================================================================================
Supplemental information:
Net capital contributions from common
stockholder in the form of participation
interests in loans $ --- $ 14,971 $198,614
Capital contributions from preferred
stockholders in the form of participation
interests in loans and leasehold improvements --- 400,000 ---
Capital distribution to common stockholders
in the form of participation interests in loans --- (1,271,362) ---
Income taxes paid --- --- ---
Interest paid --- --- ---
See notes to consolidated financial statements.
36
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION: The consolidated financial statements include the
accounts of HPCI and its subsidiary and are presented in conformity with
accounting principles generally accepted in the United States (GAAP). The
consolidated financial statements reflect all adjustments, consisting of normal
recurring accruals, which are, in the opinion of management, necessary for a
fair presentation of the consolidated financial position, the results of
operations, and cash flows for the periods presented. All significant
intercompany accounts and transactions have been eliminated in consolidation.
BUSINESS: Huntington Preferred Capital, Inc. (HPCI) is a real estate investment
trust (REIT) organized under Ohio law in 1992. HPCI is owned by three related
parties, HPC Holdings-III, Inc. (HPCH-III), a Nevada corporation, Huntington
Preferred Capital II, Inc. (HPCII), an Ohio corporation, and Huntington
Bancshares Incorporated (Huntington), a Maryland corporation headquartered in
Columbus, Ohio. HPCI and HPCII are subsidiaries of HPCH-III, which is a
subsidiary of Huntington Preferred Capital Holdings, Inc. (Holdings), an Indiana
corporation. Holdings is a subsidiary of The Huntington National Bank (the
Bank), a national banking association organized under the laws of the United
States and also headquartered in Columbus, Ohio. The Bank is a wholly owned
subsidiary of Huntington. HPCI has one subsidiary, HPCLI, Inc. (HPCLI), formed
in March 2001 for the purpose of holding certain assets (primarily leasehold
improvements).
USE OF ESTIMATES: In preparing financial statements in conformity with
accounting principles generally accepted in the United States, management of
HPCI is required to make estimates, assumptions, and judgments that affect the
reported amounts of assets and liabilities as of the date of the balance sheet
and reported amounts of revenue and expenses during the reporting period. An
accounting estimate requires assumptions about uncertain matters that could have
a material effect on the financial statements of HPCI if a different amount
within a range of estimates were used or if estimates changed from period to
period. Actual results could differ from those estimates. A material estimate
that is particularly susceptible to significant change relates to the
determination of the allowance for loan losses.
LOAN PARTICIPATION INTERESTS: Participation interests in loans are acquired from
the Bank through Holdings by HPCI at the Bank's carrying value, which is the
principal amount outstanding plus accrued interest, net of unearned income, if
any, less an allowance for loan losses. Participation interests are categorized
based on the collateral securing the underlying loan.
Interest income is primarily accrued based on unpaid principal balances of the
underlying loans as earned. The underlying commercial and commercial real estate
loans are placed on non-accrual status and stop accruing interest when
collection of principal or interest is in doubt. When interest accruals are
suspended, accrued interest income is reversed with current year accruals
charged to earnings and prior year amounts generally charged off as a credit
loss. Consumer loans are not placed on non-accrual status; rather they are
charged off in accordance with regulatory statutes governing the Bank.
Consistent with these statutes, consumer loans are charged off when the Bank, as
servicer, determines that a loan is doubtful of collection. Generally, this
occurs when a loan is 120 days past due. Residential real estate loans are
placed on non-accrual status when principal payments are 180 days past due or
interest payments are 210 days past due. A charge-off on a residential real
estate loan is recorded when the loan has been foreclosed and the loan balance
exceeds the fair value of the collateral.
HPCI uses the cost recovery method in accounting for cash received on
non-accrual loans. Under this method, cash receipts 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. When, in
management's judgment, the borrower's ability to make periodic interest and
principal payments resumes, the loan is returned to accrual status.
Loan fees, which are comprised of origination fees, commitment fees, prepayment
fees, late fees, and other fees are recognized on a cash basis. Annually,
management compares loan fees received and recognized as fee income to the fees
that would have been recognized had such fees been deferred and amortized over
the lives of the respective loan participations on the interest method. For the
three years ended December 31, 2002, the difference in the fees received versus
those that would have been recognized under a deferral method was immaterial.
