Item 1: Business
General
Huntington Preferred Capital, Inc. (HPCI) was organized under Ohio law in 1992 and designated as a real estate investment trust (REIT) in 1998. At December 31, 2004, three related parties owned HPCI’s common stock: HPC Holdings-III, Inc. (HPCH-III), 67.37%; Huntington Preferred Capital II, Inc. (HPCII), 32.5%; and Huntington Bancshares Incorporated (Huntington), 0.13%. Effective February 18, 2005, Huntington Preferred Capital Holdings, Inc. (Holdings) transferred 34% of its ownership in HPCH-III to Huntington Capital Financing LLC (HCF). On March 31, 2005, HPCH-III liquidated into Holdings and HCF. As a result of liquidation, since March 31, 2005, four related parties own HPCI’s common stock: HCF, 47%; HPCII, 32.5%; Holdings, 20.37%; and Huntington, 0.13%. HCF, HPCII and Holdings are direct or indirect subsidiaries of The Huntington National Bank (the Bank), a national banking association organized under the laws of the United States and headquartered in Columbus, Ohio. The Bank is a wholly owned subsidiary of Huntington. Huntington is a multi-state diversified financial holding company organized under Maryland law and headquartered in Columbus, Ohio. The Bank, on a consolidated basis with its subsidiaries, at December 31, 2005, accounted for 99% of Huntington’s consolidated total assets and, for the year ended December 31, 2005, accounted for 94% of Huntington’s consolidated net income. Thus, consolidated financial statements for the Bank and for Huntington were substantially the same for these periods. HPCI has one subsidiary, HPCLI, Inc. (HPCLI), a taxable REIT subsidiary formed in March 2001 for the purpose of holding certain assets (primarily leasehold improvements). The following chart outlines the relationship among affiliates at December 31, 2005:
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). HPCI must satisfy other asset and income tests in order to remain qualified as a REIT. In addition, HPCI must satisfy other tests in order to maintain its exemption from the registration requirements of the Investment Company Act. Additional information regarding these tests is set forth in the “Qualification Tests” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of this report.
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, 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, 2005, $3.0 billion, or 89.4%, 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. The remaining balance is comprised of $0.2 billion of second, third, and fourth mortgages, and $0.2 billion of loans secured by non-real property.
Consumer Loans
HPCI owns participation interests in consumer loans secured by automobiles, trucks, equipment, or a first or junior mortgage on the borrower’s primary residence. Many of these mortgage loans were made for reasons such as home improvements, acquisition of furniture and fixtures, or 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 Federal Home Loan Mortgage Corporation (FHLMC) or Federal National Mortgage Association (FNMA). 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, 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 loans underlying HPCI’s loan participations at December 31, 2005:
Table 1 - Total Loan Participation Interests by Geographic Location
Principal Balances
The following table shows data with respect to the principal balance of the loans underlying HPCI’s loan participations at December 31, 2005:
Table 2 - Total Loan Participation Interests by Principal Balances
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 17.2% of HPCI’s capitalization; and HPCI does not anticipate incurring any indebtedness other than permitted indebtedness, which includes acting as a co-borrower or guarantor of certain obligations of the Bank. HPCI’s board has limited any such pledges to 25% of HPCI’s assets. In addition, HPCI expects its interest-earning assets will continue to exceed the liquidation preference of its preferred securities. For further discussion regarding co-borrower and guarantor obligations, see “Commitments and Contingencies” in the Notes to Financial Statements included in Part II, Item 8 of this report.
Payment of dividends on the preferred securities could also be subject to regulatory limitations if the Bank fails to be “adequately capitalized” for purposes of regulations issued by The Office of the Comptroller of the Currency (OCC). 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. Capital ratios for the Bank as of December 31, 2005 and 2004 are as follows:
Table 3 - Capital Ratios for the Bank
Conflict of Interests and Related Policies
As of December 31, 2005, the Bank continued to control 98.6% of the voting power of HPCI’s outstanding securities. Accordingly, the Bank expects to 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 six of its nine directors are also officers of Huntington or the Bank. Because of the nature of HPCI’s relationship with Holdings, HPCII, HCF, 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 or Holdings, HPCI’s disposition of assets to the Bank or Holdings, 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 and subparticipation agreements. 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, Holdings, and the Bank that any agreements and transactions between them and/or their affiliates 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, the Bank and their respective affiliates. HPCI’s independent directors serve on its audit committee and review material agreements among HPCI, Holdings, the Bank, and their respective affiliates. HPCI’s independent directors have approved an agreement with the Bank with respect to the pledge of HPCI’s assets to collaterize the Bank’s borrowings from the Federal Home Loan Bank (FHLB) as more described in the Risk Factors section of this report.
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 financial 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. At December 31, 2005, there were no direct or indirect financial 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 has 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 the loans underlying HPCI’s participation interests were originated in accordance with underwriting policies customarily employed by the Bank during
the period in which the loans were originated. The Bank 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 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:
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are performing, meaning they have no more than two payments past due,
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are in accruing status,
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are not made to related parties of HPCI, Huntington, or the Bank,
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are secured by real property such that they are REIT qualifying, and
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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, 2005, 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 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 policy prohibits the retention 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.
HPCI’s 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 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. For each of the years ended December 31, 2005, 2004, and 2003, HPCI’s FFO were $274.3 million, $273.6 million, and $288.2 million, respectively. These significantly exceeded the minimum requirement of 150% of dividends on Class A, Class C, and Class D securities of $32.0 million, $22.3 million, and $21.0 million, for the same periods, respectively. 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 expected that all loans will be serviced by or through the Bank pursuant to the participation and subparticipation agreements, 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:
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invest in the securities of other issuers for the purpose of exercising control over such issuers;
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underwrite securities of other issuers;
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actively trade in loans or other investments;
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offer securities in exchange for property; or
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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 Securities and Exchange Commission, in order to qualify for this exemption, HPCI must maintain at least 55% of its assets in Qualifying Interests and also may be required to maintain an additional 25% in 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 has established a policy, which it monitors monthly, of limiting authorized investments that are not Qualifying Interests to no more than 20% of the value of its total assets.
HPCI is not prohibited by its Articles of Incorporation from repurchasing its capital securities; however, 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 distributes 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 registered public accounting firm. 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, 2005, HPCI had six executive officers and two additional officers, but no 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.
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 financial 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 (i) the participation agreement between the Bank and HPCI, (ii) the participation agreement between the Bank and Holdings and the subparticipation agreement between Holdings and HPCI.
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. The Bank may, in accordance with HPCI’s guidelines, 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, in accordance with HPCI’s guidelines, institute foreclosure proceedings, exercise any power of sale contained in any mortgage or deed of trust, obtain a deed in lieu of foreclosure, or otherwise acquire title to a mortgaged property underlying a real estate loan by operation of law or otherwise in accordance with the terms of the participation and subparticipation agreements.
Under the participation and subparticipation agreements, the Bank has the right, in the exercise of its reasonable discretion and in accordance with prudent banking practices, 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, that the Bank shall not grant or agree to any (i) waiver of any payment default, (ii) extension of the maturity, (iii) reduction of the rate or rates of interest with respect to the loans, (iv) forgiveness or reduction of the principal sum of the loans, (v) increase the lending formula or advance rates, (vi) waiver of any right to elect to foreclose on any loan in default, or (vii) amendment or modification of the financial covenants contained in the loan documents that would make such financial covenants less restrictive with respect to any of the borrowers without the prior written consent of Holdings or HPCI, except that the Bank shall be permitted to grant or agree to any of such consents, waivers, or modifications pursuant to and in accordance with guidelines and limitations provided by Holdings or HPCI to the Bank in writing from time to time.
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 and subparticipation agreements; 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 agreements, 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 and subparticipation agreements. The fees and other terms contained in the servicing arrangements are substantially equivalent to, but may be more favorable to HPCI, than those that would be attained in agreements with unaffiliated third parties. Additional information regarding the servicing fee rates are set forth under the caption “Non-Interest Income and
Non-Interest Expense” of Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of this report.
Competition
Competition that impacts Huntington’s ability to attract new business, particularly in the form of loans secured by real estate, also affects HPCI’s availability to invest in participation interests in such loans. Huntington is impacted by 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 which 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.
Segment Reporting
HPCI’s operations consist of acquiring, holding, and managing its participation interests. Accordingly, HPCI only operates in one segment.
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.
Formal Regulatory Supervisory Agreements
On March 1, 2005, Huntington announced entering into a formal written agreement with the Federal Reserve Bank of Cleveland (FRBC), as well as the Bank entering into a formal written agreement with the Office of the Comptroller of the Currency (OCC), providing for a comprehensive action plan designed to enhance corporate governance, internal audit, risk management, accounting policies and procedures, and financial and regulatory reporting. The agreements called for independent third-party reviews, as well as the submission of written plans and progress reports by Huntington’s management and remain in effect until terminated by the banking regulators.
On October 6, 2005, Huntington announced that the OCC had terminated its formal written agreement with the Bank dated February 28, 2005, and that the FRBC written agreement remained in effect. Huntington was verbally advised that it was in full compliance with the financial holding company and financial subsidiary requirement under the Gramm-Leach-Bliley Act (GLB Act). This notification reflected that Huntington and the Bank met both the “well-capitalized” and “well-managed” criteria under the GLB Act. Huntington’s management believes that the changes it has already made, and is in the process of making, will address the FRBC issues fully and comprehensively. No assurances, however, can be provided as to the ultimate timing or outcome of these matters, including any effects on HPCI.
Available Information
HPCI’s investor information is accessible on Huntington’s internet website, under the “Investor Relations” link found on Huntington’s homepage at www.huntington.com. HPCI makes available free of charge, its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after those reports have been electronically filed or submitted to the SEC. These filings are also accessible on the SEC’s website at www.sec.gov. The public may read and copy any materials HPCI files with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
Item 1A:
Item 1A: Risk Factors
HPCI is subject to a number of risks, many of which are outside of Management’s control, though Management strives to manage those risks while optimizing returns. In addition to the other information included 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 Ohio, Indiana, Kentucky, and Michigan. Adverse conditions in those states, in particular, could negatively impact HPCI’s result of operations and ability to pay dividends.
At December 31, 2005, 95.9% 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. 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.