ALLOWANCE FOR LOAN LOSSES: An allowance for loan losses (ALL) is transferred to
HPCI through Holdings from the Bank on loans underlying the participations at
the time the participations are acquired. Prior to the fourth quarter of 2001,
HPCI had been transferring a portion of the ALL related to loan paydowns and
other similar transactions underlying the participation interests back to the
Bank. Subsequently, with concerns over the general economy and the deteriorating
credit quality in the loan participation portfolio, HPCI ceased transferring the
allowance for such transactions to allow
37
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
the ALL to build appropriately. The allowance for loan losses reflects
management's judgment as to the level considered appropriate to absorb inherent
losses in the loan participation portfolio. This judgment is based on a review
of individual loans underlying the participations, historical loss experience of
similar loans owned by the Bank, economic conditions, portfolio trends, and
other factors. When necessary, the allowance or credited for loan losses will be
adjusted through a provision for loan losses charged or credited to earnings.
Loan losses are charged against the allowance when management believes the loan
balance, or a portion thereof, is uncollectible. Subsequent recoveries, if any,
are credited to the allowance.
The allowance consists of an allocated and unallocated portion. The components
of the allowance represent estimates developed pursuant to Statement of
Financial Accounting Statement (SFAS) No. 5, Accounting for Contingencies, and
SFAS No. 114. The allocated portion of the allowance reflects expected losses
resulting from quantitative analyses developed through historical loss
experience and specific credit allocations at the individual underlying loan
level for commercial and commercial real estate loans. The specific credit
allocations are based on a continuous analysis of all loans by internal credit
rating. The historical loss element is determined using a loss migration
analysis that examines both the probability of default and the loss in the event
of default by loan category and internal credit rating. The loss migration
analysis is performed periodically and loss factors are updated regularly based
on actual experience. The portion of the allowance allocated to homogeneous
consumer loans is also determined by applying specific probability of default
and loss in the event of default factors to various segments of the loan
portfolio. Management's determination of the amounts necessary for
concentrations and changes in portfolio mix are also included in the allocated
component of the allowance. The unallocated portion of the allowance is
determined based on management's assessment of general economic conditions, as
well as specific economic conditions in the individual markets in which
Huntington operates. This determination inherently involves a higher degree of
subjectivity and considers current risk factors that may not have yet manifested
themselves in HPCI's historical loss factors used to determine the allocated
portion of the allowance.
PREMISES AND EQUIPMENT: Premises and equipment, primarily leasehold
improvements, are stated at cost, less accumulated depreciation and
amortization. Depreciation and amortization is computed principally by the
straight-line method over the estimated useful lives of the related assets.
Buildings are depreciated over an average of 30 to 40 years. Land improvements
are depreciated over 10 years. Leasehold improvements are amortized over the
lesser of the asset life or term of the related leases.
EARNINGS PER SHARE: All of HPCI's common stock is owned by Huntington, HPCII,
and HPCH-III and therefore, earnings per common share information is not
presented.
INCOME TAXES: HPCI has elected to be treated as a REIT for Federal income tax
purposes and intends to comply with the provisions of the Code. Accordingly,
HPCI will not be subject to Federal income tax to the extent it distributes its
earnings to stockholders and as long as certain asset, income and stock
ownership tests are met in accordance with the Code. As HPCI expects to maintain
its status as a REIT for Federal income tax purposes, only a provision for
income taxes is included in the accompanying financial statements for its
subsidiary's taxable income. HPCLI is a taxable REIT subsidiary for federal
income tax purposes.
STATEMENT OF CASH FLOWS: Cash and cash equivalents are defined as "Non-interest
bearing balances with The Huntington National Bank". There were no interest
payments or Federal income tax payments made in any year presented. The accrued
interest on participations purchased was previously reported as an investing
activity. Amounts have been reclassified from an investing activity to an
operating activity for all prior periods presented to conform to the current
year's presentation. For 2001 and 2000, net cash provided by operating
activities was increased by $455.3 million and $456.8 million, respectively. Net
cash provided by or used for investing activities decreased by the same
respective amounts.
2. PREFERRED SECURITIES
In October 2001, HPCI created three new classes of preferred securities, Class C
and Class D preferred securities and blank check preferred securities. HPCI
issued the Class C and D preferred securities to Holdings and received common
equity in October 2001 in exchange for $452.6 million of participation interests
in performing and non-performing commercial loans, including commercial real
estate loans, and consumer loans, with $86.5 million of specific loan loss
reserves, $45.4 million of leasehold improvements, and $3.5 million of accrued
interest that Holdings had acquired from the Bank. The underlying consumer loans
included a combination of automobile, truck, and equipment loans. The
38
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
company transferred the leasehold improvements to HPCLI in exchange for its
common shares. Holdings then sold the Class C preferred securities to the public
in November 2001 for cash consideration of $25 per share. HPCI did not receive
any of Holdings' proceeds from the sale of the securities. On December 27, 2002,
Holdings contributed its ownership in HPCI's Class A and Class D preferred
securities to HPCH-III.
3. LOAN PARTICIPATION INTERESTS
At December 31, loan participation interests were comprised of the following:
- ------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001
- ------------------------------------------------------------------------------
Commercial $ 344,858 $ 646,509
Commercial real estate 3,922,467 3,678,061
Consumer 612,357 783,735
Residential real estate 153,808 270,671
- ------------------------------------------------------------------------------
TOTAL LOAN PARTICIPATIONS $5,033,490 $5,378,976
==============================================================================
There are no underlying loans outstanding which would be considered a
concentration of lending in any particular industry, group of industries, or
business activity. Underlying loans are, however, concentrated in the four
states of Ohio, Michigan, Indiana, and Kentucky and comprise 95.8% of the
portfolio at December 31, 2002.
On December 31, 2001, in anticipation of the eventual sale by the Bank of its
Florida banking operations to SunTrust Banks, Inc. (SunTrust), which closed on
February 15, 2002, HPCI distributed participation interests in Florida-related
loans to its then common shareholders, Holdings and Huntington. This
distribution approximated $1.3 billion and consisted of cash and the net book
value of participation interests in loans, net of $18.6 million of ALL, which
were included in the sale to SunTrust, including the related accrued interest.
This distribution represented approximately 17% of HPCI's total assets as of
December 31, 2001.
PARTICIPATIONS IN NON-PERFORMING LOANS AND PAST DUE LOANS
At December 31, 2002 and 2001, the participations in loans in non-accrual status
and loans past due 90 days or more and still accruing interest, were as follows:
- -----------------------------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001
- -----------------------------------------------------------------------------------------------------
Commercial $57,112 $ 156,874
Commercial real estate 32,979 32,492
Residential real estate 6,455 8,232
- -----------------------------------------------------------------------------------------------------
TOTAL PARTICIPATIONS IN NON-ACCRUAL LOANS $96,546 $ 197,598
=====================================================================================================
PARTICIPATIONS IN ACCRUING LOANS PAST DUE 90 DAYS OR MORE $26,060 $ 24,279
=====================================================================================================
The amount of interest that would have been recorded under the original terms
for participations in loans classified as non-accrual was $8.6 million for 2002,
and $5.8 million for 2001. Amounts actually collected and recorded as interest
income for these participations totalled $3.5 million and $2.8 million for 2002
and 2001, respectively.
4. ALLOWANCE FOR LOAN LOSSES
An allowance for loan losses (ALL) is transferred to HPCI from the Bank on loans
underlying the participations at the time the participations are acquired. Prior
to the fourth quarter of 2001, HPCI had been transferring a portion of the ALL
related to loan paydowns and other similar transactions underlying the
participation interests back to the Bank through Holdings. Subsequently, with
concerns over the general economy and the deteriorating credit quality in the
loan participation portfolio, HPCI ceased transferring the allowance for such
transactions.
39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
A summary of the transactions in the allowance for loan losses follows for each
of the three years ended December 31:
- ---------------------------------------------------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001 2000
- ---------------------------------------------------------------------------------------------------------------------------
BALANCE, BEGINNING OF YEAR $175,690 $ 91,826 $104,151
Allowance of loan participations acquired, net 37,020 113,291 (9,434)
Distribution of participations in Florida-related loans --- (18,604) ---
Net loan losses (72,196) (59,333) (5,184)
Provision (credit) for loan losses (161) 48,510 2,293
- ---------------------------------------------------------------------------------------------------------------------------
BALANCE, END OF YEAR $140,353 $ 175,690 $ 91,826
===========================================================================================================================
During October 2001, HPCI acquired participation interests in $452.6 million of
performing and non-performing commercial and real estate loans from Holdings,
along with specific loan losses reserves of $86.5 million, $45.4 million of
leasehold improvements, $3.5 million of accrued interest, and received common
equity in exchange for the issuance of its Class C and D preferred securities.
An underlying loan involved in a participation acquired by HPCI is considered
impaired when, based on current information and events, it is determined that
estimated cash flows are less than the cash flows estimated at the date of
purchase. A loan originated by the Bank is considered impaired when, based on
current information and events, it is probable that it will be unable to collect
the scheduled payments of principal or interest when due according to the
contractual terms of the loan agreement. Factors considered by management in
determining impairment include payment status, collateral value, and the
probability of collecting scheduled principal and interest payments when due.
Loans that experience insignificant payment delays and payment shortfalls
generally are not classified as impaired. Management determines the significance
of payment delays and payment shortfalls on a case-by-case basis, taking into
consideration all of the circumstances surrounding the loan and the borrower.