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:
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local and other economic conditions affecting real estate and other collateral values;
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the continued financial stability of a borrower;
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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;
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the tenant’s ability to make lease payments;
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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 concentration in participation interests in commercial real estate loans is subject to certain risks inherent in the underlying commercial real estate assets.
At December 31, 2005, 61.8% 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 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.
A decline in the Bank’s capital levels may result in HPCI’s 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 OCC, as the primary regulator of the Bank, has the ability to cause the exchange of HPCI’s Class C preferred securities if:
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the Bank becomes “undercapitalized;”
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the OCC, in its sole discretion, anticipates that the Bank will become “undercapitalized” in the near term; or
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the Bank is placed in conservatorship or receivership.
None of the holders of HPCI’s Class C preferred securities, HPCI, or the Bank can require or force such an exchange. In the event of an OCC-directed exchange, each holder of HPCI’s Class C preferred securities would receive a Class C preferred security from the Bank for each Class C preferred security of HPCI. 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’s preferred securities.
In the event of a liquidation of the Bank, the claims of depositors and creditors of the Bank are 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.
The Bank would be considered to be “undercapitalized” if: its Tier 1 risk-based capital (“RBC”) ratio is below 4%, its Total RBC ratio is below 8% or its Tier 1 leverage ratio is below 4%. The Bank currently intends to maintain its capital ratios in excess of the levels it needs to be considered to be “well-capitalized” under regulations issued by the OCC. These guidelines, as well as the Bank’s regulatory capital ratios for December 31, 2005, are discussed in table 3 of Item I, Part 1 of this report.
The Bank is a wholly owned subsidiary of Huntington. Huntington is a one-bank holding company which files annual, quarterly, and current reports, proxy statements, and other information with the Securities and Exchange Commission (the SEC), under the Securities Exchange Act of 1934, as amended (the Exchange Act). The financial statements of the Bank and Huntington are substantially the same and thus current or future holders of HPCI’s preferred securities can obtain important information on an ongoing basis about the Bank and Huntington by reviewing Huntington’s SEC filings. These filings are available to the public over the Internet at the SEC’s web site at http://www.sec.gov and on the investor relations page of Huntington’s website at http://www.huntington.com. Any document filed by Huntington with the SEC can be read and copied at the SEC’s public reference facilities. Further information on the operation of the public reference facilities
can be obtained by calling the SEC at 1-800-SEC-0330. Copies of these SEC filings can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street N.E., Washington, D.C. 20549. In addition, copies of these SEC filings can also be obtained by written request to Investor Relations, Huntington Bancshares Incorporated, 41 South High Street, Columbus, Ohio 43287 or by calling 614-480-4060. Huntington’s financial statements for the fiscal year ended December 31, 2005 are also filed with this report as Exhibit 99 (b).
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 have the right to examine HPCI and its activities and, under certain circumstances, impose restrictions on the Bank or HPCI. These restrictions could impact HPCI’s ability to conduct its business and could adversely affect 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 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. The payment of dividends on the preferred securities could also be subject to regulatory limitations if the Bank becomes “under-capitalized” for purpose of regulations issued by the OCC, as described under the heading “Dividend Policy and Restrictions” in Item I, part 1 of this report.
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, HCF, 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;
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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 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, 2005, all of its officers and six of its nine directors are also officers or directors of the Bank and/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, HCF, 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 control of voting power of HPCI’s outstanding securities, 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 conflicts regarding 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 Holdings’s, HCF, 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. HPCI has no control over the actions of the Bank in pursuing collection of any non-performing assets. 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 $11.2 million in 2005, $9.9 million in 2004, and $7.6 million in 2003.
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 guarantee 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 (FHLB). 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 and other obligations under any such guarantee or pledge, if any. Any such guarantee and/or pledge in connection with the Bank’s advances from the FHLB falls within the defination of Permitted Indebtedness (as defined in HPCI’s articles of incorporation) and, therefore, HPCI is not required to obtain the consent of the holders of its common or preferred securities for any such guarantee and/or pledge.
Currently, HPCI’s assets have been used to secure only one such facility. The Bank has obtained a line of credit from the FHLB, which line was capped by the Bank’s holdings of FHLB stock at $1.7 billion as December 31, 2005. As of that same date, the Bank had borrowings of $1.2 billion under the facility.
HPCI has entered into an amended and restated agreement with the Bank with respect to the pledge of HPCI’s assets to collateralize the Bank’s borrowings from the FHLB. The agreement provides that the Bank will not place at risk HPCI’s assets in excess of an aggregate 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. Prior to October 31, 2004, the aggregate FHLB advance limit established by HPCI’s board was $1.0 billion. Effective as of October 31, 2004, the limit was adjusted to 25% of HPCI’s total assets, or $1.3 billion as of December 31, 2005, as reflected in HPCI’s month-end management report for the previous month. This limit may be changed in the future by the board of directors, including a majority of HPCI’s independent directors. As of December 31, 2005, HPCI’s total loans pledged were limited to one-to-four family residential mortgage portfolio and consumer second mortgage loans, which aggregated to $1.1 billion as of that same date. A default
by the Bank on its obligations to the FHLB 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, standards, policies, and interpretations could significantly impact HPCI’s strategic initiatives, results of operations, cash flows, 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 compliance, 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, Public Company Accounting Oversight Board, and various taxing authorities 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. Huntington’s business recovery plan may not work as intended or may not prevent significant interruptions of our operations.
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, 2005, 33% 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 increases 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 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 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, 2005, HPCI had qualifying income and qualifying assets that exceeded 75%.
Although HPCI currently 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.
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 of servicer, the Bank may be forced to foreclose on a defaulted commercial mortgage and/or residential mortgage loan underlying HPCI participation interest to recover HPCI’s investment in the mortgage 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 and holders of such securities may receive a redemption amount that is less than the then current market price for the securities.
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;
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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
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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).
In the event HPCI redeems its Class C or Class D preferred securities, holders of such securities will be entitled to receive $25.00 per share plus accrued and unpaid dividends on such shares. The redemption amount may be significantly lower than the then current market price of the Class C preferred securities.
Item 1B:
Item 1B: Unresolved Staff Comments
Not Applicable.
Item 2:
Item 2: Properties
HPCI does not own any material physical property or real estate.
Item 3:
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:
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.
Part II
Item 5:
Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
There is no established public trading market for HPCI’s common stock. As of February 28, 2006, there were four common shareholders of record, all of which are affiliates of the Bank. During 2005, 2004, and 2003, dividends of $279.7 million, $263.8 million and $289.6 million were declared to common shareholders, respectively. These dividends were either accrued or paid by the last business day in each year.
Information regarding restrictions on dividends, as required by this item, is set forth in Part I, Item 1 “Dividend Policy and Restrictions”.
HPCI did not sell any unregistered equity securities during the year ended December 31, 2005. Neither HPCI nor any “affiliated purchaser” (as defined by Rule 10b-18(a)(3) under the Securities Exchange Act of 1934) repurchased any equity securities of HPCI in any month within the fourth quarter ended December 31, 2005.
Item 6:
Item 6: Selected Financial Data
The table below represents selected financial data relative to HPCI as of and for the years ended December 31, 2005, 2004, 2003, 2002, and 2001.
Table 4 - Selected Financial Data
All of HPCI’s common stock is owned by Huntington, HCF, HPCII, and Holdings and, therefore, net income per common share information is not presented. At the end of all years presented, HPCI did not have any interest-bearing liabilities and, therefore, no liabilities are presented under this item.
Item 7:
Item 7: Managements’s Discussion and Analysis of Financial Condition and Results of Operations
INTRODUCTION
Huntington Preferred Capital, Inc. (HPCI) is an Ohio corporation operating as a real estate investment trust (REIT) for federal income tax purposes. HPCI’s principal business objective is to acquire, hold, and manage mortgage assets and other authorized investments that will generate net income for distribution to its shareholders.
HPCI is a party to a Third Amended and Restated Loan Subparticipation Agreement with Holdings and a Second Amended and Restated Loan Participation Agreement with the Bank. The Bank is required, under the participation and/or subparticipation agreements, to service HPCI’s loan portfolio in a manner substantially the same as for similar work for transactions on its own behalf. The Bank collects and remits principal and interest payments, maintains perfected collateral positions, and submits and pursues insurance claims. In addition, the Bank provides to HPCI accounting and reporting services as required. The Bank is required to adhere to HPCI’s policies relating to the relationship between HPCI and the Bank and to pay all expenses related to the performance of the Bank’s duties under the participation and subparticipation agreements. All of HPCI’s participation interests to date were acquired directly or indirectly 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. These include descriptions of plans, or objectives of Management for future operations, and forecasts of its revenues, earnings, cash flows, 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 could cause actual conditions, events, or results to differ significantly from those described in the forward-looking statements. These factors include, but are not limited to, those set forth under the heading “Risk Factors” included in Item 1A of this report and other factors described from time to time in HPCI’s other filings with the Securities and Exchange Commission (SEC).
Management encourages readers of this report to understand forward-looking statements to be strategic objectives rather than absolute forecasts of future performance. 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 were made or to reflect the occurrence of unanticipated events.
Critical Accounting Policies and Use of Significant Estimates
HPCI’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The preparation of financial statements in conformity with GAAP requires Management to establish critical accounting policies and make accounting estimates, assumptions, and judgments that affect amounts recorded and reported in its financial statements. Note 1 to the consolidated financial statements included in this report lists significant accounting policies used by Management in the development and presentation of HPCI’s 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 the organization and its financial position, results of operations, and cash flows.
An accounting estimate requires assumptions about uncertain matters that could have a material effect on the financial statements if a different amount within a range of estimates were used or if estimates changed from period 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. Management has identified the allowances for credit losses (ACL) as the most significant accounting estimate. At December 31, 2005, the ACL was $61.7 million and represented the sum of the allowance for loan losses (ALL) and allowance for unfunded loan participation commitments (AULPC). The ACL represents Management’s estimate as to the level of allowances considered appropriate to absorb probable inherent credit losses in the loan participation portfolio, as well as unfunded loan participation commitments. Many factors affect the ACL, some quantitative, some subjective. Management believes the process for determining the ACL considers the potential factors that could result in credit losses. However, the process includes judgment and quantitative elements that may be subject to significant change. To the extent actual outcomes differ from Management estimates, additional provision for credit losses could be required, which could
adversely affect earnings or financial performance in future periods. At December 31, 2005, the ACL as a percent of total loan participation commitments was 1.37%. Based on the December 31, 2005 balance sheet, a 10 basis point increase in this ratio to 1.47% would require $4.5 million in additional provision for credit losses, and would also negatively impact 2005 net income by approximately $4.5 million. A discussion about the process used to estimate the ACL is presented in the Credit Risk section of Management’s Discussion and Analysis in this report.