This includes the length of the delay, the reasons for the delay, the borrower's
prior payment record, and the amount of the shortfall in relation to the
principal and interest owed. Loan impairment is measured on a loan-by-loan basis
by comparing the recorded investment in the loan to the present value of
expected future cash flows discounted at the loan's effective interest rate, the
loan's obtainable market price, or the fair value of the collateral if the loan
is collateral dependent. Loans totaling $96.5 million at December 31, 2002,
compared with $197.6 million and $41.9 million at December 31, 2001 and 2000,
respectively, which have been identified as impaired and were on nonaccrual
status, have been measured by the fair value of existing collateral. At December
31, 2002, total participation interests in impaired loans was 1.9% of total loan
participations.
5. PREMISES AND EQUIPMENT
At December 31, premises and equipment stated at cost were comprised of the
following:
- -------------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001
- -------------------------------------------------------------------------------------
Land and land improvements $ 365 $ 365
Buildings 533 533
Leasehold improvements 108,505 110,967
- -------------------------------------------------------------------------------------
Total premises and equipment 109,403 111,865
Less accumulated depreciation and amortization 71,315 67,224
- -------------------------------------------------------------------------------------
NET PREMISES AND EQUIPMENT $ 38,088 $ 44,641
=====================================================================================
Depreciation and amortization charged to expense was:
TWELVE MONTHS ENDED
DECEMBER 31,
- -----------------------------------------------------------------------------------------------------------------------
(in thousands of dollars) 2002 2001 2000
- -----------------------------------------------------------------------------------------------------------------------
Total depreciation and amortization of premises and equipment $ 5,767 $ 1,529 $ ---
=======================================================================================================================
40
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. DIVIDENDS AND STOCK SPLIT
Holders of Class A preferred securities are entitled to receive, if, when, and
as declared by the Board of Directors of HPCI out of funds legally available,
dividends at a rate of $80.00 per share per annum of the initial liquidation
preference ($1,000.00 per share). Dividends on the Class A preferred securities,
if declared, are payable annually in December to holders of record on the record
date fixed for such purpose by the Board of Directors in advance of payment.
Dividends paid to the holders of the Class A preferred securities totaled
$80,000 annually.
The holder of the Class B preferred securities, HPC Holdings-II, Inc., a direct
non-bank subsidiary of Huntington, is entitled to receive, if, when, and as
declared by the Board of Directors of HPCI out of funds legally available,
dividends at a variable rate equal to three-month LIBOR published on the first
day of each calendar quarter. Dividends on the Class B preferred securities,
which are declared quarterly, are payable annually and are non-cumulative. No
dividend, except payable in common shares, may be declared or paid upon Class B
preferred securities unless dividend obligations are satisfied on the Class A,
Class C, and Class D preferred securities. Dividends paid to the holder of the
Class B preferred securities totaled $7.5 million, or $18.814075 per share, in
2002, and $17.7 million, or $44.225 per share, in 2001.
Holders of Class C preferred securities are entitled to receive, if, when, and
as declared by the Board of Directors of HPCI out of funds legally available,
dividends at a fixed rate of 7.875% per annum, payable quarterly. Dividends
accrue in each quarterly period from the first day of each period, whether or
not dividends are paid with respect to the preceding period. Dividends are not
cumulative and if no dividend is paid on the Class C preferred securities for a
quarterly dividend period, the payment of dividends on HPCI's common stock and
other HPCI-issued securities ranking junior to the Class C preferred securities
(i.e., Class B preferred securities) will be prohibited for that period and at
least the following three quarterly dividend periods. Dividends paid to the
holders of the Class C preferred securities totaled $3.9 million, or $1.9685 per
share, in 2002, and $853,000, or $0.4265625 per share, in 2001.
The holder of Class D preferred securities, HPCH-III (Holdings, prior to
December 27, 2002), is entitled to receive, if, when, and as declared by the
Board of Directors of HPCI out of funds legally available, dividends at a
variable rate established at the beginning of each calendar quarter equal to
LIBOR plus 1.625%, payable quarterly. Dividends accrue in each quarterly period
from the first day of each period, whether or not dividends are paid with
respect to the preceding period. Dividends are not cumulative and if no dividend
is paid on the Class D preferred securities for a quarterly dividend period, the
payment of dividends on HPCI's common stock and other HPCI-issued securities
ranking junior to the Class D preferred securities (i.e., Class B preferred
securities) will be prohibited for that period and at least the following three
quarterly dividend periods. Dividends paid to the holder of the Class D
preferred securities totaled $12.3 million, or $0.8766 per share, in 2002, and
$3.2 million, or $0.22885 per share, in 2001.