Summary Discussion of Results
HPCI’s income is primarily derived from its participation in loans acquired from the Bank and Holdings. Income varies based on the level of these assets and their respective interest rates. The cash flows from these assets are used to satisfy 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 $314.3 million for 2005, $284.5 million for 2004, and $308.5 million for 2003. The increase in net income before dividends for 2005 was primarily the result of increased interest income from commercial real estate and consumer loan participation interests, partially offset by a decline in the reduction in allowances for credit losses. Net income available to common shares was $279.7 million, $263.8 million, and $289.6 million for the same respective periods. Return on average assets (ROA) was 6.02% for 2005, 5.15% for 2004, and 5.46% for 2003. Return on average equity (ROE) was 6.05% for 2005, 5.18% for 2004, and 5.47% for 2003.
HPCI had total assets of $5.4 billion at December 31, 2005, a decrease compared to the December 31, 2004 balance of $5.7 billion. Total assets consists principally of participation interests in loans which were an aggregate of $4.5 billion and $4.9 billion at December 31, 2005 and 2004, respectively. The decline in total loan participation interests and total assets is due to the reduced availability of new loan participation purchases that meet HPCI’s policies, primarily commercial real estate loans. In the first quarter of 2006, the Bank released HPCI’s consumer loans from being pledged as collateral with the FHLB. This release will provide HPCI the opportunity for more loan participation purchases.
The following table shows the composition of HPCI’s gross participation interests in loans at the end of the most recent five years.
Table 5 - Loan Participation Interests (1)
(1)
Percentages represent the percentage of each loan category to total assets.
HPCI’s participation interests in commercial loans represented 0.9% and 1.9% of total assets as of December 31, 2005 and 2004, respectively. The decrease was due to continued portfolio run off. Participation interests in commercial real estate loans at December 31, 2005, which represented 61.8% of total assets, decreased compared to the same period last year primarily due to run off and decreased new loan purchases. Consumer loan participation interests were 18.6% of total assets at December 31, 2005, compared to 14.4% of total assets for the same date in 2004. This increase was due to purchases of consumer home equity loan participations. Residential real estate loan participation interests represented 2.9% and 4.0% of total assets as of December 31, 2005 and 2004, respectively. The balance decline was due to portfolio run off as there were no additional residential real estate loan purchases in this time period.
HPCI incurs no direct loan origination costs. In lieu of paying higher servicing fees to the Bank with respect to commercial and commercial real estate loans, HPCI waived its right to receive any origination fees associated with participation interests in commercial and commercial real estate loans transferred on or after July 1, 2004, until such time as loan servicing fees are reviewed in 2006.
Cash and interest-bearing deposits with the Bank totaled $810.1 million and $800.3 million at December 31, 2005 and 2004, respectively. Typically, cash is invested with the Bank in an interest-bearing account. These interest-bearing balances are invested overnight or may be invested in Eurodollar deposits with the Bank for a term of not more than 30 days at market rates.
HPCI also had an amount due from the Bank of $46.3 million at December 31, 2005, and $0.2 million at December 31, 2004. The increase primarily relates to the reclassification of a receivable from cash and interest bearing deposits with The Huntington National Bank to due from The Huntington National Bank. The amount reclassified represents principal and interest payments on loan participations remitted by customers directly to the Bank but not yet received by HPCI. The receivable was settled with the Bank shortly after period-end.
Total liabilities were $704.4 million, and $603.8 million at December 31, 2005, and 2004, respectively. The increase was due to a larger dividends and distributions payable.
Shareholders’ equity was $4.6 billion at December 31, 2005, compared to the December 31, 2004 balance of $5.1 billion. This decline reflected the aggregate dividends and distributions declared on common and preferred securities offset by the $314.3 million of net income in 2005.
QUALIFICATION TESTS
Qualification as a REIT involves application of specific provisions of the Internal Revenue Code relating to various asset tests. A REIT must satisfy six asset tests quarterly: (1) 75% of the value of the REIT’s total assets must consist of real estate assets, cash and cash items, and government securities; (2) not more than 25% of the value of the REIT’s total assets may consist of securities, other than those includible under the 75% test; (3) not more than 5% of the value of its total assets may consist of securities of any one issuer, other than those securities includible under the 75% test or securities of taxable REIT subsidiaries; (4) not more than 10% of the outstanding voting power of any one issuer may be held, other than those securities includible under the 75% test or securities of taxable REIT subsidiaries; (5) not more than 10% of the total value of the outstanding securities of any one issuer may be held, other than those securities includible under the 75% test or securities of taxable REIT subsidiaries; and (6) a REIT cannot own securities in one or more taxable REIT subsidiaries which comprise more than 20% of its total assets. At December 31, 2005, HPCI met all of the quarterly asset tests.
Also, a REIT must annually satisfy two gross income tests: (1) 75% of its gross income must be from qualifying income closely connected with real estate activities; and (2) 95% of its gross income must be derived from sources qualifying for the 75% test plus dividends, interest, and gains from the sale of securities. In addition, a REIT must distribute 90% of the REIT’s taxable income for the taxable year, excluding any net capital gains, to maintain its non-taxable status for federal income tax purposes. For the tax year 2005, HPCI met all annual income and distribution tests.
HPCI operates in a manner that will not cause it to be deemed an investment company under the Investment Company Act. The Investment Company Act exempts from registration as an investment company an entity that is primarily engaged in the business of “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate” (Qualifying Interests). Under positions taken by the SEC staff in no-action letters, in order to qualify for this exemption, HPCI must invest at least 55% of its assets in Qualifying Interests and an additional 25% of its assets in real estate-related assets, although this percentage may be reduced to the extent that more than 55% of its assets are invested in Qualifying Interests. The assets in which HPCI may invest under the Internal Revenue Code therefore may be further limited by the provisions of the Investment Company Act and positions taken by the SEC staff. At December 31, 2005, HPCI was exempt from registration as an investment company under the Investment Company Act and intends to operate its business in a manner that will maintain this exemption.
RESULTS OF OPERATIONS
Interest and Fee Income
HPCI’s primary source of revenue is the interest and fee income on its participation interests in loans. At December 31, 2005 and 2004, HPCI did not have any interest-bearing liabilities or related interest expense. Interest income is impacted by changes in the levels of interest rates and earning assets. The yield on earning assets is the percentage of interest income to average earning assets.
The table below shows HPCI’s average annual balances, interest and fee income, and yields for the three years ending December 31:
Table 6 - Interest and Fee Income
(1)
Income includes interest and fees.
Interest and fee income for the years ended December 31, 2005 and 2004 was $302.8 million and $262.2 million, respectively. The increase in interest and fee income was the result of higher yields partially offset by lower earning assets balances. For the years ended December 31, 2005 and 2004, the yield increased from 4.74% to 5.84%, or an effective 1.1%, while average total earning asset balances decreased by $345.7 million or 6.3%. The tables above include interest received on participations in loans that are on a non-accrual status in the individual portfolios.
(Reduction in Allowance) Provision for Credit Losses
The (reduction in allowance) provision for credit losses is the charge (or credit) to earnings necessary to maintain the ACL at a level adequate to absorb Management’s estimate of inherent probable losses in the loan portfolio. The reduction in allowance for credit losses was a credit of $19.8 million for 2005, versus a credit of $31.6 million and $41.2 million for 2004 and 2003, respectively. The continued reduction in the allowance was indicative of lower net charge-offs during the year.
Non-Interest Income and Non-Interest Expense
Non-interest income was $9.4 million, $7.2 million, and $6.9 million in 2005, 2004, and 2003, respectively. This income consists of rental income received from the Bank related to leasehold improvements owned by HPCLI and includes fees from the Bank for use of HPCI’s assets as collateral for the Bank’s advances from the Federal Home Loan Bank (FHLB). Collateral fees totaled $3.0 million, $0.7 million, and $0.7 million in 2005, 2004, and 2003, respectively. The increase in collateral fees was due to an Amended and Restated Agreement, between the Bank and HPCI, effective April 1, 2005, which changed the fees from 12 basis points per year on certified collateral to 35 basis points per year on total pledged loans. In the first quarter of 2006, the Bank released approximately $1.0 billion of HPCI’s consumer loans pledged as collateral with the FHLB. This will result in lower collateral fee income in 2006. See note 10 to the consolidated financial statements included in this report for more information regarding use of HPCI’s assets as collateral for the Bank’s advances from the FHLB.
Non-interest expense was $17.1 million, $16.3 million, and $13.9 million in 2005, 2004, and 2003, respectively. The predominant components of HPCI’s non-interest expense are the fees paid to the Bank for servicing the loans underlying the participation interests and depreciation and amortization on its premises and equipment. The servicing costs for the years ended December 31, 2005, 2004 and 2003 totaled $11.2 million, $9.9 million, and $7.6 million, respectively. The increases were due to higher service fee rates on loan participation balances. Depreciation and amortization expenses totaled $4.4 million, $5.3 million, and $5.5 million for the years ended December 31, 2005, 2004, and 2003, respectively.
In 2005 and 2004 the annual servicing rates the Bank charged with respect to outstanding principal balances were:
Pursuant to the existing participation and subparticipation agreements, the amount and terms of the loan-servicing fee between the Bank and HPCI are determined by mutual agreement from time to time during the terms of the agreements. Effective July 1, 2004, in lieu of paying higher servicing costs to the Bank with respect to commercial and commercial real estate loans, HPCI waived its right to receive any origination fees associated with participation interests in commercial and commercial real estate loans transferred on or after July 1, 2004. This waiver was subsequently extended until such time as loan servicing fees are reviewed in 2006. Effective July 1, 2005, in connection with the periodic review of the servicing fees, the parties reduced the current servicing rate on outstanding principal balances of underlying consumer loans to 0.650% from 0.750%. On an annualized basis, it is expected that this change will decrease non-interest expense by approximately $0.9 million. No changes were made to the servicing rates for the commercial, commercial real estate, or residential real estate portfolios.
Income Taxes
HPCI has elected to be treated as a REIT for federal income tax purposes and intends to maintain compliance with the provisions of the Internal Revenue Code and, therefore, is not subject to income taxes. HPCI’s subsidiary, HPCLI, elected to be treated as a taxable REIT subsidiary and, therefore, a separate provision related to its income taxes is included in the accompanying consolidated financial statements.
MARKET RISK
Market risk represents the risk of loss due to a decline in interest rates, which is the primary risk to which HPCI has exposure. If there is a decline in market interest rates, HPCI may experience a reduction in interest income from its loan participation interests and a corresponding decrease in funds available to be distributed to shareholders. Market risk arises in the normal course of business when HPCI purchases a participation interest in a fixed-rate loan, and as of December 31, 2005, approximately 33% of the loan participation portfolio had fixed rates.
Huntington conducts its monthly interest rate risk management on a centralized basis and does not manage HPCI’s interest rate risk separately. Two broad approaches to modeling interest rate risk are employed: income simulation and economic value analysis. An income simulation analysis was used to measure the sensitivity of forecasted interest income to changes in market rates over a one-year horizon. The economic value analysis was conducted by subjecting the period-end balance sheet to changes in interest rates and measuring the impact of the changes in the value of the assets. The models used for these measurements assumes, among other things, no new loan participation volume.
Using the income simulation model for HPCI as of December 31, 2005, interest income for the next 12-month period would be expected to increase by $18.3 million, or 7.4%, based on a gradual 200 basis point increase in rates above the forward rates implied in the yield curve. Interest income would be expected to decline $18.5 million, or 7.5%, in the event of a gradual 200 basis point decline in rates from the forward rates implied in the yield curve.
Using the economic value analysis model for HPCI as of December 31, 2005, the fair value of loan participation interests over the next 12 month period would be expected to increase $74.8 million, or 1.7%, based on a immediate 200 basis point decline in rates above the forward rates implied in the yield curve. The fair value would be expected to decline $76.2 million, or 1.7%, in the event of a immediate 200 basis point increase in rates from the forward rates implied in the yield curve.
The following table shows data with respect to interest rates of the loans underlying HPCI’s loan participations at December 31, 2005 and 2004, respectively.
Table 7 - Total Loan Participation Interests by Interest Rates
(1)
The variable rate category includes loan participation interests with variable and adjustable rates.
CREDIT QUALITY
Credit Risk
Credit risk is the risk of loss due to adverse changes in a borrower’s ability to meet its financial obligations under agreed upon terms. Credit risk is mitigated through a combination of credit policies and processes and portfolio diversification. These include loan origination/underwriting criteria, portfolio monitoring processes, and effective problem asset management.
HPCI’s exposure to credit risk is managed by personnel of the Bank through this credit risk management process. Based upon an assessment of the credit risk inherent in HPCI’s portfolio of loan participation interests, an ALL is transferred from the Bank to HPCI on loans underlying the participations at the time the participations are acquired.
The maximum level of credit exposure to individual commercial borrowers is limited by policy guidelines based on the default probabilities associated with the credit facilities extended to each borrower or related group of borrowers. All authority to grant commitments is delegated through the Bank’s independent credit administration function, and is monitored and regularly updated in a centralized database.
Concentration risk is managed with limits on loan type, geographic and industry diversification, country limits, and loan quality factors. The checks and balances in the credit process and the independence of the credit administration and risk management functions are designed to minimize problems and to facilitate the early recognition of problems when they do occur.
The following table provides delinquency information for the loans underlying HPCI’s loan participations at December 31, 2005.
Table 8 - Loan Participation Interests Delinquencies
(1)
Includes non-accrual loans.
Commercial Credit
Commercial credit approvals are made by the Bank and are based on, among other factors, the financial strength of the borrower, assessment of the borrower’s management, industry sector trends, type of exposure, transaction structure, and the general economic outlook. There are two processes for approving credit risk exposures. The first involves a centralized loan approval process for the standard products and structures utilized in small business lending, where individual credit authority is granted to certain individuals on a regional basis to preserve the Company’s local decision-making focus. The second, and more prevalent approach, involves individual approval of exposures. These approvals are consistent with the authority delegated to officers located in the geographic regions who are experienced in the industries and loan structures over which they have responsibility.
All commercial (C&I) and commercial real estate (CRE) credit extensions are assigned internal risk ratings reflecting the borrower’s probability-of-default and loss-in-event-of-default. This two dimensional rating methodology, which has 192 individual loan grades, provides improved granularity in the portfolio management process. The probability-of-default is rated on a scale of 1-12 and is applied at the borrower level. The loss-in-event-of-default is rated on a 1-16 scale and is associated with each individual credit exposure based on the type of credit extension and the underlying collateral.
In commercial lending, ongoing credit management is dependent on the type and nature of the loan. In general, quarterly monitoring is normal for all significant exposures. The internal risk ratings are revised and updated with each periodic monitoring event. There is also extensive macro portfolio management analysis on an ongoing basis to continually update default probabilities and to estimate future losses.
In addition to the initial credit analysis initiated by the portfolio manager during the underwriting process, the loan review group performs independent credit reviews. The loan review group reviews individual loans and credit processes and conducts a portfolio review at each of the regions on a regular basis.
Borrower exposures may be designated as “watch list” accounts when warranted by individual company performance, or by industry and environmental factors. Such accounts are subjected to additional quarterly reviews by the business line management, the loan review group, and credit administration in order to adequately assess the borrower’s credit status and to take appropriate action.
The Bank has also established a specialized credit workout group to manage problem credits. The group handles commercial recoveries, workouts, and problem loan sales, as well as the day-to-day management of relationships rated substandard or worse. The group is responsible for developing an action plan, assessing the risk rating, and determining the adequacy of the reserve, the accrual status, and the ultimate collectibility of the credits managed.
Consumer Credit
Extensions of consumer credit by the Bank are based on, among other factors, the financial strength of the borrower, type of exposure, transaction structure, and the general economic outlook. Consumer credit decisions are generally made in a centralized environment utilizing decision models. Each credit extension is assigned a specific probability-of-default and loss-in-event-of-default. The probability-of-default is generally a function of the borrower’s credit bureau score, while the loss-in-event-of-default is related to the type of collateral and the loan-to-value ratio associated with the credit extension.
In consumer lending, credit risk is managed from a loan type and vintage performance analysis. All portfolio segments are continuously monitored for changes in delinquency trends and other asset quality indicators. The Bank makes extensive use of portfolio assessment models to continuously monitor the quality of the portfolio and identify under-performing segments. This information is then incorporated into future origination strategies. The Bank’s independent risk management group has a consumer process review component to ensure the effectiveness and efficiency of the consumer credit processes.
Allowances for Credit Losses (ACL)
HPCI maintains two reserves, both of which are available to absorb probable credit losses: the allowance for loan losses (ALL) and the allowance for unfunded loan participation commitments (AULPC). When summed together, these reserves constitute the total allowances for credit losses (ACL).
The ALL represents the estimate of probable losses inherent in the loan portfolio at the balance sheet date. Additions to the ALL and AULPC result primarily from an allocation of the purchase price of participations acquired.
It is HPCI’s policy to rely on the Bank’s detailed analysis as of the end of each quarter to estimate the required level of the ALL and AULPC. The Bank’s methodology to determine the adequacy of the ALL relies on a number of analytical tools and benchmarks. No single statistic or measurement, in itself, determines the adequacy of the allowance. For determination purposes, the allowance is comprised of two components: the transaction reserve and the economic reserve.
Transaction Reserve
The transaction reserve component of the ACL includes both (a) an estimate of loss based on characteristics of each commercial and consumer loan, lease, or loan commitment in the portfolio and (b) an estimate of loss based on an impairment review of each loan greater than $500,000 that is considered to be impaired. For commercial and commercial real estate loans, the estimate of loss is based on characteristics of each loan through the use of a standardized loan grading system, which is applied on an individual loan level and updated on a continuous basis. The reserve factors applied to these portfolios were developed based on internal credit migration models that track historical movements of loans between loan ratings over time and a combination of long-term average loss experience of the Bank’s own portfolio and external industry data.
Huntington’s management analyzes each commercial and commercial real estate loan over $500,000 for impairment when the loan is non-performing or has a grade of substandard or lower. The impairment tests are done in accordance with applicable accounting standards and regulations. For loans determined to be impaired, an estimate of loss is reserved for the amount of the impairment. In the case of more homogeneous portfolios, such as consumer loans and leases, and residential mortgage loans, the determination of the transaction reserve is conducted at an aggregate, or pooled, level. For such portfolios, the development of the reserve factors includes the use of forecasting models to measure inherent loss in these portfolios. Models and analyses are updated frequently to capture the recent behavioral characteristics of the subject portfolios, as well as any changes in loss mitigation or credit origination strategies. Adjustments to the reserve factors are made as needed based on observed results of the portfolio analytics.
Economic Reserve
Changes in the economic environment are a significant judgmental factor Huntington’s management considers in determining the appropriate level of the ACL. The economic reserve incorporates a determination of the impact on the portfolio of risks associated with the general economic environment. The economic reserve is designed to address economic uncertainties and is determined based on a variety of economic factors that are correlated to the historical performance of the loan portfolio. Because of this more quantitative approach to recognizing risks in the general economy, the economic reserve may fluctuate from period to period.
In an effort to be as quantitative as possible in the ACL calculation, Huntington’s management developed a revised methodology for calculating the economic reserve portion of the ACL in 2004. The revised methodology is specifically tied to economic indices that have a high correlation to the Company’s historic charge-off variability. The indices currently in the model consists of the U.S. Index of Leading Economic Indicators, U.S. Profits Index, U.S. Unemployment Index, and the University of Michigan Current Consumer Confidence Index. Beginning in 2004, the calculated economic reserve was determined based upon the variability of credit losses over a credit cycle. The indices and time frame may be adjusted as actual portfolio performance changes over time. Huntington’s management has the capability to judgmentally adjust the calculated economic reserve amount by a maximum of +/- 20% to reflect, among other factors, differences in local versus national economic conditions. This adjustment capability is deemed necessary given the newness of the model and the continuing uncertainty of forecasting economic environment changes.
This methodology allows for a more meaningful discussion of the Bank’s view of the current economic conditions and the potential impact on HPCI’s credit losses. The continued use of quantitative methodologies for the transaction reserve and the economic reserve may result in period-to-period fluctuation in the absolute and relative level of the ACL.