For HPCI to meet its statutory requirement for a REIT to distribute 90% of its
taxable income to its shareholders, the holders of common shares received
dividends declared by the board of directors, subject to any preferential
dividend rights of the outstanding preferred securities. Dividends on common
stock declared for each of the years ended December 31, 2002, 2001, and 2000,
were $382.8 million, $539.2 million, and $458.3 million, respectively.
In April 2001, the board of directors declared a 18,666.67-for-1 stock split on
its common stock outstanding. The result of the transaction increased the number
of authorized, issued, and outstanding common shares from 750 to 14 million.
7. RELATED PARTY TRANSACTIONS
HPCI holds a 100% subparticipation interest in Holdings' 99% participation
interests in loans originated by the Bank and its subsidiaries. The
participation and subparticipation interests are in commercial, commercial real
estate, residential real estate, and consumer loans that were either directly
underwritten by the Bank and its subsidiaries or acquired by the Bank. HPCI
expects to continue to purchase such interests, net of ALL, in the future from
Holdings, the Bank, or their affiliates. See Note 3 for the amount of the
participations outstanding.
41
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Under HPCI's subparticipation agreement with Holdings and Holding's
participation agreement with the Bank, the Bank performs the servicing of the
commercial, commercial real estate, residential real estate, and consumer loans
underlying the participations held by HPCI in accordance with normal industry
practice. The servicing fee the Bank charges is 0.125% per year of the
outstanding principal balances of the commercial, commercial real estate, and
consumer loans underlying the participation interests and 0.282% per year of the
interest income collected on the underlying residential real estate loans.
Servicing fee expense paid to the Bank totaled $6.7 million for 2002, $8.3
million for 2001, and $7.8 million for 2000. In its capacity as servicer, the
Bank collects and holds the loan payments received on behalf of HPCI until the
end of each month. At month end, the payments are transferred to HPCI and
accordingly, HPCI does not reflect any receivables for payments from the Bank in
the accompanying consolidated financial statements.
HPCI, Huntington, and the Bank share personnel to handle day-to-day operations
of the company such as accounting, financial analysis, tax reporting, and other
administrative functions. On a monthly basis, HPCI reimburses the Bank and
Huntington for the cost related to the time spent by employees for performing
these functions. The personnel costs were $162,000 for each of the years ended
December 31, 2002, 2001, and 2000.
In February 2001, Huntington purchased 18,667 shares of the 14 million
outstanding common shares of HPCI from Holdings (after adjusting for the April
2001 18,666.67-for-1 stock split). Prior to February 2001, Holdings was the
owner of 100% of the outstanding common stock of HPCI. On July 1, 2002, Holdings
exchanged 4.55 million common shares of HPCI and certain other assets for two
classes of HPCII's preferred stock. On December 27, 2002, Holdings contributed
its ownership in HPCI's Class A and Class D preferred securities and its
remaining common stock to HPCH-III.
Huntington received $1.0 million and $719,000 in common dividends in 2002 and
2001, respectively, while HPCH-III received Class A dividends (with a record
date of December 30, 2002) of $80.00 per share on 891 shares and common
dividends and return of capital amounting to $505.2 million on December 31,
2002. HPCII received the remaining common stock dividend in 2002 of $243.8
million. Holdings received all dividends paid of $3.0 million on the Class D
preferred securities in 2002. Holdings received common dividends of $538.5
million for the twelve months ended December 31, 2001 and $458.3 million for the
same period in 2000.
At December 31, 2002, 10.9% of the Class A preferred securities are owned by
current and past employees of Huntington and its subsidiaries in addition to the
89.1% owned by HPCH-III. The Class A preferred securities are non-voting and
have a dividend rate of $80.00 per share per year. All of the Class B preferred
securities are owned by HPC Holdings-II, Inc., a non-bank subsidiary of
Huntington. The Class B preferred securities have a variable dividend rate based
on LIBOR, which is determined quarterly. In 2001, the Class C preferred
securities were sold to Holdings, who sold them to the public. Various board
members and executive officers of HPCI purchased these shares in the open
market. At December 31, 2002, a total of 7,100 shares, or 0.355%, were
beneficially owned by the group as a whole. Dividends on this class of stock are
paid quarterly at a fixed rate of 7.875%. All of the Class D preferred
securities owned by HPCH-III are being held for possible sale to the public in
the future. The Class D preferred securities have a variable dividend rate based
on LIBOR plus 1.625% that is determined quarterly. See Note 6 for dividends paid
on these preferred securities.
HPCI's premises and equipment were acquired from the Bank through Holdings.