The levels of the ALL and AULPC are adjusted based on the results of the above-mentioned detailed quarterly analysis. This adjustment may be either an increase (provision) or a reduction. Such adjustments for the year ended December 31, 2005 resulted in reductions of the allowance of $19.8 million. These reductions compared to reductions of $31.6 million for the year ended December 31, 2004. The continued reduction of the allowances for credit losses was indicative of Management’s judgment regarding the adequacy of those allowances particularly in light of lower net loan losses in the current year.
The following table shows the activity in HPCI’s ALL and AULPC for the last five years:
Table 9 - Allowances for Credit Loss Activity
In 2005 the ACL included a refinement in methodology that transferred $0.9 million of the ACL’s economic reserve component from ALL to AULPC. Previously, the entire economic reserve component was included in ALL.
Effective March 31, 2004, HPCI reclassified $4.3 million of its ALL to a separate liability on the balance sheet titled AULPC. The AULPC is based on expected losses derived from historical experience. HPCI believes that this reclassification better reflects the nature of this reserve and represents improved financial statement disclosure. Prior period financial statements have not been revised due to immateriality.
In Management’s judgment, both the ALL and the AULPC are adequate at December 31, 2005, to cover probable credit losses inherent in the loan participation portfolio and loan commitments.
HPCI, through reliance on methods utilized by the Bank, 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, these credit grades are reevaluated. The aggregation of these factors represents an estimate of the probable 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.
The following table shows the allocation in HPCI’s ALL and AULPC:
Table 10 - Allowance for Credit Losses by Product (1)
(1)
Percentages represent the percentage of each loan category to total loan participation interests.
Net Charge-offs
Total net charge-offs were $8.5 million, or 0.18%, of total average loan participations, for the year ended December 31, 2005, down from $9.2 million, or 0.18%, for the year ended December 31, 2004. The decline in net charge-offs reflects the improvements made in underwriting, the origination of higher quality loans, and the success in lowering individual concentrations in larger commercial and commercial real estate credits.
Table 11 - Net Charge-offs (1)
(1)
Percentages represent the percentage in each loan category to average loan participation interests.
Non-Performing Assets (NPAs)
NPAs consist of participation interests in underlying loans that are no longer accruing interest. Underlying commercial and commercial real estate loans are placed on non-accrual status and stop accruing interest when collection of principal or interest is in doubt or generally when the underlying loan is 90 days past due. Underlying residential real estate loans are generally placed on non-accrual status within 180 days past due as to principal and 210 days past due as to interest. When interest accruals are suspended, accrued interest income is reversed with current year accruals charged to earnings and prior year amounts generally charged off as a credit loss. Consumer loans are placed on non-accrual status within 180 days past due. At September 30, 2004, HPCI adopted a new policy of placing consumer home equity loan participations on non-accrual status when they exceed 180 days past due. Prior practice was to continue to accrue interest until collection or resolution of the loan participations. Such loan participations were previously classified as accruing loans past due 90 days or more.
The following table shows NPAs at the end of the most recent five years:
Table 12 - Non-Performing Assets
(1)
At September 30, 2004, HPCI adopted a new policy of placing consumer home equity loan participations on non-accrual status when they exceed 180 days past due. Prior practice was to continue to accrue interest until collection or resolution of the loan participations. Such loan participations were previously classified as accruing loans past due 90 days or more.
Total NPAs increased to $26.6 million at the end of 2005 from $14.3 million at December 31, 2004, representing 0.59% and 0.29% of total participation interests, respectively. The increase primarily related to commercial real estate loans.
The reductions from 2001 levels were the result of an improving economy, tightening of credit underwriting standards, and the redesign of the credit approval process. As well, in early 2002, the Bank’s credit workout group was further strengthened, with the objective of aggressively seeking economically advantageous opportunities to reduce the level of NPAs, including NPA sales. These efforts were reflected in HPCI’s NPA portfolio sales in 2002, 2003, and 2004.
Underlying loans past due ninety days or more but continuing to accrue interest were $3.2 million at the end of 2005 and $11.7 million at December 31, 2004.
Under the participation and subparticipation agreements, the Bank may, in accordance with HPCI’s guidelines, 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, in accordance with HPCI’s guidelines, institute foreclosure proceedings, exercise any power of sale contained in any mortgage or deed of trust, obtain a deed in lieu of foreclosure, or otherwise acquire title to a property underlying a mortgage loan by operation of law or otherwise in accordance with the terms of the participation and subparticipation agreements. Prior to completion of foreclosure or liquidation, the participation is sold to the Bank at fair market value. The Bank then incurs all costs associated with repossession and foreclosure.
OFF-BALANCE SHEET ARRANGEMENTS
Under the terms of the participation and subparticipation agreements, HPCI is obligated to make funds or credit available to the Bank, either directly or indirectly through Holdings so that the Bank may extend credit to any borrower, or pay letters of credit issued for the account of any borrowers, to the extent provided in the loan agreements underlying HPCI’s participation interests. At December 31, 2005 and 2004, unfunded commitments totaled $827.3 million and $761.4 million, respectively. It is expected that cash flows generated by the existing portfolio will be sufficient to meet these obligations.
LIQUIDITY AND CAPITAL RESOURCES
The objective of HPCI’s liquidity management is to ensure the availability of sufficient cash flows to fund its existing loan participation commitments, to acquire additional participation interests, and to pay operating expenses and dividends. Unfunded commitments and additional participation interests in loans are funded with the proceeds from repayment of principal balances by individual borrowers, utilization of existing cash and cash equivalent funds, and if necessary, new capital contributions. Payment of operating expenses and dividends will be funded through cash generated by operations.
In managing liquidity, HPCI takes into account forecasted principal and interest payments on loan participations as well as various legal limitations placed on a REIT. To the extent that additional funding is required, HPCI may raise such funds through retention of cash flow, debt financings, additional equity offerings, or a combination of these methods. However, any cash flow retention must be consistent with the provisions of the 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.
At December 31, 2005 and 2004, HPCI maintained cash and interest bearing deposits with the Bank totaling $810.1 million and $800.3 million, respectively. HPCI maintains and transacts all of its cash activity with the Bank and may invest available funds in Eurodollar deposits with the Bank for a term of not more than 30 days at market rates.
At December 31, 2005, HPCI had no material liabilities or contractual obligations, other than unfunded loan commitments of $827.3 million, with a weighted average maturity of 2.1 years, and dividend and distributions payable of $700.0 million.
Shareholders’ equity was $4.6 billion at December 31, 2005, compared to the December 31, 2004 balance of $5.1 billion. This decline reflected the aggregate dividends and distributions declared on common and preferred securities offset by the $314.3 million of net income in 2005.
The preferred dividend coverage ratio for 2005 was 9.08, compared to 13.72 in 2004. The decrease from the prior year primarily relates to higher dividends declared on Class B and Class D preferred securities due to an increase in the three-month LIBOR rates.
RESULTS FOR THE FOURTH QUARTER
Table 13 - Quarterly Statements of Income
(1)
All of HPCI’s common stock is owned by Huntington, HCF, HPCII, and Holdings and therefore, net income per share is not presented.
N.M., Not Meaningful
Net income for the fourth quarter 2005 was $84.8 million, up 6.3% from $79.8 million for the fourth quarter 2004. Net income applicable to common shares was $74.8 million for the fourth quarter of 2005, an increase from $73.6 million, or 1.6%, compared to the fourth quarter of 2004. Dividend declarations on preferred stock increased by 61.9% in the most recent quarter to $10.1 million compared to $6.2 million for the fourth quarter 2004, due to higher three-month LIBOR rates on which payments on Class B and Class D preferred shares are based.
Interest and fee income for the recent quarter was $82.2 million, which was up from $69.2 million for the prior year quarter, due to higher interest rates on variable rate loans, increased consumer loan balances, and interest income from deposits with the Bank. The yield on earning assets increased to 6.17% from 4.89% for the same respective quarterly periods.
Total assets decreased to $5.4 billion at the end of 2005, from $5.7 billion at December 31, 2004. The reduction primarily related to lower commercial real estate balances.
The ACL increased to 1.37% of total loan participation interests at December 31, 2005, from 1.33% at the end of the prior year quarter. Net charge-offs in the fourth quarter of 2005 were $1.0 million versus $2.0 million for the fourth quarter of 2004. This represents 0.09% and 0.17% of average loan participations for the same respective quarterly periods.
HPCLI received rent from the Bank of $1.6 million for each of the fourth quarters of 2005 and 2004, which is reflected in non-interest income. Non-interest expense included depreciation and amortization expense for all premises and equipment, which amounted to $1.0 million and $1.2 million for the fourth quarters of 2005 and 2004. Servicing fees paid by HPCI were $2.7 million for each of the fourth quarters of 2005 and 2004. HPCLI is a taxable REIT subsidiary and therefore provisions of $0.3 million and $0.1 million for income taxes applied to its taxable income are reflected in the fourth quarters of 2005 and 2004, respectively.
Item 7A:
Item 7A: Quantitative and Qualitative Disclosures about Market Risk.
Information required by this item is set forth in the caption “Market Risk” included in Item 7 above.
Item 8:
Item 8: Financial Statements and Supplementary Data
The following consolidated financial statements of HPCI at December 31, 2005 and 2004 and for the years ended December 31, 2005, 2004, and 2003 are included in this report at the pages indicated. Quarterly statements of income are found on page 31 of this report.
Report of Management
The management of HPCI (the Company) 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.
Management maintains a system of internal accounting controls, which includes 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 2005, the audit committee of the board of directors met regularly with Management, HPCI’s internal auditors, and the independent registered public accounting firm, Deloitte & Touche LLP, to review the scope of the audits and to discuss the evaluation of internal accounting controls and financial reporting matters. The independent registered public accounting firm and the internal auditors have free access to, and meet confidentially with, the audit committee to discuss appropriate matters. Also, HPCI maintains 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, chief financial 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 and the chief financial officer.
Report on Management’s Assessment of Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company, including accounting and other internal control systems that, in the opinion of Management, provide reasonable assurance that (1) transactions are properly authorized, (2) 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. HPCI’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. In making this assessment, Management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on that assessment, Management believes that, as of December 31, 2005, the Company’s internal control over financial reporting is effective based on those criteria. Deloitte & Touche LLP, the Company’s independent registered public accounting firm, has issued an attestation report on Management’s assessment of the Company’s internal control over financial reporting.
By:
/s/ Donald R. Kimble
Donald R. Kimble
By:
/s/ Thomas P. Reed
Thomas P. Reed
President
Vice President
(Principal Executive Officer)
(Principal Financial and Accounting Officer)
March 23,
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Huntington Preferred Capital, Inc.
Columbus, Ohio
We have audited management’s assessment, included in the accompanying Report on Management’s Assessment of Internal Control Over Financial Reporting, that Huntington Preferred Capital, Inc. and subsidiary (the “Company”) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2005 of the Company and our report dated March 23, 2006 expressed an unqualified opinion on those financial statements.
Columbus, Ohio
March 23, 2006
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Huntington Preferred Capital, Inc.
Columbus, Ohio
We have audited the accompanying consolidated balance sheets of Huntington Preferred Capital, Inc. and subsidiary (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity, and cash flows for the years then ended. These consolidated 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. The consolidated financial statements of the Company for the year ended December 31, 2003 were audited by other auditors whose report, dated March 19, 2004, expressed an unqualified opinion on those statements.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (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, such consolidated 2005 and 2004 financial statements present fairly, in all material respects, the financial position of Huntington Preferred Capital, Inc. and subsidiary at December 31, 2005 and 2004, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 23, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Columbus, Ohio
March 23, 2006
Huntington Preferred Capital, Inc.
Consolidated Balance Sheets
See notes to consolidated financial statements.
Huntington Preferred Capital, Inc.
Consolidated Statements of Income
See notes to consolidated financial statements.
Huntington Preferred Capital, Inc.
Consolidated Statements of Changes in Shareholders’ Equity
See notes to consolidated financial statements.
Huntington Preferred Capital, Inc.
Consolidated Statements of Cash Flows
See notes to consolidated financial statements.
Notes to the Consolidated Financial Statements
Note 1 - Significant Accounting Policies
Basis of Presentation: The consolidated financial statements include the accounts of Huntington Preferred Capital, Inc. (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, 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) was organized under Ohio law in 1992 and designated as a real estate investment trust (REIT) in 1998. At December 31, 2004, three related parties owned HPCI’s common stock: HPC Holdings-III, Inc. (HPCH-III), 67.37%; Huntington Preferred Capital II, Inc. (HPCII), 32.5%; and Huntington Bancshares Incorporated (Huntington), 0.13%. Effective February 18, 2005, Huntington Preferred Capital Holdings, Inc. (Holdings) transferred 34% of its ownership in HPCH-III to Huntington Capital Financing LLC (HCF). On March 31, 2005, HPCH-III liquidated into Holdings and HCF. As a result of liquidation, since March 31, 2005, four related parties own HPCI’s common stock: HCF, 47%; HPCII, 32.5%; Holdings, 20.37%; and Huntington, 0.13%. HCF, HPCII and Holdings are direct or indirect subsidiaries of The Huntington National Bank (the Bank), a national banking association organized under the laws of the United States and headquartered in Columbus, Ohio. The Bank is a wholly owned subsidiary of Huntington. Huntington is a multi-state diversified financial holding company organized under Maryland law and headquartered in Columbus, Ohio. The Bank, on a consolidated basis with its subsidiaries, at December 31, 2005, accounted for 99% of Huntington’s consolidated total assets and, for the year ended December 31, 2005, accounted for 94% of Huntington’s consolidated net income. Thus, consolidated financial statements for the Bank and for Huntington were substantially the same for these periods. HPCI has one subsidiary, HPCLI, Inc. (HPCLI), a taxable REIT subsidiary formed in March 2001 for the purpose of holding certain assets (primarily leasehold improvements). HPCI’s principal business objective is to acquire, hold, and manage mortgage assets and other authorized investments that will generate net income for distribution to its shareholders.
Use of Estimates: The preparation of financial statements in conformity with GAAP requires Management to make estimates and assumptions that affect amounts reported in the financial statements. Actual results could differ from those estimates.
Due from The Huntington National Bank: HPCI’s due from The Huntington National Bank primarily consists of principal and interest payments on loan participations remitted by customers directly to the Bank but not yet received by HPCI. The receivable also includes earned but not collected amounts for collateral fees, leased premises, and interest on interest bearing deposits. The receivable is settled with the Bank shortly after period-end.
Loan participation interests: Loan participation interests are purchased from the Bank either directly or 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. The purchase price paid approximates fair value on the date the loan participations are purchased. Participation interests are categorized based on the collateral securing the underlying loan. HPCI does not purchase loan participation interests in loans made to Huntington’s directors or executive officers.
Interest income is 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. The underlying consumer loans are charged off in accordance with regulatory statutes governing the Bank. At September 30, 2004, HPCI adopted a new policy of placing consumer home equity loan participations on non-accrual status when they exceed 180 days past due. Prior practice was to continue to accrue interest until collection or resolution of the loan participations. Such loan participations were previously classified as accruing loans past due 90 days or more. 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.
The Financial Accounting Standards Board (FASB) Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Cost of Leases (FAS 91), addresses the timing of recognition of loan and lease origination fees and certain expenses. The statement requires that such fees and costs be deferred and amortized over the estimated life of the asset. HPCI began to defer origination fees prospectively for all loans purchased after June 30, 2003.
A loan 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 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. The significance of payment delays and payment shortfalls is determined 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 estimated market price, or the fair value of the collateral if the loan is collateral dependent. Impaired loans are taken into consideration when evaluating the allowance for loan losses.
Allowances for Credit Losses (ACL): The ACL is comprised of the allowance for loan losses (ALL) and the allowance for unfunded loan participation commitments (AULPC). It is HPCI’s policy to rely on the Bank’s detailed analysis as of the end of each quarter to estimate the required level of the ALL and AULPC. The ACL represents Management’s estimate as to the level of reserves considered appropriate to absorb inherent probable credit losses in the loan portfolio, as well as unfunded loan participation commitments. 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. ALL is transferred to HPCI either directly or through Holdings from the Bank on loans underlying the participations at the time the participations are acquired. When necessary, the allowance for loan losses will be adjusted through either a provision for credit losses charged to earnings or a reduction in allowance for credit losses credited to earnings. Credit 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 ACL consists of two components, the transaction reserve, which includes a specific reserve in accordance with Statement No. 114, Accounting by Creditors for Impairment of a Loan, and the economic reserve. Loan and lease losses related to the transaction reserve are recognized and measured pursuant to Statement No. 5, Accounting for Contingencies, and Statement No. 114, while losses related to the economic reserve are recognized and measured pursuant to Statement No. 5. The two components are more fully described below.
Transaction Reserve
The transaction reserve component of the ACL includes both (a) an estimate of loss based on characteristics of each commercial and consumer loan, lease, or loan commitment in the portfolio and (b) an estimate of loss based on an impairment review of each loan greater than $500,000 that is considered to be impaired. For commercial and commercial real estate loans, the estimate of loss is based on characteristics of each loan through the use of a standardized loan grading system, which is applied on an individual loan level and updated on a continuous basis. The reserve factors applied to these portfolios were developed based on internal credit migration models that track historical movements of loans between loan ratings over time and a combination of long-term average loss experience of the Bank’s own portfolio and external industry data.
Huntington’s management analyzes each commercial and commercial real estate loan over $500,000 for impairment when the loan is non-performing or has a grade of substandard or lower. The impairment tests are done in accordance with applicable accounting standards and regulations. For loans determined to be impaired, an estimate of loss is reserved for the amount of the impairment. In the case of more homogeneous portfolios, such as consumer loans and leases, and residential mortgage loans, the determination of the transaction reserve is conducted at an aggregate, or pooled, level. For such portfolios, the development of the reserve factors includes the use of forecasting models to measure inherent loss in these portfolios. Models and analyses are
updated frequently to capture the recent behavioral characteristics of the subject portfolios, as well as any changes in loss mitigation or credit origination strategies. Adjustments to the reserve factors are made as needed based on observed results of the portfolio analytics.
Economic Reserve
Changes in the economic environment are a significant judgmental factor Huntington’s management considers in determining the appropriate level of the ACL. The economic reserve incorporates a determination of the impact on the portfolio of risks associated with the general economic environment. The economic reserve is designed to address economic uncertainties and is determined based on a variety of economic factors that are correlated to the historical performance of the loan portfolio. Because of this more quantitative approach to recognizing risks in the general economy, the economic reserve may fluctuate from period to period.
In an effort to be as quantitative as possible in the ACL calculation, Huntington’s management developed a revised methodology for calculating the economic reserve portion of the ACL in 2004. The revised methodology is specifically tied to economic indices that have a high correlation to the Company’s historic charge-off variability. The indices currently in the model consists of the U.S. Index of Leading Economic Indicators, U.S. Profits Index, U.S. Unemployment Index, and the University of Michigan Current Consumer Confidence Index. Beginning in 2004, the calculated economic reserve was determined based upon the variability of credit losses over a credit cycle. The indices and time frame may be adjusted as actual portfolio performance changes over time. Huntington’s management has the capability to judgmentally adjust the calculated economic reserve amount by a maximum of +/- 20% to reflect, among other factors, differences in local versus national economic conditions. This adjustment capability is deemed necessary given the newness of the model and the continuing uncertainty of forecasting economic environment changes.
This methodology allows for a more meaningful discussion of the Bank’s view of the current economic conditions and the potential impact on HPCI’s credit losses. The continued use of quantitative methodologies for the transaction reserve and the economic reserve may result in period-to-period fluctuation in the absolute and relative level of the ACL.
The levels of the ALL and AULPC are adjusted based on the results of the above-mentioned detailed quarterly analysis. This adjustment may be either an increase (provision) or a reduction. Such adjustments for the year ended December 31, 2005 resulted in reductions of the allowance of $19.8 million. These reductions compared to reductions of $31.6 million for the year ended December 31, 2004. The continued reduction of the allowances for credit losses was indicative of Management’s judgment regarding the adequacy of those allowances particularly in light of lower net loan losses in the current year.
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.
Net Income per Share: All of HPCI’s common stock is owned by Huntington, HCF, HPCII, and Holdings and, therefore, net income 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 Internal Revenue 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 Internal Revenue 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. Deferred tax amounts relate primarily to depreciation of fixed assets. At December 31, 2005, net deferred taxes are included in accrued income and other assets.