Leasehold improvements were subsequently contributed to HPCLI for its common
shares in the fourth quarter of 2001. HPCLI charges rent to the Bank for use of
applicable facilities by the Bank. The amount of rental income received by HPCLI
during 2002 and 2001 was $6.8 million and $1.6 million, respectively, and is
reflected as the only component of non-interest income in the consolidated
statements of income.
HPCI has a non-interest bearing receivable from Holdings amounting to $7.4
million and $293.8 million at December 31, 2002 and 2001, respectively. These
balances represent unsettled cash transactions involving its participation
interests that occur in the ordinary course of business.
The Bank is eligible to obtain advances from various federal and
government-sponsored agencies such as the Federal Home Loan Bank of Cincinnati.
From time to time, HPCI may be asked to act as guarantor of the Bank's
obligations under such advances and/or pledge all or a portion of its assets in
connection with those advances. See Note 10 for further information regarding
the pledging of HPCI's assets in association with the Bank's advances.
42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
HPCI maintains and transacts all of its cash activity through a non-interest
bearing demand deposit account with the Bank. In addition, HPCI invests
available funds in Eurodollar deposits with the Bank for a term of not more than
30 days, the following amounts were on deposit with the Bank:
- -------------------------------------------------------------------------------
AT DECEMBER 31,
-----------------------------
(in thousands of dollars) 2002 2001
- -------------------------------------------------------------------------------
Non-interest bearing $ 534,254 $ ---
Interest bearing --- 364,912
- -------------------------------------------------------------------------------
Total deposits with the Bank $ 534,254 $ 364,912
===============================================================================
8. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following is a summary of the unaudited quarterly results of operations for
the years ended December 31:
- --------------------------------------------------------------------------------------------------------------------------------
(in thousands of dollars) FIRST SECOND THIRD FOURTH
- --------------------------------------------------------------------------------------------------------------------------------
2002
INTEREST AND FEE INCOME $ 90,112 $ 89,484 $ 86,702 $ 81,456
PROVISION (CREDIT) FOR LOAN LOSSES 16,839 3,000 --- (20,000)
NON-INTEREST INCOME 1,535 1,806 1,721 1,697
NON-INTEREST EXPENSE 3,639 3,257 3,152 3,234
- --------------------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 71,169 85,033 85,271 99,919
INCOME TAXES (117) 25 22 25
- --------------------------------------------------------------------------------------------------------------------------------
NET INCOME BEFORE PREFERRED DIVIDENDS 71,286 85,008 85,249 99,894
DIVIDENDS ON PREFERRED STOCK 5,982 6,231 5,892 5,709
- --------------------------------------------------------------------------------------------------------------------------------
NET INCOME APPLICABLE TO COMMON SHAREHOLDERS $ 65,304 $ 78,777 $ 79,357 $ 94,185
===============================================================================================================================
2001
Interest and fee income $140,736 $132,950 $ 130,114 $ 122,645
Provision for loan losses 3,927 6,751 6,428 31,404
Non-interest income 14 14 15 1,603
Non-interest expense 2,031 2,156 2,102 3,726
- --------------------------------------------------------------------------------------------------------------------------------
Income before income taxes 134,792 124,057 121,599 89,118
Income taxes --- --- --- 26
- --------------------------------------------------------------------------------------------------------------------------------
Net income before preferred dividends 134,792 124,057 121,599 89,092
Dividends on preferred stock --- --- 15,090 6,737
- --------------------------------------------------------------------------------------------------------------------------------
Net income applicable to common shareholders $134,792 $124,057 $ 106,509 $ 82,355
================================================================================================================================
9. 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 due from The Huntington National Bank and interest bearing deposits in
The Huntington National Bank - The carrying value approximates the fair value
for cash and short-term investments.
Loan participation interests - 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 in the loan portfolio. Based upon the
calculations, the carrying values disclosed in the accompanying consolidated
financial statements approximate fair value.
43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. COMMITMENTS AND CONTINGENCIES
The Bank is eligible to obtain advances from various federal and
government-sponsored agencies such as the Federal Home Loan Bank of Cincinnati
(FHLBC). From time to time, HPCI may be asked to act as guarantor of the Bank's
obligations under such advances and/or pledge all or a portion of its assets in
connection with those advances. Any such guarantee and/or pledge would rank
senior to HPCI's common and preferred securities upon liquidation. Accordingly,
any federal or government-sponsored agencies that make advances to the Bank
where HPCI has acted as guarantor or has pledged its assets as collateral will
have a liquidation preference over the holders of HPCI's securities. Any such
guarantee and/or pledge in connection with the Bank's advances from federal or
government-sponsored agencies falls within the definition of Permitted
Indebtedness (as defined in HPCI's articles of incorporation) and, therefore,
HPCI is not required to obtain the consent of the holders of its common or
preferred securities for any such guarantee and/or pledge.