Statement of Cash Flows: Cash, cash equivalents, and interest-bearing deposits are defined as “Cash and cash equivalents.”
Note 2 - New Accounting Pronouncements
AICPA Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3): In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued SOP 03-3, to address accounting for differences between the contractual cash flows of certain loans and debt securities and the cash flows expected to be collected when loans or debt securities are acquired in a transfer and those cash flow differences are attributable, at least in part, to credit quality. As such, SOP 03-3 applies to such loans and debt securities purchased or acquired in purchase business combinations and does not apply to originated loans. The application of SOP 03-3 limits the interest income, including accretion of purchase price discounts, that may be recognized for certain loans and debt securities prior to the receipt of cash. Additionally, SOP 03-3 requires that the excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) not be recognized as a current period adjustment of yield or valuation allowance, such as the allowance for loan losses. Subsequent to the initial investment, increases in expected cash flows generally should be recognized prospectively through adjustment of the yield on the loan or debt security over its remaining life. Decreases in expected cash flows should be recognized as impairment. SOP 03-3 is effective for loans and debt securities acquired in fiscal years beginning after December 15, 2004. In the normal course of business, HPCI does not purchase loan participation interests in loans that have exhibited a deterioration in credit quality since origination. Therefore, the impact of this new pronouncement was not material to HPCI’s financial condition, results of operations, or cash flows.
FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations (FIN 47) - In March 2005, the FASB issued FIN 47, which clarifies that the term “conditional asset retirement obligation” as used in FASB Statement No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. An entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. FIN 47 became effective for fiscal years ending after December 15, 2005. There was no impact from adopting the provisions of FIN 47 in the fourth quarter of 2005.
Financial Accounting Standards Board (FASB) Statement No. 154, Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3 (Statement No. 154) - In May 2005, the FASB issued Statement 154, which replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. Statement 154 changes the requirements for the accounting for and reporting of a change in accounting principle. Statement 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The impact of this new pronouncement is not expected to be material to HPCI’s financial condition, results of operations, or cash flows.
Note 3 - Loan Participation Interests
Loan participation interests are categorized based on the collateral underlying the loan. At December 31, loan participation interests were comprised of the following:
There were no underlying loans outstanding that would be considered a concentration of lending in any particular industry, group of industries, or business activity. Underlying loans were, however, generally collateralized by real estate and were made primarily to borrowers in the four states of Ohio, Michigan, Indiana, and Kentucky, which comprise 95.9% and 96.6% of the portfolio at December 31, 2005 and 2004, respectively.
Participations in Non-Performing Loans and Past Due Loans
At December 31, 2005 and 2004, the participations in loans in non-accrual status and loans past due 90 days or more and still accruing interest, were as follows:
The amount of interest that would have been recorded under the original terms for participations in loans classified as non-accrual was $2.7 million for 2005, $0.9 million for 2004, and $2.6 million for 2003. Amounts actually collected and recorded as interest income for these participations totalled $0.7 million, $0.5 million, and $1.2 million over the same respective years.
Note 4 - Allowances for Credit Losses (ACL)
An allowance for credit losses (ACL) is transferred to HPCI from the Bank on loans underlying the participations at the time the participations are acquired. The ACL is comprised of the allowance for loan losses (ALL) and the allowance for unfunded loan participation commitments (AULPC).
The following tables reflect activity in the ACL for the three years ended December 31:
(1)
Includes impaired commercial and commercial real estate loans. A loan is impaired when it is probable that Huntington will be unable to collect all amounts due according to the contractual terms of the loan agreement. The amount of interest recognized on impaired loans while they were considered impaired was less than $0.1 million in 2005 and $0.2 million in 2004. There was no interest recognized in 2003 on impaired loans while they were considered impaired.
In the 2005 second quarter the ACL included a refinement in methodology that transferred $0.9 million of the ACL’s economic reserve component from ALL to AULPC. Previously, the entire economic reserve component was included in ALL.
Effective March 31, 2004, HPCI reclassified $4.3 million of its ALL to a separate liability on the balance sheet titled AULPC. The AULPC is based on expected losses derived from historical experience. HPCI believes that this reclassification better reflects the nature of this reserve and represents improved financial statement disclosure. Prior period financial statements have not been revised due to immateriality.
Note 5 - Premises and Equipment
At December 31, premises and equipment stated at cost were comprised of the following:
Premises and equipment related depreciation and amortization, in the amounts of $4.4 million, $5.3 million, and $5.5 million, were charged to expense in the years ended December 31, 2005, 2004, and 2003, respectively.
Note 6 - Dividends
Holders of Class A preferred securities, a majority of which are held by Holdings and the remainder by current and past employees of the Bank, are entitled to receive, if, when, and as declared by the Board of Directors of HPCI out of funds legally available, dividends at a fixed rate of $80.00 per share per annum. 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.
The holder of the Class B preferred securities, HPC Holdings-II, Inc., a direct non-bank subsidiary of Huntington, is entitled to receive, if, when, and as declared by the Board of Directors of HPCI out of funds legally available, dividends at a variable rate equal to the three-month LIBOR published on the first day of each calendar quarter times par value. Dividends on the Class B preferred securities, which are declared quarterly, are payable annually in December and are non-cumulative. No dividend, except payable in common shares, may be declared or paid on Class B preferred securities unless dividend obligations are satisfied on the Class A, Class C, and Class D preferred securities.
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, of the initial liquidation preference of $25.00 per share, 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.
The holder of Class D preferred securities, Holdings, 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 three-month LIBOR published on the first day of each calendar quarter, plus 1.625% times par value, 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.
A summary of dividends declared by each class of preferred securities follows for the periods indicated:
As of December 31, 2005 and 2004, all declared dividends on preferred securities were paid to shareholders.
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, 2005, 2004, and 2003, were $279.7 million, $263.8 million, and $289.6 million, respectively.
Note 7 - Related Party Transactions
HPCI is a party to a Third Amended and Restated Loan Subparticipation Agreement with Holdings and a Second Amended and Restated Loan Participation Agreement with the Bank. The Bank is required, under the participation and/or subparticipation agreements, to service HPCI’s loan portfolio in a manner substantially the same as for similar work for transactions on its own behalf. The Bank collects and remits principal and interest payments, maintains perfected collateral positions, and submits and pursues insurance claims. In addition, the Bank provides accounting and reporting services to HPCI. The Bank is required to adhere to HPCI’s policies relating to the relationship between HPCI and the Bank and to pay all expenses related to the performance of the Bank’s duties under the participation and subparticipation agreements. All of these participation interests to date were acquired directly or indirectly from the Bank.
The Bank performs the servicing of the commercial, commercial real estate, residential real estate, and consumer loans underlying the participations held by HPCI in accordance with normal industry practice under the participation and subparticipation agreements. In its capacity as servicer, the Bank collects and holds the loan payments received on behalf of HPCI until the end of each month. Servicing costs paid to the Bank totaled $11.2 million, $9.9 million, and $7.6 million for the respective years ended 2005, 2004, and 2003.
In 2005 and 2004 the annual servicing rates the Bank charged with respect to outstanding principal balances were:
Pursuant to the existing participation and subparticipation agreements, the amount and terms of the loan-servicing fee between the Bank and HPCI are determined by mutual agreement from time to time during the terms of the agreements. Effective July 1, 2004, in lieu of paying higher servicing costs to the Bank with respect to commercial and commercial real estate loans, HPCI waived its right to receive any origination fees associated with participation interests in commercial and commercial real estate loans transferred on or after July 1, 2004. This waiver was subsequently extended until such time as loan servicing fees are reviewed in 2006. Effective July 1, 2005, in connection with the periodic review of the servicing fees, the parties reduced the current servicing rate on outstanding principal balances of underlying consumer loans to 0.650% from 0.750%. On an annualized basis, it is expected that this change will decrease non-interest expense by approximately $0.9 million. No changes were made to the servicing rates for the commercial, commercial real estate, or residential real estate portfolios.
Huntington’s and the Bank’s personnel handle day-to-day operations of HPCI such as financial analysis and reporting, accounting, tax reporting, and other administrative functions. On a monthly basis, HPCI reimburses the Bank
and Huntington for the cost related to the time spent by employees for performing these functions. These personnel costs totaled $0.5 million, $0.6 million, and $0.3 million for the years ended December 31, 2005, 2004, and 2003, respectively, and are recorded in other non-interest expense.
The following table represents the ownership of HPCI’s outstanding common and preferred securities as of December 31, 2005:
As of December 31, 2005, 10.5% of the Class A preferred securities were owned by current and past employees of Huntington and its subsidiaries in addition to the 89.5% owned by Holdings. The Class A preferred securities are non-voting. All of the Class B preferred securities are owned by HPC Holdings-II, Inc., a non-bank subsidiary of Huntington and are non-voting. In 2001, the Class C preferred securities were obtained by Holdings, who sold the securities to the public. Various board members and executive officers of HPCI have purchased a portion of the Class C preferred securities. At December 31, 2005, HPCI board members and executive officers beneficially owned, in the aggregate, a total of 4,713 shares, or 0.236%. All of the Class D preferred securities are owned by Holdings. In the event HPCI redeems its Class C or Class D preferred securities, holders of such securities will be entitled to receive $25.00 per share plus accrued and unpaid dividends on such shares. The redemption amount may be significantly lower than the then current market price of the Class C preferred securities.
Both the Class C and Class D preferred securities are entitled to one-tenth of one vote per share on all matters submitted to HPCI shareholders. The Class C and Class D preferred securities are exchangeable, without shareholder approval or any action of shareholders, for preferred securities of the Bank with substantially equivalent terms as to dividends, liquidation preference, and redemption if the Office of the Comptroller of the Currency (OCC) so directs only if the Bank becomes, or may in the near term become, undercapitalized or the Bank is placed in conservatorship or receivership. The Class C and Class D preferred securities are redeemable at HPCI’s option on or after December 31, 2021, and December 31, 2006, respectively, with prior consent of the OCC.
As only related parties hold HPCI’s common stock, there is no established public trading market for this class of stock.
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 was $6.4 million, $6.5 million, and $6.2 million for years ended December 31, 2005, 2004, and 2003, respectively. Rental income is reflected as a component of non-interest income in the consolidated statements of income.
HPCI had a non-interest bearing receivable from the Bank of $46.3 million at December 31, 2005, and $0.2 million at December 31, 2004. The increase primarily relates to the reclassification of a receivable from cash and interest bearing deposits with The Huntington National Bank to due from The Huntington National Bank. The amount reclassified represents principal and interest payments on loan participations remitted by customers directly to the Bank but not yet received by HPCI. The receivable was settled with the Bank shortly after period-end.
The Bank is eligible to obtain collateralized advances from various federal and government-sponsored agencies such as the Federal Home Loan Bank (FHLB). From time to time, HPCI may be asked to act as guarantor of the Bank’s obligations under such advances and/or pledge all or a portion of its assets in connection with those advances. See Note 10 for further information regarding the pledging of HPCI’s assets in association with the Bank’s advances.
HPCI maintains and transacts all of its cash activity through the Bank. Typically, cash is invested with the Bank in an interest-bearing account. These interest-bearing balances are invested overnight or may be invested in Eurodollar deposits with the Bank for a term of not more than 30 days at market rates.
Note 8 - Quarterly Results of Operations (Unaudited)
The following is a summary of the unaudited quarterly results of operations for the years ended December 31:
Note 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 interest-bearing deposits, and due from The Huntington National Bank - The carrying value approximates the fair value.
Loan participation interests - Underlying variable rate loans that reprice frequently are based on carrying amounts, as adjusted for estimated credit losses. The fair values for other loans are estimated using discounted cash flow analyses and employ interest rates currently being offered for loans with similar terms. The rates take into account the position of the yield curve, as well as an adjustment for prepayment risk, operating costs, and profit. This value is also reduced by an estimate of probable losses in the loan portfolio. Based upon the calculations, the carrying values disclosed in the accompanying consolidated balance sheets approximate fair value.
Note 10 - Commitments and Contingencies
The Bank is eligible to obtain advances from various federal and government-sponsored agencies such as the FHLB. From time to time, HPCI may be asked to act as guarantor of the Bank’s obligations under such advances and/or pledge all or a portion of its assets in connection with those advances. Any such guarantee and/or pledge would rank senior to HPCI’s common and preferred securities upon liquidation. Accordingly, any federal or government-sponsored agencies that make advances to the Bank where HPCI has acted as guarantor or has pledged all or a portion of its assets as collateral will have a liquidation preference over the holders of HPCI’s securities. Any such guarantee
and/or pledge in connection with the Bank’s advances from the FHLB falls within the definition of Permitted Indebtedness (as defined in HPCI’s articles of incorporation) and, therefore, HPCI is not required to obtain the consent of the holders of its common or preferred securities for any such guarantee and/or pledge.
Currently, HPCI’s assets have been used to secure only one such facility. The Bank has obtained a line of credit from the FHLB, which line was capped by the Bank’s holdings of FHLB stock at $1.7 billion as of December 31, 2005. As of that same date, the Bank had borrowings of $1.2 billion under the facility.
HPCI has entered into an Amended and Restated Agreement with the Bank with respect to the pledge of HPCI’s assets to collateralize the Bank’s borrowings from the FHLB. The agreement provides that the Bank will not place at risk HPCI’s assets in excess of an aggregate dollar amount or aggregate percentage of such assets established from time-to-time by HPCI’s board of directors, including a majority of HPCI’s independent directors. Prior to October 31, 2004, the pledge limit established by HPCI’s board was $1.0 billion. Effective as of October 31, 2004, the pledge limit was adjusted to 25% of HPCI’s total assets, or approximately $1.3 billion as of December 31, 2005, as reflected in the HPCI’s month-end management report for the previous month. This pledge 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 total loans pledged by HPCI. As of December 31, 2005, HPCI’s total participation interests pledged was limited to 1-4 family residential mortgage portfolio and consumer second mortgage loans. As of that same date, HPCI’s participation interests in 1-4 family residential mortgages and second mortgage loans pledged totaled $1.1 billion. The Bank paid HPCI a total of $3.0 million, $0.7 million, and $0.7 million in the respective annual periods ended December 31, 2005, 2004, and 2003. The fee represented thirty-five basis points per year on total pledged loans after April 1, 2005, and twelve basis points per year on the certified collateral prior to April 1, 2005, as compensation for making such assets available to the Bank. In the first quarter of 2006, the Bank released approximately $1.0 billion of HPCI’s second mortgage loans pledged as collateral with the FHLB.
Under the terms of the participation and subparticipation agreements, HPCI is obligated to make funds or credit available to the Bank, either directly or indirectly through Holdings, so that the Bank may extend credit to any borrowers, or pay letters of credit issued for the account of any borrowers, to the extent provided in the loan agreements underlying HPCI’s participation interests. As of December 31, 2005 and 2004, the unfunded loan commitments totaled $827.3 million and $761.4 million, respectively.
Note 11 - Formal Regulatory Supervisory Agreements
On March 1, 2005, Huntington announced entering into a formal written agreement with the Federal Reserve Bank of Cleveland (FRBC), as well as the Bank entering into a formal written agreement with the Office of the Comptroller of the Currency (OCC), providing for a comprehensive action plan designed to enhance corporate governance, internal audit, risk management, accounting policies and procedures, and financial and regulatory reporting. The agreements called for independent third-party reviews, as well as the submission of written plans and progress reports by Huntington’s management and remain in effect until terminated by the banking regulators.
On October 6, 2005, Huntington announced that the OCC had terminated its formal written agreement with the Bank dated February 28, 2005, and that the FRBC written agreement remained in effect. Huntington was verbally advised that it was in full compliance with the financial holding company and financial subsidiary requirement under the Gramm-Leach-Bliley Act (GLB Act). This notification reflected that Huntington and the Bank met both the “well-capitalized” and “well-managed” criteria under the GLB Act. Huntington’s management believes that the changes it has already made, and is in the process of making, will address the FRBC issues fully and comprehensively. No assurances, however, can be provided as to the ultimate timing or outcome of these matters, including any effects on HPCI.
Note 12 - Segment Reporting
HPCI’s operations consist of acquiring, holding, and managing its participation interests. Accordingly, HPCI only operates in one segment. HPCI has no external customers and transacts all of its business with the Bank and its affiliates.
Item 9:
Item 9: Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not Applicable
Item 9A:
Item 9A: Controls and Procedures
Disclosure Controls and Procedures
HPCI’s management, with the participation of its President (principal executive officer) and the Vice President (principal financial officer), evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon such evaluation, HPCI’s President and Vice President have concluded that, as of the end of such period, HPCI’s disclosure controls and procedures are effective.
Internal Controls Over Financial Reporting
Information required by this item is set forth in “Report of Management” and “Report of Independent Registered Public Accounting Firm” included in Part II, Item 8 of this report.
Changes in Internal Control Over Financial Reporting
There have not been any changes in HPCI’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended December 31, 2005 to which this report relates that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.
Item 9B:
Item 9B: Other Information
Not applicable.
Part III
Item 10:
Item 10: Directors and Executive Officers of the Registrant
Information required by this item is set forth under the caption “Election of Directors” and under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” of HPCI’s 2006 Information Statement, and is incorporated herein by reference.
Item 11:
Item 11: Executive Compensation
Information required by this item is set forth under the caption “Compensation of Directors and Executive Officers” of HPCI’s 2006 Information Statement and is incorporated herein by reference.
Item 12:
Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
No HPCI securities were issued under equity compensation plans. Additional information required by this item is set forth under the caption “Ownership of Voting Stock” of HPCI’s 2006 Information Statement and is incorporated herein by reference.
Item 13:
Item 13: Certain Relationships and Related Transactions
Information required by this item is set forth under the caption “Transactions with Directors and Officers” and “Transactions with Certain Beneficial Owners” of HPCI’s 2006 Information Statement and is incorporated herein by reference.
Item 14:
Item 14: Principal Accounting Fees and Services
Information required by this item is set forth under the caption “Proposal to Ratify the Appointment of Independent Registered Public Accounting Firm” of HPCI’s 2006 Information Statement and is incorporated herein by reference.
Part IV
Item 15:
Item 15: Exhibits and Financial Statement Schedules
(a)
The following documents are filed as part of this report:
(1)
The report of independent registered public accounting firm 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 53 and 54 of this Form 10-K.
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 24th day of March, 2006.
HUNTINGTON PREFERRED CAPITAL, INC.
(Registrant)
By:
/s/ Donald R. Kimble
By:
/s/ Thomas P. Reed
Donald R. Kimble
Thomas P. Reed
President and Director
Vice President and Director
(Principal Executive Officer)
(Principal Financial and 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 24th day of March, 2006.
Richard A. Cheap *
Richard A. Cheap
Director
Stephen E. Dutton *
Stephen E. Dutton
Director
R. Larry Hoover *
R. Larry Hoover
Director
Edward J. Kane *
Edward J. Kane
Director
Roger E. Kephart *
Roger E. Kephart
Director
James D. Robbins *
James D. Robbins
Director
Karen D. Roggenkamp *
Karen D. Roggenkamp
Director
/s/ Donald R. Kimble
Donald R. Kimble
* Attorney-in fact for each of the persons indicated.
Exhibit Index
This document incorporates by reference certain documents listed below that HPCI has previously filed with the SEC (file number 000-33243). The documents incorporated by reference may be read and copied at the Public Reference Room of the SEC at 100 F Street N.E., Washington, D.C. 20549. The SEC also maintains an internet world-wide web site that contains reports, proxy statements, and other information about issuers, like HPCI, who file electronically with the SEC. The address of the site is http://www.sec.gov.
revised on April 19, 2005, as applicable to all of its affiliated companies, and ratified by HPCI’s Board of Directors on March 25, 2004, are available on Huntington Bancshares Incorporated’s website at http://www.investquest.com/iq/h/hban/main/cg/cg.htm.
21.
List of Subsidiaries.
24.
Power of Attorney.
31.(a).
Rule 13a-14(a) Certification - Chief Executive Officer.
31.(b).
Rule 13a-14(a) Certification - Chief Financial Officer.
32.(a).
Section 1350 Certification - Chief Executive Officer.
32.(b).
Section 1350 Certification - Chief Financial Officer.
99.(a).
Opinion of Ernst & Young LLP, Independent Registered Public Accounting Firm.
99.(b).
Consolidated Financial Statements of Huntington Bancshares Incorporated as of and for the year ended December 31, 2005.