The Bank is currently eligible to obtain one or more advances from the FHLBC
based upon the amount of FHLBC capital stock owned by the Bank. As of December
31, 2002, the Bank's total borrowing capacity under this facility was capped at
$1.3 billion. As of this same date, the Bank had borrowings of $1.0 billion
under this facility in addition to a standby letter of credit that was issued
and outstanding in the amount of $18.2 million.
HPCI has entered into an agreement with the Bank with respect to the pledge of
HPCI's assets to collateralize the Bank's borrowings from the FHLBC. The
agreement provides that the Bank will not place at risk HPCI's assets in excess
of an aggregate amount or percentage of such assets established from time to
time by HPCI's board of directors, including a majority of HPCI's independent
directors. HPCI's board has set this limit at $1 billion, which limit may be
changed in the future by the board of directors, including a majority of HPCI's
independent directors. The agreement also provides that the Bank will pay HPCI a
monthly fee based upon the eligible collateral held by HPCI. As of December 31,
2002, HPCI's pledged collateral was limited to 1-4 family residential mortgages
and second mortgage loans. As of that same date, HPCI's participation interests
in 1-4 family residential mortgages and second mortgage loans pledged as
collateral aggregated $543 million. The Bank paid $614,000 to HPCI in 2002,
representing one basis point per month on the collateral pledged, as
compensation for making such assets available to the Bank as collateral since
February 2002 for possible advances under this FHLBC facility.
11. 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.
44
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
N/A.
PART III
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required by this item is set forth under the caption "Election of
Directors" on pages 1 through 3 and under the caption "Section 16(a) Beneficial
Ownership Reporting Compliance" on page 7 of HPCI's 2003 Information Statement,
and is incorporated herein by reference.
ITEM 11: EXECUTIVE COMPENSATION
Information required by this item is set forth under the caption "Compensation
of Directors and Executive Officers" on page 4 of HPCI's 2003 Information
Statement and is incorporated herein by reference.
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information required by this item is set forth under the caption "Ownership of
Voting Stock" on beginning on page 5 of HPCI's 2003 Information Statement and is
incorporated herein by reference.
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this item is set forth under the caption "Transactions
with Directors and Officers" on page 4 and "Transactions with Certain Beneficial
Owners" on pages 6 and 7 of HPCI's 2003 Information Statement and is
incorporated herein by reference.
ITEM 14: CONTROLS AND PROCEDURES
On March 24, 2003, HPCI, in conjunction with Huntington, carried out an
evaluation, under the supervision and with the participation of its management,
including the President (Chief Executive Officer or CEO) along with the Vice
President (Chief Financial Officer or CFO), of the effectiveness of the design
and operation of its disclosure controls and procedures pursuant to Exchange Act
Rule 13a-14. Based upon that evaluation, the CEO along with the CFO concluded
that HPCI's disclosure controls and procedures are effective in timely alerting
the CEO and CFO to material information relating to HPCI (including its
consolidated subsidiary) required to be included in its periodic SEC filings.
There have been no significant changes in HPCI's internal controls or in other
factors that could significantly affect its internal controls subsequent to the
date it carried out this evaluation.
45
PART IV
ITEM 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
(1) The report of independent auditors and consolidated financial
statements appearing in Item 8.
(2) HPCI is not filing separately financial statement schedules because of
the absence of conditions under which they are required or because the
required information is included in the consolidated financial
statements or the notes thereto.
(3) The exhibits required by this item are listed in the Exhibit Index on
pages 50 and 51 of this Form 10- K.
(b) Reports on Form 8-K.
During the quarter ended December 31, 2002, HPCI filed no Current
Reports on Form 8-K.
(c) The exhibits to this Form 10-K are on pages 50 and 51.
(d) See Item 15 (a) (2) above.
46
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 28th day of
March, 2003.
HUNTINGTON PREFERRED CAPITAL, INC.
(Registrant)
By: /s/ Michael J. McMennamin By: /s/ John D. Van Fleet
--------------------------------- -----------------------------------
Michael J. McMennamin John D. Van Fleet
President and Director Vice President and Director
(Principal Executive Officer) (Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated on the 25th day of March, 2003.
Richard A. Cheap* Director
- --------------------------------------
Richard A. Cheap
Stephen E. Dutton* Director
- --------------------------------------
Stephen E. Dutton
R. Larry Hoover* Director
- --------------------------------------
R. Larry Hoover
Edward J. Kane* Director
- --------------------------------------
Edward J. Kane
Roger E. Kephart* Director
- --------------------------------------
Roger E. Kephart
James D. Robbins* Director
- --------------------------------------
James D. Robbins
Director
- --------------------------------------
Paul V. Sebert
* /s/ Michael J. McMennamin
- --------------------------------------
Michael J. McMennamin
Attorney-in fact for each of the persons indicated
47
CERTIFICATION
I, Michael J. McMennamin, certify that:
1. I have reviewed this annual report on Form 10-K of Huntington
Preferred Capital, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations, and
cash flows of the registrant as of, and for, the periods presented in
this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize, and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: March 28, 2003
/s/ Michael J. McMennamin
-----------------------------------
Michael J. McMennamin
President and Director
48
CERTIFICATION
I, John D. Van Fleet, certify that:
1. I have reviewed this annual report on Form 10-K of Huntington
Preferred Capital, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations, and
cash flows of the registrant as of, and for, the periods presented in
this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize, and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: March 28, 2003
/s/ John D. Van Fleet
-----------------------------------
John D. Van Fleet
Vice President and Director
49
EXHIBIT INDEX
3(i) Amended and Restated Articles of Incorporation (previously filed as
Exhibit 3(a)(ii) to Amendment No. 4 to Registration Statement of Form
S-11 (File No. 333-61182), filed with the Securities and Exchange
Commission on October 12, 2001, and incorporated herein by reference.)
3(ii) Code of Regulations (previously filed as Exhibit 3(b) to the
Registrant's Registration Statement of Form S-11 (File No. 333-61182),
filed with the Securities and Exchange Commission on May 17, 2001, and
incorporated herein by reference.)
4 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.
10(a) Loan Participation Agreement, dated May 1, 1998 between The Huntington
National Bank and Huntington Preferred Capital Holdings, Inc. (f/k/a
Airbase Realty Holding Company) (previously filed as Exhibit 10(a) to
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.)
(b) Amendment to Loan Participation Agreement, dated March 1, 2001, between
The Huntington National Bank and Huntington Preferred Capital Holdings,
Inc. (f/k/a Airbase Realty Holding Company) (previously filed as Exhibit
10(b) to 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.)
(c) Loan Subparticipation Agreement, dated May 1, 1998, between Huntington
Preferred Capital Holdings, Inc. (f/k/a Airbase Realty Holding Company)
and Huntington Preferred Capital, Inc. (f/k/a Airbase Realty Company)
(previously filed as Exhibit 10(c) to 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.)
(d) Amendment to Loan Subparticipation Agreement, dated March 1, 2001,
between Huntington Preferred Capital Holdings, Inc. (f/k/a Airbase
Realty Holding Company) and Huntington Preferred Capital, Inc. (f/k/a
Airbase Realty Company) (previously filed as Exhibit 10(d) to
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.)
(e) Amendment to Loan Subparticipation Agreement, dated May 16, 2001,
between Huntington Preferred Capital Holdings, Inc. and Huntington
Preferred Capital, Inc. -- previously filed as Exhibit 10(e) to Annual
Report on Form 10-K for the year ended December 31, 2001, and
incorporated herein by reference.
(f) Subscription Agreement, dated October 15, 2001, for the Class C
preferred securities between Huntington Preferred Capital, Inc., The
Huntington National Bank, and Huntington Preferred Capital Holdings,
Inc. -- previously filed as Exhibit 10(f) to Annual Report on Form 10-K
for the year ended December 31, 2001, and incorporated herein by
reference.
(g) Subscription Agreement, dated October 15, 2001, for the Class D
preferred securities between Huntington Preferred Capital, Inc., The
Huntington National Bank, and Huntington Preferred Capital Holdings,
Inc. -- previously filed as Exhibit 10(g) to Annual Report on Form 10-K
for the year ended December 31, 2001, and incorporated herein by
reference.
(h) Amendment to Loan Participation Agreement, dated March 27, 2002, between
The Huntington National Bank and Huntington Preferred Capital Holdings,
Inc. -- previously filed as Exhibit 10(h) to Annual Report on Form 10-K
for the year ended December 31, 2001, and incorporated herein by
reference.
50
(i) Amendment to Loan Subparticipation Agreement, dated March 27, 2002,
between Huntington Preferred Capital Holdings, Inc. and Huntington
Preferred Capital, Inc. -- previously filed as Exhibit 10(i) to Annual
Report on Form 10-K for the year ended December 31, 2001, and
incorporated herein by reference.
21 List of Subsidiaries
24 Power of Attorney
51